Frontline Special On Financial Regulation

All,

PBS will be airing an episode of Frontline focused on financial regulation tonight (Tuesday, October 20, 2009 ) at 9 PM (ET) for those of you in NYC, but check local listings as airing times may differ in your location. I’m told that derivatives will be a featured topic. We’ll see what they say… While the title of the episode, “The Warning,” suggests that I will probably not agree with many of the arguments they put forth, Frontline is generally a very high quality program and I encourage all of you to watch it. I will be watching as well.

***UPDATE*** If you missed the program you can watch it online here. I was honestly quite disappointed with the program. It presented very complex issues in a terribly one-sided manner, utilized a very corny plot of a thwarted would be hero and of course referred to the OTC derivatives market as a $500 trillion “complex and arcane” industry. Clearly they don’t read this blog.

I understand it’s T.V., and you can’t get into that much detail, but there was absolutely no discussion of what derivatives are used for, no discussion of how widely used they are, and they seemed to suggest that OTC derivatives were at the heart of this crisis, which is a dubious claim at best. In any case, watch the video. If anything, it’s a valuable insight into how poorly understood the industry is, even among intelligent people. When you’re done watching the video, take a look at this article for a bit more context and color on the OTC derivatives market.

Regards,

Charles

Asset Bubbles and Economic Activity

Also published on the Atlantic Monthly’s Business Channel.

The internet economic debate du jour is summed up nicely by economist Paul Krugman as follows here:

why [doesn't] a housing boom — which requires shifting resources into housing — … produce the same kind of unemployment as a housing bust that shifts resources out of housing.

And here:

why … isn’t [ there ] mass unemployment when bubbles are growing as well as shrinking — why didn’t we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

His point is, on balance, both booms and busts involve the reallocation of resources, yet only busts seem to produce mass unemployment. While Krugman and Arnold Kling* are wrapped up in a debate about how the question influences our understanding of government stimulus, I’d like to simply offer up an answer.

For any fixed amount of capital available for investment, an increase in the amount of capital allocated to one area implies that the amount of capital allocated to some other area must have decreased. In short, capital allocation with a fixed amount of capital is a zero sum game. The same is true of society’s capital. If the pie doesn’t grow, but stays fixed, and society shifts more of its capital into one area of economic activity, it necessarily implies that we have taken capital away from some other activity.

Asset bubbles, however, are, according to my theory of the world, able to temporarily increase the amount of capital society has available for investment because of the effect that asset bubbles have on the market’s expectation of incurring losses on investments tied to the bubble-asset. Some of the capital that society has available for investment is held back by the market in cash or cash-like investments, such as short term Treasuries, in order to cover potential losses that might arise from investments. Some entities, such as banks and insurers, are subject to regulations that dictate how much capital must be set aside to cover these potential losses. Other entities are free to estimate the amount of capital that needs to be held back in order to cover these losses. So, if we took a snap shot of all of society’s capital available for investment at a given point in time, some portion of that would be withheld as a loss reserve in cash or cash like investments. That means some portion of the capital available for investment isn’t really being allocated to “investments,” but being withheld to cover potential losses on bona fide investments.

Asset bubbles create value out of thin air. Price trends develop that deviate sharply from historical norms, and eventually a new, albeit temporary, norm is established. As a result, asset bubbles make the bubble-asset look like a much better investment than it will eventually turn out to be in the long term. As such, asset bubbles create capital available for investment out of thin air because they cause the market to underestimate the amount of capital that has to be set aside to cover potential losses arising from investments tied to the bubble-asset. This means that the effective pie, the portion that actually gets invested in non-cash assets, can be temporarily expanded, removing the zero sum accounting restriction, simply because less of society’s resources are used to cover losses.

When homes across the U.S. all started increasing in value more or less in tandem, home owners felt, and in fact were, richer than they were the day before. They could access the newly found equity in their home to purchase other goods, or double-down and purchase yet another home. As this process escalates and apparent price trends develop, banks feel more confident in making loans tied to housing and begin to compete for those loans. Mortgage lending, which was traditionally considered a “safe” lending business, got even more “safe” since the value of the collateral would surely continue to increase over the life of the loan. So even if the borrower lost his job or his legs, he could always sell the house to cover the loan: there will surely be plenty of equity between the face value of the loan and the price of the home upon sale. And so as lenders’ expectations of an upward trend in price becomes more entrenched, lenders become willing to lend greater amounts of money tied to real estate and can do so without subtracting from other lending activities by simply reserving less capital for losses on their real estate lending.

So what happens when bubbles pop? Once losses exceed expectations, the market is forced to reallocate its capital to cover those losses or face insolvency. If the price of the bubble-asset drops far enough, this could force fire sales outside the bubble-asset market as firms scramble to cover their liabilities. Once this happens, economic actors have less access to capital than they did before the bubble got started, leading to a sharp contraction in economic activity and concomitant upticks in unemployment.

One thing that still puzzles me is why bubbles pop when the bubble-asset isn’t usually expected to produce a cash flow. For example, capital invested in internet companies (e.g., internet stocks) should at some point generate the return that everyone was expecting. When internet startups don’t generate positive cash flows, those returns fail to materialize en mass, and that’s a clear signal to the market that its expectations were off. And so the bubble pops. But what sort of return were people expecting from housing? What was the signal that caused the bubble to pop? Clearly, defaults on bonds backed by real estate were the signal to the capital markets, but what caused the price plateau in the underlying housing market that got the defaults rolling? Was it that credit was extended to the maximum extent possible, and so no further appreciation was possible? Or was the cause psychological, a sort of vertigo price point at which both lenders and borrowers lose their nerve?

*Arnold Kling has proposed an alternate explanation involving the timing of bubbles, arguing that bubbles are gradual while busts are sudden, and that’s the cause. While shocks to expectations are generally bad for markets, I think that this explanation is intellectually unsatisfying because (i) it doesn’t explain why busts are sudden and (ii) it tacitly assumes that sudden changes create unemployment, which is probably true, but is merely descriptive and not explanatory.

On Asset Bubbles

All,

I’ve got a new post up on Atlantic Business concerning asset bubbles. Hope you enjoy.

Regards,

Charles

FT Interview With Mandelbrot

All,

I cannot recommend the following interviews highly enough. John Authers strikes gold again, interviewing Benoit Mandelbrot, mathematician (whom the celebrated Mandelbrot set is named after), and early critic of efficient market theory.

The interviews are available here.

Best,

Charles

FinReg21 Article (Rethinking OTC Credit Derivatives)

All,

The article I wrote for FinReg21, “Rethinking OTC Credit Derivatives,” is now up and available here. FinReg21 features content from academics, policy makers and practitioners and I encourage all of you to make the site part of your daily reading.

Regards,

Charles

Holiday’s Over

I’m back, and despite Felix’s advice to the contrary, I’m telling you about it. I probably won’t post anything this week or next week because I’m working on an article for a quasi-academic/quasi-practitioner journal that I’m very excited about. The topic of the article is … you guessed it, derivatives, particularly CDS. I will post links once it is available to the public.

Regards,

Charles

Time For A Break

I’m off to the land of fjords and Edvard Grieg for a much needed break from the world of swaps, stocks, and forwards. It’s been a remarkable year in many respects, and being able to discuss my thoughts on the events that transpired with a deeply intelligent audience has been tremendously enlightening and a whole lot of fun. That said, I need a break.

Best,

Charles

Naked CDS: Exposed

Also published on the Atlantic Monthly’s Business Channel.

The term “naked CDS (Credit Default Swap)” has been tossed around a lot lately, with little to no examination of the etymology of the term. You may have heard of “naked short selling” of stock, and a bit of Google action will tell you that naked short selling is generally illegal. So, you’d be inclined to think that naked CDS must be similar in nature to naked short selling, and inevitably conclude that naked CDS would be illegal but for Wall Street’s tentacles. But of course, you’d be wrong.

Naked Short Selling

Naked short selling has nothing to do with being a hedonistic financier. Ordinarily, to short sell a stock, you (i) borrow the stock and then (ii) sell it to someone else. This pair of transactions leaves you with an amount of cash equal to the price of the stock at the time of the sale and an obligation to deliver the stock to the lender at some time in the future. If the price of the stock drops after the sale, you can purchase the stock in the market for less than the price you sold it for, deliver the stock to the lender, and pocket the difference. Fantastic. Naked short selling is very similar, except you never actually borrow the stock. That’s right, you sell something you don’t actually own. There are circumstances where this wouldn’t be much of a problem (e.g., I don’t own the stock right now but I will in the next couple of minutes) and we might want to allow the practice to occur. But exactly when the practice is acceptable is beyond the scope of this discussion. The key point is that naked short selling involves the sale of an asset you do not currently own.

Naked CDS

A naked CDS position is a short position that is unhedged by the underlying credit risk. For example, I have a short position on a bond through a CDS but I don’t actually own the bond. This means that I profit if the price of CDS protection on the bond increases, which usually means that the underlying bond is more likely to default than when I opened up the CDS trade. Note that I have not sold anything that I don’t own. The equivocation between naked CDS and naked short selling stems from the observation that in each case, you don’t own the thing in question. Sure, but in the case of a naked CDS position, you’re not trying to sell the thing you don’t own.  It is the sale without current ownership that makes naked short selling problematic in certain contexts. In contrast, in the case of a naked CDS position, you simply enter into a trade expressing a negative view on a credit, that is all.

Naked CDS positions are similar to unhedged puts: buying a put on a stock without actually owning the stock. A put gives you the right to exchange stock for a fixed amount of cash, called the strike price. If the market price goes below strike price, you can go and buy the stock from the market, exercise the put, and pocket the difference between the strike price and the market price. Fantastic. So the more the price of the stock falls, the more you profit. How evil. Of course, no one has a problem with unhedged puts, even though they express a negative view on an asset in almost the same way a naked CDS position does. But don’t forget, puts are not part of the “shadow banking system,” or whatever other garbage meme is being pumped this week.

Same Same But Different

Pundits also grumble because naked CDS positions are speculative, as are short positions on commodities, such as the price of fuel. But of course, the custom crafted pundit logic applies differently to different markets. For example, in the context of CDS, naked CDS speculators are bad because they magically cause the price of the underlying bond to decrease. But when it comes to commodities, pundits claim that speculators cause the price of the underlying commodity to increase. They hold this to be true despite the fact that both the CDS market and the futures markets are comprised of an equal number of long and short positions, by definition. Moreover, speculators can make money on both the long and the short end of a trade in either market, so why should we assume they consistently choose the “evil side” of the trade? Why markets with such similar characteristics yield such different criticisms is beyond me, but perhaps one day I too will wield the Möbius strip of pundit logic.

Understanding The OTC Derivatives Market

Also published on the Atlantic Monthly’s Business Channel.

In 2006, few people outside of the derivatives market had used the word “credit default swap” in casual conversation. By 2008, it had become an inescapable household term. People continue to throw around buzz words gleaned from the pink pages of the FT, but as my colleague, Daniel Indiviglio recently asked: Does anyone out there really understand what the Over-The-Counter (OTC) Derivatives market is? Since I consider myself the resident derivatives wonk at Atlantic Business, I felt compelled to respond. But rather than focus on any particular instrument or issue, I thought it would be best to focus on the overall structure of the market – who the people in the market are, what they do, and what relationships they have to each other – and leave the banker-bashing to someone else.

Market-Makers

If you were to base your understanding of financial markets on your experiences as a consumer of financial products, you would probably think that any and all types of financial products are available upon demand – all you need to do is pay for them, right? No. The reason you can purchase stocks over the internet with a few clicks of the mouse is because at the other end of that trade is someone else willing to assume the exact opposite end of the trade. If you want to buy, they’re willing to sell. If you want to sell, they’re willing to buy. The folks that do this are known as market-makers. Simply put, their willingness to both buy and sell assets creates a market in which others can trade these assets.

Liquidity risk is the risk that you won’t be able to sell an asset, or more generally unwind a trade, for an amount of cash close to its expected value at any given moment. So which assets carry the most liquidity risk? As a general rule, the greatest liquidity risk comes from assets in thinly traded markets. That is, the fewer times an asset is traded on any given day, the greater the liquidity risk. For example, stock in Coca Cola carries much less liquidity risk than a Victorian mansion for the simple reason that Coca Cola stock is heavily traded every business day all over the world. As a result, Coca Cola stock trades can be executed quickly through intermediaries who are willing to buy it from or sell it to you, since these intermediaries know that at some point in the near future, someone else will show up at their door asking to buy or sell some more. So these market-makers must be the greatest people on the Earth, willing to devote their time to make markets liquid, all for the greater good of humanity, right? No.  You bought your lunch, even if you don’t remember paying for it. In exchange for providing liquidity, market-makers get to pocket the difference between the prices at which they buy and sell.

A swap is a very common type of OTC derivative, which includes that destroyer of economies, the credit default swap (CDS). While industry folk commonly speak of a buy-side and a sell-side to the swap market, you can’t really buy or sell a swap in the classic sense, since a swap is an instrument in which both sides have obligations to perform in the future. That is, if the underlying rate moves against either party, that party will have to pay up, much like a future or forward contract. This is in contrast to an option from the perspective of its holder. An option grants the right, not the obligation, to the option holder to buy a particular asset; and creates an obligation on the part of the option writer to sell that asset. You can sell a right and assume an obligation. You cannot sell an obligation. Well, there are probably a few bozos out there. But in any case, both parties to a swap could end up having an obligation to pay at some point in the future.

The Sell-Side

Swap dealers are market-makers for swaps: the sell-side of the market. But how do they create markets when you can’t really buy or sell a swap? At all times except execution, swaps have positive value to one of the parties to the swap and negative value to the other. At execution, the market value of the swap to each side of the swap is zero.  This is because the price of the swap will be based upon the value of some rate at execution. One party will be long on the rate (benefiting if the rate goes up) and the other will be short on the rate (benefiting if the rate goes down). After execution, that rate will move, up or down, which will create value to one of the parties. What swap dealers do to net their positions is offset their long positions with short positions; and offset their short positions with long positions. In reality, this process is not so simple. The face value of each trade, known as the notional amount, is not likely to match up so perfectly with the other trades, despite being executed by masters of the universe. As a result, they have to work pretty hard to make all of their trades match up.

The Buy-Side

So who is out there using these swaps aside from those evil useless bankers? Well, I’m sorry to disappoint you, but pretty much everyone: corporations of every variety, particularly heavy consumers of energy products, municipalities of every variety, and of course, hedge funds. There are others, like insurers, who have played a now infamous role in the OTC derivatives market, but the preceding list, while not exhaustive, at least provides some insight into the broad variety of market participants out there using these weapons of mass financial destruction.

So why do these firms voluntarily use these evil, destructive, terrible things which will inevitably cause them to suffer? Well, it’s not original sin. It’s because firms that engage in various types of economic activities have natural exposure to various types of risk. And swaps get traded on pretty much every type of rate you can think of. There are the typical and fairly well known swaps like credit default swaps, which are priced against credit spreads; interest rate swaps, which are priced against interest rate spreads; FX and currency swaps, which are priced against currency spreads; and then there are less well known swaps such as energy, weather, and catastrophe swaps, each priced against their own respective spreads. Liquidity varies across these different categories, for the same reasons outlined above: some are less commonly traded than others. Some swaps, known as bespoke swaps, are never traded at all. They are custom tailored trades designed to hedge the risks of specific parties.

So how do these rates correspond to risk? Taking a position on a given rate, long or short, allows you to assume the risk that the rate will move. If you’re naturally exposed to increasing energy prices, taking a long position on a swap keyed to some energy rate, say the price of oil, will allow you to cash in when the price of oil moves up. Because your business loses money when oil prices go up, the net effect of your business losses and your swap gains are zero, if it’s done right. And what if the price of oil goes down? Then your business does well and your swap does not. Again, if that’s done right, your net position is zero with respect to the price of oil. This lets you forget about the price of oil and focus on your business activities. So who takes up the other end of the trade? Even if a dealer takes on the short position in our example, the dealer will usually find someone else who wants to take the short position of the trade and pass the exposure onto them. So why would this other party want to short the price of oil? There are a number of reasons. They could have the exact opposite business problem that you have, and lose money when the price of oil goes down. Or, they could be one of those evil speculators. Yes, speculators serve a bona fide economic function and actually help make markets more liquid.  Again, sorry to disappoint.

Inter-dealer Trading

Dealers rely on each other to supply liquidity to the OTC market. That is, as mentioned above, it is unlikely that any one dealer’s clients will demand a perfectly balanced set of products. As a result, dealers rely heavily on their ability to trade with each other, and smooth over any imbalances in their books. And because of this heavy inter-dealer trading, swap markets have a lot of inter-dealer credit risk, which means that dealers are exposed to the risk that another dealer will default. In general, counterparty risk, which is the risk that the party you’re trading with won’t pay as promised, is of paramount concern in the swap market. The general market practice is and has been to require your counterparty to post collateral based on daily mark-to-market valuation against the relevant spread. But dealers are so important to the market and their positions are so large that even well-collateralized positions that fail to payout in full can have disruptive, even devastating effects. As a result, a central counterparty (CCP) has been set up, which acts as a heavily capitalized hub through which trades are channeled, and most importantly, netted against each other. Right now, there is only one CCP and it is dedicated to a subset of the CDS market. Other CPPs may very well follow. For more on CCPs, go here.

The image below, which does not take into account any CCP, provides an overall graphical representation of the OTC swap market, with dealers performing the classic bank-style role of intermediary between end-users of financial products.

One thing you should notice about the image above is that the swap market connects otherwise disparate parties in the financial system. This has the beneficial effect of providing each with the risk profiles they desire. But it also has the effect of causing the entire system to assume the credit worthiness of the entire system. In other words, as I mentioned above, swaps create exposure to counterparty risk, which is in essence credit risk. One of the obvious-in-hindsight lessons of this crisis is that counterparty risk is highly correlated to macroeconomic credit risk. That sounds fancy and deep, but really it’s just restating the obvious: counterparty risk is a type of credit risk, and so, as the overall risk of default rises, so does the risk of counterparty default. This means that CDS protection sellers are least likely to payout at the very moment they’re obligated to: upon someone else’s default. That said, the OTC derivatives market – the CDS market in particular – has done a simply incredible job of maintaining functionality through even the worst parts of this crisis and has adapted quickly to increase liquidity and administrative efficiency. While those outside the industry seem convinced there’s some kind of trillion-dollar ruse going on, that is certainly not the case. The OTC derivatives market is an invaluable and remarkably sophisticated market that adds real value to the financial markets and the world’s economies. Without it, our lunch will get a lot more expensive.

Understanding Obama’s Financial Overhaul

Also published on the Atlantic Monthly’s Business Channel.

Joe Nocera has said his peace with respect to Obama’s proposed overhaul of the financial system. And in doing so, he expressed disappointment with several aspects of the proposal. In particular, he is displeased that the proposal “doesn’t attempt to diminish the use of … bespoke derivatives.” That certainly sounds ominous. But it’s also not true.

The proposal calls for increased capital charges on bespoke trades, which is a strong incentive away from them. But frankly, I’m sick of writing about the proposal. So rather than regurgitate and parse the administration’s plans for financial regulation, I’d like to take a moment to get familiar with some of the key concepts at play in the proposal, so that you can read it and come to your own conclusions. The two core areas I focus on here are derivatives and regulatory capital. With an understanding of these two areas, you should be able to get a grasp on what the administration is thinking and what effects the proposal will have in practice.

OTC Derivatives

I write about OTC derivatives pretty often, so rather than reinvent the wheel, I’ll shamelessly reuse a piece of introductory text I have handy:

A derivative is a contract that derives its value by reference to “something else.” That something else can be pretty much anything that can be objectively observed and measured. That said, when people talk about derivatives, the “something else” is usually an index, rate, or security. For example, an option to purchase common stock is a fairly well-known and ubiquitous derivative. So are futures for commodities such as pork belly and oil. However, these are not the kind of derivatives that [the proposal] is talking about. [The proposal] is talking about OTC derivatives, or “over the counter” derivatives. This category of derivatives includes the much maligned “credit default swap” market, as well as other larger but apparently less notorious markets, such as the interest rate and foreign exchange derivatives markets. The key defining characteristic of an OTC derivative is that it is entered into directly between the parties. This is in contrast to exchange-traded derivatives, such as options to purchase common stock. Highly bespoke OTC derivatives are often negotiated at length between the parties and involve a great deal of collaboration between bankers, lawyers, and other consultants. For other, more standardized OTC contracts, commonly referred to as “plain vanilla trades”, contracts can be entered into on a much more rapid and informal basis, e.g., via email.

For the limited purpose of wrapping your head around the world of derivatives, think of all derivatives as being in one of three broad categories: (1) exchange-traded derivatives (e.g., options on common stock and futures on pork belly); (2) standardized OTC contracts (e.g., your basic credit default swap); and (3) bespoke OTC contracts (transaction specific, often more complex instruments).

In fairness to Nocera, he’s not the only one weary of the third category of bespoke derivatives. But that doesn’t make his fears justified. So why do firms use custom made derivatives instead of just settling for an exchange traded derivative or a standardized swap? Despite uninformed opinions to the contrary, there are a lot of legitimate reasons for using custom derivatives. The most basic reason is what’s known as basis risk. The term refers to the risk that the difference between two rates will change. In the context of OTC derivatives, it usually refers to the risk that a hedge is imperfect. For example, a commodity user, like an airline, would like to lock in the price of jet fuel delivered to a terminal near an airport in northern California. However, the only exchange traded futures contracts available track the price of delivery to the Gulf Coast.  While we would expect these two rates – the price of delivery to CA and the price of delivery to the Gulf Coast – to be correlated, there are all kinds of events, e.g., supply disruptions, that can affect one price without affecting the other. As such, using an exchange traded future would expose the airline to basis risk. By using a customized product, the airline can more perfectly hedge its exposure to the price of local fuel.

At this point, most of the bozo pundits would say, “just move all the customized trades onto an exchange!” That’s a fine idea, but it has the unfortunate feature of being impossible. In order to have an exchange, you need a lot of liquidity, or simply put, a lot of people trading perfectly fungible assets. The reason you need perfectly fungible assets is that it allows buyers and sellers to be matched on a rapid basis without any communication between them.  Without a lot of people trading perfectly fungible assets, you don’t have a market where you can easily buy a new position or sell your current position, and therefore, you cannot have an exchange. Because bespoke derivatives are often one-off deals, hedging extremely specific risks, there is no market where they can be traded, for the simple reason that they are all unique and only useful to the parties to the original transaction. And so, bespoke derivatives are useful products that cannot always be substituted with exchange traded or standardized OTC products.

What Is Regulatory Capital?

There’s a lot of talk about regulatory capital in Obama’s proposal. So what is regulatory capital? In short, it has to do with how banks finance their operations. Banks are businesses. And like all businesses, they have investors that contribute money to the business. In the parlance of banking regulation, the money that investors contribute is called capital.  This capital can come in various forms, despite the fact that it’s all cash. The form of the capital is determined by what the investor expects in return for his capital contribution. For example, equity capital comes from investors who expect to share in the profits of the bank. That is, after all of the bank’s expenses and debts are paid, the equity investors get their share of what, if anything, is left over. Capital could also come in the form of debt. The bank’s debt investors, commonly referred to as creditors, expect regular payments in return for their investment, regardless of whether or not the bank generates a profit. As such, they get paid before any of the equity investors get paid. Because of this, we say that debt is higher in the capital structure of a bank than equity. But of course, life is a lot more complicated than simple debt and equity. And so, banks make use of a broad range of financing that falls in different places along a continuum from pure senior debt (the top of the capital structure) to pure subordinated equity. As money gets generated by the bank’s activities, that money gets pushed down the bank’s capital structure, paying investors off in order of seniority.

In the magical world of academia, capital structure isn’t supposed to matter much. But as Michael Milken reminds us, in the real world, capital structure matters, a lot. Firms that finance their activities with a lot of debt will have high fixed obligations, since creditors don’t care if you make a profit or not. They invested on terms that assured them payment, come hell or high water. And while they might not be as intimidating as the Goodfellas, creditors have a lot of power over firms that fail to pay their debts. These powers range from seizing assets pledged as collateral to forcing bankruptcy upon the firm. Obviously, these kinds of events are disruptive to a firm’s business activities. And as this crisis has taught us, the business activities of banks are pretty important. Fully aware of this, the world developed what are known as regulatory capital requirements. What these requirements do is place restrictions on the capital structure of banks based on the riskiness of the bank’s activities. As you would expect, the rules that implement these restrictions are very complicated. But the general idea is fairly intuitive: as the riskiness of the bank’s activities increases, the bulk of the bank’s financing should move down the capital structure, towards equity. This makes sense, since a bank that is running a high risk operation shouldn’t be promising too many people regular income, since by definition, their cash flows are unstable. As such, a high risk bank should make greater use of equity, since equity investors only expect their share of the profits, if and when they appear.

Most of the developed world has adopted some version of the bank capital regulations known as the Basel Accords, written by the Bank For International Settlements. Under the Basel rules, assets are assigned a weight, which is determined by the asset’s riskiness. “No risk” assets, such as short term U.S. Treasuries, are assigned a weight of 0%. High risk assets can have weights over 100%. The rules then look to the capital of the bank and break it up into three Tiers: Tier 1, Tier 2, and Tier 3. Tier 1 is comprised of pure equity and retained earnings, the absolute bottom of the capital structure; Tier 2 is comprised of financing that’s almost equity, or just above Tier 1 in the capital structure; and Tier 3 is comprised of short term subordinated debt, or the lowest part of the capital structure that can be fairly characterized as debt. Anything above Tier 3 doesn’t count as capital for the purposes of the rules.

When a bank buys an asset, they are generally required to assign a capital charge to that asset equal to 8% of the value of the asset multiplied by its risk weight. Half of the capital they set aside must come from Tier 1. So for a $100 loan with a risk weight of 50%, the bank that issued or bought the loan would need to set aside 8% x 50% x $100 = 8% x $50 = $4 worth of regulatory capital, at least half of which must come from Tier 1.

So regulatory capital requirements are a matching game between a firm’s assets and its capital structure. The more capital a firm has to set aside to purchase an asset, the fewer assets it can purchase. This means that heightened regulatory capital requirements will restrict a firm’s ability to generate returns on its capital. Well aware of this, Obama’s proposal uses regulatory capital as a tool to push firms away from certain practices. For example, as mentioned above, the proposal calls for increasing the capital charge for bespoke trades. It also threatens firms that are “too big to fail” with the spectre of overall heightened capital requirements. While Nocera thinks this is an empty threat, not everyone is so confident. But in any case, go read it yourself, at least the summary, and come to your own conclusions.

The Shadow Banking System That Operated In Broad Daylight: Part I

Also published on the Atlantic Monthly’s Business Channel.

Mark Thoma and Brad Delong are completely entrenched into the position that this crisis was brought on by the nefarious “shadow banking system.” In fairness to Thoma, he is trying quite sincerely to argue his point, and I think my disagreement with him stems mostly from my objection to labeling particular aspects of the financial system as “shadow banking.” That said, I do take issue with a few of his substantive points. Rortybomb does a fine job summarizing the recent history of this debate, highlights some of the strengths of Thoma’s position, and also clarifies the debate by providing a reasonable framework for what it is that people are referring to when they talk about the “shadow banking system.”

As for Delong, his argument takes the form of an excursion through unmitigated nonsense, as he boasts his deep knowledge of comic books, and little else. As such, in this post, I’ll begin with Delong’s argument, since it is completely unfounded. In the next post, I’ll take on Thoma’s position, as it warrants more attention and represents an opinion held by a lot of intelligent people. I just happen to disagree.

So here goes Delong:

[C]ommercial banks–with their massive retail savings deposits–have for the most part come through this all right. In fact, the possession of lots of inertial commercial savings and checking deposits that they did not have to worry might flee provided JPMorgan (with the retail banking assets of Chase) and the bank formerly known as NationsBank (with the retail banking assets of Bank of America) with competitive advantages that allowed them to pick up the assets of Bear Stearns and Merrill Lynch at what they thought were bargain prices.

Wow, those are some seriously important-sounding terms there. We’ve got “massive retail savings deposits,” “competitive advantages,” and don’t forget those “inertial commercial savings and checking deposits.” How could deposit taking banks fail with all that going for them?  Surely, deposit taking banks are doing swell! And, they are, with the noted exception of the seemingly endless list of failures that have occurred at deposit taking banks over the last 2 years. But there are even more inconvenient aspects of the observable universe that Delong must tackle before we can accept his deposits-cure-all theory of banking. For example, U.S. banks and bank holding companies are currently receiving all kinds of direct and indirect support from the U.S. government through the alphabet soup of liquidity and guarantee programs that have been set up since the crisis got underway. Also, it is my understanding that European banks, while more leveraged than their U.S. counterparts, rely much more on deposits than U.S. banks do. Yet, the European banking system is suffering a crisis that rivals our own by several measures.

Delong’s position seems to be just another manifestation of the idea that, somehow, good old fashioned banking is the answer. Deposits and lending, and that’s it. None of this fancy stuff. That has a nice ring to it. It’s sentimental, makes us think that our parents are smarter than us, and it has an almost sanctimonious aspect to it, in that it suggests that if we part with some of the more luxurious aspects of finance, we can have some more stability. However, history has a few counterexamples to this position, one being the Great Depression.

While others chalk this crisis up to SIVs, CDOs, and a bunch of other acronyms they really don’t understand, I see it in much simpler terms: banks, and others in the financial system, all made the same bad bet based on unsustainable assumptions. Sure, some of them made this bet using sophisticated means, and that itself is a topic worth exploring. But the root cause of all of this, in my opinion, is underestimating risk. This underestimating had heavy assistance from some very regulated entities and markets. As such, I reject the argument that the “shadow banking system” caused this crisis for two reasons: first, everyone that mattered and could do something about what was going on knew full well what was going on. So how is it productive to ascribe such a mysterious sounding name to something that people were fully aware of? And second, the root cause of this crisis is, in my opinion, much easier to grasp once we reduce all of the complexities to simpler constructs, and think in terms of what risks entities and markets were exposed to, and for that limited purpose, ignore the means by which they were exposed to those risks.

Hey Financial Times, Get Your Derivatives Lingo Straight!

Also published on the Atlantic Monthly’s Business Channel.

Yet another news organization has mangled Tim Geithner’s plan for over-the-counter (OTC) derivatives. This time, it’s the Financial Times. A few people at the FT have done a great job covering derivatives, particularly Gillian Tett and the folks at FT Alphaville. But the FT article in question makes the same mistake that NPR made, which is to conflate a Central Counter Party (CCP) with an exchange. The article states that because Geithner’s plan will -

require clearing of “all standardized OTC derivatives through regulated central counterparties,” [it] marks a sweeping change to the way OTC derivatives are handled, implying a shift away from the dealers at banks who brokered such contracts to the formal exchanges that have long jealously eyed the huge OTC markets.

That is false. A CCP is not an exchange. A CCP is somewhere that trades get moved to after they’ve been executed.

First the trades are executed directly between the parties, then they get moved to a CCP. So, under Geithner’s plan, trades cleared on a CCP would still be entered into between buy-side clients and OTC dealers. This means that the dealers are not losing business to exchanges, at least not under this part of Geithner’s plan. In fact, the market has already started moving dealer-to-dealer trades onto CCPs in anticipation of this kind of regulation.

If you’re interested in reading more about CCPs, you can read my break down of Geithner’s plan here and another article on the benefits of CCPs here.

Could Government Intervention Help Markets Function Better

Also published on the Atlantic Monthly’s Business Channel.

If free markets never fail, there’s no inherent need for government intervention, though we might object to the resultant wealth distribution on moralistic grounds. But if markets do occasionally fail, then it’s possible that government intervention could be used to realign incentives, and “nudge” the market to a higher order equilibrium.

View From An Ivory Tower

Neoclassical economists believe that only a few types of market failures are possible, no matter how often reality disagrees. In particular, neoclassical economists reject the idea that coordination failures can occur. A coordination failure can be roughly described as a scenario where each individual in a group acts in a way that maximizes its own expected outcome, but by doing so fails to maximize the expected outcome of the group. You might ask, how is it possible for everyone to do their best and still reach an outcome that is inferior to some other outcome? The answer is: a failure to coordinate. That is, just because everyone does their best individually does not imply that the group as a whole will do its best collectively. This is a very simple concept with a lot of intuitive appeal. Yet, neoclassical economists reject coordination failures as a possibility, since they argue that if it is profitable for coordination to occur, it will. That also has a lot of intuitive appeal, which is why that theory stuck around for so long. But neoclassical theory doesn’t describe the world we live in, which is filled with crooks, liars, and idiots. It describes an idealized world where people can overcome their short-term expectations and desires, collaborating whenever it’s profitable, inadvertently advancing the greater, long-term common good.

About As Far As I Can Throw You

There are a variety of real world scenarios where a failure to coordinate can occur. The most basic example is when the parties simply don’t trust each other. For example, I would rather pay you to paint my house than paint it myself; and you would rather be paid cash for painting my house than sit around all day. But what I would prefer most of all is to have my house painted for free; and what you would prefer most of all is to get paid for doing nothing. That said, both of us could be better off than we currently are if I paid you to paint my house. However, one of us has to take the risk that the other won’t perform. That is, I pay you today and you take the money and run; or you paint my house today and I tell you to piss off when you’re done. If either of us expects that the other will not perform, we will not coordinate.

Free market zealots would argue that reputation alone is sufficient to solve this problem. That is, if either of us fails to perform, we will have a bad reputation, and in the future others will not trust us. That would probably work in a tiny village where everyone knows everyone else, travel is infrequent, and therefore reputations are easy to track. But in the developed world, it’s impractical and creates a fantastic opportunity for those willing to move around a lot pretending to be a painter. Moreover, even if it were practical, any system based on reputation alone would favor incumbents and make it very difficult for new entrants to compete, since no one wants to be the first to find out that their painter is actually a career swindler. So what’s the solution? Enforceable contracts. That is, the government, which has all kinds of power over its citizens, can force you to perform under your agreements. In this respect, the existence of government solves a basic coordination problem by supplanting bilateral trust. But this mechanism doesn’t completely eliminate the issue of trust, it just substitutes the mutual trust of the parties with their trust in the government. That is, I will trust that my contract is valid and enforceable insofar as I believe in the government’s ability and willingness to enforce it. This whole government substitution process can be viewed as a variation on the reputation game. But in the context of governments enforcing contracts, keeping track of reputation becomes practical, since it’s fairly easy to keep track of the enforcement records of a handful of governments. As such, enforcing contracts is, in my opinion, a necessary form of government intervention into otherwise free markets.

Better Than Worse

I am more than willing to concede that the market, when left to its own devices, could arrive at an equilibrium that is suboptimal. That is, the aggregate effect of market participants making (hopefully) rational decisions does not necessarily produce the best possible outcome. Again, neoclassical economists reject this since they view price as the only element required to properly coordinate market participants. But as I’ve argued in the past, and as recent events suggest, prices are also affected by coordination failures. So what’s the solution? Here’s the classic law school answer: it depends.

There are some obvious examples where the disparate bargaining power and levels of sophistication between parties warrant regulation to prevent unsophisticated parties from getting screwed or even physically injured by extremely sophisticated parties, even if the former are not technically mislead. That said, when sophisticated parties are dealing with other sophisticated parties, the case for regulation is much weaker. And it’s not because sophisticated parties know everything. It’s because they probably know more than the government, and have a lot more to lose, since governments have control over entities which they do not own (insert joke here), and therefore they can act upon those entities without bearing any direct financial consequences that spring from their actions. Moreover, there’s no reason to think that regulators and legislators aren’t subject to the same incentive quagmires that occur in markets.

Even if regulation is well intentioned, the risks of getting regulation wrong are enormous. Literal compliance with the letter of the law allows market participants to wash their hands of any other actions, and creates a false sense of security in their counterparties. For example, the popular wisdom seems to be that this crisis was caused in large part by the deregulation of the financial sector that occurred under the Clinton administration. That argument has one thing going for it that is impossible to refute: the crisis occurred after the Clinton administration left office. But this position ignores the possibility that this crisis wasn’t the product of an absence of regulation, but rather the omnipresence of poor regulation. For all the talk of systemic risk, very little emphasis is being placed on the fact that the regulatory regime in place prior to the crisis – and still in place now – gave rating agencies systemic influence. Because ratings were woven into almost every aspect of the regulatory regime, particularly those that determined whether a bank has adequate capital, any errors in those ratings would have systemic consequences. And it seems that they did. The Atlantic’s own Dr. Manhattan has already done a fine job exploring that subject, so I’ll spare the world my opinions on the matter.

So what’s the take-away? It depends. As a general matter, I’m opposed to the idea of governments having an active role in markets, particularly setting prices. But then again, if it weren’t for the FED, I’d be hunting deer on Park Avenue instead of writing this article. So like I said, it depends.

How NPR Mangled Geithner’s Plan For OTC Derivatives

Also published on the Atlantic Monthly’s Business Channel.

Timothy Geithner has released his proposal on how to regulate the OTC derivatives market. The proposal is broad in its scope and the regulations proposed would have a profound impact on market practice if implemented. Despite this, the sleuths at NPR claim to have discovered a “huge loophole” in the plan. I’ve also been studying both Geithner’s proposal and the NPR article on the subject, and the only holes that I found were in NPR’s understanding of the OTC market. In order to fully understand the earthly implications of Geithner’s policies and the gargantuan errors made on Planet Money, we should probably understand what the OTC derivatives market is. So, let’s begin with a brief overview of what the OTC market is and what it isn’t.

What Is An OTC Derivative?

A derivative is a contract that derives its value by reference to “something else.” That something else can be pretty much anything that can be objectively observed and measured. That said, when people talk about derivatives, the “something else” is usually an index, rate, or security. For example, an option to purchase common stock is a fairly well-known and ubiquitous derivative. So are futures for commodities such as pork belly and oil. However, these are not the kind of derivatives that Geithner is talking about. Geithner is talking about OTC derivatives, or “over the counter” derivatives. This category of derivatives includes the much maligned “credit default swap” market, as well as other larger but apparently less notorious markets, such as the interest rate and foreign exchange derivatives markets. The key defining characteristic of an OTC derivative is that it is entered into directly between the parties. This is in contrast to exchange-traded derivatives, such as options to purchase common stock. Highly bespoke OTC derivatives are often negotiated at length between the parties and involve a great deal of collaboration between bankers, lawyers, and other consultants. For other, more standardized OTC contracts, commonly referred to as “plain vanilla trades”, contracts can be entered into on a much more rapid and informal basis, e.g., via email.

For the limited purpose of wrapping your head around the world of derivatives, think of all derivatives as being in one of three broad categories: (1) exchange-traded derivatives (e.g., options on common stock and futures on pork belly); (2) standardized OTC contracts (e.g., your basic credit default swap); and (3) bespoke OTC contracts (transaction specific, often more complex instruments).

The “Huge Loophole”

NPR claims that Geithner’s proposal has a “huge loophole”, which they uncover through the following summary:

- Banks and other players have to tell the government when they buy and sell these derivatives. That means the government can know how many are out there and who has them.

- If banks and others are buying and selling standardized derivatives, they must trade them on an exchange, sort of like how stocks are traded on an exchange. That way it’s more transparent and the prices should more accurately reflect the market sentiment.

- But — and here’s the big but — banks and others are perfectly free to continue trading custom-made derivatives as private transactions between two parties.

In case you didn’t catch it, that last part was supposed to be the clincher. But before we can appreciate why it’s not a clincher, we need to do a bit more homework on the OTC market. In Geithner’s proposal, there’s a lot of talk about CCPs, or “central counterparties.” These are often incorrectly equated with exchanges. CCPs are not exchanges. They are exactly what their name suggests: a central counterparty for swaps of a particular type. After two parties enter into an OTC trade together, they novate, or more colloquially, move their trades to the CCP. So unlike trades executed on an exchange, CCP trades are entered into directly between the two parties, but later shifted over to the CCP. There are a lot of reasons why this is done, and they’re beyond the scope of this article. But if you’re interested in reading more about CCPs, go here. The key take-away is that CCPs are not exchanges, but more like risk repository/management systems where trades get moved to after they’re executed.

So, NPR believes that because OTC market participants are not forced to trade on exchanges, their trades will continue to be unnoticed and unregulated. This is completely false for two reasons: first, trades that are capable of being moved to a CCP would be required to be moved to a CCP under Geithner’s plan; second, even if they weren’t, Geithner’s plan calls for all OTC trades, including those in the third bespoke category, to be recorded in what are known as “trade repositories,” such as DTCC’s Deriv/SERV. Here is the relevant language from Geithner’s proposal:

[I]f an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.

[A]ll trades not cleared by CCPs [are] to be reported to a regulated trade repository.

This is in contrast to NPR’s second point above, which asserts that all such trades would be traded on an exchange. That is wrong. What this says is: all trades that can be moved to a CCP (not an exchange) should be, and it will be assumed that this is required; and if they’re not moved to a CCP, they have to be recorded in a trade repository. So, by definition, this proposal would make regulators aware of every single trade in the OTC market since every trade is either on a CCP, in which case the CCP will record its existence, or not on a CCP, in which case the trade repository will record its existence. But how do we explain NPR’s blunder in their third point? That blunder comes from yet another equivocation between a CCP and an exchange. The relevant language from Geithner’s proposal is as follows:

[Relevant laws should be amended to impose] the encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

NPR hones in on the “encourage” language, taking this to mean that market participants will have a choice between using an exchange or being unregulated financial pirates. Of course, those swashbuckling financiers will choose the latter. As I’m sure you’re starting to see, this is a false dilemma. What Geithner is suggesting here is that regulated institutions avoid the OTC market altogether, and make use of derivatives from the first category above (the exchange traded ones). Of course, such a policy should be suggestive and not prescriptive, because contrary to popular belief, OTC products serve legitimate needs that exchange traded products don’t meet, at least not yet.

Customized Misinformation

No finance bashing story is complete without a kooky conspiracy theory, and so in order to fulfil the meme, NPR offers us an explanation as to why those crazy credit default swaps are so darn complex:

It seems reasonable to expect that every single sales team on Wall Street will work very hard to convince their customers that they have Very Special, One-Of-A-Kind Credit Derivatives that are far better than the boring old ones traded on the exchange.

Unfortunately for NPR, this is complete nonsense. The vast majority of credit default swaps are completely standardized and have been for a while. Recent changes to how CDS are priced has increased fungibility even further. In fact, one of NPR’s commenters actually pointed this out. The NPR commenter writes:

Virtually ALL CDS contracts are standardized. Which is to say that I can open a position with Goldman Sachs and unwind that position at Citigroup. These instruments will be covered under the Obama proposal and are well suited to being exchange traded. Are there bespoke products available in the derivative market place? Absolutely. But they account for a minuscule portion of the overall business.

But NPR doesn’t stop there. Acknowledging the possibility (fact) that they are wrong about standardized CDS, they go on to claim that:

[Even assuming the commenter] is right (he probably is) and most currently-traded CDS would qualify for a new exchange or clearinghouse; it seems fair to guess that lots of CDS operations will be looking for ways to avoid that clearinghouse and all the extra regulation and transparency and lowered commissions it brings with it.

Yet again, unfortunately for NPR, that is more nonsense. The major swap dealers have already set up a CCP on their own, before regulators required them to do so, and are currently moving trades to it. Swap dealers do not make money by over-complicating products and duping trillions of dollars worth of capital. They make money by creating a market. That is, they buy and sell swaps, creating a market, and pocket the difference between the prices at which they buy and sell. If you want to use jargon, you would say they create “liquidity” for swaps. That’s their business. Making complicated products that aren’t fungible does not advance that business model. Even more importantly, as we noted above, Geithner’s proposal wouldn’t let them off the hook simply because they used bespoke products. If the trade is accepted on a CCP, it is presumed to be required to go there. And even if it’s not, it gets reported anyway.

Clearly Planet Money doesn’t think it’s a very good proposal. But in my humble opinion, it’s at least a reasonable proposal for the residents of planet Earth.

Boring Banking Will Not Save You

Also published on the Atlantic Monthly’s Business Channel.

Paul Krugman wants us to believe that by making banking boring again, we can prevent another crisis from occurring in the future. Although Krugman doesn’t provide any clear definition of what it means to make banking boring again, the context suggests that he is pushing for a return to a simpler and smaller banking sector. As such, Krugman offers up a very comforting theory, since the benefits of making banking boring are twofold: ridding us of devastating downturns while simultaneously smiting those greedy bankers. So in addition to fitting nicely into the fashionable banker-bashing meme, Krugman’s argument provides comfort in that it suggests the problem has already been identified and has a simple fix. Unfortunately, making banking boring again would probably have a devastating affect on the availability of credit, particularly at the consumer level, and won’t do a thing to stop asset bubbles from occurring in the future.

Krugman paints the recent history of banking with broad strokes – in contrast to James Surowiecki’s reasonably detailed article on the subject – drawing primarily on what is little more than the coincidence of boring banking and economic stability. In essence, he claims that we did our best when banking was boring. Presumably, we are to infer that this coincidence compels us to accept that boring banking is indeed the cause of economic stability. Answering such a complex question with such a simple and obviously flawed form of argumentation would normally smack of idiocy. But in Krugman’s case, it smacks of paternalism. Krugman is undoubtedly smart enough to know that abstracting from historical coincidences is an unacceptable method of discovering theories of causation, even for an economist. So, with this, I invite Mr. Krugman to explain why boring banking is superior to interesting banking. In the meantime, here are some things to consider before smashing banking back into the Stone Age.

Securitization And The Capital Markets

Securitization takes money from the capital markets and funnels it into the consumer credit market by bundling individual loans, lines of credit, and mortgages that would otherwise be unattractive to investors on a piecemeal basis. Tremendous sums of money are funneled to consumers using this process, particularly in the mortgage space. If the boring banking regime precludes securitization, we can expect this capital to either sit idle or go elsewhere, thereby depriving consumers of credit and spending power.

Bubbles Are Nothing New

Markets experienced bubbles long before credit default swaps and securitization were even a glimmer in a greedy banker’s eye. And so stripping bankers of the tools and techniques of modern finance will do nothing to stop them from occurring again. Whether it’s tulips, internet stocks, or spec houses, humans create investment fads that skew prices upwards and create value out of thin our. Then, once the jig is up, prices tank, and those still dancing are left holding the bag. And so, every asset bubble will create a class of losers: those who bought during the boom and held on past the bust. In my humble opinion, the severity of this bust will turn on who’s in that class of losers. If that class of losers turns out to be a group of individuals or businesses that perform a vital function in the economy, e.g., lending, we should expect the effects of the bust to be pretty severe. At this juncture, a boring banking argument could be made. That is, we don’t want banks to be heavily exposed to asset bubbles popping, whether it’s through lending or direct ownership. But this is no different than saying that we don’t want banks to make too many risky investments, since systemic bank failures have severe consequences. So even in the context of bubbles, it’s not the complexity or sophistication of banking that is at issue, but rather the accuracy of valuations and the adequacy of the capital that banks set aside in anticipation of losses.

The Suggestion Box

I realize that many of you have questions about the financial markets that I probably have yet to answer. As such, I’m taking requests. So please leave a comment below and let me know what you’d like me to write about. If there are any topics that prove to be of common interest, I will write something about them. Depending on the level of feedback, this might be something I’ll do again.

Regards,

Charles

Rethinking Central CDS Counterparties

Also published on Cluster Stock

Regulators have been largely supportive of the credit default swap market’s efforts to move all standard CDS (a.k.a. “vanilla” CDS) contracts onto a central counterparty (CCP). Within a relatively short amount of time, the CDS market garnered the support of both the SEC and the Federal Reserve, setup shop, and executed CDS transactions totaling $71 billion in notional amount on ICE Trust LLC (ICE), the first of what could be a handful of CCPs. Given that the CDS market is still serving time on the pillory, this kind regulatory largess seems to imply that a CCP must undoubtedly be a good thing. However, not everyone is convinced. In a recent paper, Darrell Duffie and Haoxiang Zhu of Standford University described the state of affairs with and without a CCP in mathematical terms, proposed a measure of efficiency which they use as a proxy for counterparty risk, applied this measure to each state of affairs, and came to conclusions that are surprising, but not counterintuitive once you take a moment to consider the trade-offs between a distributed dealer system and a CCP.

There are two central points in their paper: (1) the benefits of having a CCP compared to not having a CCP (the distributed dealer system) is a function of the number of dealers (i.e., the more dealers, the more the system benefits from having a CCP) and that the current number of CDS dealers might be too small to realize any benefits from a CCP; and (2) even if having a single CCP is more efficient than not having one, having more than one CCP is never more efficient than having none at all. The assumption underlying these two points is that having a CCP as opposed to not having a CCP is in essence a choice between (i) multilateral netting across a single asset class and (ii) bilateral netting across multiple asset classes. After a bit of back and forth with Duffie, I agree that this is the case, but only in the short term. That is, there is nothing about a CCP that precludes netting across asset classes, even if the current model doesn’t facilitate it. I also disagree with the two central conclusions, mostly due to shortcomings of the model that the authors acknowledge in their paper. Specifically, they acknowledge that their model doesn’t deal with so called “knock-on effects,” or simply put, how one dealer default can lead to another. I also disagree with how Duffie and Zhu measure the benefits of netting, but we’ll spare our brains the heavy lifting and focus on the more practical issues. In this article, I’ll focus on explaining why a CCP does not preclude netting across asset classes. In a follow up article, I’ll explain how a CCP mitigates counterparty risk by facilitating trade compression.

What Is A Central Counterparty?

Rather than provide a one line, academic definition, I’ll proceed gradually, and by way of example. For starters, a CCP is not an exchange. Even with a CCP, inter-dealer trades will still be entered into between dealers, and price discovery will still take place across dealers. That is, dealers will still trade with each other, at least initially. After two dealers enter into a CDS trade, they will transfer, or “novate” their positions to the CCP. For example, in the prototypical CCP transaction, if Dealer A sells protection to Dealer B, each dealer would then novate its position to the CCP. After the novation, the state of affairs is such that A sells protection to the CCP and the CCP sells protection to B. When payments are made on the CDS, they get made to the CCP and then passed on to the parties.

At first blush, it might seem like all we’ve done is throw an extraneous and useless 3rd party into the transaction that does little more than operate as a conduit. However, this is not the case. The CCP is a distinct entity that has an interest in its own survival, and since the CCP is now liable to both dealers, it has an interest in being well-capitalized. While individual dealers also have an interest in being well-capitalized, they are unable to determine whether the CDS market as a whole is well-capitalized. And even if they were able to determine whether or not that is the case, each individual dealer has no power to convince others to increase the capital allocated to their positions. By centralizing all of the trade information into one entity and giving that entity control over the levels of collateral that dealers must post, we have created a method through which we can better ensure the adequate capitalization of the entire CDS market. For example, if one dealer is unable to fully collateralize its positions, the CCP can draw on its own capital and the capital of the other dealers to make up for the shortage. Without a CCP, that shortage of collateral would probably trigger events of default, which could “knock-on,” or cascade through the market. But as always, there’s no free lunch, and despite all of this upside, we have also concentrated the risk of counterparty failure.

Payment Netting And Payment Settlement

As Duffie and Zhu note, dealers net their payments and collateral across different types of vanilla swaps. So, for example, if Dealer A owed Dealer B $5 under a vanilla interest rate swap on some payment date, while Dealer B owed Dealer A $3 under a vanilla CDS, A would simply pay B $2. This type of bilateral netting across asset classes reduces the risk that dealers will default when compared to not having such netting because it reduces the total amount of cash that is needed to meet payment obligations. Duffie and Zhu argue that because CCPs segregate vanilla CDS trades from all other types of vanilla swaps, we miss the opportunity to net across asset classes. This is not necessarily the case.

First, we need to distinguish between the entities that are liable for the trades (i.e., the dealers and the CCP) and the entities that actually process the trade information and payments. In the case of ICE, trade information is processed by DTCC. After that trade information gets processed, DTCC submits payment instructions to CLS Bank, which actually handles the payments. So, the CCP itself is not able to net payments across various asset classes, since it only handles CDS trades and moreover doesn’t actually settle the payments. However, DTCC will submit payment instructions to a settlement agent, CLS Bank, that actually handles the cash payments. CLS Bank could also receive payment instructions for other asset classes from the dealers (i.e., payment instructions on interest rate swaps, etc.) and net the payment instructions from the DTCC against the payment instructions from the dealers’ other activities. In fact, CLS Bank is also a leading settlement agent in the FX market.

In short, netting CDS contracts first does not preclude you from netting against other swaps later, especially since trading and settlement are handled by distinct entities.

The Sorry State Of The Dismal Science

Also published on the Atlantic Monthly’s Business Channel.

John Authers’ recent interview with University of Chicago professor Richard Thaler is a fine example of what I hope are broader trends in economic thought. To some, it might seem like just another interview. But Authers undoubtedly recognizes its significance. Thaler is a professor at the University of Chicago, which is the birth place of the Efficient Market Hypothesis, and Authers is a well-respected columnist for the Financial Times, which is arguably the voice of the free market in the press. And yet, there they are, casting doubt upon the very theories underpinning a generation of thought that have made the University of Chicago the epicenter of free market ideology. In the language of soda-pop-economics, this interview is a “black swan.”

It seems Authers is leaning ever closer towards a world view informed by behavioral economics. While I haven’t done any empirical research into Authers’ work, I do read his column, The Short View, religiously (personally, I recommend you do the same). And as the recent downturn developed, I noticed several articles that suggest he’s come to question at least some of the assumptions underlying the old free market dogmas, particularly the Efficient Market Hypothesis. In my opinion, this is a welcomed development. And I sincerely hope it is part of a broader trend away from grandiose theories about how humans make decisions and towards precise theories which are supported by real-world observations.

Those that have toiled through my writing in the past know that I am a big fan of free markets. Yet, I am not a big fan of the EMH. And in general, I find a lot of economic theory, particularly macroeconomic theory, to be little more than hand-waving. There’s an almost priestly air about it that makes me deeply suspicious of its validity. In gentler terms, Economics lacks a rigorous epistemological theory. That is, economists have no robust system of determining which statements about economics are true, and which are not. This is in stark contrast to say, mathematics. A statement about an alleged mathematical truth is verifiable (putting Gödel and Turing aside for the moment). If you tell me that you have discovered a new mathematical truth, you can sit down and in a finite number of words, provide a logical path from assumptions we both agree are true to your new found conclusions that I must accept as true, else I reject either the assumptions or logic itself. Now, I understand that economics can never be a purely deductive sport, since it is complicated by the nuance and uncertainty of, well, reality. But that doesn’t mean we can’t do better than simply assuming away all of human ridiculousness.

The economics that assumes rational behavior on the part of humanity is, in my opinion, dead. It is simply at odds with everyday experience. It’s arguable that the desire for wealth is itself an inherently irrational impulse for most of the developed world, given that our needs would likely be satisfied on public assistance. That said, those who are able to control their behavior and act rationally do a much better job at generating and accumulating wealth. But once they get the money, they go and do something absurd with it, like buy a fleet of planes. So while reason and deferred consumption might be the means by which we accumulate wealth, the end goal of accumulating wealth seems to be driven by a need to express dominance, or at least an antisocial impulse to be free of society’s constraints. This view finds support in popular culture, which often equates wealth with conspicuous consumption, sexuality, and control. All of this suggests that somewhere buried under all of those pinstripes is a real brute.

If I am correct, and there is a sea change taking place in how economists view human behavior and the markets humans create, then there may be a lot of quackery in the short term. That is, during the intellectual power vacuum that will follow the demise of the old Chicago School, a few crackpots might temporarily seize power as we trace our way from the four humors to phlogiston. But when we finally get our Lavoisier, this time let’s remember to keep his head on, despite our penchant for the irrational.

Cluster Stock

I’ve written an article for Cluster Stock on the benefits of central counterparties for credit default swaps. I might write for them in the future, so be sure to check them out.

Regards,

Charles

Credit Default Swaps and Control Rights, Redux

Also published on the Atlantic Monthly’s Business Channel.

Felix Salmon and I are usually on the same side of the jury box when it comes to the trial of credit default swaps. However, it appears we have reached an impasse concerning creditor control rights in the context of restructurings and bankruptcies. While that sounds like an awfully narrow issue to quibble about, the policy implications of this seemingly obscure issue are far reaching and call into question both the orderly functioning of the debt markets and the soundness of the current bankruptcy regime.

Let’s begin by outlining the issue at hand. In my previous article, I wrote:

Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC’s bankruptcy. The problem seems obvious: B either doesn’t care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.

In fairness to Felix, here’s his added qualification of the issue from his response to my article:

The problem is a bit more subtle than that, and is simply that bondholders who have bought CDS protection have much less incentive to participate in restructuring negotiations.

The key to understanding why we shouldn’t expect this change in incentives to lead to any material change in the restructuring process is rooted in the distinction between incentive to act and power to act. Clearly, anyone who expects to profit more from option A than B will choose A given the chance. And so, a bondholder who expects to receive a larger payout from CDS than from a restructuring will choose the CDS payout given the chance. But does that bondholder have any power to bring this result about? As a general matter, probably not.

One Is the Loneliest Number

Restructurings generally take place across the entire capital structure of firm. A firm could have multiple issuances of bonds, loans, and may even have other hybrid debt-equity financing. Each class of creditors has holders with certain control rights. While this complicates the restructuring efforts for the firm, since the firm will have to coordinate with various classes of creditors which may have competing incentives, it also mitigates the influence that any individual creditor/creditor-class can exert on the restructuring process. In addition, it usually means that the firm will require different thresholds of creditor approval from each class. For example, ABC concludes for a given restructuring plan that it needs the approval of 75% of class A holders, 60% of class B holders, etc. The actual threshold will be determined in large part by two main drivers: (i) the agreements that determine the rights of each creditor class (ii) and the number of on-board creditors needed to make the deal economically feasible.

So, even acknowledging the clear incentive on the part of those who stand to gain more from a bankruptcy than a restructuring, their impact on the success of the restructuring will be determined by their ability to affect the firm’s ability to achieve the required thresholds. Thus, their impact will be determined by their ownership stake in the debt. And so, in order for Felix’s argument to be taken as a serious point of concern, we must posit the existence of a class of hedged creditors who stand to gain more in bankruptcy than restructuring that is so large and well coordinated that it is able to obstruct the restructuring efforts of the firm and those creditors that stand to gain more from restructuring than bankruptcy. While not impossible in a nominal sense, this strikes me as a rather fortuitous state of affairs.

Bankruptcy Is Not A Sure Bet

In analyzing the incentives of the participants, Felix assumes that bankruptcy is certain in the case that a restructuring fails. This is not necessarily the case. He wrote:

I might end up with just 45 cents on the dollar — $450,000 — if I agree to the company’s [restructuring] plan. If I just let it go bust, on the other hand, I get $600,000 [from CDS]. And so I have an incentive to opt for the more economically-destructive option.

Every filing for involuntary bankruptcy is reviewed by a judge and can be contested by the debtor. And CDS don’t payout until judgment is entered against the debtor. That means payout under a CDS as it relates to bankruptcy is an uncertain event. That means that your expected payout should be discounted by the probability that the event will occur. So in the example above, the expected payout should be some fraction of $600,000, which could easily bring it below the $450,000 indifference point.  What’s worse, that probability might be impossible to calculate for your average bondholder, which holds its bonds passively and is not likely to have access to up to the minute progress reports on the firm’s financial condition or the restructuring process.

Review by a judge also means that only meritorious claims for bankruptcy will survive. And so, again, we run into the distinction between the incentive to act and the power to act. That is, whether or not someone would like a firm to go into bankruptcy, its ability to cause that to occur is restricted to only those circumstances where it would have been permissible anyway.

Covenant Thy Lender

In the previous article, I suggested that if companies were truly concerned about their creditors stocking up on CDS and fouling up restructurings, they could require the bondholders to promise to not hedge beyond a certain threshold. Felix responded with the following:

And Charles Davi’s idea that companies could somehow constrain their creditors from buying credit protection is even sillier — and probably illegal. The whole point of issuing bonds is that they’re tradable, fungible, and anonymously held. You can’t covenant up bondholders in the same way you can with bank lenders.

First, loans are covenant-heavy for the borrower, not the lender. That’s why companies like issuing bonds in the capital markets, as opposed to taking on loans. Second, without commenting directly on the legality of the scheme (though I’ll note that Felix cites no authority for his claim), it is common place in the MBS market for large, wrapped deals to condition voting rights on bona fide economic exposure. In a wrapped deal, there’s an insurer that guarantees payment on the bonds. If the bonds don’t pay, the insurer does. In these types of deals, the insurer controls all of the bondholders’ voting rights, unless the insurer defaults or goes belly up. So, what bondholders have in these deals are bonds whose voting rights are contingent upon their exposure to risk.

If CDS were truly a problem in the context of restructuring, I would expect companies to issue bonds with voting rights contingent upon maintaining bona fide economic exposure, in a manner analogous to what is done in the MBS market. That said, I wouldn’t expect them to be very popular with bondholders.

Note that this voting restriction would not affect tradability or fungibility at all. The bonds would still be identical and therefore completely fungible.

The “Restructuring” Credit Event

Finally, Felix misstates the requirements for recovering under a restructuring. He wrote:

[A]ny restructuring as drastic as the one I described would count as an event of default — so owners of credit protection would get paid out either way.

That is simply incorrect. First, an “Event of Default” is distinct from a “Credit Event.” A Credit Event is caused by the issuer referenced in the CDS. An Event of Default is caused by one of the two parties to the CDS. The former triggers a payout under the CDS. The latter triggers a payout for damages, in essence for breach of contract. For example, if X and Y enter into a CDS naming ABC Co. as the reference entity, any failure by ABC to make a payment on its bonds would be a “Credit Event” and would trigger a payout, let’s say from X to Y. Any failure by X or Y to make a payment required under their CDS would be an “Event of Default.” The two concepts are completely distinct.

More importantly, Felix misstates the circumstances under which payout occurs. At the outset of a CDS trade, the parties will agree which Credit Events will cause a payout. And indeed, Restructuring is one type of Credit Event. However, only those parties who specifically elect Restructuring as a Credit Event will be entitled to payout upon the occurrence of a restructuring. As such, his analysis of the incentives of participants, which assumes that all trades include Restructuring as a Credit Event, is flawed.

Most importantly, if someone is using CDS to truly hedge against credit risk, they will elect to have Restructuring as a Credit Event. Assuming that this is the case, Felix’s entire argument is out the window, since in that case, the hedged creditor is either indifferent towards or, in the case he’s over-hedged, has an incentive to see the Restructuring succeed.

Credit Default Swaps and Control Rights

Also published on the Atlantic Monthly’s Business Channel.

Megan McArdle asks, “Do We Hate Credit Default Swaps for The Wrong Reasons?” As Megan notes, blaming credit default swaps for all kinds of things is quite fashionable these days, since simply uttering the term makes commentators feel sophisticated. While this is itself a topic worthy of discussion, the more interesting point in Megan’s article concerns how credit default swaps affect the incentives of bondholders in the context of restructurings.

The basic argument is as follows: Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC’s bankruptcy. The problem seems obvious: B either doesn’t care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.

At first blush, this looks like a serious loophole and a nice way to make some fast cash. Sadly, there are several reasons why this is not the case. The key factor to understanding why we shouldn’t expect this to be a major problem is to appreciate that there is no CDS vending machine. You cannot go to the market and demand credit protection on all of your bonds at your whim. You have to find someone willing to take the exact opposite position that you are taking. That is, if you bet heads they bet tails, by definition. As a result, if everyone knows the next toss is coming up heads, you probably won’t find someone to take the opposite side of that bet.

As discussed above, when you buy protection, you (the protection buyer) buy it from someone else (the protection seller) who will end up paying out if a bankruptcy does indeed occur. These protection sellers are very interested in making money, and so, as the probability of default increases, the price of protection or “spread” widens, making it more expensive to purchase protection. So, as firms get closer to a restructuring or bankruptcy, the cost of buying CDS protection on soon-to-be-junk bonds skyrockets. And not only does the cost of protection go up, liquidity, or your ability to enter into CDS trades, on distressed entities dries up. There’s a fine reason for this too. As the probability of default edges closer to certainty, fewer people are willing to take the other side of the trade. They’re just as convinced as you are that ABC will fail, and they’ll tell you to go sell your bridge to someone else.

This means that in order to take advantage of the restructuring-sabotage-strategy, you have to either (i) guess which companies are doomed for failure well in advance of any real trouble; or (ii) wait for trouble and then lay out a ton of cash and find someone stupid enough to take the obviously wrong side of a bet with you. Neither scenario seems likely to occur often, since (i) requires some fairly remarkable foresight and (ii) requires remarkably stupid counterparties. Moreover, in the case of (i), if you’re truly convinced that ABC is headed for restructuring or bankruptcy, you can buy protection with “Restructuring” as a credit event, which means that if ABC does restructure, you’ll get paid. So, in that case, you don’t have to sabotage anything. You can just sit back and wait for an ABC restructuring or ABC bankruptcy, since you’ll get paid in either case.

Moreover, rather than waste all that time and effort trying to sabotage a restructuring, you can cash in before a bankruptcy ever occurs. As the spread widens beyond the point at which you bought in, your end of the trade is “in the money,” and so it already has intrinsic value that you can realize in a variety of ways. For example, assume that when you bought protection on ABC, the spread was 150 bps. When rumors abound that ABC is entering talks with its bondholders, you can be sure that the spread will be well above 150 bps. Let’s say that the spread widened to 1000 bps. As a protection buyer, your side of the trade has economic value that you can realize by entering into another trade in which you sell protection to someone else. (The CDS market has recently begun changing the way CDS spreads are paid, but we’ll assume we’re operating under the old system where the protection buyer pays the spread in quarterly installments). That is, you sell protection at 1000 bps, pay for protection at 150 bps, and keep the remaining 850 bps for yourself. Sure, you could go for the gold and sabotage a restructuring, but that’s a lot more involved than simply entering into an offsetting trade and pocketing the juice.

In addition to the market based reasons above, there are corporate governance reasons why we shouldn’t coddle these kinds of claims. When a company issues bonds, it includes terms that it and its bondholders must live up to. That is, each bondholder could be asked to swear on a stack of bibles that, “I will not go out and buy CDS protection to the hilt and ruin you.” If a company were truly concerned about the risk of restructuring-sabotage, it would include such terms.

The Art Of The Banking Controversy

Also published on the Atlantic Monthly’s Business Channel.

Now that we are well into the depths of a recession, banker-bashing is all the rage. In addition to being fashionable, these “arguments” have an air of credibility about them, given the dire context in which they are made. As a result, the debate over regulating the financial sector is being recontextualized by portraying Wall Street as little more than a vacuous pig-pen. This view is informed by a grand equivocation, which lumps together all of finance under one roof, somewhere on Wall Street, where bankers convene and discuss how they can further redirect the world’s resources towards their pockets. And the shapeless anger that follows from this view has consumed not only the main stream media, but bloggers as well.

Brad Delong takes the view that both compensation and profits in the financial sector are wholly unjustified. Matthew Yglesias agrees. Another even more dubious theory, also espoused by Matthew Yglesias, is that those in finance are morally inept. (You can find Conor Clarke’s response to Yglesias here). Together, Delong and Yglesias employ straw men, false dichotomies, equivocation, conflate coincidence and causation, and in general treat a complex subject with glib answers that suggest the authors have no concern with getting it right, or have just finished reading Schopenhauer’s, “The Art of Controversy.”

Summary Judgment

In a sparsely worded opinion, Justice Delong condemns all of finance, finding the Economist’s piece on the likely pitfalls of blaming the wealthy for the current downturn an unconvincing defense to the charges. In structuring his opinion, Delong provides us with only two avenues through which we may prove our worth:

The rise in [financial sector] profits [as a share of domestic American corporate profits] from 20% to 40% would have been justified had finance produced (a) better corporate governance and thus better management, or (b) more successful diversification and thus a lowered risk-adjusted cost of and a higher risk-adjusted return to capital.

To say that profits can be justified only by satisfying exogenous factors strikes me as bizarre, especially coming from an economist. To say that there are only two such factors is simply ridiculous. There is no mandate which financial institutions must satisfy, other than the law, in order to prove their worth. The fact that Mr. Delong would like to see more emphasis on corporate governance and diversification does not create the presumption that profits earned at financial firms were somehow unjustified. Investors and clients are not in the business of making charitable contributions to financial institutions. If they paid financial institutions for services or products, they believed that they were getting good value in return at the time.

One sensible explanation for the rise in financial sector profits is that investor appetite was voracious during the relevant period. This was due at least in part to an influx of capital available for investment from the Middle East and elsewhere, which was itself due to record commodity prices, and a period of seemingly unbounded asset appreciation, each of which skewed the market’s appreciation for risk. Note that this explanation would not satisfy Delong’s demand for the justification of such profits. That is, Delong suggests that the mere existence of lawfully earned profits which the market elects to create through the demand for goods and services is insufficient. After all that happens, he, or some other economic Tsar, gets to determine which are justifiable and which are not.

Similarly, Yglesias writes:

Could it really be the case that so many people were naive enough to trust their monies to institutions that were only claiming to have brilliant investment models? Well, it seems to me that it could.

If we assume that financial institutions were merely feigning the existence of “brilliant investment models,” whatever that means, are we to simultaneously believe that these institutions were unaware of their inadequacy? After all, to accept Yglesias’ argument is to believe that Wall Street was not drinking its own Kool-Aid, but only selling it to others. This theory is quickly debunked by considering the glowing counterexample of Bear Stearns. Employees up and down the spine of corporate governance were married to Bear in the form equity. When Bear’s equity got wiped out, so did its employees, who held approximately one third of the company’s stock.

Despite Delong’s and Yglesias’ pronouncements to the contrary, the goings-on of Wall Street are not an elaborate ruse fashioned by the well-connected to deplete the world’s “precious bodily fluids.” That said, something has gone disastrously wrong. But indulging in argumentation that amounts to little more than hand waving will not help anyone to understand what happened, and more importantly, what policies should be implemented to prevent it from occurring again.

New Collaborative Blog

I have started a collaborative blog, Shadow Bankers, with John Kiff, and Ranjan X. Roy. The purpose of the blog is to offer an insider’s perspective on the banking industry, particularly those corners which have been dubbed the “shadow banking industry.” Because there will be three authors, instead of just one, we will be able to offer regularly updated content. I will continue to post all of my material here on Derivative Dribble, but will syndicate it on Shadow Bankers.

In addition to providing more content, John and Ranjan will bring new perspectives on areas that I am less familiar with. John is a Senior Financial Sector Expert at the International Monetary Fund and Ranjan is a Forex trader. Each has a deep understanding of their field and both are great and entertaining writers.

I am very excited about this project and I hope all of you subscribe.

The Regulatory Pendulum And Electoral Guillatine

Also published on the Atlantic Monthly’s Business Channel.

The conventional wisdom is that market regulation goes through booms and busts as the public oscillates through its love-hate relationship with the capitalist ethos. When all is well, high-earning executives are the embodiment of capitalism’s well-oiled wealth distribution machine at work. When all is not well, they are the embodiment of the structural deficiencies inherent in a capitalist society that favor those on top. Moving in sympathy with public sentiment, the regulatory pendulum swings from what some consider under-regulation to what others consider over-regulation, blowing past the inevitable resting point, and pausing only at the extremes.

This phenomenon has a simple, albeit unscientific explanation that would surely disappoint Galileo. During booms, deregulation is less contentious since the public is punch-drunk on the boons of capitalism’s bounty. And so, during booms, politicians can garner campaign funding from and scratch backs with those that have an interest in deregulation, all without taking much of a public flogging. During busts, regulation is politically advantageous since the public will be eager to blame someone for the economic malaise. Those who benefited the most during the preceding boom make easy targets, and so politicians can earn points with the electorate by appearing outraged at the conduct of under-regulated, overpaid executives. My sources tell me that this is to go on, back and forth, in perpetuity, leaving reason and prudence by the wayside.

Getting What You Want

Some might say that this process is inefficient, since the market swings back and forth from poindexter to cowboy, missing opportunities in the former case and betting the farm in the latter. I agree. However, there’s also an argument to be made that this behavior pattern is preference maximizing, at least at the time it occurs. Simply put, during booms, the public is wide-eyed and wants to believe that one day they too will have a CEO haircut and a Learjet. During these times, the public wants to see business at work, unfettered by those pansy leftists who just want to choke the life out of the American Dream. During busts, people are frightened, crave security, stability, and most importantly, someone to blame. The public will quickly abandon its love of well-oiled hairdos and private jets, and demand an accounting for the harm that’s been done. In each case, our elected representatives give us want we want at the time, and so we are satisfied at each juncture. If we add in the assumption that people make decisions based on short-term expectations (some modified version of a preference for present consumption), we have a reasonable theory as to why the phenomenon persists.

Given the opportunity to choose a different overall strategy from a neutral perspective,  something akin to Rawls’ “viel of ignorance,” we would, hopefully, chose a regulatory structure that maximizes our preferences over the long run. But assuming that human decision making is dominated by short term expectations, we will continue to prefer extremes and our representatives will continue to take extreme actions.

And so goes the hapless and headless story of the free world.

The Unbearable Lightness of Nassim Taleb

Also published on the Atlantic Monthly’s Business Channel.

As Conor notes, Nassim Taleb offered up some less than sage advice in a recent “article” in the Financial Times. The article, which takes the form of a talismanic list, was crafted in order to  deliver humanity from its suffering by pointing our mind’s eye towards the failures of our regulatory dogma. Wielding powerful metaphors such as “Make an omelette with the broken eggs,” Taleb fails to meet even the lowest of standard for a statement on regulatory policy. “Counter-balance complexity with simplicity” might be an acceptable policy position for Deepak Chopra. But it is certainly unacceptable for an economist.

Looking beyond Taleb’s absurd delivery, the substance of his policies is, in large part, absent, and where present, addresses the real issues at play in a superficial and borderline whimsical fashion. It is unclear whether this is the product of haste, or the product of a complete lack of command over the issues and concepts. For example, Taleb states that:

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

To say that only Ponzi schemes depend on confidence — they don’t, since they’re the product of fraud and misrepresentation — is factually incorrect and suggests intellectual laziness. The extension of credit and contracting depend on confidence in the ability of a counterparty to perform. In a broader sense, the organizational structure of society depends on people being able to rely on the predictability of certain events around them (e.g., bus, train, and plane arrivals, banks maintaining deposits, etc.).

This organizational structure is itself a product of confidence. I am confident that the train will arrive shortly after I get to the train station in the morning, and as a result, I plan on taking the train to work each day. I am confident that my bank will maintain my deposit level, and so I don’t have a mattress full of cash. When confidence is eroded, the incentives of individuals become misaligned.

Take, for example, the case of a bank run. Each depositor has an incentive to withdraw its deposits based solely upon the assumption that all other depositors are doing so, since we have a fractional reserve banking system. Yet each would be better off if none of them withdrew their deposits. When the assumption rings true in the minds of enough depositors, that is, when confidence breaks down, the bank will experience a run. To deal with this problem, we have deposit insurance, which the Government provides to create and maintain confidence in the banking system.

The Kling And I On Credit Default Swaps

Also published on the Atlantic Monthly’s Business Channel.

Arnold Kling and I will probably never agree when it comes to credit default swaps (CDS). Kling and I have had words in the past over CDS, and so have Kling and Felix Salmon. But so long as spirited debate proves interesting to us and our readers, I’m happy to participate in that hallowed, nerd-sport-of-choice: arguing over the internet.

Kling seems convinced that because he cannot conceive of a way to hedge credit risk using the long end of a CDS (the protection seller’s end) it follows that CDSs have no “natural seller.” In short, his position is the following:

“[N]o institution was in a position to sell credit default swaps as a natural hedge against its other business.”

Why would both ends of a CDS need to hedge some risk in order for the CDS to be economically beneficial? I fail to see how hedging is the sine qua non of economic utility. If that were the case, who is a natural buyer of bonds? I’m sure Kling is incapable of answering that question because as a matter of pure logic, any answer to that question is an answer to his, since selling protection through a CDS is economically equivalent to buying the underlying bond (ignoring CDS collateral, which complicates the matter).

In any case, it seems futures and forwards are acceptable means of speculation, but CDS are not. In the case of fuel and other energy and commodity derivatives, there are those in the market who have bona fide economic exposure to the underlying risk. For example, an airline might enter into a swap or a forward contract to lock in a price for fuel, so that it can plan around that price and won’t be brutalized by volatility in fuel prices. The other end of the trade could very well be an entity with no bona fide economic exposure to fuel prices. Rather, that entity wishes to speculate on the movement of energy prices. Both benefit through contract in that both get what they want: the airline wants stable fuel prices and the speculator wants the opportunity to profit by expressing a view on the movement of fuel prices.

The same applies to CDS. Certain entities in the market have bona fide economic exposure to credit risk. For example, banks. In order to shed this risk, banks will contract with another party, the protection seller, to absorb this credit risk. The bank wants to unload its credit risk and the other party wants to speculate as to the probability of default on and, more generally, the movement of credit spreads relative to the underlying credit. And so, both parties get what they want and the transaction is, at a minimum, economically useful ex ante.

How To Speak “Structured Finance”

Also published on the Atlantic Monthly’s Business Channel.

With all the accusations of excessive speculation on Wall Street, the media has certainly done its fair share of speculation as to what goes on in the structured finance market. And given all the public outrage, this is information the press should should get straight before they report.

Like every trade, the world of structured finance has developed its own little language describing the things that people in the market do. The first step to understanding that language is building a vocabulary. I would say that most folks in the media have developed to the point where they can identify, point at, and grunt towards objects in the structured finance space. But it’s not just the media that doesn’t understand structured finance. It’s economists, pundits, and perhaps most ironic, financiers!  Even that giant of finance, George Soros has loused up explanations of how credit default swaps work. I’ve called out economists in the past for their mumblings on credit default swaps and the like, and so has Megan McArdle. This is a serious problem because economists, finance giants, and the like command a level of authority that my local TV news anchor does not.

Continuing in the tradition of misinformation, it appears Hernando De Soto has joined the ranks of economists who demonstrate a complete lack of understanding of the subject area. But rather than devote an entire article to bashing an intelligent man, I’ve decided to use the errors in his opinion piece in The Wall Street Journal as the first step in exploring the world of structured finance for those (lucky) folks who have hitherto had little exposure to the area.

Speaking Structured Finance

Speaking “Structured Finance” is not as hard as those around you suggest. Sure, these are not ideas and terms you’ve grown up around. But with a bit of reading and thinking, you’ll be the star of your next wine and cheese night. In this article, I provide topical treatment of a wide range of subjects, but provide links for those brave souls who really want to dive in and impress their cheese-eating friends.

First, Mortgage Backed Securities are not derivatives. To my fellow finance wonks, this may be a trivial observation. But apparently Mr. De Soto was not aware of this distinction:

[A]ggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

A Mortgage Backed Security (MBS) is just that, a security and not a derivative. Investors that own MBSs receive regular income from these securities. What distinguishes them from traditional securities, such as corporate bonds, is that the MBS is backed by a pool of mortgages. That is, investors buy MBSs, and as a result, they have a right to the cash flows produced by that pool of mortgages. As the homeowners whose mortgages are in the pool pay off their mortgages, the money gets funneled to and split up among the MBS holders. In effect, MBSs offer investors the opportunity to finance a portion of each mortgage in the pool and receive a portion of the returns on the pool.  For more on MBS, go here.

Similarly, a Collateralized Debt Obligation (CDO) is not a derivative, but a security. It is similar in concept to an MBS, except the pool is not made up of mortgages, but rather various debt instruments, such as corporate bonds.  The pool underlying the CDO could be made up of loans, in which case it’s referred to as a Collateralized Loan Obligation (CLO). In general, a CDO has a pool of assets that generate cash. As that cash is generated, it gets funneled to and split up among the investors. For more on CDOs, go here and here.

A Credit Default Swap (CDS) is a derivative. So De Soto got 1 out of 3. Well then, what’s a derivative? A “derivative” is a bilateral contract where the value of the contract is derived from some other security, derivative, index, or measurable event. For example, a call option to buy common stock is a fairly well known and common derivative. A call option grants the option holder the right (they can do it) but not the obligation to buy common stock at a predetermined price. The person who sold the option has the obligation (they must do it) and not the right to sell common stock at that predetermined price. So the value of a call option that entitles the holder to buy 100 shares of ABC Co. at $10 per share would depend on the current price of ABC’s stock. If ABC is trading above $10, it would be worth something to the holder, a.k.a., “in the money.” If it’s trading below $10, it would be “out of the money.”

So what are OTC Derivatives? The term “OTC” means “over the counter.” The spirit of the term comes from the fact that OTC Derivatives are not traded on an exchange, but entered into directly between the two parties. “Swaps” are a type of OTC Derivative. And the Interest Rate Swap market is by far the largest corner of the OTC Swap market, despite media protestations as to the size of the CDS market. For more an Interest Rate Swaps, go here.

Despite the fact that the Interest Rate Swap market is an order of magnitude larger than the CDS market, we will succumb to media pressure and skip right past Interest Rate Swaps and onto the most senselessly notorious OTC Derivative of all: the Credit Default Swap.

What Did You Just Agree To?

Under a typical CDS, the protection buyer, B, agrees to make regular payments, usually quarterly, to the protection seller, D. The amount of the quarterly payments, called the swap fee, will be a percentage of the notional amount of their agreement. The term notional amount is simply a label for an amount agreed upon by the parties, the significance of which will become clear as we move on. So what does B get in return for his generosity? That depends on the type of CDS, but for now we will assume that we are dealing with what is called physical delivery. Under physical delivery, if the reference entity defaults, D agrees to (i) accept delivery of certain bonds issued by the reference entity named in the CDS and (ii) pay the notional amount in cash to B. After a default, the agreement terminates and no one makes any more payments. If default never occurs, the agreement terminates on some scheduled date. The reference entity could be any entity that has debt obligations.

Now let’s fill in some concrete facts to make things less abstract. Let’s assume the reference entity is ABC. And let’s assume that the notional amount is $100 million and that the swap fee is at a rate of 8% per annum, or $2,000,000 per quarter. Finally, assume that B and D executed their agreement on January 1, 2009 and that B made its first payment on April 1, 2009.  When July 1, 2009 rolls along, B will make another $2,000,000 payment. This will go on and on for the life of the agreement, unless ABC triggers a default under the CDS. While there are a myriad of ways to trigger a default under a CDS, we consider only the most basic scenario in which a default occurs: ABC fails to make a payment on one of its bonds. If that happens, we switch into D’s obligations under the CDS. As mentioned above, D has to accept delivery of certain bonds issued by ABC (exactly which bonds are acceptable will be determined by the agreement) and in exchange D must pay B $100 million.

Why Would You Do Such A Thing?

To answer that, we must first observe that there are two possibilities for B’s state of affairs before ABC’s default: he either (i) owned ABC issued bonds or (ii) he did not. I know, very Zen. Let’s assume that B owned $100 million worth of ABC’s bonds. If ABC defaults, B gives D his bonds and receives his $100 million in principal (the notional amount). If ABC doesn’t default, B pays $2,000,000 per quarter over the life of the agreement and collects his $100 million in principal from the bonds when the bonds mature. So in either case, B gets his principal. As a result, he has fully hedged his principal. So, for anyone who owns the underlying bond, a CDS will allow them to protect the principal on that bond in exchange for sacrificing some of the yield on that bond.

Now let’s assume that B didn’t own the bond. If ABC defaults, B has to go out and buy $100 million par value of ABC bonds. Because ABC just defaulted, that’s going to cost a lot less than $100 million. Let’s say it costs B $50 million to buy ABC issued bonds with a par value of $100 million. B is going to deliver these bonds to D and receive $100 million. That leaves B with a profit of $50 million. Outstanding. But what if ABC doesn’t default? In that case, B has to pay out $2,000,000 per quarter for the life of the agreement and receives nothing. So, a CDS allows someone who doesn’t own the underlying bond to short the bond.

So why would D enter into a CDS?  Most of the big swap dealers buy and sell protection and pocket the difference. But, D doesn’t have to be a dealer. D could sell protection without entering into an offsetting transaction. In that case, he has gone long on the underlying bond. That is, he has almost the same cash flows as someone who owns the bond. So a CDS allows someone who doesn’t own the bond to gain bond-like credit exposure to the reference entity.

I will follow this article up with another elaborating further on why derivatives are used and why they are your friends.

Surely Schadenfreude

Also published on the Atlantic Monthly’s Business Channel.

What began as bitterness has burst into a full blown battle between the haves and the havenots. Whatever the level of tension was at the outset of this crisis, public sentiment has turned an entirely new shade of red. But it’s not all bad. I’m sure this period in history will prove to be a petri dish for social scientists and political theorists for decades to come. So maybe we’ll learn something from it.  At a minimum, we can expect SSRN’s servers to be put to extensive use (if they’re not torched as part of the bourgeois conspiracy).

So what got this whole movement started? Aside from obvious causes like crashing asset prices and mass unemployment, I think we can find additional causes by looking to popular culture, how it shaped the public’s perception of wealth, and how wealth and the wealthy took center stage, just before they all disappeared.

I’m Just Gonna Keep On Dancing

When times were good and most people had enough to get along, the public, especially in the U.S., was more than willing to envy the wealthy. This was the case whether the wealthy individual was a derivatives trader, rapper, actor, or heiress. We had gotten to the point where people were famous simply for being wealthy, whether or not they had contributed anything to the world to generate or even justify their wealth. The mere possession of wealth was fetishized, arguably beyond the level of physical beauty. A famous mantra of the era sums up the ethos nicely: “Money, power, respect – it’s the key to life.”

During this period, which I would define roughly as the last decade, the residents of Manhattan embraced an exaggerated, almost ridiculous adherence to this “bling culture.” To live in Manhattan during this time period was to submit to wealth and celebrity being determinative of your daily experiences. And even the wealthy were peasants here. Real estate prices ballooned to unimaginable levels with 1 bedroom apartments renting at costs that exceeded the average income of U.S. citizens.  Manhattan had become the epicenter of American capitalism, and Wall Street was without question its Holy See.

Although there were some economic rough patches over the last decade, in retrospect it seems like a straight shot to the top, at least when compared to the current situation. The salaries of young professionals skyrocketed to create a well educated, highly paid, stimulus addicted sub-culture. And there was nowhere else that young professionals would care to call home than a four thousand dollar a month closet in one of the many coveted neighborhoods of Manhattan’s downtown area.  With ready access to “bling” that the rest of the hoi polloi could experience only on television, Wall Street’s traders, bankers, and lawyers were the fuel of Manhattan’s economic engine. The feigning of celebrity through wealth was the apparent end. Conspicuous consumption, designer clothes, and late hours were the means. Without being famous, 6 and 7 figure-earning 20-something professionals could “party like rock stars” at the city’s restaurants, bars, and clubs and burn out every ember they had left during the 12 hours a week they weren’t working.

Wall Street’s riches were no secret to the public.  Stories of hedge fund managers receiving compensation in excess of a billion dollars a year were already old-hat by the time the housing crisis got underway. But what reports of wealth never focused on was how the money was made. The story of the rise to wealth was secondary to reports of its present expenditure.  Reality TV shows featuring the wealthy, their homes, their boats, and their conquests offer little insight into how wealth is generated. And it seems the public’s perception of how wealth is generated has suffered as a result. The emphasis on the present status of being wealthy has left gaps in the story, and seems to justify the presumption that the wealthy are undeserving, that the money just appeared. But this should not come as a surprise to anyone. After all, entertainment is a product, subject to competition, and only the most fit products will survive. So ask yourself, what’s more entertaining: a piece on a 28 year-old banker strung out on uppers at 4AM grinding through a power point presentation on the cash flows of some pharmaceutical company; or that same 28 year-old banker drunk out of his mind spending thousands of dollars on bottle service and a raw bar at some trendy club with techno music blasting and scantily clad women dancing on tables? I think we’d all agree that the latter would be an easier sale to the networks.

And Then The Music Stopped

And then it all came crashing down on top of us. What began with the collapse of markets in obscure corners of high finance escalated to a global liquidity crisis, and then a global recession. And now, jobless, and angry, the public remembers that piece about the 28 year-old slurring his speech with a piece of crab hanging off his chin. They think to themselves, “This is who did this to me. This brat making more money than I can count and eating food I can’t pronounce.” What they don’t think is, here’s the kid who is the pride of his family, who’s worked hard his entire life to get into top schools and get a job at a top bank, working 80 hours a week at a cubicle strung out on uppers to push him through to the next day. And yes, on Saturdays at 3 AM he can be found somewhere on the Lower East Side with a piece of crab attached to his face.

The danger we face is not a lack of understanding or sympathy for the wealthy. Wall Street is not running a charity. People who work there know what they’re getting into and don’t deserve sympathy for choosing demanding careers. And in any case the thanks come via direct deposit. Rather, the danger we face is shaming the accumulation of wealth. Those who forcefully pursue their own selfish goals within the bounds of the law generate wealth for those around them. This is a tried and tested fact. By succumbing to anger and an easy answer for what went wrong, in the short term we run the risk of being distracted from the more pressing issues before us. And in the long term, we run the risk of discouraging the entrepreneurship and progress that has lifted humanity out of poverty.

The Non-Event That Is AIG’s Counterparty List

Also published on the Atlantic Monthly’s Business Channel.

Why is anyone surprised that AIG made substantial payments to large financial institutions? Wasn’t the entire purpose of bailing out AIG to prevent the collapse of the financial system? Such a purpose would imply that without a bailout, the financial system would collapse. Therefore, we should expect the result of any bailout made with that purpose to result in substantial payments into the financial system. Since large financial institutions are at the heart of the financial system, we should expect such a bailout to result in substantial payments to large financial institutions. Is the world so devoid of news that such a trifling and obvious result warrants extensive coverage?

Without the report, we could not have known exactly who had received funds. But, we could have used information that was already available and apply categorical logic (or common sense if you prefer) to infer what sector was on the receiving end, as I have demonstrated above. But then again, it appears logic, common sense, and facts have nothing to do with public policy or debate on this crisis. Rather, populist rage, childish blame, and jealousy are firmly in the lead.

The Fallacy Of Home Prices And The Reality Of Mortgage Modification

Also published on the Atlantic Monthly’s Business Channel.

Why A Decline In Home Prices Should Not Cause Defaults

It seems that we have taken as an axiom the idea that if the price of a home drops below the face value of the mortgage, the borrower will default on the mortgage. That sounds like a good rule, since it’s got prices dropping and people defaulting at the same time, so there’s a certain intuitive appeal to it. But in reality, it makes no sense. Either the borrower can afford the mortgage based on her income alone or not.  However, it does make sense if you also assume that the borrower intended to access the equity in her home before the maturity of the mortgage. That is, the home owner bought the home with the intention of either i) selling the home for a profit before maturity or ii) refinancing the mortgage at a higher principle amount.

If neither of these are true, then why would a homeowner default simply because the home they lived in dropped in value? She wouldn’t. She might be irritated that she paid too much for a home. Additionally, she might experience a diminution in her perception of her own wealth, which may change her consumption habits. But the fact remains that at the time of purchase, she thought her home was worth X. And she agreed to a clearly defined schedule of monthly payments over the life of the mortgage assuming a price of X. The fact that the value of her home suddenly drops below X has no impact on her ability to pay, unless she planned to access equity in the home to satisfy her payment obligations.  Annoyed as she might be, she could continue to make her mortgage payments as promised.  Thus, those mortgages which default due to a drop in home prices are the result of a failed attempt to access equity in the home, otherwise known as failed speculation.

In short, if a home drops in value, it does not affect the cash flows of the occupants so long as no one plans to access equity in the home. And so, the ability of a household to pay a mortgage is unaffected in that situation. This is in contrast to being fired, having a primary earner die, or divorce. These events have a direct impact on the ability of a household to pay its mortgage.

I am unaware of any proposal to date which offers assistance to households in need under such circumstances.

The Dismal Science Of Mortgage Modification

Simply put, available evidence suggests that mortgage modifications do not work.

The charts above are from a study conducted by the Office Of the Comptroller of the Currency. The full text is available here. As the charts above demonstrate, within 8 months, just under 60% of modified mortgages redefault. That is, the borrowers default under the modified agreement. If we look only at Subprime mortgages, just over 65% of modified mortgages redefault within 8 months. This may come as a surprise to some. But in my mind, it reaffirms the theory that many borrowers bought homes relying on their ability to i) sell the home for a profit or ii) refinance their mortgage. That is, it reaffirms the theory that many borrowers were unable to afford the homes they bought using their income alone, and were actually speculating that the value of their home would increase.

Morally Hazardous And Theoretically Dubious

Why should mortgages be adjusted at all? Well, one obvious reason to modify is that the terms of the mortgages are somehow unfair. That’s a fine reason. But when did they become unfair? Were they unfair from the outset? That seems unlikely given that both the borrower and the lender voluntarily agree to the terms of a mortgage. Although people like to fuss about option arm mortgages and the like, the reality is, it’s not that hard for a borrower to understand that her payments will increase at some point in the future. Either she can afford the increased payments or not. This will be clear from the outset of the mortgage.

So, it doesn’t seem like there’s much of a case for unfairness at the outset of the agreement. Well then, did the mortgage become unfair? Maybe. If so, since the terms didn’t change, it must be because the home dropped in value and therefore the borrower is now paying above the market price for the home. That does sound unfortunate. But who should bear the loss? Should the bank? The tax payer? How about the borrower? Well, the borrower explicitly agreed to bear the loss when she agreed to repay a fixed amount of money. That is, the borrower promised “to pay back X plus interest within 30 years.” This is in contrast to “I promise to pay back X plus interest within 30 years, unless the price of my home drops below X, in which case we’ll work something out.” Both are fine agreements. But the former is what borrowers actually agree to.

Not enforcing voluntary agreements leads to uncertainty. Uncertainty leads to inefficiency. This is because those who have agreements outstanding or would like to enter into other agreements cannot rely on the terms of those agreements. And so the value of such agreements decreases and the whole purpose of contracting is defeated. In a less abstract sense, uncertainty creates an environment in which it is impossible to plan and conduct business. As a result, this type of regulatory behavior undermines the availability of credit.

But even if we do not accept that voluntary agreements should be enforced for reasons of efficiency, mortgages represent some of the most clear and unambiguous promises to repay an obligation imaginable. The fact that a borrower was betting that home prices would rise should not excuse them from their obligations. There are some situations where human decency and compassion could justify a readjustment of terms and socializing the resultant losses. For example, the death of a primary earner or an act of war or terrorism. But making a bad guess about future home prices is not an act that warrants anyone’s sympathy, let alone the socialization of the losses that follow.

The Elephant In The Room

This notion that Subprime borrowers were victimized as a result of some fraudulent wizardry perpetuated by Wall Street is utter nonsense. Whether securitized assets performed as promised to investors is Wall Street’s problem. Whether people pay their mortgages falls squarely on the shoulder of the borrower. Despite this, we are spending billions of public dollars, at a time when money is scarce and desperately needed, on a program that i) is demonstrably ineffective at achieving its stated goals (helping homeowners avoid foreclosure) and ii) rewards poor decision making and imprudent borrowing. Given the gravity of the moment, a greater failure is difficult to imagine. But then again, we live in uncertain times, so my imagination might prove inadequate.

There Won’t Be An Economy To Stimulate Without Solvent Banks

Also published on the Atlantic Monthly’s Business Channel.

Uncertainty, Volatility, And Inaction

Since this crisis began, we’ve seen uncertainty, volatility, and inaction play out not only in the financial markets, but also in the halls and minds of our elected officials. Each is a bane to the economy, and stifles the ability of market participants and consumers to plan and carry out the business activities that keep people employed and spending money. A new chapter in our venture into the unknown began when Timothy Geithner announced his six and a half page plan to save the Universe. Although the DJIA is often and unjustifiably described as the “market” and any movements therein deemed the “market’s response,” it was clear by the end of that Tuesday that at a minimum, the equity markets did not like Geithner’s plan. But more importantly, in my opinion, is the reemergence of a disturbing upward trend in certain indicators, such as the Swap Spread. This suggests that banks are, once again, becoming more reluctant to lend to each other. To put things in less technical terms, the inter-bank lending markets are providing the steady drum beat of our death march, while the equity markets contribute unwieldy gesticulations of terror.  The result is hardly efficient, and something drastic must be done if the banking system and the broader financial markets are to recover.

Defibrillator For A Corpse

Regardless of your position on government spending and its effects on the economy, without solvent and functioning banks, there will be no economy to stimulate. If we continue to ignore the fundamental role that banks play in our economy, debates on government spending versus lower taxes will be had over burning garbage bins and cans of beans.

Our economy requires functioning credit markets in order to operate. Credit markets have grown to become dependent on the broader financial system because of the way in which credit risk is traded and distributed. Therefore, without functioning, solvent banks to create and manage these markets, and without investors confident in the stability of the broader financial system, our economy cannot function, no matter how much money we throw at it.

Despite this, the current administration has thrown all of its weight behind a gargantuan spending bill without first solving the core issue that precipitated and underlies the crisis: bank insolvency and illiquidity. This influx of cash may stem the tide by keeping certain businesses and consumers afloat with government cash, but it does little to nothing in the way of restoring stability and confidence in the financial system. In short, no matter what your economic philosophy is, pragmatism dictates taking action to restore the viability of the banks.

Surely You’re Joking, Mr. Soros!

Also published on the Atlantic Monthly’s Business Channel.

Behavioral Polemics

In times of crisis, society develops a need for a theory of the crisis itself. That is, there must be a set of logically interconnected ideas that explains what happened before, what is happening now, and what will happen afterward. This is a laudable instinct, since once we can explain what brought us here, we can agree to not do it again. In the narrative of our current crisis, we as a society have forsaken the need for a coherent theory of events and have settled for a confused and hazy mythology inspired by the very real suffering of millions and the fear of more suffering to come. Like many other mythologies, its development was organic. Along the course of its development, the collective thinking of millions hashed together a cast of demons, sages, and saviors. Bombarded with images, sounds, and stories of calamity, we embarked on a psychological witch hunt, succumbing to the primal need to identify and destroy the cause of our suffering. Somehow, the derivatives market made the cast of demons in this mythology. And it seems that even some of the sharper tools in the box believe, in my opinion without any real theoretical basis, that the derivatives market has earned its place in that cast.

A Tall Order That Came Up Short

In a recent Financial Times article, George Soros explained his own theory of the crisis. While certainly less mythological than most others, it is still theoretically unsound and factually inaccurate in several respects. In this article I take issue only with his treatment of derivatives. I happen to agree with many of his opinions on the Efficient Market Hypothesis and in a limited sense, what he calls “reflexivity,” which holds that a market price is not only a reflection of fundamentals but can also affect fundamentals.

Soros begins his argument by explaining how the risks of shorting a stock differ from the risks of owning a stock. Although there are other ways to short stock, let’s assume that we are talking about the method that involves borrowing stock, selling it, and then repurchasing the stock (hopefully at a lower price) and delivering it to the lender. Soros correctly points out that by shorting a stock, you leave yourself exposed to an effectively unlimited amount of risk, since the stock price could rise to arbitrarily high levels (back when those things used to happen), and you would be responsible for going out to the market, repurchasing it, and delivering it to the original lender, leaving you on the hook for the difference between the sale price and the repurchase price. He says that this means that ownership of stock and shorting a stock have “asymmetrical” risks. He then states that this asymmetry “serves to discourage the short selling of stocks.” While that statement is a bit unclear and incomplete, I get what he’s trying to say, and I can live with that.

He then incorrectly claims that shorting a bond through credit default swaps creates similar “asymmetrical” risks between buying protection and selling protection. He states that protection buyers have “unlimited profit potential” while protection sellers have “unlimited risks”. That is categorically false. Those who read my blog often know that the maximum risk exposure of a protection seller is capped at the notional amount of the CDS, which also limits the maximum reward of the protection buyer. Without the jargon, this means that both sides agree to the amount of protection bought at the outset of the contract. The protection seller never has to pay more than that amount and the protection buyer will never receive more than that amount. Thus, both sides of a CDS have a cap to the amount of credit risk they are exposed to.

This pulls the cornerstone out of Soros’ argument that CDSs over incentivize buying protection. There may be other arguments to that effect, though I doubt it given the bilateral nature of the contracts and the rule of no free lunch. In any case, his is certainly not one of those arguments.

Betting On Failure

Soros then argues that both the shorting of stock and the buying of protection through CDSs contributed to a lack of confidence, by lowering the price of stocks and raising the cost of protection respectively, each of which accelerated the demise of several institutions. This second argument is much more difficult to debunk as a practical matter. But that doesn’t imply that it is sound. The validity of this argument, and its inverse, depend on which occurred first: the lack of confidence or the shorting/protection buying. My instinct is that we may never know.

Moreover, the cyclical self-fulfilling dynamic that Soros is alluding to can be created without derivatives, shorting, or any of those fancy techniques: see e.g., bank runs. Whenever the dynamic running a market is a high level of demand for short term capital (which is what occurs during a liquidity crisis) coupled with the fear that you will be the last to exit a market, prices will plummet. This is because each participant has an incentive to maximize the short term value of its assets. And each participant knows that if it doesn’t convert its assets to cash or other low risk short term assets, the collective selling of others will erode the value of any assets that it doesn’t sell. So, even if a given participant doesn’t want to sell and values its assets at a price that is higher than the current market price, it will sell anyway if it needs capital in the short term.

Note that this logic creates an exception to the EMH. That is, when there is insufficient short term capital, there isn’t enough available cash to bring prices back up to efficient levels. This logic also explains the recent mad rush into short term Treasuries.

In short, even if Soros is correct that short selling and protection buying exacerbate self fulfilling market dynamics, which I doubt, they can occur anyway.

Credit Default Swaps And Mortgage Backed Securities

Also published on the Atlantic Monthly’s Business Channel.

Like Your Grandsire In Alibaster

In this article, I will apply my usual dispassionate analysis to the role that credit default swaps play in the world of Mortgage Backed Securities (MBSs). We will take a brief look at the interactions between the issuance of mortgages, MBSs, and how the concept of loss plays out in the context of derivatives and mortgages. Then we will explore how the expectations of the parties to a lender/borrower relationship differ from that of a protection seller/buyer relationship and how credit default swaps, by allowing markets to express a negative view of mortgage default risk, facilitate price correction and mitigate net losses. This is done by applying the concepts in my previous article, The Demand For Risk And A Macroeconomic Theory of Credit Default Swaps: Part 2, to the context of credit default swaps on MBSs. This article can be considered a more concrete application of the concepts in that article, which will hopefully clear up some of the confusion in that article’s comment section.

The Path Of Funds In the MBS Market

Mortgage backed securities allow investors to gain exposure to the housing market by taking on credit risk linked to a pool of mortgages. Although the underlying mortgages are originated by banks, the existence of investor demand for MBSs allows the originators to effectively pass the mortgages off to the investors and pocket a fee. Thus, the greater the demand for MBSs, the greater the total value of mortgages that originators will issue and ultimately pass off to investors. So, the originators might front the money for the mortgages in many cases, but the effective path of funds is from the investors, to the originators, and onto the borrower. As a result, investors in MBSs are the effective lenders in this arrangement, since they bear the credit risk of the mortgages.

This market structure also has an effect on the interest rates charged on the underlying mortgages. As investor demand for MBSs increases, the amount of cash available for mortgages will increase, pushing the interest rates charged on the underlying mortgages down as originators compete for borrowers.

Loss In The Context Of Derivatives And Mortgages

I often note that derivatives cannot create net losses in an economy. That is, they simply transfer money between two parties. If one party loses X, the other gains X, so the net loss between the two parties is zero. For more on this, go here. This is not the case with a mortgage. The lender gives money to the borrower, who then spends this money on a home. Assume that a lender and borrower entered into a mortgage and that before maturity the value of the home falls, prompting the borrower to default on its mortgage. Further assume that the lender forecloses on the property, selling it at a loss. Since the buyer receives none of the foreclosure proceeds, the buyer can be viewed as either neutral or incurring a loss, since at least some of the borrower’s mortgage payments went towards equity ownership and not just occupancy. It follows that there is a loss to the lender and either no change in or a loss to the borrower and therefore a net loss. This demonstrates what we have all recently learned: poorly underwritten mortgages can create net losses.

Net Losses And Efficiency

You can argue that even in the case that both parties to an agreement incur losses, the net loss to the economy is zero, since the cash transferred under the agreement was not destroyed but merely moved through the economy to market participants that are not a party to the agreement. That is, if you expand the number of parties to a sufficient degree, all transactions will net to zero. While this must be the case, it misses an essential point: I am using net losses to bilateral agreements as a proxy for inefficient allocation of capital. That is, both parties expected to benefit from the agreement, yet both lost money, which implies that neither benefited from the agreement. For example, in the case of a mortgage, the borrower expects to pay off the mortgage but benefit from the use and eventual ownership or sale of the home. The lender expects to profit from the interest paid on the mortgage. When both of these expectations fail, I take this as implying that the initial agreement was an inefficient allocation of capital. This might not always be the case and depends on how you define efficiency. But as a general rule, it is my opinion that net losses to a bilateral agreement are a reasonable proxy for inefficient allocation of capital.

Expectations Of Lender/Borrower vs. Protection Seller/Buyer

As mentioned above, under a mortgage, the lender expects to benefit from the interest paid on the mortgage while the borrower expects to benefit from the use and eventual ownership or sale of the home. Implicit in the expectations of both parties is that the mortgage will be repaid. Economically, the lender is long on the mortgage. That is, the lender gains if the mortgage is fully repaid. Although application of the concepts of long and short to the borrower’s position is awkward at best, the borrower is certainly not short on the mortgage. That is, in general, the borrower does not gain if he fails to repay the mortgage. He might however mitigate his losses by defaulting and declaring bankruptcy. That said, the takeaway is that both the lender and the borrower expect the mortgage to be repaid. So, if we consider only lenders and borrowers, there are no participants with a true short position in the market. Thus, price, which in this case is an interest rate, will be determined by participants with similar positive expectations and incentives. Anyone with a negative view of the market has no role to play and therefore no effect on price.

This is not the case with credit default swaps (CDSs) referencing MBSs. In such a CDS, the protection seller is long on the MBS and therefore long on the underlying mortgages, and the protection buyer is short. That is, if the MBS pays out, the protection seller gains on the swap; and if the MBS defaults, the protection buyer gains on the swap. Thus, through the CDS, the two parties express opposing expectations of the performance of the MBS. Thus, the CDS market provides an opportunity to express a negative view of mortgage default risk.

The Effect Of Synthetic Instruments On “Real” Instruments

As mentioned above, the CDS market provides a method of shorting MBSs. But how does that effect the price of MBSs and ultimately interest rates? As described here, the cash flows of any bond, including MBSs, can be synthesized using Treasuries and CDSs. Using this technique, a fully funded synthetic bond consists of the long end of a CDS and a Treasury. The spread that the synthetic instrument pays over the risk free rate is determined by the price of protection that the CDS pays the investor (who in this case is the protection seller). One consequence of this is that there are opportunities for arbitrage between the market for real bonds and CDSs if the two markets don’t reach an equilibrium, removing any opportunity for arbitrage. Because this opportunity for arbitrage is rather obvious, we assume that it cannot persist. That is, as the price of protection on MBSs increases, the spread over the risk free rate paid by MBSs should widen, and visa versa. Thus, as the demand for protection on MBSs increases, we would expect the interest rates paid by MBSs to increase, thereby increasing the interest rates on mortgages. Thus, those with a negative view of MBS default risk can raise the cost of funds on mortgages by buying protection through CDSs on MBSs, thereby inadvertently “correcting” what they view as underpriced default risk.

In addition to the no-obvious-arbitrage argument outlined above, we can consider how the existence of synthetic MBSs affects the supply of comparable investments, and thereby interest rates. As mentioned above, any MBS can be synthesized using CDSs and Treasuries (when the synthetic MBS is unfunded or partially funded, it consists of CDSs and other investments, not Treasuries). Thus, investors will have a choice between investing in real MBSs or synthetic MBSs. And as explained above, the price of each should come to an equilibrium that excludes any opportunity for obvious arbitrage between the two investments. Thus, we would expect at least some investors to be indifferent between the two.

Depending on whether the synthetics are fully funded or not, the principle investment will go to the Treasuries market or back into the capital markets respectively. Note that synthetic MBSs can exist only when there is a protection buyer for the CDS that comprises part of the synthetic. That is, only when interest rates on MBSs drop low enough, along with the price of protection on MBSs, will protection buyers enter CDS contracts. So when protection buyers think that interest rates on MBSs are too low to reflect the actual probability of default, their desire to profit from this will facilitate the issuance of synthetic MBSs, thereby diverting cash from the mortgage market and into either Treasuries or other areas of the capital markets. Thus, the existence of CDSs operates as a safety valve on the issuance of MBSs. When interest rates sink too low, synthetics will be issued, diverting cash away from the mortgage market.

Atlantic Monthly Business Channel

Some of my material will now appear first on the Atlantic Monthly’s Business Channel. I will continue to post the material here, but many articles will appear in the AM first.

Here’s the latest: Demon Credit Default Swaps: the case of the Synthetic Security

Regards,

Charles

Why Credit Default Swaps?

Imps and Impetus

In this article, I will give a few explanations as to why credit default swaps, Satan’s financial tool of choice, exist.

That Which I Do Not Understand Must Be Evil

There are formal rules of logic which distinguish between sound arguments and fallacies. Although most of us are not conscious of these rules, I would like to think that somewhere in the recesses of all human minds there is at least an abstract appreciation for these rules, despite the fact that we often argue and act with complete disregard for their existence. That said, we should expect more from those who claim to know things. Those who claim to know things should be able to explain exactly how it is that they know these things. Yet, for some reason, it has become acceptable for pundits discussing credit default swaps to claim to know that credit default swaps have no bona fide economic purpose simply because they cannot come up with one. So, rather than outlining the path to their knowledge, such pundits concede failure in their search for knowledge, and then infer that because of this failure, the knowledge sought after does not exist. I’m no logician, but I’m fairly certain that argument rests upon the assumption that these pundits know everything.

The Advantage Of Unfunded Instruments

As a general matter, credit default swaps are unfunded. That is, the protection seller does not post the notional amount of the contract into an account for the benefit of the protection buyer. This allows the protection seller to invest that amount elsewhere, earning a return. If the notional amount is posted or held in Treasuries, then the cash flows received by the protection seller will be roughly equivalent to the cash flows of the reference obligation on which he has sold protection. This is because the protection seller will earn the risk free rate on the Treasuries and will receive the swap fee from the protection buyer, which should be approximately the spread over the risk free rate that the underlying reference obligation pays. So in a fully funded CDS, the protection seller earns the risk free rate plus a spread. This is explained in greater detail here. But if the protection seller invests an amount of cash equal to the notional amount in non-risk free instruments, he will be able to earn a return above the risk free rate, in addition to earning the swap fee, which implies that the total return will be higher than that of the underlying reference obligation. So in the case of an unfunded CDS, the protection seller earns a return above the risk free rate plus a spread. Thus, credit default swaps allow for unfunded exposure to credit risk, which facilitates a return that is higher than the underlying bond.

The Advantage Of Simplified Documentation

Credit default swaps also offer the advantage of simplified and standardized documentation, which allows market participants to precisely tailor the credit risks to which they are exposed. The document templates are prepared and published by the International Swaps and Derivatives Association, and then modified by market participants to define the terms of particular transactions. So ISDA publishes standardized forms, and then market participants customize the forms to reflect their individualized needs. Because almost all credit default swaps are based on the same form, it makes review and comprehension easier and faster, which reduces transaction costs.

The Advantage Of Contract

Credit default swaps are contracts, and so the rights and obligations of each party can be whatever the parties agree to. This allows for the creation of essentially infinite variations on the basic credit default swap theme. For example, rather than name a single reference obligation, a CDS could name a group of different bonds, known as a basket, on which protection is to be sold. This allows the protection seller to gain exposure to a basket of credit risks and the protection buyer to receive protection on that same basket. And this is done without either party purchasing a single bond.

Another common variation is the n-th to default CDS. In an n-th to default CDS, protection is bought on a basket of reference obligations, but the protection buyer only receives payment from the protection seller upon the occurrence of n defaults. So if n = 3, the protection buyer will only receive payment upon the 3rd default of the reference obligations in the basket. In an ordinary CDS, n = 1, since payment is made upon the 1st default. There are variations on this theme as well. For example, the CDS could be structured so that payment occurs only upon the n-th default, terminating the agreement. Alternatively, payment could be made for the n-th default and all defaults after that. It is up to the parties to decide how the deal is structured.

The point in both of these examples is that because swaps are rooted in contract, they offer a level of customization that would be prohibitively expensive and in some cases impossible using traditional financial instruments. If you can come up with a method of simulating an n-th to default CDS using only traditional instruments, please impress us all in the comment section.

The Demand For Risk And A Macroeconomic Theory of Credit Default Swaps: Part 2

Redux And Reduction

In the previous article, we defined a highly abstract framework that considered the subjective expected payout of both sides of a fixed fee derivative.  In this article, we will apply that model to the context of credit default swaps and will show that the presence of credit default swaps and synthetic bonds should be expected to reduce the demand for “real” bonds (as opposed to synthetic bonds) and thereby reduce the net exposure of an economy to credit risk.

The Demand For Credit Default Swaps

In the previous article, we plotted the expected payout of each party to a credit default swap as a function of the fee and each party’s subjective valuation of the probability that a default will occur. The simple observation gleaned from that chart was that if we fix the subjective probabilities of default, protection sellers expect to earn more as the price of protection increases and protection buyers expect to earn more as the price of protection decreases.  Thus, as the the price of protection increases, we would expect protection seller side “demand” to increase and expect protection buyer side “demand” to decrease.  But how can demand be expressed in the context of a credit derivative? The general idea is to assume that holding all other variables constant, the size of the desired notional amount of the CDS will vary with price. So in the case of protection sellers, the greater the price of protection, the greater the notional amount desired by any protection seller.

In order to further formalize this concept, we should consider each reference entity as defining a unique demand curve for each market participant. We should also distinguish between demand for buying protection and demand for selling protection. For convenience’s sake, we will refer to the demand for selling protection as the supply of credit protection and demand for buying credit protection as the demand for credit protection. For example, consider protection seller X’s supply curve and protection buyer Y’s demand curve for CDSs naming ABC as a reference entity. The following chart expresses the total notional amount of all CDSs desired by X and Y as a function of the price of protection.

As the price of protection approaches zero, Y’s desired notional amount should approach infinity, since at zero, Y is getting free protection and should desire an unbounded “quantity” of credit protection. The same is true for X as the price of protection approaches infinity.

Synthetic Bonds As Competing Goods With “Real” Bonds

Imagine a world without credit derivatives and therefore without synthetic bonds. In that world, there will be a demand curve for real ABC bonds as a function of the spread the bonds pay over the risk free rate, holding all over variables constant. Now imagine that credit default swaps were introduced to this world. We know that the cash flows of any bond can be synthesized using Treasuries and credit default swaps. For example, assume we have synthesized the cash flows of ABC’s bonds using the method described here. We would expect at least some investors to be indifferent between real ABC bonds and synthetic ABC bonds, since they both produce the same cash flows. Thus, the two are competing products in the sense that investors in real ABC bonds should be potential investors in synthetic ABC bonds. So because some investors will be indifferent between synthetic ABC bonds and real ABC bonds, synthetic ABC bonds will siphon some of the cash that would have otherwise gone to real ABC bonds. Thus, in a world with credit derivatives, we would expect there to be less demand for real bonds than would be present without credit derivatives. In the following chart we express the macroeconomic demand for real ABC bonds in terms of the spread over the risk free rate and the total par value desired by the market.

Thus, the demand for credit derivatives diminishes the demand for real bonds. Although we cannot know exactly what the effect on the demand curve for real bonds will be, we can safely assume that it will be diminished at all levels of return, since at each level, at least some investors will be indifferent to real bonds and synthetic bonds, since each offers the same return.

Real Cash Losses Versus Wealth Transfers Through Derivatives

Economics already has a term to describe payouts under credit default swaps: wealth transfers. Although ordinarily used to describe the cash flows of tax regimes, the term applies equally to the payments under a credit default swap. As described in the previous article, there are no net cash losses under a credit default swap. There is a payment of money from one party to another, the net effect of which is a wealth transfer. That is, credit default swaps, like all derivatives, simply rearrange the current allocation of cash in the financial system, and nothing is lost in process (ignoring transaction costs, which are not relevant to this discussion).

When a real bond defaults, a net cash loss occurs. The borrower has taken the money lent to it by investors, lost it, and the investors are not fully paid back. Therefore, both the borrower and the investors incur a cash loss, creating a net cash loss to the economy. So, in the case of a synthetic ABC bond, upon the default of one of ABC’s bonds,  a wealth transfer occurs from the protection seller to the protection buyer and the net effect is null. In the case of a real ABC bond, upon the default of that bond, the investors will lose some of their principle and ABC has already lost some of the money it was lent, the net effect of which is a loss to the economy.

So every dollar siphoned away from real bonds by synthetic bonds is a dollar that will not be lost in the economy upon the occurrence of a credit event. If there were no credit derivatives, then that dollar would have been invested in real bonds and thereby lost upon the occurrence of a credit event. Therefore, the net losses to the economy upon the occurrence of a credit event is less with credit derivatives than without. In the following diagram, the two circles of each transaction represent the parties to that transaction. In the case of real bonds, one of the parties is ABC and the other is an investor. In the case of synthetic bonds, one is the protection seller and the other is the protection buyer of the credit default swap underlying the synthetic bond.

This diagram simply demonstrates what was described above. Namely, that with credit derivatives, some investors will choose synthetic bonds rather than real bonds, thereby reducing the amount of cash exposed to credit risk. Thus, rather than increase the impact of credit risk, credit default swaps actually decrease the impact of credit risk by placating the demand for exposure to credit risk with synthetic instruments that are incapable of producing net losses. However, there may be consequences arising from credit default swaps that cause actual cash losses to an economy, such as a firm failing because of its obligations under credit default swaps. But the failure is not caused by the instrument itself. The nature of the instrument is to reduce the impact of credit risk. The firm’s failure is caused by that firm’s own poor risk management.

My Apologies For The Delay

I have had the flu for the last 3 weeks, and now have bronchitis. But do not worry, I will be posting more content soon as I am (hopefully) at the tail end of my illness.
Regards,

Charles