I’ve written my first piece in a very long time, this time on the National Debt. I’ve put quite a bit of work into it, and I’d appreciate your thoughts.

Best,

Charles

Gregory White of the Business Insider has done a fine job with this interview of John Authers, discussing Authers’ new book, The Fearful rise of Markets, and the impact of moral hazard on the financial markets.

Regards,

Charles

Those interested in attending should contact Vikram Singh of Astute Forums:

Jeremy’s work on HFT is the best I’m aware of in the mainstream media, so again, I recommend you follow his work. Jeremy tends to interview people who actually work in the industry,  so the interviews are generally incisive and concrete.

Regards,

Charles

Jeremy Grant of the FT has put together a fantastic article on algorithmic and high frequency trading. Unlike all the hype and nonsense floating around on the subject, Jeremy’s article is a refreshingly in-depth, yet approachable piece. I highly recommend you take the time to read it.

Regards,

Charles

Hope you and yours have a happy holiday weekend.

Regards,

Charles

Jeremy Grant of the Financial Times has been doing a great job reporting on some of the most poorly understood corners of finance, including OTC Derivatives and High Frequency Trading. The material is assembled on his micro site, the FT Trading Room.

Perhaps the most unique aspect of, and in my opinion the most valuable resource in, the FT Trading Room is the collection of video interviews Jeremy has conducted with industry practitioners, which is available here. These interviews offer a rare and often candid industry perspective on some of the most contentious areas of finance. I encourage all of you to make the FT Trading Room part of your daily reading.

Regards,

Charles

Also published on the Atlantic Monthly’s Business Channel.

Most OTC derivatives are highly standardized, heavily traded products that are more fairly described as unfamiliar than complex.  Nonetheless, a small corner of the market comprised of customized, or bespoke, trades has captured the imagination of both the public and the press. The descriptions put forth to date muddle the scale of the market, purportedly in the hundreds of trillions of dollars, with words like “complex” and “arcane,” all to convey a sense of simultaneous condemnation — the result of some vague concept of inherent mischief — and unholy admiration for the wizards who put these “black boxes” together. In an effort to tone down the more florid descriptions of bespoke trades, what follows is introduction to the market conditions that cause certain market participants to prefer bespoke trades to more standardized alternatives.

Pecking Order

All financial agreements involve mutual promises to deliver assets and/or cash. But some financial agreements limit the scope of assets that can be drawn upon under the agreement. That is, each party has only limited rights to the assets and/or cash flows of the other. For example, assume that A wants to enter into an interest rate swap simultaneously with the issuance of floating rate bonds.  For simplicity’s sake, we will assume that (i) the swap in question is a vanilla fixed for floating rate swap where A pays a fixed rate to A’s counterparty, swap dealer D, and D pays the floating rate on the bonds to A and (ii) the payment dates on the swap are the same as the payment dates on the bonds. This arrangement allows A to pay the bondholders a floating rate, but still manage its interest rate risk by having its payments under the bonds and the swap net out to an effective fixed rate.

But what if the prospective bondholders want to be assured that the swap will not interfere with the credit quality of the bonds? They could insist that A’s payments on the swap be made subordinate to A’s payments on the bonds. That is, A makes payments on the bonds before it makes payments under the swap. This is a basic payment waterfall. This waterfall must be memorialized in both the bonds and the swap agreement, which means that a standardized swap will not do.

In practice, the credit terms of the swap could be much more complex, taking into account various agreements that A has in place, and even differentiate between certain types of payments under the swap, placing each at different levels in the payment waterfall. In short, even the most elementary swap, a fixed for floating interest rate swap, could require intense structuring simply because other agreements require it.

No Market

Another common motivation for bespoke trades is the lack of a market. That is, the risk in question is unique to the party looking to hedge it or too unusual to support a liquid hedging market. For example, assume that A is a heavy oil consumer in town X. Town X is a major delivery point for oil and so there are exchange traded oil futures that track the price of fuel delivered to X. These futures allow A to do a reasonably good job of hedging its exposure to fluctuations in the price of oil delivered to its town X operations. However, A is setting up a venture in town Y which will also consume a large quantity of oil. The price of oil delivered to Y usually tracks the price of oil delivered to X, but can deviate sharply under certain conditions. As such, A would rather not rely on futures tracking delivery to X, but would prefer a hedge that tracks the cost of delivery to Y. A could enter into a swap with dealer D where A pays a fixed rate and D pays the cost of delivery to Y. The net effect of this all-cash swap is that A has locked in a price for delivery to Y.

Further Reading

I’ve written a fair number of articles on the OTC market and related topics, but the well of financial knowledge is orders of magnitudes deeper than the information assembled by this lone wonk. But fret not, because The Qatar Financial Center has set up a simply gigantic resource, QFinance, that is fully searchable and contains information on all corners of finance. It is in essence an encyclopedic compilation of the current state of finance. It seems that most of the entries were written by high level practitioners, with others by academics and regulators. That said, it is a gigantic database, so I have reviewed only a small fraction of the entries. In any case, it is certainly worth checking out.

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.

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

Regards,

Charles