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.
http://consumerist.com/2010/03/fear-the-boom-and-bust-a-hayek-vs-keynes-rap-anthem.html
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.
Sunday, March 7, 2010
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.
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.
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.
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.
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.
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.
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.
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