Some readers may take issue with the headline, but bear me out.
Within ten days of 1987 stock market crash, President Reagan established what was popularly called the Brady Commission to investigate the causes of the meltdown and recommend remedies. A little more than two months after it was created, the Commission submitted its report.
The 1987 crash was trivial in complexity compared to our current mess. Stocks trade on exchanges, so transaction sized, prices, and execution time are a matter of public record. Even though foreign markets swooned in sympathy with the US downdraft, the crisis was a domestic event.
Contrast the 1987 panic with our credit meltdown. The 1987 crash was a single country event, in transparent markets (equities and equity futures). This crisis revolves around multiple over the counter markets (asset backed securities, including securitized auto, student, residential and commercial real estate loans, CDOs, CLOs, CDS) that were originated and sold around the world. The authorities have an weak to non-existent picture of trading volumes and prices. In addition. they also do not have a good feel for the terms of the instruments themselves (these were privately negotiated agreements; unlike registered securities, the offering documents are not a matter of public record). And the lack of an understanding of the range and mix of types of deals impedes developing sound policy. For instance: it is widely known that many residential mortgage-backed securities contain restrictions on modifying mortgages. Admittedly, some do not prohibit them, but some bar them completely, others limit them to a certain percentage of the pool. But since these deals were all sold OTC with no document registry, no one knows what the distribution among these three types is.
I have complained for some time that it is inexcusable for the authorities to be fumbling in the dark as they are without trying to light a candle. One could argue that in the first two acute phases of the crisis (August-September 2007 and November-December 2007), the authorities. could tell themselves that their remedies would work, this would pass relatively quickly. like the Asian crisis (while the affected countries suffered a long aftermath, the international market disruption resolved itself much faster). But by the Bear failure, with other investment banks known to be in precarious shape, it was clear this crisis was not going to resolve itself quickly. That was when the need to get a better grasp on what was going on was undeniable.
Before readers say it would take too long and be too hard, consider: if you had a mysterious disease, would you rather have your doctor treat by analogy to common ailments or do the needed testing to come up with a diagnosis?
Even with a full court press starting in March 2008, it probably would have taken 6 months to get a better picture. It would be impossible to get a full picture in that time, but if one set investigation priorities well, one could have a great deal of insight on the key issues (most things in life are 80/20, meaning 80% of the value comes from the top 20%; there is no reason why an effort like this should be any different). And before you say regulators were overtaxed and lacked sufficient personnel, the Brady Commission was headed on a day-to-day basis by a Harvard Business School finance professor and staffed largely by junior-mid career people from the private sector with relevant analytical and industry knowledge (they were seconded from their firms; it was considered an honor and a career boost to participate).
A Financial Times comment recognized the same underlying problem, but suggests going about it in a different way. Otmar Issing and Jan Krahnen suggest putting in place mechanisms to capture information that would help give a better overview of the financial system, as opposed to just individual institutions. I am not convinced that the data gathering would create a “risk map” as they contend, but it would provide an enormously valuable database and should greatly reduce the number of regulatory blind spots (at least those due to lack of data).
From the Financial Times:
Consider the insights gained during this crisis. First, supervision has to focus on containing systemic risk rather than on avoiding individual bank defaults. Second, early warning signals need to be backed up by reliable information on all financial markets, including derivatives. Both aspects have been neglected in the past and continue to be neglected today.
Setting up a solid information base capturing global financial exposures is imperative. There is a long list of exposures that are not transparent today, for example the cross-border links between large, complex financial institutions (LCFIs) and the whereabouts of credit default swaps, collateralised debt obligations and other asset-backed securities. Putting together a global “risk map” displaying financial links among LCFIs as well as the most important risk drivers, such as asset price changes and yield spread dynamics, would enable authorities to carry out financial system stress tests.
The basis for the risk map would be a global database. We have proposed that standards be defined by a task force of experienced international agencies, such as BIS, the European Central Bank, the Organisation for Economic Co-operation and Development and the International Monetary Fund, allowing the data to be aggregated by region or by product. Data privacy conditions and capacity limits mean data collection must be defined on a discrete – for example, quarterly – basis. The risk map project could be chaired by the IMF. Data sharing could be on an aggregated level to preserve data privacy and to maintain a level playing field for international competition. Furthermore, data analysis would focus on an early warning methodology and a general assessment of systemic risk, which in turn could feed directly into the minimum capital requirement of international banks. Such a hard-wiring of systemic risk analysis to capital standards would allow supervisors to carry out counter-cyclical policies.
The control of systemic risk could be further enhanced by the use of a global credit register, which would essentially extend the risk map to exposures of banks with regard to large corporations. Existing credit registers are basically still national. This is an anachronism at a time when companies borrow and banks lend on a global scale.
Returning to our initial questions: have central banks and supervisors taken appropriate action to establish a reliable data foundation for systemic risk assessment? The answer is, unfortunately, no. Although 18 months have elapsed since the outbreak of the financial crisis, there is still no co-ordinated initiative.
What explains the reluctance of governments to get involved in a data generation exercise? The most likely explanation draws on the competitive situation in international financial markets, with governments aiming at preserving the competitive advantage of national banking industries.
Referring to the first question in the introduction, the answer is negative as well. We are still not prepared to avoid a disastrous financial crisis like the one that started 18 months ago.
However, in the interest of improved macro-prudential super vision, one can see at least what needs to be done. As the huge losses caused by the financial crisis forcefully show, macro-financial stability is a public good that has to be actively managed. The risk map is one element in such an endeavour, and a vital element for that matter.
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Because facing reality, thinking objectively and adapting is hard (especially if you have a bad case of hubris). Pushing old ideas, concepts, beliefs and models is so much easier.
Because it is hard – in fact, I fear impossible – to switch from massive systemic fraud and corruption when it compromises, paralyzes, and contaminates everything it touches.
– StewPDX
Excellent post.
Let’s remember what _hasn’t_ happened that would increase transparency. Congress has done nothing to regulate CDS or to place OTC derivatives under CFTC (we’re now 11 months after Bear). Obama could issue an emergency order to this purpose — good luck with that. Hedge funds could be required to disclose more than their short positions. Hasn’t happened, probably won’t. Some of those folks are probably holding back data as a bargaining chip to get government backstops.
So instead we have the Fed doing the best it can, on marshy legal ground, just the way the contribution-sucking politicians like it. The Fed can make any agreement it wants with its European counterparts on a clearing house for CDS–but nothing will happen (nothing so far HAS happened) without the agreement of ISDA and the market participants.
I’m not wholly convinced that large aggregations of market data would even be helpful from a policy perspective. The most important policy decisions are being made at a level where political – not economic – considerations are most important.
What Issing and al. do not realize is that the universe of “modern” financial product is far too complex to be captured in a quarterly reporting. A big part of the complexity lays in the optional positions. By “optional position” I mean not only financial derivative with a strike price and an expiry date, these are,relatively speaking,the easy ones. I rather mean the potential triggering of covenant clauses in a loan, the loss-experience dependant change of asset management responsability in CDO’s,etc… I remember once hearing a very good Head Quant of a respected “LCFI” saying that it found impossible to price accurately all the contigent clauses embedded in a “plain” CDO documentation.
Consequently, there is NO WAY to have any meaninful global reporting before the universe of permitted financial instruments is drastically simplified.
I would leave vanilla loans and deposit for banks,
and exchange traded forex, equity, bonds and derivative for anyone else. Funnily, could have a place in such a chastitized financial world, as contracts traded in an exchange based on underlying bonds traded on the same exchange…
The banks are likely to want to trade: we open our books and let you put our counterparty exposures into your database, and you(the government) take responsibility for the losses at some level.
That is unacceptable. We have to seize these guys by the necks, use regulatory authority to extract the information without asking their permission, then use the data to manage a restructuring of the worldwide industry. But that still leaves the question: why?
If the government manages the restructuring at this level, the temptation will remain to have the taxpayers “participate”.
Actually I don’t see why the data is necessary. If the banks cannot show they are solvent, use Mankiw’s new prescription: wipe out the shareholders, put the bondholders in as the new shareholders, and let them figure it all out.
I used to have a post from some old derivatives publication which had a reference to Moody's or S&P; this was circa 2002 or so. There were derivatives exploding all over the world and the rating agencies basically admitted that they didn't understand the structuring of these new products, but it would be a mistake to not capture some of the market action and increase rating capacities. I'll see if I can find that, but the bottom line obviously has been, in retrospect, that the rating agencies and government regulators were totally unaware of what was going on and they used out-dated risk modeling and out-dated policies which were then linked to the political agenda of The Bush Ownership Society, which relied on non-regulation and non-accountability. That was and still is, The Perfect Storm!
Thank you very much …
You’ll understand the system as much as you want to understand it.
The long and short of it is that for 10 years people got greedy, the greed wasn’t restrained, and this resulted in massive bad investments and the United States and Europe are now massively over indebted.
There are only two ways out of insolvency: loan restructuring or default.
If the government itself is insolvent, then the government must go to its creditors for loan restructuring. The US and Europe could go to China, Japan, and all the other foreign *sovereign* holders of US and European sovereign debt. This group is small enough to be an oligopoly.
The US and Europe could sign an agreement where the sovereign creditor oligopoly will guarantee continued to loans to US/EU provided that US/EU guarantee restructuring their economies to export what the sovereign creditor oligopoly want to consume. Sort of like a Chapter 11. This would lower the risk on US and European bonds. The US and European governments could then take that money and put it into restructuring of debt in the private sector.
China is providing help on the financial front to the US. In return the US is helping China in terms of foreign policy: to regain Taiwan and perhaps, according to rumors I have heard in the past day or two, in other ways.
Others are being left out in the cold, but it seems that a US-China collaboration is in the works.
Anyone remember this gem from Citi?
At September 30, 2006 and December 31, 2005, the Company’s maximum potential
amount of future payments under these guarantees was approximately $1.1 trillion
and $709 billion, respectively. For this purpose, the maximum potential amount
of future payments is considered to be the notional amounts of letters of
credit, guarantees, written credit default swaps, written total return swaps,
indemnifications, and recourse provisions of loans sold with recourse, and the
fair values of foreign exchange options and other written put options, warrants,
caps and floors.
I’m finding some great old hits as I look for something; anyone remember this (The Perfect Storm)
Chairman Ben S. Bernanke
Before the Independent Community Bankers of America's Annual Convention and Techworld, Honolulu, Hawaii
(via satellite)
March 6, 2007
GSE Portfolios, Systemic Risk, and Affordable Housing
FYI: "A straightforward means of anchoring the GSE portfolios to a clear public mission would be to require Fannie and Freddie to focus their portfolios almost exclusively on holdings of mortgages or mortgage-backed securities that support affordable housing. The evolution of mortgage markets since the GSEs were created strongly suggests that a concentration on affordable-housing products would provide the greatest public benefit. Markets for highly rated assets–including most residential mortgages and the pools of MBS backed by such mortgages–have become extremely deep and liquid, with more than $25 trillion in outstanding instruments. These markets are international in scope, and market participants include thousands of banking organizations, insurance companies, pooled investment vehicles, institutional investors and, increasingly, foreign governmental authorities. Given the size and depth of the secondary market for most residential mortgages, the GSEs’ purchase and retention of highly rated mortgages and of their own MBS are unlikely to do much to enhance liquidity in the secondary markets for these assets or to promote affordable housing. On the other hand, the vast size of the market for highly rated assets greatly increases the potential for rapid growth of GSE portfolios and, consequently, systemic risk."
>> Why is Ben still around? He crashed the friggn economy and then dug a deeper hole with Paulson and now what, how deep can this go before someone like Obama say, screw you? These Go To Eleven $ Trillion
No mention of how Basel 2 turned the rating agencies into for profit regulators of the financial system. Derivatives are just a symptom of an approach to risk management that explicitly ignored issues such as counter-party risk. The rules allowed you to net derivatives with different counter-parties and poof, the risk vanishes; until one of the counter-parties (AIG, for example) can’t meet it’s obligations.
In my opinion, it is because the fed and the bankers believe there is an unlimited amount of debt they can “force” on the lower and middle class. It is all about negative real earnings growth for MOST people, more and more debt on the lower and middle class, and making sure the debt gets repaid even if the fed has to monetize it while making sure price inflation and wage inflation do NOT occur.
May I suggest a coverup as the reason?
Vinny Goldberg
If anyone think there is oversight of TARP funds, well, it is the best oversight a bunch of 20 something former campaign staffers can do:
“The Congressional Oversight Panel, the body named by Congress to oversee the $700 billion bailout, consists of five strong-minded members who agree about the enormity of their task, and little else.
The short-staffed panel is drawing heavily on the Harvard University law students and colleagues of its chairwoman, law professor Elizabeth Warren, as it churns out reports at a break-neck pace. Most of the staffers are 20-something aides from the Obama campaign, though an executive director and two banking lawyers were hired recently.”
http://online.wsj.com/article/SB123509144351728451.html
hahaha, they understand it Yves. They really get it. But you have to understand, the whole point of government is to protect corporations and banks.
The vast majority of people just provide cheap labor. Obama and co are pretty smart people but they protect the interests of the elite first.
Everyone knows there was massive fraud and greed going on, but no one is going to do a thing. A few fish here and there will get fried but otherwise same old, same old.
They do not to understand because those are the ones who screwed it up….The day that banks will disclose balance sheets and open their books it will be a nightmare and maybe too late. It is a market of lemons where information holders can and are allowed to cheat. But it is getting out of hands…
I’m with Michael. I don’t really think aggregated data would be particular useful or valuable.
This is not plain vanilla equities with open and transparent pricing.
This is structure finance.
With all due respect, it would take 500 sophisticated expert analysts a year just to figure out Citi’s current exposure. By the time they finished, their analysis would be useless as it would be completely out of date
Wouldn't participation in the investigation of this meltdown, also be way for juniors to differentiate & divorce themselves the failed status quo? Sounds like a great education and resume addition in an industry that will be exceptionally leery of youthful disregard of risk & consequence.
I learned one thing from this event: in a stable free-market financial system, the market interest rate on loans of any maturity is that point at which there are the same number of private actors who want to lend at that maturity and rate, as borrow at it.
Ie: "borrowing short and lending long" is not a free-market activity.
And if you don't have a stable free-market financial system (which hopefully means you have a stable non-free-market financial system, not an unstable non-free-market financial system, and sure as hell not a black, smoking hole in the ground), you sure as heck need to manage the heck out of it.
Because either the thing flies on its own, or it doesn't. If it doesn't, you need to fly it.
Ie: if you build a fragile liquidity structure out of systematic maturity mismatching, the structure will collapse unless it is protected by loan guarantees. Loan guarantees do not issue themselves.
If your maturity pyramid is underprotected, we get what just happened. If it is overprotected, you get bad lending – eg, the S&Ls. Where do you draw the line? With good management. And so on.
The problem is: everyone is assuming that USG can get its act together, patch the open artery, and get back to business as usual with the same basic financial system, but comprehensive, effective and modern regulation.
If there is any evidence that this assumption is realistic, much less true, it has escaped my attention…
Yves,
This is the crucial point, and the one that will matter in the long run.
How do we build a system/society that is capable to analyse, understand and self-correct en route, without first having to steer off the road, crash and then start over, go full throttle (“OH, what a lovely bubble economy”), and then crash again, eventually. There are parallels with global warming etc.
This is what my next pice of research will cover
Bit like rock and roll rehab, clean up and start over, you gotta love the drug = (re-discover childhood).
skippy
How’s the LaRouche movement doing in the US? Last night I found a pile of leaflets by his Australian affiliate at the train station. Frankly, his call to write off the whole financial system that we have, and replace it with a new accounting based on physical productivity, almost sounded plausible – and certainly sounded plausible enough to attract the support of people who are losing their jobs and trying to understand finance for the first time.
It’s getting to the point that being in favor of capitalism now is like being in favor of socialism after the Berlin Wall came down.
Yves, perhaps you should have mentioned that Otmar Issing is the head of the group of experts set up by the German government to plan reform of the international finance system. Other key members of the group are Asmussen and Weidmann, who run Finance Minister Steinbrueck’s office. So this is not just an FT comment.
Securitisation though is really only one element behind systemic risk. How do we judge exposure to external systemic risk. For instance how do we judge the news that the Russian Regional Bank Association denied of imminent corporate debt restructuring and said that it’s only a concept, after rumors circulated that russian banks are asking for government’s help in restructuring $400b of loans with foreign bank.
How do we assess whether a banks or countries financial portfolio is balanced and supportable. How exposed in France’s Société Générale through Rosbank to russia and eastern europe and how exposed is HSBC to the downturn in Hong Kong. How do we asses the size of the Irish banking system relative to GDP for example.
How do we assess rumours and there potential impact on financial institutions. For example today there are rumours that citibank has stopped lending in denmark and is curtailing lending globally. Internet commentators are claiming this is a sign that citibank is about to go under. Whether we believe Finn Ostrup who is a professor of Finance at Copenhagen Business School or not this rumour has the potential to trigger further banking problems.
Looking at asset price changes, yield spread dynamics and exposures of banks with regard to large corporations is not enough, you need to think about currency exposures, cross border lending diversity, politics and many other aspects. This is the realm of the bank analyst and despite the fact that bank mandarins failed to listen, some don’t appear to be doing that bad a job (Meredith whitney).
Although I am ignorant of financial technicalities, I find Charles’ argument cogent. IT-enabled credit and financial processes seem to have taken on a complex life of their own, with a whole range of emergent properties as a result, which are as easy to monitor and predict as the weather, fashion, or any other complex, non-linear process. I fear any system of risk mapping would always be the crucial two or three steps behind.
As for the top-line question, why no government is keen to get involved in the kind of fact-finding and data-gathering that Issing proposes? Issing gives the answer himself: “The most likely explanation draws on the competitive situation in international financial markets, with governments aiming at preserving the competitive advantage of national banking industries.” Bang on!
This is also, by the way, one reason for the reluctance to embrace the now inevitable nationalization of ailing banks. The US, UK, Germany, and so on are all afraid of ending up with state-owned (and inevitably purely nationally oriented) banks while other countries’ banks can still operate freely in the international market. This is a very big problem for the US (loss of global financial hegemony) and the UK (loss of London role as financial center).
http://www.portfolio.com/views/blogs/market-movers/2009/02/18/when-academic-papers-arent-replicable
From Felix Salmon. My point would be that how much “research” means anything in economics or finance? There is a lot of “bias” in research, in that all sorts of results are just “drawered” because they’re considered uninteresting (in real science – in finance, I’m sure it is much worse).
In the present case of these (CDS, CDS,etc) “individual” non-transparent and even legally dubious instruments (how many MBS’s prohibit any changes to the underlying mortgages? Will that stand up in court?) – what will we find out, other than what we already suspect: non-transparent, individual contracts, not backed by any legally required reserves, are worthless when a bubble pops?
It is/was counter-cyclical policies that got us into this mess. By not allowing the systems to clear themselves we end up producing garbage. Stop Summer from turning into Fall, and see what happens – a global cesspool.
Is it a failure to understand or just more lies. Do moronic investors actually believe the financial statements correctly reflect the financial position of any company? How could anyone who understood the accounting rules and the incestuous relationship between auditors and the companies that pay the auditors to sign off on their financial statements possibly believe this? The regulators barely have a handle on how fractional reserve lending works, how in the world could the regulators possibly deal with MBS and CDOs especially when mixed in with arcane misleading accounting rules that allow liabilities and losses to be offloaded from balance sheets (kind of like what the Fed and Treasury are now doing with all their new 100% controlled/owned companies). All the “investors” whom I refer to as idiots, got exactly what they deserved for purportedly believing in a system that is fraught with corruption and fraud, it is not like all this information was not public knowledge if anyone took the time to review the facts (and has not happened over and over and over through out time, ponzi schemes are not a recent phenomena). The Government can regulate until the cows come home, it won’t matter. Perhaps, banks should be restricted to merely fractional reserve lending but that creates problems in of itself for the lying thieves in Politics who need GDP to rise or stay high so they can justify increased government spending (thievery). In order for the banks to clear their balance sheets to continue the economic ponzi scheme of ever increasing GDP, their balance sheets must at least on paper be cleared, it is truly simple. The economic philosophy of Schumpter can not be beaten by financial alchemy, it can be stretched but eventually all things revert to the mean or worse, no matter how much idiot Americans Hope otherwise
Its really easy to understand the Global Financial System
Get a couple of packs of playing cards, label the cards with things like Credit Default Swaps, Debt Secularizations, Massive Trade Deficits, Massive Current Account Deficits, Massive Leverage, Straw Berry Pickers getting $750,000 Mortgages, Idiot Politicians, Greedy Idiot Bankers, etc. Then build the biggest tallest House Of Cards that you can. Then just wait for the right breeze or slamming of a door and watch the House Of Cards collapse.
DJF
1987 was a Single country event? No Yves. Here is a site that will shed some light on 1987
Could this possibly be a global financial coup?
Good post Yves, and likening the problem to a “mysterious disease’ suggests the immediate remedy — quarantine the diseased products. That is obvious and should have been done long ago (it was suggested by many), while concurrently commencing the diagnostics you suggest which by now would have also been completed.
Soooo … the real question now is why are the “authorities” still “fumbling in the dark”? Why have they not been “trying to light a candle” as you ask? What is the real motive for the black out – the secrecy?
At some point one has to make the simple realization that the “authorities” are not unsophisticated boobs and the information black out is as intentional as was the creation of the credit bubble and the sowing of these derivative products of that bubble into the global financial arena.
It is well past the time for good citizens to seriously consider and discuss the fact that this just may be a global financial coup being perpetrated by the scamerican ruling elite and their global central bank cohorts.
It is well past the time for good citizens to seriously consider and discuss the fact that that this just may be an integral part, and extension of, the ‘full spectrum dominance’ plan laid out by the PNAC and the Strauss neocons.
It is well past the time for good citizens to seriously consider and discuss the fact that the “authorities”, the same small group of disingenuous scum bags that got us into this crisis, and who had no qualms about killing a million innocent Iraqi citizens, would hesitate for one moment in decimating and exploiting the domestic population (now well under way). Especially when the Strauss philosophy recognizes an elite ruling class and seeks to create a two tier societal structure of ruler and ruled, with the ruled in perpetual conflict with each other.
Or that population control to prevent the world from reaching an unsustainable rate may also be an integral part of the plan.
The ‘rule of law’ in scamerica is now a blatant scam being modified at will and on the fly by a very small gangster elite.
The time for assessing the danger of unknown derivatives has passed. Energy expended in that direction will only be dissipated on the wrong task. (Create a crisis so as to be the hero in resolving the crisis and at the same time engage the victims in energy dissipating remedial measures that will never be implemented or listened to.)
The danger that must be addressed NOW is deception. It is time for a thorough connecting of the dots and shining of sunshine on the inner political machinations so as to capture the cockroaches as they run.
Deception is the strongest political force on the planet.
i on the ball patriot
The problem now is that the people who need to change are the people in control; so they will do anything to hold onto power, including throwing the rest of us under the bus. The mystery is why we go along with it.
http://menznews.blogspot.com
Why bother wondering? The federal government has no interest in deleveraging itself. Until it does, this is the circus we get.
per Charles and Michael, the global OTC contract registry proposal suffers from synoptic delusion: “the fiction that all the relevant facts are known to some one mind, and that it is possible to construct from this knowledge of the particulars a desirable social order.” (Hayek, Law, Legislation and Liberty, Vol. 1, Chap 1)
I’ve often found myself revisiting ol’ Fred Hayek’s dusty tomes these days. In particular, his insistence that complexity outstrips our ability to understand, let alone shape, events is constantly popping up in my mind as I read news and essays on this “crisis.”
fatalism, turn me loose!
ignorantmike
The government’s main focus should be to foster competition rather than giving approval of huge megamergers. If there were more but smaller actors, “systemic failure” would not be a concern.
Our main problem is that our government spends too much time checking off items on large corporations’ wish lists.
As others have said, all the people who caused/allowed it all to happen are still in place, so they are doing their damndest to hide it all and many of them are out to make as much as they can, yet again.
Also once the books are opened, we will all be able to see the size of the fraud perpetrated and that figure will dwarf all the ones that have already stunned us.
Yves, Can you, would you comment about the swaps that are being sold as insurance/bets against countries like Ireland et al now. i am sure the sellers of these swaps are happy to collect the fees, but can they pay if need be? who knows if they can and what percentage of sales go into a reserve to cover loses?
Michael
artichoke wrote: “If the banks cannot show they are solvent, use Mankiw’s new prescription: wipe out the shareholders, put the bondholders in as the new shareholders, and let them figure it all out.”
Do you think one time around will be enough, or is this a “lather, rinse, repeat” situation?
Charles wrote: “I remember once hearing a very good Head Quant of a respected “LCFI” saying that it found impossible to price accurately all the contigent clauses embedded in a “plain” CDO documentation.”
Ugh. You don’t suppose they’ve gone and Goedelized the financial system, do you? In math, if you consider statements each of the form “the value of variable N is X if the value of variable P is less than Y”, you can build sets of such statements that are not consistent – there is no possible assignment of values to variables.
A contingent clause of the form “this instrument pays $X on date specified if instrument P has not paid at least $Y” is pretty much the same as the above. It would not be difficult to accidentally build inconsistent contract groups, especially if many contracts were being generated by people who weren’t even aware of the others’ actions.
Ken, it might be “lather, rinse, repeat” of course. If we fix this problem, humans will create another problem down the road. So why bother? Good question, anyway I’m fascinated with it, that’s why I bother and why I got into it. What other drama is as great?
It’s certainly possible (or just plain certain) that these contracts, taken together, contain positive feedback loops. But any single financial institution may not know it because the loop would involve contracts residing in multiple institutions.
Anyway, even if the contracts do ultimately have a meaning, we will never find it for sure because the complexity is too great. There will continue to be bankruptcy-like proceedings where deals are cut to cancel many of the contracts.