Complexity economics

Complexity is one of the hottest concepts currently nipping at the fringes of economic research. But what is it? Richard Holt, David Colander and Barkley Rosser last year write a nice essay on the concept which makes some excellent points, and they're certainly optimistic about the prospects for a sea change in the way economic theory is done:

The neoclassical era in economics has ended and has been replaced by an unnamed era. We believe what best characterizes the new era is its acceptance that the economy is complex, and thus that it might be called “the complexity era.”

Indeed, something like this seems to be emerging. I've been writing about complexity science and its applications in physics, biology and economics for a decade, and the ideas are certainly far more fashionable now than they were before.

But again -- what is complexity? One key point that Holt and colleagues make is that complexity science recognizes and accepts that many systems in nature cannot be captured in simple and timeless equations with elegant analytical solutions. That may have been true with quantum electrodynamics and general relativity, but it's decidedly not true for most messy real world systems -- and this goes for physics just as much as it does for economics. Indeed, I think it is fair to say that much of the original impetus behind complexity science came out of physics in the 1970s and 80s as the field turned toward the study of collective organization in disordered systems -- spin glasses and glassy materials, granular matter, the dynamics of fracture and so on. There are lots of equations and models used in the physics of such systems, but no one has the intention or hope of discovering the final theory that would wrap up everything in a tidy formula or set of axioms.

Most of the world isn't like that. Rather, understanding means creating and using a proliferation of models, every one of which is partial and approximate and incomplete, which together help to illuminate key relationships -- especially relationships between the properties of things at a lower level (atoms, molecules, automobiles or people) and those at a higher level (crystal structures, traffic jams or aggregate economic outcomes).

Holt and colleagues spend quite some time discussing definitions of complexity, a task that I'm not sure is really worth the effort. But they do arrive at a useful distinction between three broad views -- a general view, a dynamic view, and a computational view. The second of these seems most interesting and directly related to emerging research focusing on instabilities and rich dynamics in economic systems. As stated by Rosser, a system is "dynamically complex" if...

it endogenously (i.e. on its own, and not because of external interference) does not tend asymptotically to a fixed point, a limit cycle, or an explosion.

In other words, a dynamically complex system never settles down into one equilibrium state, but has rich internal dynamics which persist. I'm not sure this definition covers all the bases, but it comes close and certainly strikes in the right direction.

Holt, Colander and Rosser go on to outline a number of areas where the complexity viewpoint is currently altering the landscape of economic research. I wouldn't quibble with the list: evolutionary game theory is bringing institutions more deeply into economic analysis, ecological economics is actually bringing the consideration of biology into economics (imagine that!), behavioural economics is taking account of how real people behave (again, what a thought!), agent-based models are providing a powerful alternative to analytical models, and so on.

This is all insightful, but I think perhaps one point could be more strongly emphasized -- the absolute need to recognize that what happens at higher macro-levels in a system often depends in a highly non-intuitive way on what happens at the micro-level. One of the principle barriers to progress in economics and finance, in my opinion, has been the the systematic effort by theorists over decades to avoid facing up to this micro-to-macro problem, typically through various analytical tricks. The most powerful trick -- a pair of tricks, really -- is to assume 1) that individuals are rational (hence making the study of human behaviour a problem not of psychology but of pure mathematics) and 2) assuming (in what is called the representative agent method) that the the behaviour of collective groups, indeed entire markets and economies, can be calculated as the simple sum of the rational actions of the people making it up.

The effect of this latter trick is actually quite amazing -- it eliminates from the problem, by definition, all of the interesting interactions and feed backs between people which make economies and markets rich and their dynamics surprising. Having done this, economics becomes a mathematical task of exploring the nature of rational behaviour -- it essentially places the root of complex collective economic outcomes inside the logical mind of the individual.

To put it most simply, this way of thinking tends to attribute outcomes in collective systems directly to properties of parts at the individual level, which is a terrific mistake. This might sometimes be the case. But we know from lots of examples in physics, biology and computer science that very simple things, in interaction, can give rise to astonishing complexity in a collective group. We should expect the same in social science: many surprising and non-intuitive phenomena at the collective level may reflect nothing tricky at all in the behaviour of individuals, but only the tendency for rich structures and dynamics to emerge in collective systems, created by myriad pathways of interaction among the system's parts.

Taking this point seriously is what I think most of complexity science -- as applied to social systems -- is about. It's certainly central to everything I write about under the phrase the "physics of finance." I take physics in the broad sense as the study of how organization and order and form well up in collective systems. It so happened that physics started out on this project in the context of physical stuff, electrons, atoms, molecules and so on, but that's merely a historical accident. The insights and methods physics has developed aren't bound by the nature of the particular things being discussed, and this project of understanding the emergence of collective order and organisation goes well beyond the traditional subject matter of physics.

Holt, Colander and Rosser make one other interesting point, about the resistance of macro-economists in general to the new ways of thinking:

Interestingly, these cutting edge changes in micro theory toward inductive analysis and a complexity approach have not occurred in macroeconomics. In fact, the evolution of macroeconomic thinking in the United States has gone the other way. By that, we mean that there has been a movement away from a rough and ready macro theory that characterized the macroeconomics of the 1960s toward a theoretically analytic macro theory based on abstract, representative agent models that rely heavily on the assumptions of equilibrium. This macro work goes under the name new Classical, Real Business cycle, and the dynamic stochastic general equilibrium (DSGE) theory, and has become the mainstream in the U.S.

This is quite depressing, of course, but if most of what Holt and colleagues write in their essay is true, it cannot possibly stay this way for long. Economics as a whole is changing very rapidly and macro can't remain as it is indefinitely. Indeed, there are already a number of researchers aiming to build up macro-economic models "from the bottom up" -- see this short essay by Paul De Grauwe, for example. All this spells certain near-term doom for the Rational Expectations crowd, and that doom can't come a moment too soon.

A Good Shake

I have been watching the live streaming and reading news all day about the 3rd general strike in Greece. Now it is 4 pm my time and it is night out there in Athens. Thousands of people, estimated to be around 40000+ , have blocked the Greek Parliament. Police have fired teargas towards the crowd who are slowly becoming unruly.

We are seeing it in a country which is supposed to be part of the developed world, not a third world country. The anger of the population is so immense that one can almost touch it. The same anger is growing in the youth of Spain, people in Ireland are getting restive. And I wonder, whether we shall see that kind of anger in USA.

Iceland was smart. They gave the middle finger to the European bankers and now they are on the path to recovery. Everywhere else in the developed world, the bankers have passed on all the losses to the population and now it is the bottom 90% who are asked to sacrifice, the social safety net programs are being dismantled or reduced, Public utilities are being sold off to private entities and the politicians are trying to reduce the tax rate on the rich. This is not "Democracy", this is "Oligarchy". And this is also the recipe for disaster. Social unrest will definitely follow in a big way and the capital market will be destroyed. Democracy and capitalism as we know today will not be the same. But that is another day.

As we talk, S&P 500 is sitting just above the 200 DMA. Last time it was below 200 DMA was in Sept 2010. Today S&P 500 fell over 22 points or 1.73%. All the gains of yesterday were given back and some more. This is exactly what I said yesterday, that do not believe in this bull$hit rally.  Where it will go from here, nobody can say. But we can make an educated guess, based on so many other parameters, some fundamental, some technical and some based on the observation of the market manipulation.

I think the market will close green tomorrow as they will try to kill as many puts as possible. Because CBOE equity only put call ratio now reflect more put buying by the retail investors. The short term average of the ratio now stand at 0.76 (from 0.64 last week), which is highest since last summer’s correction.

However the week after Triple witching week is usually bad. Dow has declined 19 of the past 21 years in the week after.  I therefore do not think that a low has been set in. While VIX has touched the top of the Bollinger band, it has not yet jumped through it. I think, sometime in the next 10 days, there will be one night when the Futures, as well as the entire world is in deep red, and if you are long, (purchased the f**king dip) you will find it very hard to sleep and market keeps selling off until you feel pain in the stomach, don’t hit the sell button yet because most likely the bottom is in then.  

From the top of 1370, we should expect a 10% selloff as a normal correction and therefore we have to close well below the March low. I would think the range is somewhere between 1230 to 1240 when we can call a bottom. By then gold, silver, oil and every other risk trade would have got a good shake out. 

And I plan to go long thereafter.  

Slippery bankers slither through the constraints...

A couple months ago I wrote this short article in New Scientist magazine (it seems freely available without subscription). It pointed out a troubling fact about recent measures proposed to stop bankers (and CEOs and hedge fund managers, etc.) from taking excessive risks which bring them big personal profits in the short run while saddling their firms (and taxpayers) with losses in the long run. The problem, as economists Peyton Young and Dean Foster have pointed out, is that none of these schemes will actually work. If executives keep tight control on details about how they are running their firms and how they are investing, they can always game the system by making it look outwardly to others that they're not taking excessive risks. There's no way to control it without much greater transparency so shareholders or investors can see clearly what strategies executives are using.

Here's the gist of the article:

You might think that smarter rules could get around the problem. Delay the bonuses for five years, perhaps, or put in clauses allowing the investor to claw back pay if it proves undeserved. But it won't work. Economists Dean Foster of the University of Pennsylvania in Philadelphia and Peyton Young of the University of Oxford have now extended Lo's argument, showing that the problem is simply unsolvable as long as investors cannot see the strategies used by managers (Quarterly Journal of Economics, vol 125, p 1435).

As they point out, delaying bonuses for a few years may deter some people as the risky strategies could explode before the period is up. But a manager willing to live with the uncertainty can still profit enormously if they don't. On average, managers playing the game still profit from excess risk while sticking the firm with the losses.

So-called claw back provisions, in the news as politicians ponder how to fix the system, will also fail. While sufficiently strong provisions would make it unprofitable for managers to game the system, Young and Foster show that such provisions would also deter honest managers who actually do possess superior management skills. Claw back provisions simply end up driving out the better managers that incentives were meant to attract in the first place.

This work by Young and Foster is among the more profound things I've read on the matter of pay for performance and the problems it has created. You would think it would be front and center in the political process of coming up with new rules, but in fact it seems to get almost no attention whatsoever. From this article in today's Financial Times, it seems that bankers have quite predictably made some quick adjustments in the way they get paid, conforming to the letter of new rules, without actually changing anything:

Bank chiefs' average pay in the US and Europe leapt 36 per cent last year to $9.7m, according to data compiled for the Financial Times, despite variable performance across the sector....

Regulators have declined to impose caps on bank pay, instead introducing changes they believe will limit incentives to take excessive risks. That has led many banks to increase fixed salaries, reduce employees’ reliance on annual bonuses and defer cash and stock awards over several years.

“The real story around pay is the progress on ensuring bonuses are deferred, paid in shares and subject to clawback and performance targets, rather than the headline figure,” said Angela Knight, British Bankers’ Association chief executive.

 It's just too bad that we already know it won't work.

The Fear Index rises...

So far this month the so-called Fear Index -- the Chicago Board Options Exchange's volatility index, the VIX -- has risen by 24%. The VIX is a measure, roughly speaking, of how volatile market participants expect the markets to be over the next month, and these people, apparently, have growing uncertainty about a whole lot of things. What's going to happen with Greece and is the Eurozone itself safe? In the US, what happens now that the Federal Reserve has stopped its program of "quantitative easing" -- i.e. increasing the supply of money?

In the Financial Times, Gavyn Davies suggests the world's economic leaders are "out to sea" and simply unable to coordinate in their actions. The situation, he suggests, has been...

...triggered by the realisation that policy-makers around the world are no longer in any condition to rescue the global economy from a further slowdown, should that occur. Economies, and therefore markets, are currently flying without an automatic safety net from either fiscal or monetary policy.  And that brings new risks, compared to the situation which has been in place for most of the period since the 2009.

This is the world as reflected in the financial press -- one in which emotions and fears and hunches and uncertainty play a huge, indeed central role. Hardly surprising.

What is surprising and rather odd, is how far this is from the view of academic economists who assume (most of them, at least) that irrational fears and crazy expectations have little to do with market outcomes, which actually reflect in some way individuals' rational assessments of future prospects. This is the Rational Expectations view of economics, currently still considered, amazingly enough, as the gold standard in economic theorizing. It's been dominant for around 40 years, since first proposed by economists John Muth and Robert Lucas. Fortunately, it is finally giving way to a more realistic and less rigid view (more on this below) which takes note of something that is quite important to human beings -- our ability to learn and adapt.

I've long found it hard to understand how the Rational Expectations idea has come to be taken seriously at all by economists. It's primary assertion is that the predictions of individuals and firms about the economic future, while they may not be completely identical, are not on average incorrect. People make random but unbiased errors, the idea goes, and so the average expectation is rational -- it captures the true model of how the economy works. This is indeed patently absurd in the face of historical experience: the average view of the future in 2005, for example, was not that a global financial and economic crisis lay just around the corner. Perhaps a determined Rational Expectations enthusiast would disagree. What evidence is there after all about what peoples' expectations really were at the time?

The standard defense of the Rational Expectations framework follows the same three-tiered logic used in defense of the Efficient Markets Hypothesis (not surprisingly, given the close link between the two ideas). The first defense is to assert that people are indeed rational. Given evidence that they are not, the second defense is to admit that, OK, people make all kinds of errors, but to assert that they make them in different ways; hence, they are not irrational on average. Of course, the behavioral economics crowd has now thoroughly trashed this defense, showing that people are systematically irrational (over confident, etc) in similar ways, so their errors won't cancel out. Hence, the third line of defense -- arbitrage. Starting with Milton Friedman and continuing for decades, defenders of the rational core of economic theory have argued that competition in the marketplace will drive the irrational out of the market as the more rational participants take their money. The strong prey upon the weak and drive them out of existence.

For example, in 1986, Robert Lucas wrote the following, expressing his view that anything other than rational expectations would be weeded out of the market and ultimately play no role:  

Recent theoretical work is making it increasingly clear that the multiplicity of equilibria ... can arise in a wide variety of situations involving sequential trading, in competitive as well as finite-agent games. All but a few of these equilibria are, I believe, behaviorally uninteresting: They do not describe behavior that collections of adaptively behaving people would ever hit on.

Alas, this evolutionary or adaptive defense turns out not to work either. As Andrei Shliefer and others have shown, an arbitrager would need access to an infinite amount of capital to be able to drive the irrational (so-called "noise traders") from the market, essentially because market "inefficiencies" -- mispricings due to the stupid actions of noise traders -- may persist for very long times. The market, as the famous saying goes, can stay irrational longer than you can stay solvent.

None of this has stopped most economists from plodding right on along behind the Rational Expectations idea, and they may well continue this way for another 50 years, stifling macroeconomics, with the rest of us paying the price (well beyond our tax dollars that go to fund such research). But there is fresh air in this field, let in by researchers willing to throw open some windows and let high theory be influenced by empirical reality.

It is obvious that expectations matter in economics. What happens in the future in markets or in the larger economy often depend on what people think is likely to happen. The problem with RE (Rational Expectations) isn't with the E but with the R. A far more natural supposition would be that people form their expectations not through any purely rational faculty but through a process of learning and adjustment, adaptively, as we do most other things. Indeed, a number of people have been exploring this idea in a serious way, through both models and experiments with real people. The results are eye-opening and demonstrate how much has been lost in a 40 year trance-like distraction at the (supposed) mathematical beauty of the rational expectations theory.

Cars Hommes has written a beautiful review of the area that is well worth close study. As he notes, there have been about 1000 papers published in the past 20 years on "bounded rationality" -- the finite mental capacity of real people -- and learning. These include agent-based models of markets in which the agents all use different, imperfect strategies and learn as they go, and other studies looking more closely at the process by which people form their expectations. Here are a few highlights:

* Studies from about 10 years ago explored the actual strategies followed by traders in a hog and beef market, and found empirical evidence for heterogeneity of expectations. One study estimated that "about 47% of the beef producers behave naively (using only the last price in their forecast), 18% of the beef producers behaves rationally, whereas 35% behaves quasi-rationally (i.e. use a univariate autoregressive time series model to forecast prices)."

Think of that -- in an ordinary hog and beef market we have roughly half the market participants behaving on the basis of an extremely simple heuristic.

* More recently, a number of researchers have used agent models to characterize data from markets for stock, commodities, foreign exchange and oil. As the review notes, "Most of these studies find significant time-variation in the fractions of agents using a mean-reverting fundamental versus a trend-following strategy."

That is, not only do the participants have distinct expectations, but those expectations and the basic strategies they follow shift over time. Not surprising really, but clearly not consistent with the rational expectations view.

* The review also points to recent seminal work by a team of physicists led by Fabrizio Lillo. This study looked at investors in a Spanish stock market and found that they fell into different groups based on their strategies, including trend followers and contrarians who bought against trends.

* And who says simple surveys can't be instructive? Various studies over 15 years using this traditional technique have found that financial experts "use different forecasting strategies to predict exchange rates. They tend to use trend extrapolating rules at short horizons (up to 3 months) and mean-reverting fundamentalists rules at longer horizons (6 months to 1 year) and, moreover, the weight given to different forecasting techniques changes over time." Similarly, for peoples' views on inflation, a study found that "heterogeneity in inflation expectations is pervasive..."

So then, why does the use of rational and homogeneous expectations continue in economics and finance? The review doesn't answer these questions, but in view of the massive quantities of data pointing to a much richer and complex process by which people form their expectations, the persistence of the rational expectations view in mainstream macroeconomic models -- this is my understanding, at least -- seems fairly scandalous.

So what's going on with the VIX? No one really knows, and I'm absolutely sure that the answer cannot emerge from any general equilibrium model with rational expectations. Times of uncertainty lead, in general, to two effects -- 1) a growing diversity in views, given the lack of information that would push most people toward one, and 2) a growing urgency to find some clue about the future, some guide to future behaviour. Urgency in the face of uncertainty leads many people -- as this study in Science from a couple of years ago showed -- to see what they take to be meaningful patterns even in purely random noise. Hence, we need a theory of adaptive expectations, and it needs to include irrational expectations. The good news is that this idea is finally getting a lot of attention, and the old faith that evolutionary competition in some form would enforce the tidy picture of rational expectations can be consigned to the dustbin of history.

         *** UPDATE ***

I just want to clarify that what I've written in this post doesn't begin to do justice to the rich material in Cars Hommes review article. I mentioned some of the earlier empirical work he discusses, but much of the paper reviews then results of extensive laboratory experiments, by his group and other groups, exploring how people actually do form expectations in situations where the experimenter has close control on the process in question. For example, a price fluctuates from period to period and volunteers are asked to predict it over 50 periods. They are told very little, except some facts about where the prices come from -- from a speculative market such as a stock market, or instead from a very different market with perishable goods. Skeletal information of this kind can make them expect positive feed backs, hence the potential for self-reinforcing trends, or quite the opposite.

There's nothing in these experiments that explains why they weren't done 30, 40, 50 years ago. Why didn't someone in the 1970s start such a program to really test the Rational Expectations idea? (Did they and I'm just not aware of it?). It's a shame because these experiments yield a wealth of insight, as well as directions for future work. I'll just quote from Hommes conclusions (my comments in brackets):

Learning to forecast experiments are tailor-made to test the expectations hypothesis, with all other model assumptions computerized and under control of the experimenter. Different types of aggregate behavior have been observed in different market settings. To our best knowledge, no homogeneous expectations model [rational or irrational] fits the experimental data across different market settings. Quick convergence to the RE-benchmark only occurs in stable (i.e. stable under naive expectations) cobweb markets with negative expectations feedback, as in Muth's (1961) seminal rational expectations paper. In all other market settings persistent deviations from the RE fundamental benchmark seem to be the rule rather than the exception.

Risk is on for this Week.

As I have been saying here, the HFT Bots and Big Bank Algos will take SPY in the range of $ 130 - $ 132 by this Friday 17^th June, 2011, the “Risk” trade is on today. It is in perfect sync. with Euro. See the chart below:

The Euro is on the right hand side and S&P 500 is on the left hand. S&P is the red line and Euro are the candle sticks

The futures were up 15 handles before the ordinary investors could participate in the rally. That is how they game the system people. Now the lemmings will follow the pied piper and pile on to the long side. If you remember, nothing, absolutely nothing in the economic indicators changed between yesterday and today, except the bull shit economic report from China. Even that was in line with expectation.

However the selling is not yet over and once the option expiration is behind us, we shall again see renewed selling and a lower low will be visited so that all the stop loss points for the bulls are taken out. The idea is to inflict the maximum pain to maximum people.

The market will rally one last time in summer and I shall keep you informed about a good entry point soon.

So do not give much thought to the rally, one way or other. As a trader, we can take short term profits in up move or down move. But as a long term investor, we better keep our  cash ready to pile on the short side by fall.

Economy and Stock Market.

Is stock market an indicator of the economy or is it a rear view mirror?

There is no clear answer to that. I would think that in an ideal world, where Governments and central Banks do not continually try to influence the stock markets, where manipulation is within a certain limit, stock markets can be regarded as an indicator of the economic health of the country. But not so in today’s situation.

Today the biggest creditor nation of the world is trying to hold on to the proverbial straw to stay afloat. The situation has come to such that the US Government is actively monetizing its debt, although it is illegal in its constitution. They do it in a not so subtle manner. 1^st one arm of the Government sells the Tbonds to the primary dealers and then another arm of the same Government buys them back. The primary dealers who are the powerful banks and the .01% of the population who virtually control the Government, make money in the process.  By the end of June 2011, Fed will hold 16% of the US debt vs. 12% for the Chinese.

The two trillion dollars injected in the system since 2008, have done nothing to kick start the US economy except re-flating the US Stock market and jacking up the price of the commodity. Only the top 10% of the US population own any stocks. (Congratulation to you for being in that top 10%, otherwise you would not have read this blog). The bottom 90% are squeezed dry every day. They are paying more for their food and gas and their purchasing power has gone down as wages have not gone up, dollar has gone down and  today the use of food stamps are at the record high and increasing. Where is the growth they talk about?

Between the top 10%, there is another sub division. The top 0.05% and then the next 9.95%. The objective of the uber top is to take the last drop of money from the rest and leave them in semi slavery. May be that’s what capitalism is all about. That’s how human history was for all these years before western civilization invented democracy about few hundred years back where lofty ideals like equality and fairness were talked about and cherished.

If stock market were to follow the economy , S&P 500 would have been below 500 level. There is huge disconnect between the real economy and the stock market. The classic example is the Oil prices. We know that consumers cannot afford $100 a barrel oil and such high price leads to demand destruction, as consumers, those bottom 90%, live pay check to pay check, have to adjust their spending pattern and cut down on other expenses just to get by. That leads to slower growth. But the manipulators don’t really care. The oil price today is not a factor of demand and supply but of speculation. There is not enough storage in the world to hold all the oil in the oil contracts.

Today the stock market is all smoke and mirror. Very soon that smoke and mirror will crush and it will catch down the real economy.

In the mean time, S&P 500, which is having a sell off of some kind, will now rebound before the option expiration. I think the March 2011 lows will be broken in a dramatic gap down in the morning of Monday or Tuesday to take out all the bull stop loss points. Then there will be sharp turn / reversal to finish the Triple Witching week at 1300 plus level. Just when bulls get some hope, I expect the market to back test the lows again. That is the nature of the beast. It will back test the lows before a bottom is in. if you believe my theory about the top 0.05%, who manipulate and control the market, they will inflict the maximum pain on the rest 9.95%. I also expect a sustained rally in summer because everyone is expecting a crash.

But as I said before, at some point, the smoke and mirror come crashing down and in this case the stock market will catch down with the real economy. I am betting that September 2011 will be that time when the end game starts.

US Banks sitting on another ticking bomb.

There are many reasons for the US Economy is in a mess. Undue risk taking by the US Banks and over-leveraging by the “Too big to Fail” Banks must be counted as a major reason. But the whining of the Banks never stops and the story of greed and unnecessary risk taking goes on.

Frank- Dodd bill did nothing to solve the last crisis and prevent the coming one. The derivatives are the MAD of the world and the switch of destruction is in the hands of few power drunk greedy souls. One of the major component of all the outstanding derivatives in the books of the Banks are the “ Credit Default Swaps”. The Bank of International Settlement s has presented a 146 page report on these credit default swaps with lots of data and charts. http://bis.org/publ/qtrpdf/r_qa1106.pdf

Economist Kash Mansori has done an excellent job of analyzing this BIS report and you can read his report at  http://streetlightblog.blogspot.com/2011/06/betting-on-pigs.html .  

From Kash’ s blog :

“It seems that approximately 30% of total potential exposures to debt from the PIGs are covered by default insurance (see the figures in red). Put another way, if one of the PIGs defaults, creditors who actually hold bonds from that country will absorb about 70% of the losses, while agents (primarily banks and insurance companies) that sold insurance against the possibility of default will have to cover the remaining 30%. That's not a trivial amount.”

There is “striking differences between how European and US creditors would be hit in the case of default by one of the PIGs. If Greece were to default, for example, approximately 94% of the direct losses would fall on European creditors, and only 5% would fall on US creditors. However, US banks and insurance companies would have to make about 56% of the default insurance payouts triggered by such an event, while European agents would make only 43% of those payouts.”

“Finally, it's worth noting that once you account for the substantial payouts that US agents will have to make to European creditors in the case of a default by one of the PIGs, financial institutions in the US have roughly as much to lose from default as those in France and Germany. (See the figures in blue in the table above.) The apparent eagerness of US banks and insurance companies to sell default insurance to European creditors means that they will now have to substantially share in the pain inflicted by a PIG default.”

The implications of the above observation are ominous. The European Banks, who are filled up to their gill with the toxic bonds and loans of the PIGs, know that it is a question of when, not if these countries will go broke. May be this September, 2011, may be another year. So the European Banks are systematically buying insurance to cover these ripe to explode stinks even when the price of the insurance is getting higher everyday. Basically, the Europeans are betting that a debt default will happen sooner rather than later.

Now who are selling them these insurances? Our very own US Banks. Just like AIG, they are looking to collect the upfront insurance payment and putting their head in the sand and hoping that the default will never happen. Talk about greed and risk taking!

When, not if, Greece defaults, these US banks will have to pay substantial amounts to their European counterparts and once again US Taxpayers will be called upon to bail out these too big to fail Banks. Lehman Brothers episode was just a trailer for the real show that is coming up soon.