What the Fed Could Have Done Differently

Question: What could the Fed have done differently in 2007 to mitigate the severity of the crisis? (Steven Landsburg, The Big Questions)

Ernest Patrikis: I don’t know if it was 2007, or earlier when there was good luck in the marketplace.  I remember there was an early intervention by the European Central Bank putting liquidity into the market.  It was massive.  And the Fed followed and put in less liquidity.  And I said to myself, gosh, look at those guys in Frankfurt and all, they’re trying to look like heroes taking this major action.  And the Fed was just following to show that they were there.  And I looked back at that one and I say to myself, I was absolutely wrong in terms of my judgment about it.  That the ECB had it right, and more liquidity should have been provided to the market earlier on.  Again, not a cure all, but perhaps could have tempered the impact on the market somewhat. 

Question: Was less control for CDS’s a general system wide problem, or was it only for AIG counterparties? (Jeffrey Friedman, Causes of the Crisis)

Ernest Patrikis: No, I think the question, I guess, for the counterparties at AIG, and this is a major issue, and not just swaps, but in the wholesale market and that is, to what extent do participants in their market know the current financial position of their counterparties?  I think the answer is, people don’t ask.  They just deal with each other.  This has been a question for 20 years.  Why should I do the trade with you, what’s your financial condition today, and then one answer is, well, if it’s an institution that trades a lot, it can be completely different tomorrow in terms of the financial condition. 

The credit default swap as an instrument has been unfairly attacked.  Now, I have my prejudice.  I was on the board of ISDA, the Swaps Trade Association for a number of years, but I think the product worked well, it continues to be a product that gives us price on securities, and it’s a good indication of price on securities.  Outside of AIG it’s worked well.  In Lehman, there used to be issues on documentation and I credit Tim Geitner in terms of toughing up as should have been done long ago on the need for firms to tighten up and get their documentation complete. 

And someone was telling me of the number of trades, that Lehman has a huge number of trades.  Only one resulted in litigation regarding the validity of the trade because of documentation.  So, I think the swap worked well.  That’s not to say that there’s not a need for standardized swaps to be dealt with on trading platforms and settlement mechanisms, for regulators.  For example, the Basil II perhaps in dealing with the trading book as opposed to the credit book perhaps didn’t have a high enough capital charge.  It’s not to say that everything was perfect, but I think the credit defaults were up was deemed to be the evil instrument because of AIG. 

At AIG it was an issue of risk management.  And I put these two and say the two key words for the next several years in terms of banking supervision are quality of risk management, and quality of liquidity management. 

Question: Was the main counterparty to AIG Goldman Sachs?

Ernest Patrikis:  I don’t know.  I read the papers and say, yes, Goldman Sachs was a major counterparty and there were many stories in the market about debates between Goldman Sachs and AIG on valuations and things like that, that were a bit strange.  So, when someone writes the book maybe they will be able to give us more insight as to really what was going on there. 

Question: Goldman Sachs has claimed the $14 billion they received from AIG’s rescue was immaterial for their bottom line. Do you believe this to be true? (Russ Roberts, Café Hayek)

Ernest Patrikis: Well, I mean, if they were getting collateral from AIG it was good quality collateral.  What were they doing with it?  They were probably re-pledging it.  Hopefully, they were re-pledging it with collateral and were seeking back something that was liquid so that they would have the opportunity if they needed to pay it back as rates changed, market rates change.  So, to me, we’re talking about collateral.  It is an issue of where is my collateral, with the counterparty, that will be focused on by examiners.  The rate I’m charged on my swap will depend in part if I have to put up collateral, whether I let my counterparty re-hypothecate the collateral to another party.  Will people become nervous? 

I had one instance where there was a client who was posting collateral with a bank and the central bank of that country guaranteed all deposits.  So, the client said to the counterpart branch in a foreign bank here in New York, “I want to place that collateral with the bank in the foreign country where it’s 100% guaranteed”  So, in a nervous world we’ll see things like that happen.

Recorded on November 9, 2009

Ernie Patrikis, former AIG head council, argues that credit default swaps have been unfairly attacked.

Related Articles

Scientists discover what caused the worst mass extinction ever

How a cataclysm worse than what killed the dinosaurs destroyed 90 percent of all life on Earth.

Credit: Ron Miller
Surprising Science

While the demise of the dinosaurs gets more attention as far as mass extinctions go, an even more disastrous event called "the Great Dying” or the “End-Permian Extinction” happened on Earth prior to that. Now scientists discovered how this cataclysm, which took place about 250 million years ago, managed to kill off more than 90 percent of all life on the planet.

Keep reading Show less

Why we're so self-critical of ourselves after meeting someone new

A new study discovers the “liking gap” — the difference between how we view others we’re meeting for the first time, and the way we think they’re seeing us.

New acquaintances probably like you more than you think. (Photo by Simone Joyner/Getty Images)
Surprising Science

We tend to be defensive socially. When we meet new people, we’re often concerned with how we’re coming off. Our anxiety causes us to be so concerned with the impression we’re creating that we fail to notice that the same is true of the other person as well. A new study led by Erica J. Boothby, published on September 5 in Psychological Science, reveals how people tend to like us more in first encounters than we’d ever suspect.

Keep reading Show less

NASA launches ICESat-2 into orbit to track ice changes in Antarctica and Greenland

Using advanced laser technology, scientists at NASA will track global changes in ice with greater accuracy.

Firing three pairs of laser beams 10,000 times per second, the ICESat-2 satellite will measure how long it takes for faint reflections to bounce back from ground and sea ice, allowing scientists to measure the thickness, elevation and extent of global ice

Leaving from Vandenberg Air Force base in California this coming Saturday, at 8:46 a.m. ET, the Ice, Cloud, and Land Elevation Satellite-2 — or, the "ICESat-2" — is perched atop a United Launch Alliance Delta II rocket, and when it assumes its orbit, it will study ice layers at Earth's poles, using its only payload, the Advance Topographic Laser Altimeter System (ATLAS).

Keep reading Show less