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.