Tuesday, March 30, 2010

Wall Street doesn’t run the world.

Time, liquidity and control

Consumers and investors, as in the general public, have an immense advantage over many institutional investors, especially in terms of reducing systemic stability. Usually discussions of individuals verses institutional traders and investors focus on information (e.g., access to research and market information favors the pro), size of trades (e.g., the limited liquidity available to support large block trades by institutions favors the individual), resources (e.g., classic economies of scale favoring the pro), etc.

There is an often overlooked factor that can be decisive. Western economic thinking focuses almost exclusively on the competition between market participants on the same side of the market: sellers compete with sellers, and buyers with other buyers. It is true that some of the discussions of the economics of information advantages (asymmetric information in the technical jargon) address buyer verses seller competition. But, the technical literature makes simplifying assumptions that exclude an important factor from consideration.

With respect to investing, the simplifying assumption often made is that there is parity in objectives, or put differently, everyone’s after the same thing. Granted the assumption that every investor wants to make money is reasonable as far as it goes. But, it doesn’t go far enough. Make money with what risk exposure, with what liquidity requirements, under what accounting constraint, with what potential tax implications, relative to what alternative, and over what time frame? These factors alone can create sufficiently difference incentives to make a market even if all parties share a uniform perception about the future.

To illustrate from a recent example, let’s consider Kimberly-Clark. (A disclosure is in order. I own it and acquired more despite the event noted below. But, the disclosure is really unimportant. Nothing I do, or will do, is going to have any impact on the market). Here’s the quote which I found on MARKETWATCH (www.marketwatch.com). It was in the comments. I pulled the full comment from the blogger’s page at ( http://community.marketwatch.com/Balthaszar ). The quote is from March 22nd and goes:

“Story: Kimberly-Clark sticks to 2010 earnings view
I find it amusing that Goldman Sachs issued a SELL recommendation on KMB recently. They were afraid that the company was going to disclose some bad news today, in spite of the upbeat scenario management pitched earlier this year. Glad I picked this up when it slipped under $60 earlier this year. The stock slumped even as dividend increase was announced. But, babies and incontinent adults need their diapers. Women need their monthly "paper fix.” Kimberly Clark continually sells it to them, regardless of the state of the economy.
I feel sorry for anyone who would act on a sell rating from an investment bank, just as I feel sorry for anybody who thinks GS is the devil. GS is overrated anyway you look at them.”

One can look at the SELL recommendation quite differently. To some extent, the quote emphasizes out-analyzing Goldman (better information). That is one way to go. However, it is equally constructive to take a totally different approach. One should never assume greater smarts than another seller or buyer. It’s risky; it isn’t important, and it shows a tendency toward over confidence. None of those behaviors serve an investor well.

The safer assumption is that Goldman’s recommendation was right for someone. Then an individual investor can look at KMB and decides whether the recommendation fits that individual’s unique objectives. If not, the recommendation can create an opportunity: someone’s circumstances are sufficiently different to create a reason for them to do the opposite of the buyer’s incentives. Further, whether the substance of the recommendation is correct doesn’t matter. In fact, the best circumstance is when it is clearly right, but irrelevant within the context of the individual’s objectives. If it is right, it may create additional opportunities.

What’s the individual’s advantage and how does it relate to information asymmetry? Using the Goldman example, the individual knows a lot more about Goldman’s target market than Goldman knows about the individual. It isn’t the individual institution that matters; rather it is the collected institutional investors. One can discern these constraints for institutional investors collectively and for their target markets. I’d argue that there are so many similarities between institutional investors that over time individual investors can use the information to their advantage. Thus, from a buyer to seller perspective, the information asymmetry favors the individual.

Now, let’s get back to the title “time, liquidity, and control.” Individual investors should consider time their ally. Not just because of the power of compounding, but because control of timing is a powerful ally. To illustrate, nothing can wreck a good day like a forced sale. It is well known that prices in forced sales differ from market prices.

“How does this help the individual?” you ask. Well, the individual knows more about their timing requirements and has more control over them than do most institutional investors. Yes, the individual can give up that advantage by taking on leverage or by trading in time constrained products. But, that’s different from never having had the advantage. The individual investor can decide how to use that control of timing. They can use it to buy and hold, to try to time the market, to rebalance on their own schedule, to shift to alternative investments, or to do whatever is necessary.

Let’s talk liquidity next. Time and liquidity are obviously related. One might argue that differences in how investors are affected by the need for liquidity are all timing related. But, there is another side to it. That has to do with the interaction between balance sheets and cash flows.

Just as the individual knows more about their time constraints, individuals have more control over their liquidity requirements. To illustrate, the savings rate recently became positive and the media is full of stories about consumer saving more to rebuild their balance sheets. It is probably true, but the saving rate is a flow statistic and doesn’t say anything about balance sheets directly. Further, from the perspective of liquidity requirements, the more important point is that the positive saving rate is demonstrating that consumers control their cash flow requirements.

In the vernacular of start-ups, they are demonstrating an ability to control their burn rates. Said another way, they are demonstrating that they can control the rate at which they generate free cash flow. Controlling free cash flow is controlling one dimension of cash requirements. Ultimately, cash requirements determine liquidity requirements. When individuals are saving, it demonstrates that they are probably meeting their liquidity requirements from current income without any forced adjustments to their collective balance sheets. The control derived from saving results from the act of saving. What is done with the savings probably reinforces the control, but if consumers burned their savings, the act of saving would still indicate that they are meeting their current cash requirements from current income.

Individuals’ cash flow requirements are less a product of their balance sheet size than is true of institutional investors. For individuals, cash flow requirements are more a function of age and lifestyle choices. But even if liquidity requirements aren’t a separate factor from timing, they at least magnify the individual’s advantage. Individuals who know they won’t need liquidity have a broader set of options that they can easily access. Hedge funds try to get lock up periods during which funds can’t be pulled because they recognize this advantage. Instant liquidity has a price. The price of liquidity is usually lower average long run returns.

This is one aspect of control. Another related advantage that individuals have is that they don’t need to mark to market or continuously maintain any specific financial posture. They can if it serves their financial objectives, but that’s different.

How does this work to the individual’s advantage? An asset with a falling price will produce (note: that is produce, not attract) sellers from among institutional investors. It is well known that the prices in forced sales differ from market prices. It is hard for individual investors to time the importance of their advantage because in the cut throat jargon of Wall Street: “blood in the water attracts sharks.” So, once Wall Street senses falling prices are producing forced sales, the sharks show up. But, the individual can take a position based on their individual circumstances and avoid the risk that mark to market will push them into a sale. Again, they can leverage the purchase in ways that eliminate that advantage, but that’s different from not having it.

There’s a sayings about runs forcing assets into “strong hands.” In a down market individuals grossly underestimate their ability to be the strong hands. Most individuals should have a much longer time horizon than institutional investors for at least some, perhaps most, of their investments.

Seeking alpha (i.e., beating some benchmark) is always stylish. But, individuals can pick their own alpha. The Street has to accept the alpha imposed on it.

Monday, March 22, 2010

Nothing serious…

But, with tongue firmly it cheek.

Political aptitude

If the delinquencies and defaults on sub-prime lending were due to predatory lending and FHA loans are experiencing similar rates, which is true?
1) We tax payers have decided to become predatory sub-prime lenders and take advantage of borrowers
2) There really are foolish borrowers although they can’t distinguish themselves from victims
3) Lending money and getting paid back is not as easy as we are told
4) During a period of rising housing prices bankers are dumb enough to lend 95-100% of the price believing prices only go up, but it takes a government agency to do it when prices are falling
5) Politicians don’t think defaults matter because they can modify the loans that get behind, give the borrowers reduced payments, and be out of office before the chickens come home to roust.
6) All of the above

If you implement a mortgage loan mitigation program that provides a reduced payment by the borrower, and then a large portion of the people re-default after going through the program, it suggests:
1) That it’s time to claim the banks aren’t mitigating loans fast enough
2) It should be blamed on unemployment whether the people are working or not
3) You need to ask for more money
4) Push for control of consumer protection since you’ve demonstrated by 1, 2,& 3 above that you know how to do it
5) Make sure no one mentions balance sheets of the borrowers, because, heaven forbid people start thinking about balance sheets
6) Pay some first time home buyers to move into homes regardless of whether they can afford them in order to insure a future supply of troubled loans
7) Claim success and move on to a new issue

Math aptitude

A trillion is to a hundred billion as:
1) A dollar is to a dime
2) A Democrat is to a Republican
3) A Chinese lender is to a Japanese lender
4) Heartburn is to a headache
5) I don’t care I’m not paying it back, it’s the kids’ problem
6) A better way to buy votes
7) All of the above

If the government is planning to spend $3.6-3.7 trillion and take in $2.4 trillion then:
1) The party in power will get re-elected
2) It’s time to plan a new $800 billion program
3) It’s not a problem if you attack anyone who questions the wisdom; they’re dinosaurs or right wing conspirators
4) It’s a clear indication that someone else needs blame
5) Reaffirm that taxes will only go up on bad guys who are, of course, someone else
6) Who cares? Ask for a re-count and claim it’s just scoring

Vocabulary aptitude

The media refers to loans to businesses as bailouts because:
1) They think most people don’t understand that debts have to be repaid.
2) Paying debts is actually optional and the Chinese just haven’t figured it out
3) Money lent by a bank is exploitation, but government loans are different
4) Most reporters are up to there eyeballs in debt and think that’s a good thing
5) They’re journalism majors, not math majors, and someone keeps putting numbers on the page and confusing a good story by trying to interject facts
6) Every reporter knows the lender of last resort is supposed to be a subsidy for the arts
7) Who gives a darn? Someone’s making more money than I am and that’s not fair.

Toxic assets are:
1) Shorthand for I think you can’t understand this, so string some meaningless words together and try to slip it by
2) Shorthand for, my God, if I explain this to you, then you will understand and be really mad, so string some meaningless words together and try to slip it by
3) An oxymoron that slips by the media because they lost their dictionaries
4) All assets since they can’t be spent today
5) Any asset on the books at a price other than the market price because markets are always right
6) The prefect investment for a public pension since the bond payments can be matched with unfunded pension obligations and the people promising the pension payments will be out of office when the thing blows up.

Saturday, March 20, 2010

They did it again


Last weekend it was quantitative trading. This time it’s derivatives. The March 4th posting discussed putting derivatives on exchanges. Well, Baron’s again provides a very good elaboration on the issues surrounding derivatives in “The Case for Regulating Financial Derivatives” ( http://online.barrons.com/article/SB126904675323664995.html?mod=BOL_hps_mag ). It presents some relevant data. It’s worth reading. Last weekend I didn’t bother to nit pick regarding the issue on quantitative trading. But, this time there is a point worth noting. It is worth noting because it is a question of fact. There are other issues regarding policy detail where readers can reach their own conclusions.

Let me again point out that the article is worth reading because this is really nit picking. The article implies, almost states, that regulators didn’t know of the risks imbedded in the derivatives market. That overstates the case, at least as it relates to the New York Fed. My impression was that the New York Fed was concerned because that they did know the risk was there. That concern was heightened by the fact that they didn’t have the data to quantify it or to ascertain who bore how much of the risk.

My impressions may be easy to dismiss, but, remember, the New York Fed had been through Long-Term Capital Management and the October 1987 stock market collapse. They knew the risk first hand. Further, there are speeches and articles to that effect. The author of the article even points out that the Fed had been working on “modernizing” derivative markets since 2005. If you want an example of revealed preference (that’s economist speak for placing your money where your mouth is or acting on your beliefs) here’s one. They hired away an economist from a former employer after he wrote a very insightful article highlighting the risk.

When referring to regulators who didn’t see the risk, the author of the Barron’s article may mean regulators more concerned about K Street than Wall Street. That has certainly been the case. But, more importantly, the article Baron’s spells out the argument for exchange trading quite well.

If one prefers a book format, A DEMON OF OUR OWN DESIGN: MARKETS, HEDGE FUNDS, AND THE PERILS OF FINANCIAL INNOVATION, by Richard Bookstaber is appropriate. However, I found it too preachy. It also seemed to be too focused on hedge funds. But, one can’t argue that he wasn’t onto something, and the tone may be justified by the seriousness of the topic. Written in 2007 it was certainly timely. Its sales may have been hurt by the fact that shortly after it came out, one didn’t need the book. Its thesis was playing out real time in the national media.

By contrast, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT, by Roger Lowenstein was a pure delight to read. It was written in 2000. The fact that it was written seven years before Bookstaber’s may explain Bookstaber’s emphasis on hedge funds.

Either book can be read for fun as a financial market “who-done-it.” Lowenstein’s works best as a “who-done-it.” Bookstaber by contract is more explicit about the connection between the risk imbedded in complex derivatives and liquidity.

Friday, March 19, 2010

Who would be the best systemic risk regulator?

Don’t let the title fool you. The focus is changing.

Previous postings addressed a variety of proposed financial regulatory reforms. It seems it is impossible to keep up with the inventive mind in Washington. They can come up with new schemes at a dizzying pace. So, here’s a totally different approach. What could eliminate the systemic risk, at least as most of us experience it?

Previous discussions, especially the discussion of too big to fail, mentioned that stopping a cascade failure required that one of two conditions be met. But, only one really works.

One way a cascade stops is it reaches that proverbial immovable object. For a picturesque image, think of a big wave rolling across a beach and crashing against a seawall. In the recent crisis, the seawall was the Fed and Treasury. But, as I argued in the discussion of too big to fail, the notion of an immovable object is an illusion. To continue with the analogy, the wave bounces off the wall and only loses energy to the extent the impact absorbs the energy. It can then surface as a nasty back flow or a dangerous undertow.

The second way to stop a cascade is for something outside the run of the cascade to intervene. For those who think of the government as outside the financial system, my only comment is “get real.” The government is the world largest debtor, I believe, and if that isn’t participating, what is? Alexander Hamilton almost created Wall Street. He clearly understood the need for the Treasury to have a place to borrow. The Fed, in turn, creates the money we all play with. Money also seems rather central to the financial system.

Well, if the government isn’t an external source of a potentially stabilize impact, who is? Are you ready for a shocker? Don’t laugh until you hear me out: it’s the consumer and the investor. Your thinking that consumers are also debtors (or, believe it or not, potential investors), and investors seem to be in the middle of things. Well, I said that they can be the external source, not that they were or are.

“How?” you might ask could consumers stabilize the system. Well, people keep pointing out that consumption is about 70% percent of the economy. That certainly makes them important enough. Further, traditionally, consumption has been one of the more stable components of GDP (i.e., the economy).

There’s another point people often overlook. Let’s call it the JBQ effect, after Jane Bryant Quinn since that’s where I first came across it, but it could as easily be the Dave Ramsey, Jonathan Ponds or Suze Orman effect. It’s this; people who have a liquid reserve of some numbers of months of expenses tend to be financially stable. They tend to be robust to both macroeconomic and financial market volatility.

But, you say: “investors are in the thick of it.” Well, recently, the Vanguard Group surveyed their accounts and found: “Most mutual fund investors did not abandon stocks during the market decline of 2008-09…. The equity abandonment report analyzed the activity of 2.7 million IRA investors from the beginning of 2007 through October 2009, and found results in Vanguard’s administrative data that are consistent with a spring 2009 Vanguard survey of U.S. investors” (see http://onlinepressroom.net/vanguard/ ).

Similarly, a recent Charles Schwab’s “On Investing” ( http://oninvesting.texterity.com/oninvesting/2010spring/?u1=texterity ) contained interviews of a couple of retired investors. They described their attitudes toward the recent market declines. While hardly a sample, the interviews add flavor. To summarize, the interviewees, they felt concern, but didn’t react as if, or express a view that, they were at the mercy of forces beyond their control.

So, not all investors felt vulnerable to the crisis we recently went through, or, at least, didn’t feel that it justified a major change. How “in the thick of it” investors are seems to be either a function of why they invest or how “in it” they think they are. The point being that investor attitudes determine whether they exert a stabilizing or destabilizing influence.

Now you ask: “why are they the best systemic risk regulator?” First, as argued elsewhere, they may be best by default if too big to fail is the illusion described on March 5, “by default” because they may be the only true systemic risk regulator. The second reason is because they may be able to fill that role simply by believing they can, or I’ll argue in a future posting, realizing they can. Another reason is they may already be doing what is required to fill that role, and finally, the steps that would make them the systemic risk regulator make sense anyway.

There’s plenty of material for future postings in that last paragraph. But, for now let’s just say they’re there and can only play lumps at their own risk. If they don’t act, someone else will, and consumers and borrower may not like the results.

Thursday, March 18, 2010

What is systemic risk anyway?

Further definition with some help

First, let’s set some limits on the two leading candidates, leverage risk and aggressive speculation. They play an important role in macroeconomics. Thus, it isn’t surprising that they crop up in a discussion of systemic risk. Hopefully, we can establish their role without a full blown macroeconomic discourse.

Often, the implicit assumption built into the discussion is that leverage is the primary source of systemic risk. That is a reasonable argument. Everybody now knows that leverage is a source of risk. That’s true even if a lot of people forgot it for a while, and even though some politicians believe that the government is above such mundane risks.

Joseph Schumpeter of “creative destruction” fame built his theory of business cycles around technology cycles and financial cycles (basically leverage cycles). There was also a very good academic paper on leverage cycles published a few years ago. It had a very concisely constructed model. Regrettably, I lost it. Generally, but not always, I’ll reference books, web sites, and current periodicals rather than “the literature.” They are harder for me to lose as well as easily accessible to interested readers. Besides, in this case, Schumpeter’s book BUSINESS CYCLES is still one of the better reads on the issue.

One can’t dismiss the role of leverage. Capital requirements, moving derivatives to exchanges, and margin requirements are some of the responses discussed in various postings. Are they enough? Note that this is a business cycle theory. A business cycle may or may not create systemic risk. Leverage has been treated as a “necessary, but not sufficient” source of systemic risk. Granted, little has been said to justify even saying it is necessary. But, if the reader does think leverage creates risk, my advice is to run for national office. You will find a set of fellow believers.

Keynes turned to “animal spirits” to explain risk cycles and their role in business cycles. We now live in a world where an individual can start a hedge fund or private equity fund and gear up the leverage to phenomenal levels. They can do it by borrowing or through the instruments they trade. That’s aggressive speculation based on leverage. Clearly, the two are related. In fact, measuring leverage is a valuable tool for measuring risk appetites.

However, leverage isn’t the only expression of risk appetites, nor is it the only risk. Some of the players seek out risk in the form of volatility. They then bet on it in various ways. Trying to arbitrage even minor anomalies is one. Another is to make directional bets. There is also a fairly reasonable argument that seeking asymmetric returns is an expression of risk seeking, although the entire discussion of asymmetric returns hinges on assumptions about the marginal utility of money. But, we are still only dealing with business cycles.

Perhaps the best way to address “animal spirits” is as “a necessary, but not sufficient” source of systemic risk. However, an implicit assumption in a number of the discussions of various proposals has been that judging the right risk appetite over time is hard, if not impossible. Ignoring that fact is a dangerous form of hubris. During good times, taking risks seems like a good bet --“pour on the risk!” When thing get shaky, being conservative looks smart. Behavior economists are having a field day with that fact right now.

Another assumption that needs to be made explicit is that changes in risk appetites are more important than the absolute level of risk taking. That view should color one’s attitude toward proposals. But, we are still talking about business cycle risk. So, a logical question is: what is different about systemic risk?

It’s time to put leverage and risk appetites them in context. Summarizing the discussions in previous postings, debt markets were the source of the crash. It went way beyond being an indicator. There was a lot of reckless borrowing and lending. Once debt markets realized how many people weren’t going to pay back their borrowing, debt markets froze. It started with mortgage debt, but spread via the shadow banking system. The liquidity needed to adjust for the mispriced Mortgage Backed Securities rippled through every market in the shadow banking system. One way to describe what happened would be that mispriced MBS debt morphed into mispriced liquidity. Any market, and therefore, any organization with a liquidity mismatch became vulnerable. That transformed a liquidity-driven contraction into a generalized fear about counterparty solvency.

Granted, that’s a simplified summary, but a complete discussion would be a book and there are plenty of them. Besides even at this level of generalization, the summary illustrates my point. Systemic risk almost has to include the potential for common mode failure, event failure, and cascade failure. Viewed from that perspective, every proposal for regulatory reform is right if it addresses one of the risks. Similarly, every individual proposal is wrong if taken in isolation.

So, how does The Hedged Economist weight these different risks of failure? Just in the interests of disclosure, let me advance the argument that cascade risk is the one that is most systemic; not necessarily the origin of the risk, but the one that makes it systemic. That said, one doesn’t have to pick. That’s good because it isn’t an opinion I’d want to have to support.

If one can argue that one factor can influence all three types of risk, picking becomes unnecessary. Some readers may want to say: “if it’s common to all three, it’s a risk of a common mode failure.” OK, but I think that overstates the case.

In any case, in addition to talking with regulators as discussed in a previous posting, between 2003 or 4 and recently, The Hedged Economist spent time talking to risk management professional in the financial service industry. My thesis was that they were mismeasuring financial risk. Given that experience, rightly or wrongly, it is natural that the frustration of that experience makes it loom large.

It’s possible that everything I said during that period was wrong, irrelevant, or impractical. But, if people were systematically mismeasuring risk, it would affect all three types of risk. So, with this posting, the focus will shift from risk regulation to risk measurement, hedging and investing. They are more interesting topics, and as argued above, more important.

Tuesday, March 16, 2010

How would regulatory reform work, if it works?

Some examples

Looking at history and recent events is one way to try to assess what financial regulatory reform can accomplish. Yesterday’s posting took that approach. It is a comfortable approach because one can cite a few sources that support or clarify particular points. The readers are then free to read the citations and see if they reach the same conclusions or cite other sources they think are more relevant. Before abandoning that approach, there is one other citation worth making although readers who have followed events might skip it.

One of the benefits of a systemic risk regulator would be that theoretically those with oversight responsibility would be thinking about what to do if a systemic crisis occurs. If you think that such scenario analysis is a waste of time, read "On the Brink: Inside the Race to Stop the Collapse of the Global Financial System" by Henry M. Paulson, Jr. It is scary to recall how totally unprepared regulators were and realize how inefficient the absence of preparation made their response. However, making this citation reflects my bias toward scenario analysis as a risk management tool.
A second approach is to speculate about how regulatory reform would work. Be forewarned, my crystal ball is turned on. But before rolling out my crystal ball, here is a quote from someone else’s crystal ball gazing. Mark Zandi has published his assessment of how regulatory reform might work at http://www.economy.com/dismal/article_free.asp?cid=115952&src=economy-hp-dismal-article . While assessing a different set of regulatory reforms, these two points are very relevant to any regulatory reform that includes the two proposals he is addressing. I cite Mark as a professional crystal ball gazer and a recognized authority, I’m not.
• With authority to act as a systemic risk regulator, the Federal Reserve might have also worked to reduce leverage throughout the financial system. This is most likely with respect to Fannie Mae and Freddie Mac: the Fed had publicly expressed skepticism about risk-taking at these institutions. Yet it is not likely the Fed would have been willing to require broker-dealers to raise more capital and reduce leverage; regulators were actually allowing many of these institutions to take on more leverage, assuming they had the acumen to manage their risks. The Fed also displayed little appetite to require more disclosure or curb risk-taking by hedge funds.
• Perhaps most importantly, the proposed regulatory regime would allow a more orderly resolution of troubled institutions. Important financial players such as Fannie and Freddie, Bear Stearns, Lehman Brothers and AIG were not under the purview of the Fed or other banking regulators when they fell; they would be under the proposed system. Resolution of these institutions was botched in part because regulators lacked clear authority; this in turn caused the financial crisis to become a financial panic last September.
His analysis illustrates some important points. It isn’t realistic to expect anyone to get everything right. Some risks made the radar; some didn’t. It also illustrates the broader focus needed to address systemic risk.

Another approach is to take a current issue and see how regulatory reform fits. Let’s use Greece as an example. Greece experienced a near-default experience recently. Anyone with Greek bonds knows that’s not good. You’re thinking you don’t care. You don’t own them; don’t have any investments in Greece; maybe don’t even have any investments. But, under our current regulatory environment, are you insulated? Bad news; you are at risk. Greek bonds are insured, and the insurer is supposed to pay up if Greece defaults. Guess what; you’re the insurer. AIG insures the bonds, and you, as a citizen of the US, own 80% of AIG.

If you want, you can get mad later, but for now think about how we got into this mess. It says a lot about the appropriate regulatory reform. For starters, score one for regulating derivatives: if adequate collateral (an exchange’s or the trader’s) were available, that would have eliminated the issue. However, it does matter where the collateral is. It does not support the idea that just having better capitalized banks will fix a thing. It is important that the capital be collateral that is connected to the obligation. Otherwise, it is dead money as the capital just sits there doing nothing about risk. In this case, Greece, as the debtor, or AIG, as the insurer, is where the capital should be.

Score two for the need for better resolution authority. First, the government decided to throw a lot of money at AIG. It judged that throwing money at the issue was less unpleasant than a wind down. Second, the government is like Brair Rabbit stuck to the Tar Baby. Now that it owns AIG, it has no option except to wait and hope things work out. Things may work out. I don’t know about you, but some of us would rather not go for that ride. Selling naked puts, which is what default insurance really is, doesn’t seem like a good business for the government.

Score one for realizing that no organization is too big to fail. The US ought to be thinking about how to insure its debt. By guaranteeing AIG, they’re just adding off balance sheet liabilities to their books. It’s like the governments own not-so-little Structure Investment Vehicle (SIV). We know how those can turn out from Enron and the recent experience of the banks.

Glass-Steagall is irrelevant; AIG is not a bank nor is Greece. The relevance of a ban on
Prop Trading by banks seems questionable. In fact, a well-run bank might hold the bonds and have taken out insurance. That would be especially true if they underwrote or syndicated the bonds. They could have a residual exposure as well as reputational risk. In addition, they face the risk of push back from customers who bought the bonds. Hedging those risks might require a net position.

How does this relate to the proposed bank liability tax? Not much. There is a chance the tax would be on exactly the right liability on exactly the right balance sheet with exactly the right tax incidence. But, the chance that the tax would be borne by the potential source of risk just is not that likely. Trading fees would actually make a little more sense than taxing liabilities, although they also would not be borne by the source of the risk. But, by reducing liquidity, they might create an incentive for traders to be a little more cautious about assuming the risk. However, they are largely irrelevant, marginal at best.

Regarding systemic risk regulation, the Greek situation is very informative. As an event, it is “manageable.” Greece has been in default about half the time since 1800. The only reason it gets so much attention is because of the potential for contagion (i.e., cascade failure in risk management jargon). It also illustrates the limitation of US systemic risk regulation. The best that US systemic risk regulation could do is to protect our financial institutions from potential cascade failure. The US exists on the same planet as Greece; we will be affected no matter what. But, that’s different from systemic failure.

It is also relevant to the issue of who is in the best position to provide systemic risk oversight. The Fed is in the middle of US international capital flows. It would end up being the instrument of any action regardless of who initiated it. Further, its role gives it unique information about what impact Greece is having on the dollar and US capital markets. If the Greek situation isn’t financially manageable, the Fed is most likely to see it. So, regardless of who is the systemic oversight regulator, the Fed often has to focus on it.

Basically, the potential issue of Greek debt-related problems shows how irrelevant many of the proposals are. But, given that Greece is over there and we’re over here, that isn’t too surprising.

Monday, March 15, 2010

What could financial reform accomplish?

Historical perspective on what could be achieved

A very interesting question people often overlook when discussing financial regulation is: whether it can work? Often they just substitute an ideological predisposition. Well, in the sprit of fair disclosure, The Hedged Economist’s is a healthy skepticism. Another approach is to substitute political self-interests (either large cap or small cap political). No aspirations there. There also seems to be a tendency to want to punish someone. Well, for that, there are plenty of other very popular web sites and blogs.

In all likelihood, both good and bad will result from regulatory reform; some of it will be intended; some will come as a complete surprise. Nevertheless, previous postings mapped out an opinion on what will and won’t “work.” All of it was done without defining “work.” So, readers deserve a discussion of what can realistically be expected. Hopefully, some of the posting stand alone in terms of addressing specific issues, but overall and, especially with respect to systemic risk, more needs to be said.

Two approaches are possible. One looks at historical experience. The other tries to foresee what could be expected in the future. Historical experience can take into account intended and unintended consequences. Trying to foresee how regulations would work obviously can not include the unintended since it was unanticipated. So, let’s start with historical perspective and put off futurecasting for a future date.

Just to set the tone, consider This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff. In about 400 pages they make the case that different economic and financial crises aren’t different. Crises occur fairly regularly and have patterns. The authors point out that the crises occur under different forms of government, in advance and developing economies, and with all sorts of different regulatory frameworks. The authors do a great job of constructing a dataset where none previously existed. The authors also point out some important impediments to understanding economic and financial crises. Two of the impediments are the opacity of government accounts and the all too frequent myopic focus on explaining individual events without reference to factors common to multiple similar events.

It is all true as far as they go, but despite the breath of their coverage, their overall conclusion is unavoidable at the 400-pages-to-present-eight-centuries level. But, at a more detailed level, different crises are different. Some are more severe than others, and each has unique features both in its cause and its effect. None occurred automatically and none was unaffected by the action of players in the drama. A wise sage once said: “History doesn’t repeat itself, it rhymes.”

Their book clearly points out that totally eliminating crises isn’t a realistic expectation. Indirectly, it shows periods of relative stability between crises and variations in how pervasive different crises were. Thus, it helps set realistic upper and lower bounds on expectations. It is worth reading for that alone.

So much for general tone; now on to details. Managing any risk is a four step process. The first step is recognizing the risk. Then, one needs to know what to do about it. That would all be for naught without the authority to do something about it. Finally, managing a risk requires the will to do something about it.

Regarding the first step, recognizing the risk, recent experience and history should temper enthusiasm. Jim Cramer’s rant that “They know nothing” pointed out the first limitation. In order to manage systemic risk, one has to recognize that it is there. If a media rant isn’t your style, a reading of A History of the Federal Reserve: Volume 1, 1913-1951 by Allen H. Meltzer is well worth the time. I don’t make that recommendation lightly; it is almost 800 pages long. Abstracting from all the detail, it makes clear that often bad things happened when risks were miss-measured. There is a tendency to find an approach that works (e.g., a theory, a policy rule, a way of measuring things) and sticking with it too long.

We are essentially in a race to learn new things about our economic and financial environment faster than the environment generates new things to learn to understand. One encouraging sign is the effort to develop new ways to measure the relative tightness of credit markets. But, bottom line; this is the aspect of systemic risk that leads this economist to seek hedges. We just don’t know as much as we think we know. Hopefully, more focus on systemic risk would help.

That said; systemic risk was explicitly discussed after postings about a number of other proposals. No accident there. Since we can’t always see systemic risks, it made no sense to discuss systemic oversight without first discussing a regulatory framework that might be robust enough to offer a chance of withstanding the limits of our ability to see risks.

The second step, knowing what to do, is a little easier if we know what the risk is. Recent events seem to indicate that once the risk is recognized, appropriate actions can be identified. That seems to be true historically, too, although sometimes the lags have been very painful. There is an element of “we wouldn’t be here if it wasn’t so” to the historical argument, but it seems to stand up despite that. Regarding recent events, one only has to think about how much was done and how much was changed in a short period of time.

There is a caveat. The appropriate actions are appropriate in the moment. With hindsight that is colored by subsequent developments, they are no longer appropriate. But, the actions themselves and the reactions they set off are what make them obsolete. If a systemic risk regulator sees a risk and takes steps to eliminate it, after the fact, the steps were unnecessary; the risk went away. Speculating about alternative histories is fun, but seldom convincing. The only thing we know is that the risk went away.

For that reason, systemic risk oversight is a thankless task. Successes were unnecessary; the risk went away. Failures will be obvious; it is systemic risk, after all. Thus, any action, and even no action, is wrong by definition. Given that, it is legitimate to question the need for systemic oversight. Just waiting for crises to surface and responding after the fact may be the only realistic option. But, that should be easier if a systemic regulator has been thinking about it ahead of time. Perhaps that should be the primary job of the systemic risk oversight.

The third step, insuring that the regulator has authority to take the appropriate actions, creates the most danger. It is dangerous because it can be back-cast. Yes, after the fact we can see what we needed to do and the factors that kept us from doing them. It is always possible to think up new authority that would have made life easier.

That doesn’t prove that having additional powers means the risk would have been handled. Further, it doesn’t prove that addressing the problem armed with the options that, in hindsight, look desirable, would yield better results than were accomplished without them. Contrary to popular belief, hindsight isn’t twenty-twenty. Nor does it say anything about whether having those powers would just have created a need for other additional powers.

Realistically, one should expect constant pressure to expand the scope of oversight. But, whenever possible, an alternative to active oversight should be found. For example, trading derivative on exchanges and trading fees were discussed in previous postings. It isn’t realistic to think we could or should provide regulators with all the authority they think they need. The continuous quest for power is a real risk and a legitimate reason to question. A good risk regulator should identify instances where regulations produce systemic risk. If they don’t, that should be questioned.

The fourth step, being willing to take action is not trivial. It is closely related to the first two steps. If the risk is in doubt, or the right response is in question, hesitation may be a legitimate response. More than likely, hubris will lead to times when hesitation is the right response, but action is taken anyway. Type one and type two errors are both possible.

However, for the moment, assume omnipotence on the part of regulators. (OK, you can stop laughing now). Even when the right action is known, all sorts of impediments can occur. Regulator capture will undoubtedly occur and down right corruption is a real risk. But regulatory reform should as least make it clearer who we should be point a finger at.

The mainstay of any regulatory reform has to be rules not regulators, but regulators have a role. A systemic risk regulator has a role, but it isn’t a second coming. Just a little bit better is all we should expect from regulatory reform and focused oversight. To expect more is unrealistic. But, to settle for less is unnecessary. If we can avoid repeating the mistakes of the past, we should. We will invent new mistakes to replace them.

Saturday, March 13, 2010

Who wants to be the next systemic risk regulator?

Systemic Risk Oversight

It is amusing to think that people in Washington are fighting over who should be responsible for systemic risk oversight. Talk about a thankless task. Nothing could better demonstrate just how power hungry people get when they inhale the DC air.

Think about it for a minute. Let’s say excessive risk is being created by too much leverage. Can the systemic risk regulator really rein it in? Keep in mind the government can and has raised its debt ceiling whenever it has a mind to spend money it doesn’t have. Aside from the potentially expansionary impact of the debt, what if sovereign risk is the most pressing risk? Can the systemic risk regulator stop it? No.

One doesn’t even have to go that far. Again, sticking with the risk of over-leverage, all that is needed is for someone to exempt a few organizations from the systemic risk regulator’s control: say, Fannie and Freddie or the FHLBs. It is easy to see how this could develop into a situation where the systemic risk regulator can’t control total leverage. At best, the regulator can only influence the form of the risk, (i.e., what assets are used as collateral). However, even that influence is limited. Credit, like money, is fungible. Credit secured by a house can be used as a substitute for other credit. It could be used to buy an SUV, a big flat screen, a night on the town, or whatever. It could also be used to buy income-producing assets. Money will go where it wants to go.

Similarly, on the flip side, lending is fungible. There was a time when regardless of who was lending, the funds came through a bank or from an individual lender. People with money then realized that they could cut out the middle man and lend the funds themselves. Borrowers found it annoying to have to depend on bankers who may or may not like the cut of the borrower’s jib. So, they were glad to cut the banker out of the action.

With securitization almost any form of loan is available to any lenders and any borrower. The systemic regulator can at best exert influence on the intermediaries (i.e., the channels). Controlling the amount of leverage in the channels will help, but it is naïve to think borrowers and lenders won’t look for or invent alternative channels. No regulator can cover all channels. Sub-prime mortgages are a good example. In this instance the market disappeared, but the government stepped in with FHA to replace it.

The example above involved excessive leverage. If the risk is too little leverage, potential responses are even more constrained. Economist talk about “pushing on a straw,” liquidity traps, aggregate demand, etc. Much of the literature focuses on the issue. It is so pervasive in the discipline that even with negative savings rates and large and growing debts, there are invariably a raft of economists that see too little leverage. So, let it suffice to point out two none-technical constraints. First, it is hard to force people to lend or borrow if they don’t want to. Second, even if they can be forced into borrowing and lending, the total amount of capital available presents a constraint.

Keep in mind the question in the title involves the NEXT systemic risk regulator. We already have one: the Federal Reserve System. As argued above, controlling systemic risk is only possible on a good day, and we just had a string of bad days. So, the Fed has only two options. Either it can argue that it just needs a little more authority which is probably true, or it can argue that it has an impossible task and should be phased out which is clearly not true on a good day. Since requesting more power is the DC default and there will never be enough centralized power to eliminate systemic risk, more power to the Fed follows.

But here’s the rub. The closer any institution gets to being able to control systemic risk, the closer it gets to really constraining government options. Everyone in government wants to run the show. From a populist perspective, a systemic risk regulator could constrain the populist’s ability to act in ways that create systemic risk. “Power to the people!” Let us be free to mortgage our future. We’re good at it. Keep it out of the hands of anyone who might actually do it.

Someone will be given systemic oversight. Despite the limitation, net-net, it makes sense. On a good day it will help. Besides, we will need a fall guy the next time systemic risk shows its ugly face.

Thursday, March 11, 2010

What is a Systemic Risk Regulation?

Systemic Risk Regulation

If one wants to discuss this issue seriously, it is essential to decide what produces systemic risk. While that seems easy, it is surprising how quickly people can “take sides” rather than be realistic. Perhaps that is the result of a need to find a sinister someone to blame. But, if one wants a sinister force, watch a James Bond movie or Star Wars. We are supposed to be addressing systemic risk; risk in the system as well as risk to the system. Otherwise, if the risk to the system is due to an evil villain, it is evil villain risk: Doctor No, Goldfinger, Specter, or Darth Vader risk. If it is evil villain risk, then we need evil villain regulation.

Here’s a question. How many of the candidate evil villains are already regulated? Not all of them are, but a lot of the current candidates are, for sure. Part of the problem was that we had regulation of the individual players but no one watching the game. The proposed reforms would re-order the entire regulatory framework. That in itself is important. But, re-ordered oversight, even with regulatory oversight added for the players not previously supervised, is not systemic oversight.

To illustrate, starting in 2003 or 4 and up until recently, The Hedged Economist had the good fortune to be talking to regulators of depositary institutions. At one, I presented a sample of some data and advanced the argument that with the data the agency could better measure systemic risk. The response was, “we know the risk isn’t on the books of the banks we supervise.” In other words, their definition of systemic constrained their focus to the internal risk within the institutions they supervised.

At another, the comment was that the risk is out there, broken up and spread around. The natural response was: “who is baring that risk?” The answer, “no one knows.” Since no one knew where the risk was, no one felt that they were responsible for measuring it, much less managing it. It was in the system, not in any individual locale. At two other agencies, the response was that the risk was too big for them to worry about given their limited resources. They just passed on systemic risk.

At another, the response was that they could not act on the risk for political reasons. In short, systemic risk was the politicians’ issue, not their issue. At the agency that was most concerned, the issue was acknowledged as was the realization that they would have to clean up the mess. However, they could not do anything to manage the risk if no one else recognized it. They had no mandate.

Needless to say, many of the firms they all supervised got clobbered, not by what the firms did, but due to the surfacing of risk in the entire system. Most of the agencies did spectacular jobs of minimizing the negative consequences of the risk within the framework of their organization. All of them had bright, motivated people, but none of them focused on the entire scope of the issue. Just re-ordering responsibilities will not eliminate that problem. So, at this abstract level, adding systemic risk oversight makes sense.

But the reader may have noticed that much of the discussion so far focused on what isn’t systemic risk and what isn’t systemic risk oversight. Well, let’s take that approach a step further.

First, a lot of people equate managing systemic risk with producing stability. It is not the same. It shouldn’t be. For starters, perfect stability is an absence of change in other words stagnation. Thus, if stability and systemic risk management were equivalent, the job of managing systemic risk would be to produce stagnation. That clearly should not be the objective.

Second, the purpose of systemic risk oversight is not to protect us from all risk of negative outcomes. Risk is inherent in every activity. Further, one can draw on some behavioral economics to see where this objective could lead. Behavioral economists tell us that most people feel loss more intensely than gain. If the primary task of a systemic risk regulator was to balance negative and positive outcomes, the bias would be to overweight avoiding negative outcomes.

Third, the systemic risk regulator’s job should not be to pick winners and losers. Clearly, effective systemic risk oversight requires making judgments about what activities create systemic risk and reining them in. But, the focus has to be on reining in the activity, not reining in actors. There will be winners and losers as a result, but they can not be the focus without subverting the objective of managing the (as yet ill-defined) phenomena of systemic risk.

Finally, the purpose of systemic risk management can not be just to keep people happy, to win popularity polls, or to get elected. That would preclude the possibility that systemic risk could ever originate from “the will of the people.”

Tuesday, March 9, 2010

On Quants

One of the disadvantages of blogging is that the blogger never gets the chance to make a complete argument. Topics worth discussing often would justify a book or at least an article. Fortunately, there are lots of people writing books and articles. Thus, readers of The Hedged Economists should expect periodic references to relevant books, news items, or articles. They will often be references to pairs of items since most issues can be addressed at multiple levels.

For today, however, I just want to cite the “Other Voices” section of this week’s edition of Barron’s. In an article entitled “Wall Street's New Race Toward Danger” by Scott S. Powell and Rui Gong (http://online.barrons.com/article/SB126783128753256821.html) there is a discussion of quantities trading. It is very relevant to the previous discussion of trading fees and prop trading. Basically they make the same point about the risks associated with quantitative trading.

If you want an enjoyable light read about quantitative traders, try “The Quants” by Scott Patterson. If you’re more interested in the details of the types of trades quants do, you’re going to have to dive head first into the field. I don't know of a how to for the non-quant. There are many good descriptions of arbitrage and quantitative analysis of markets, but they fall short of providing a feel for the field. But, if you like math and statistics, I recently re-read “A Non-Random Walk Down Wall Street” by Andrew Lo and Craig MacKinlay. It is a good reminder of what behind the curtain.

Sunday, March 7, 2010

Just for fun

You may have seen this, but I just came across it. Anyone with a background in economic history will enjoy it. This is very good. Someone put a lot of thought into having some fun with the history of economics.


Hopefully I’ll finish with the issue of bank regulation soon and get on to more interesting topics. I really want to address the mechanic of risk management. The technical issues and their implications for investors interest me more than their regulatory implications.

Saturday, March 6, 2010

A government resolution about regulatory reform?

Claw backs, cram downs, and resolution authority

Once one accepts that no organization is really too big to fail, one is faced with the issue of how to let them fail (i.e., resolution authority). But, that ultimately leads into the consequences for different players. Thus, cram downs and claw backs have to be addressed. Viewed through this lens, the idea of too big to fail (TBTF) can be seen as a really bad solution. TBTF assumes that throwing more money at the problem is an acceptable substitute for addressing negative consequences. But, wasting capital has its own severe negative consequences; never mind the moral hazard issue. While it is important and inflames the public, it is minor compared to other consequences.

It is easy to ignore these issues. They’re complicated, but ultimately they’re crucial. But the form cram downs and claw backs take are less important than that something gets done. It would be dangerous to let the complexity of cram down and claw back-related issues delay addressing the need for wind down options.

To illustrate the importance of a wind down option, consider this scenario: assume there is a run, a sudden demand for liquidity; each little run sets off another run; eventually the cascade gets noticed. The government decides to throw money at the problem, thereby avoiding the pain of wind downs. Their solution is to keep every big player going. Where has the run risk gone? Well, seems that only two possibilities exist: either the run risk went away, or it shifted to the government.

Under what conditions could it go away? If it is truly just a liquidity problem, it will go away. The government has adequate liquidity, and since it is just a liquidity problem, there are assets that can serve as collateral for the liquidity injection. It could also go away if any other player or set of players has the liquidity, although that could touch off the jealously of other players.

This solution to liquidity problems can not work if a wind down is not a viable alternative. The insolvent institutions have every incentive to accept the loan. Illiquid firms have every incentive to accept the loan as their first response rather than looking for alternatives, and organizations with liquidity will hold onto it since they will be undercut in the market. They, after all, have to worry about counterparty solvency. Consequently, it becomes impossible to differentiate between illiquid and insolvent organizations. Further, since there is a confounding of liquidity and solvency issues, it is impossible to tell when the liquidity crisis has passed.

If the run really represents balance sheet problems beyond liquidity, throwing money at it only delays and grows the problem. No one, not an individual, not a business, not a government, not even a society, can consume more than its income indefinitely. It should show up as negative cash flow, and, under an honest accounting, as assets that are lower in value than the liabilities. Without a wind down option, the government is stuck with the negative cash flow. It has just transferred the problem, not eliminated it. Further, without a wind down option, there is no exit strategy other than to hold on and hope the problem goes away.

The absence of a wind down option creates the potential of an even greater risk. The risk can also go away when it was just a crisis of confidence if there is an engineered restoration of confidence. It can be engineered by convincing the market participants that counterparties are TBTF. But, relying on the TBTF approach just shifts the risks. Throw enough money at it and the government owns the problem. The risk is now a risk to the government. Note that, in this case, the absence of a wind down option results in a risk of failure regardless of whether the original problem was liquidity or solvency. Not sorting out who is and isn’t solvent calls into question the solvency of anyone who owns the problem.

Recently commentators have realized the current problem is a balance sheet-induced recession. Similarly, Bill Gross at PIMCO has referred to corporate and sovereign debt as being comparable, more competitive. Even politicians have found it very stylish to discuss the national debt. Sovereign risk is finally getting some press. That begs the question: is the balance sheet problem one of liquidity or something more serious?

By avoiding winding down insolvent organizations, the government ends up having to prove that it is TBTF. Here the consequences can be truly ugly. Possibilities include sovereign default. Sovereign default can take multiple forms such as literal default, inflation, or by just not honoring commitments like loan guarantees and pensions (SS and Medicare cuts anyone?). A government can try to quiet default concerns by constraining
macro policies. For example, the government might be pressured to tighten monetary policy or eliminate stimulus too early and thereby risk a double dip (i.e., another recession). Another risk is currency collapse and/or the loss of international confidence with associated interest rate spikes in debtor countries like the US.

All-in-all, we seem to have been so motivated to avoid wind downs that we responded by carelessly throwing enough money at any problem. We eliminated a liquidity problem and avoided facing solvency issues. However, all we did was transferred a lot of risk to the government. We didn’t address some solvency issues and we transformed liquidity issues into questions about solvency.

Market interventions to halt a cascade don’t have to take any specific form. Sometimes loans are appropriate, sometimes wind downs, and sometimes direct intervention. And, yes, if solvency isn’t the issue, just convincing the market that the next organization is TBTF is the solution. But, without a wind down option, the default is TBTF without any guarantee of solvency. In short, if we don’t address how to let big firms fail, we risk an even bigger failure.

Friday, March 5, 2010

Too big to fail or too silly to take serious?

Too Big to Fail

There is a great temptation to skip “too big to fail” (TBTF). There is so much fuzzy thinking, populist superstition, and down right nonsense circulating about TBTF that it’s hard to take it serious. At the most superficial level TBTF is ridiculous. The Roman Empire was big. It failed. More recently, the USSR was big. It failed. Fannie and Freddie were big. They failed.

Only politicians and academics can talk at length about something without ever saying what they’re talking about. TBTF means nothing without a definition. So the first point is to clarify what we’re talking about. In a narrow sense, TBTF means that someone has concluded size should determine whether an entity should be governed by the set of laws that cover bankruptcy. It should be pointed out in passing that it is the government that makes the laws. If TBTF is an issue, it raises questions about a government that can’t design laws that can be applied uniformly.

That said, on the Sunday before Lehman’s collapse, its balance sheet by most estimates had unrealized losses on illiquid assets of about $25 bil . Bankruptcy expanded the shortfall to about $150 bil at recent market prices. Bankruptcy increased the loss and acted as a vehicle for the “contagion”. For instance, Prime Reserve Fund “broke the buck” the next day. Prime Reserve’s action spread the liquidity run to other money market funds and crippled the money market and short-term corporate debt market. So, there is legitimacy to the concern.

Things get silly quickly, however. For example, in one current proposal, TBTF is defined as one of the 50 largest financial firms. Well, we all know that’s wrong. It’s one of the top 73, or is it 37, dyslexia strikes again. No wait! It’s the top 99 or maybe 9. Try to prove any of these numbers are wrong. You can’t. People forget that New Century and American Home Mortgage Investment, neither of which was big, were early bankruptcies and the entire collapse was well underway before any large US firms approached a critical state.

Remember we’re talking about systemic risk, the collapse of the economy, a great depression or hyperinflation, the end of the world as we know it. Just picking a number at random doesn’t make sense. Arguing “we don’t know the right number but something has to be done”, is advancing the notion ignorance is justification for action. But, we’re supposed to be talking about systemic risk. One begins to suspect TBTF has nothing to do with anything as important as systemic risk.

Further, no one has made a decent case for why the institutional structure of US financial industry is so important that it alone would reduce systemic risk. Remember GM, Chrysler, and GE were all deemed TBTF. Financial firms? Not really. Right now the concern has shifted to sovereign risk, Greece in particular. Are we to start identifying countries that are too big to fail? If we do, what are we going to do, invade’em?

Again, people are ignoring the fact that HSBC was the first, or at least a very early, large firm to take a hit for credit losses from housing loans. It’s not a US firm. Well before any large US firm collapsed or even approached a critical state, LIBOR and rate spreads for corporate debt were clearly indicating a financial crisis was under way.

Financial collapses have occurred under such diverse financial structures it seems unlikely TBTF among financial firms is relevant. Financial collapses have occurred under different government structures even different economic structures. They occurred in medieval times, and based on coinage and historical references, they seem to predate my historical familiarity. They’ve occurred in the US when we had many and much smaller financial firms (1907-09 and during the depression immediately come to mind, but the one that set off the depression of the late 1800’s was probably the worst). They’ve occurred in many foreign countries with very different structures ranging from more concentrated to very fragmented.

Well, doesn’t Lehman as outlined above support the idea of TBTF? Its failure magnified the pain. But, anyone who knows anyone who has gone through a bankruptcy knows every bankruptcy magnifies the pain. People don’t get paid. Expenses are cut. Trust is destroyed. That’s the nature of the beast big or small.

That doesn’t mean there’s nothing we can do. But here’s the issue. Think for a moment of Fannie and Freddie. In that case, they had different assets and liabilities, one was bigger than the other, but the same factors brought them both down. If there had been six of each, those same factors would have brought down all twelve little fannies and freddies. That’s the nature of common mode failure.

The Bear Sterns’ mortgage funds which led to Bear Sterns’ collapse, WAMU, IndyMac, certainly Fannie and Freddie, and many other failures early in the crisis were clearly common mode failures. They could have all been one organization or a hundred times as many organizations; it didn’t mater. Size actually reduced the number of events, but it neither increased nor reduced the severity of the fallout. In common mode failures, the number of back ups doesn’t help if they all are sensitive to the same risk.

Risk dispersion (as in, we’ve sliced these pools of loans up and spread them all over the place) was very much in style going into the crisis. Much of the TBTF thinking is just a continuation of the same logic that led to the financial engineering that preceded the crisis. TBTF will have about the same impact as financial engineering: none. If anything it will do the same damage by taking a given level of risk and dispersing it so that no single entity has enough of a stake to limit the total risk to the system.

If Lehman had been six smaller firms, each with one sixth of the assets and liabilities, the same factor that brought down Lehman would have brought down all six little Lehmans. Bear Sterns, a smaller firm with a similar profile, didn’t last as long as Lehman. But, Lehman shouldn’t be described as just another common mode failure. It doesn’t fit the common mode model as cleanly. Yes, investments in mortgages and mortgage backed instruments contributed to Lehman’s failure just as they had for the failure listed before. Yet, Lehman illustrates a different risk, but, again, one not addressed be TBTF.

To understand how Lehman fits in, one needs to take into account some aspects of the shadow banking system. Lehman illustrates the point because most people view it as a clear example, but AIG or Bear Sterns could serve equally well as examples. In the commercial banking system, people are aware of the maturity mismatch. Banks take deposits that can flow out virtually on call, on depositors’ requests. They lend for longer terms for mortgages, car loans, business loans, etc. Commercial banks represent a small portion of the maturity mismatch in a healthy economy. For Lehman (or Bear Sterns and AIG), other short-run, or on demand, sources played the same role as deposits do in commercial banks.

By the time Bear Sterns and Lehman failed, a very broad common mode failure of institutions with leveraged exposure to consumer debt had become a cascade failure that had the potential to take down any institution with a maturity mismatch. As each method of borrowing short to lend long collapsed, market participants trying to borrow were forced to another method. But, participants on the other side were doing the same thing; each failure to be able to secure short term loans was taken as additional evidence that for lenders it was important to shorten maturity. Eventually this got to the point of not lending at all on one side of the market and eliminating the need for short term borrowing on the other side. At its most extreme businesses would not borrow even if it meant cutting capital expenditure, inventory purchases, and even payrolls. On the other side of the market, actually paying, that is taking negative returns, to maintain liquidity was acceptable.

For noncommercial banks the equivalent of a bank run can be measured fairly directly by rates in the repo market and other very short term funding sources. To illustrate the market-wide, not firm-specific nature of the cascade by using LIBOR overnight rates, when Bear Sterns failed, the rate, which had normally been about 10 to 15, was in the 80s. When Lehman failed, it was above 100. Clearly, Bear Sterns and Lehman weren’t the only firms in trouble.

The risk was already systemic. While LIBOR is useful because it quantifies the phenomena, nothing illustrates the point better than the fact that the stocks and credit default swaps of the entire financial sector were moving together. The entire sector could not all be long the same asset class (although an amazing number were). What they shared in common was a maturity mismatch. In this respect, the current questioning of the book of business at Goldman is particularly interesting. They were buying and selling offsetting positions. Yet, they were at risk of a run. That can be said regardless of whether they were long or short any specific asset type.

Once the issue of a cascade failure is raised, it naturally raises the issue of too connected to fail and too systemically important to fail. Lehman is sometimes used to illustrate these concepts because it was clearly the vehicle that most directly transmitted the problems into the money market and thereby the commercial paper market. But once a liquidity run starts, the run itself is the transition mechanism. Under those conditions having many small players, especially small and unconnected players, actually exacerbates the problem. Each is likely to be the victim of its own limited liquidity. Having a big enough and liquid enough institution to meet the demand for liquidity is what stops the run. That’s the philosophy behind central banks.

Thursday, March 4, 2010

Putting the adults in charge of derivative trades

Regulating Derivatives

Bringing more derivatives (i.e., like some standard interest rate and default swaps, some commodity hedges, etc.) onto exchanges makes sense. It would automatically enforce some formal margin requirements.

More importantly, it would shift the counterparty risk. Many algorithms for pricing derivatives ignore or poorly represent counterparty risk. There is no doubt that mismanagement of counterparty risk transmitted the crisis across markets. Further, concerns about counterparty risk necessitated the actions taken regarding AIG. Some people think the action was about AIG and its counterparties, but the systemic importance of the action wasn’t the event. Neither AIG’s size nor its web of relationships would have justified the action taken. At the time there was a mass realization that counterparty risk was being ignored or misrepresented. It was setting off a very real panic that became a significant contributor to a real risk of a total collapse. The action at AIG essentially established a finite limit to the system-wide liquidity collapse that counterparty risk could create.

Bringing as many derivatives as possible onto an exchange probably won’t be carried to excess. One would think that if the derivative doesn’t trade, the exchange wouldn’t want it. But, it is important that we remember that bringing derivatives onto an exchange doesn’t eliminate counterparty risk, it just shifts it. The markets need to be well capitalized. Margin requirements need to be strictly enforced and uniform across markets, preferably internationally.

Private deals could still be cut, but they’d be a smaller portion of the total. However, it is essential that all derivatives, even those traded over-the-counter, be backed explicitly by adequate collateral. Selling default insurance is the equivalent of selling naked puts. And, like selling naked puts, do it often enough and eventually you’ll get a collateral call. Nothing wreaked more havoc in the last few years than when traders woke-up and realized there was no collateral at all behind some derivatives and inadequate collateral behind many. Further, one of the reasons banks have found the private market for swaps so profitable is that regulators allowed them to do it without the level of capital the risk would justify. Offsetting positions aren’t a perfect substitute for collateral even in a smoothly functioning market much less under stress conditions.

The object shouldn’t be trying to develop the perfect balance between public markets and over-the-counter transactions. The objective is to reduce systemic risk. Simple steps and partial solutions can accomplish a lot.

Wednesday, March 3, 2010

Regulatory capital and who’s got the money?

Regulatory Capital

Increased capital is ultimately the solution. But, timing changes is probably more important than the level. What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle. It’s the fallacy of composition writ large. Individual banks are safer with higher reserves, but if every bank raises more capital, oops, no credit even for productive endeavors.

Basel 2 was supposed to address the reserve issue, but we should be skeptical. The risk models used for Basel 2 didn’t do so well at avoiding the mess we were in last year. There is no reason to believe they would protect us from the mess we’re making now. (A technical side note: if a Markov process is representative of the functioning of financial markets, then even replacing the assumption of normal distribution with realistic probability distributions will not result in risk models that would justify regulators’ faith in Basil 2. Further, without better understanding and modeling of structural characteristics that create risks of common mode, and especially cascade failures, even Monte Carlo simulations won’t yield reliable probability distributions).

Perhaps something could be done through margin requirements that apply to more types of assets. Historically, since WWII, we have done better with them, mainly because they haven’t been changed very often. Margin requirements are a subtle way to adjust capital requirements. If we could believe the government would raise margin requirements for bond positions, we might legitimately feel more comfortable. But, their history with Fannie and Freddie bonds is just the opposite. They subsidized them with an implicit loan guarantee, placed them high in banks’ capital structures, and lowered the capital requirements of Fannie and Freddie. Margin requirements as a response to systemic risk also raises the ugly issue of what type of collateral is appropriate for government bonds.

There is generally a flaw in the thinking about capital and banking. The flaw is a focus on the wrong type of risk if systemic risk is the issue. The focus is on event risk rather than common mode failure and cascade failure. The collapse of any institution is an event. But systemic risk generally doesn’t arise from the collection of events. It arises in one of two ways. One way is a common mode failure where one common factor causes a grouping of events above some critical level that justifies calling it systemic (i.e., makes it a system problem). The other is that one event triggers another until either an event of great consequence or a total of all the events justify calling it systemic. But, a cascade failure doesn’t have to start with a large institution, or even a noticeable event. Think of the butterfly effect.

Once the focus shifts from event risk to common mode and cascade failures, it calls into questions a lot of assumptions about regulatory capital. The thorniest issue is who should “hold” the capital. If the failure is common mode, then more capital at the organizations subjected to the common risk isn’t very efficient and will probably fail. Similarly, if it’s a cascade failure, the circuit breaker has to come from outside the chain reaction causing the breakdown. So, while capital requirements are important, they’re neither a quick fix nor an assured solution.

Tuesday, March 2, 2010

Consumer protection, if it sounds too good to be true, it isn’t.

Consumer Protection

No one can be against the idea of more aggressive consumer protection. It is almost good by definition. However, as with so many things that sound good by definition, it sounds good because it isn’t defined. It’s exactly the sort of thing that politicians love. Needless to say, it will be included in whatever is enacted.

But, you have to be incredibly naive to believe our leaders will protect consumers. Who's going to tell a young couple they can't afford their dream McMansion, or cut off their credit card if they are over extended? Government seems to be pushing in the opposite direction. It's a shame. Many people have borrowed their way into a hard life. It’s like the government is running the company store through Fannie, Freddie, FHA, student loan programs and GMAC. Get them in debt and keep them there.

Look at the new credit card regulations if you need an example. There is nothing in the regulations that will protect consumers from piling on debt until they can’t service it much less pay it back. Nothing to preclude offers of more credit to people who are already delinquent.

Why not use the (now banned) concept of universal default to protect consumers? Before the ban, card companies raised rates when any debt became delinquent because the delinquency indicated an increased risk of default. If so, why not consider a rule forbidding additional credit offers when any credit is delinquent by some number of days. Perhaps it’s a good idea, perhaps bad, but can a government that tries to borrow its way through its own deficits be expected to even consider whether something that constrains debt is in consumers’ best interests?

FHA is probably the most telling example of how little the government cares about protecting consumers. The government has become the new sub-prime lender. They will lend up to 97% of the appraised value of the house. Given the margin of error in appraisals (which is at least 5%), that nominally 97% loan-to-value ratio can easily be a 100% loan. If that’s not bad enough, instead of a teaser rate, the government offers a tax credit! They’re encouraging these new “home owners” to rent money instead of renting a place to live. If home prices go down or the consumer misses a few payments, bingo: more people under water.

At the macro level, we will never straighten out our balance of trade until we start putting capital into producing things to export instead of lending it to people to buy imports. But, do you really expect politicians to tell their constituents that they need to invest more and consume less. The politicians can’t even do that themselves.

Trusting Washington to protect us from debts is like asking an alcoholic to tell us when we’ve had enough to drink.

Monday, March 1, 2010

Does the Volker Plan confuse insolvency with illiquidity?

Volker Plan and Taxes on Liabilities

There is a well known quote from Bagehot’s rules for how central banks should handle financial crises: “lend freely against good collateral at a penalty rate – you will make money.” It worked for 100’s of years, yet past wisdom seems to have become a deflated currency now days.

In Bagehot’s terms, two policy mistakes were made during this crisis, and only one involved banks. In TARP they didn’t insist on good collateral (at AIG, the auto industry). We should admit the mistake and move on. The second, the one relevant to banks, didn’t involve TARP. It involved and still involves the Temporary Liquidity Guarantee Program, TLGP. Governments under-priced the Government Guarantee. They also don’t seem to have thought out the differences between short-run and long-run effects of Government guarantees.

(I’ve ignored mortgage modification because I view it more as a social program than a bailout of the financial system. It, like Fannie and Freddie, involve a totally different set of issues. They overlap and are rather central to financial and economic stability, but involve much more).

Liability taxes are part of the proposal to tax the large financial institutions. But we should all be very skeptical of that idea. Regulators have historically tried to pick the “safe” things for banks to do (e.g., higher capital requirements for certain types of loans, differential Tiers for assets, setting reserve requirements, etc). But, the results are mixed at best (i.e., off balance sheet SIVs, foreign based special purpose vehicles, over exposure to specific types of loans, shifts to fees based services such as securitization, rotating between different funding sources, and convoluted capital structures). There is no evidence governments are particularly good at assessing the risks associated with various types of liabilities other than in hindsight.

If a liability tax is to be taken seriously as anything other than a political sop, one thing that has to be considered is the size of the TLGP exposure. The government should care about the liabilities only if they have a contingent liability. If it is anywhere near the Fannie/Freddie exposure, then the issue should be revisited. But, even if the government’s exposure is large, an analysis of history would probably argue for an insurance premium for TLGP (like FDIC premiums on deposits), not a tax. Then, unlike the closest proposal floating around, the reasonable approach would be to apply the tax to (or better yet require the insurance of) every holder of the liability in question, not just unpopular institutions.

It would be far better if we just stopped giving government guarantees. Just give them on a few forms of bank liabilities (basically, deposits up to a limit a la FDIC) and then only as reinsurance after a first line insurance pool like FDIC. Once the government gets out of the business of guaranteeing liabilities, both retrospectively and prospectively, the liability tax issue becomes moot.

That’s not Monday morning quarterbacking. The argument for avoiding government guarantees is more focused on the long-run verses short-run issue. In the short-run, guaranteeing bank liabilities in any form may have been what was required to end the collapse in liquidity that was occurring in every market. The NY Fed has real time information on market liquidity and, more importantly, knows how to interpret it. We will never have that info and can’t. The only reason the institutions will share it with the Fed is because they know it won’t be disclosed. Unlike of those who see a Fed / Wall Street conspiracy, I recognize my ignorance. Besides the facts that were known publicly -- TED spreads, LIBOR rates, commercial paper market flows, default swap prices, the lock down in the auction market for munibonds – all supported the Fed’s and Treasury’s interpretation of conditions on the ground at the time. If anything, Cramer’s rant was right. The Fed was late.

But being right at the time is different from being permanently right. We know from Freddie and Fannie and a multitude of historical examples that government guarantees lead to excesses (bad financial management, excessive risk-taking, and misallocation of capital).

There is an amusing contradiction in the Volcker Plan; the government is going to tax the same liabilities their guaranteeing. Perhaps they should just tax TLGP liabilities. It would be a way to unwind the program. Since many of the banks have been able to raise capital with stock issues, the program, like many government programs, has outlived the need.

Rather than supporting an effort to manage risk by regulating the liability side of financial firms’ balance sheets, this cycle should be viewed as a case study in the futility of that approach. Each of the failed institutions experienced a run. Their liquidity was drawn down and sources of replacements were gone. But each firm used different liabilities. The mortgage banks depended on bank loans and short term bonds. WAMU and Wachovia were classic bank runs as large depositors pulled down account balances. Freddie and Fannie didn’t even have deposits. Lehman and Bear Sterns used different liabilities than Fannie/Freddie or the banks/thrifts. AIG used even different forms of liabilities. GE is the clearest case of commercial paper as a source that choked.

The entire idea of a liability tax is just a way to avoid the problem. In the 21st century, problems in the banking system originate with their assets, not their liabilities. Banks become bad loans because they made bad loans. That’s how they become insolvent. Problems originating on the liability side are always and inherently a risk. But, they are a liquidity risk. The essence of banking is a maturity miss-match. Banks lend long term using short-run liabilities. Thus, a run is always a possibility. Adding liquidity is the appropriate regulatory response. But, if the loans aren’t going to earn more than they cost, it doesn’t matter where the funding came from.