Streetwise Professor

At least not for those of us (including yours truly) who are classical liberals on domestic issues, and who support a robust, forward leaning, and heavily armed global American presence in a dangerous world. (For those Europeans and Eurowannabes who think that the lion will lie down with the lamb if only those obstreperous Americans would cease their unilateral ways and listen to the UN like good little boys and girls—be careful what you ask for.)

At the very best, Barack Obama will govern as a Continental lefty, who will make the US more like Europe, an enervated—and enervating—nanny state offering cradle to grave security (in theory) while sharply constraining the scope for personal initiative. At the very worst, he is a hard core leftist, marinated in Hyde Park/Berkeley/Upper West Side radicalism, who believes that the US is essentially malign rather than essentially good but flawed; that the vision of the Founders is fundamentally and irredeemably unjust; and that American society is irretrievably racist and repressive. His official campaign rhetoric suggests the former, more benign, but hardly encouraging, alternative. The personal and political associations of a lifetime, his own autobiography, and less guarded statements made over the years support the latter, more sinister, possibility. One of the most discouraging aspects of the just completed campaign is that due to the active collaboration of the press with Obama, we were never given the information or opportunity to learn which of these two alternatives is closer to the truth. The blindingly obvious unwillingness of the media to probe the question seriously in public leads me to believe that they know the answer—and that we have elected someone more radically left than Henry Wallace or Huey Long.

My first inclination is to take a cue from DR, and assume a Leninist “the worse, the better” attitude. Hope that Obama and Congressional Democrats rush to attempt to implement every policy wish that they have kept pent up inside for the last years—or arguably for the last 28, since Reagan’s election. Refashion completely the health care system, turning it into a government managed and financed system. Seize 401(k) accounts. Impose payroll taxes on every dollar earned. Dramatically increase the cost of energy by imposing draconian restrictions on CO2 omissions. Shove huge subsidies down “alternative energy” rat holes. Raise income taxes and capital gains taxes. Gut the military. Go all squishy when dealing with Iran and Russia. Sell Israel down the river. Restrict freedom of expression by imposing the “Fairness” Doctrine (an Orwellian expression if ever there was one.) Answer every policy dispute with accusations of racism, and criminalize speech deemed racist. All in the teeth of a recession.

You know they want to. They are almost ready to burst from the pressure of bottling up their intense desires for so long. Even the Clinton years were frustrating to them, a period of centrist triangulation after the retreat from Hillarycare.

The operative word here is “attempt.” I expect that if Obama and the extreme liberals that dominate Congress were to attempt to enact such an agenda—and it is the agenda of their desires—that even the dreamy types mesmerized by anodyne promises of change would awake from their reveries. Talk of unspecified “hope” and “change” allows the lazy listener to imagine the changes she or he hopes to see, and assume that Obama shares the same vision. (That’s how cons work.) Things are quite different when one sees the specifics, and comprehends the dramatic implications thereof. The resulting popular outrage would make the Clinton 1993-1994 explosion look like a dud firecracker.

That’s what I expect would happen—but I am not sure. There is the risk that it might not, and in the event, the costs would be catastrophic. Indeed, even if the probability of implementation of even a modest part of the agenda is small, the costs are so large that a rational, risk averse individual should recoil from thoughts of “the worse, the better.” Hence, I so recoil.

My estimation that that the risk that some of the agenda could in fact come to pass is increased by an examination of the broader election results, beyond the Presidential vote. An election in which a mean, spiritually deformed buffoon, Al Franken, might win a Senate seat, and attracted over a million votes. In which a convicted crook, Ted Stevens, retained his seat. In which a corrupt bastard (to put it as politely as I can muster, believe me) who insults his constituents and slanders Marines who faced death and agonizing decisions in a war against a dishonorable and vicious enemy is re-elected easily. In which the party in control of a Congress with lower approval ratings than Bush’s subterranean numbers increases its majority. I always try to avoid Peter Jennings-esque blame-the-voter rants when results are not as I would like, but at the same time I cannot resist the thought that the results betray a fundamental unseriousness, self-absorption, gullibility, and willingness to suspend disbelief in vast swaths of my fellow citizens. And given such a frivolous citizenry, men and women of will and guile in positions of power can achieve a lot. In some ways, the alternative is even worse—that alternative would be that people actually want to see this agenda implemented. Either way, there is a non-trivial probability of a vast enhancement of the power and intrusiveness of the Federal government at home as great as, or greater than, anything experienced since FDR. And there is a non-trivial probability of a vast diminution of American power abroad, as severe as occurred during the isolationist 20s and 30s, or during the Jefferson administration.

My wife asked me to say something positive about yesterday’s outcome. Everything I could think of reminded me of the old joke about the farm boy whose mama told him to make sure that he said something nice to his prom date. At the dance, he strained his brain to think of a compliment, finally blurting out: “You don’t sweat too much for a fat girl.” So I demurred from responding to Terry’s request.

Adam Smith wrote that there is a good deal of ruin in a country. I think we are about to test the limits of how much there is in this one.

I only know Gary Gorton through his work, which is quite impressive. He is a recognized leader in scholarship about banking, and about financial crises. According to the WSJ, Prof. Gorton also developed default loss models that AIG used to value mortgage backed securities, and default swaps on such securities. According to the article, these models did not adequately characterize the risks that AIG took on when entering into the default swaps. The article acknowledges that “Mr. Gorton’s models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn’t attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG’s finances.” That’s all very nice, but fairly or unfairly, the association of Gorton with the AIG collapse will undoubtedly lead many to blame him for providing incomplete models that led the company astray.

The article is too sketchy to support any definitive conclusion on exactly what Gorton’s models did or did not do, but ironically, it suggests that an issue that I discussed yesterday in “The Market Price of Risk” is at the heart of the matter. From the article I infer that Gorton’s models were intended to calculate the distribution of cash flows on the swaps. To get a value from that information, or to assess risk, it is necessary to discount those cash flows. If Gorton/AIG failed to take into account the substantial systematic risk inherent in the design of the underlying securities (as discussed in Coval-Jurek-Stafford), they would have underdiscounted these cash flows, overestimated the value of the securities and swaps, and underestimated the risks on these positions.

This article is also intriguing when considered in the context of some of Bernanke’s testimony in September or October. In advocating the TARP program, Bernanke argued that the market values of mortgage securities and mortgage derivatives were far below what they were worth based on estimates of their cash flows. Bernanke (citing work by Franklin Allen and Gorton) claimed that this was evidence that there was a huge illiuqidity discount embedded in the prices, and that creating a more liquid market for them through government purchases at an auction (anybody heard any more about that, BTW?) would lead to substantial increases in market value.

Bernanke’s statements about the disconnect between cash flows and market prices sound like they were based on a model like Gorton’s/AIG’s. He obviously admires Gorton’s work. So my guess is that directly or indirectly Gorton convinced Bernanke that the low market prices of mortgage derivatives excessively discounted their cash flows. This, in turn, gave impetus to–and perhaps birth to–the TARP auction plan. Just a guess, but the dots do connect.

From the Economist:

Beyond crisis response, Russian state officials are hinting at some of the steps they would like to take to avoid a repeat of the current difficulties. One measure, given the pain inflicted of late by the dollar’s surge, is to conduct more trade in currencies other than the US dollar. Another theme, to which several officials have alluded, is the need to build up a strong national financial centre, so that the country is not unduly reliant on the foreign finance that has proved so flighty in recent months.

There are many reasons why so much capital has been exported in recent years; one of them is the ambition of Russian companies to become global players. Another, however, is that Russia’s rich do not feel their wealth is fully secure in the country. In this sense, Russia is suffering acutely because of the chronic political risk attached to property rights in the country. Domestic and foreign investors might hope that the authorities will conclude that there is a need to strengthen property rights. Yet for the moment, other considerations must take precedence.

The diagnosis of the root of Russia’s long term problem–political risk and the resultant insecurity of property rights, is spot on. But “Hope” for an official recognition that property rights must be strengthened? “Fantasize” is more like it. Beyond a few verbal flourishes (“legal nihilism”) there has been virtually no recognition by the powers that be (and there is even reason to dispute that the man who uttered “legal nihilism” can be called such) that attacks on property rights need to cease, or that Russia’s long term future is dependent on protecting property from the predation of the state, or its favored interests.

“Other considerations” will take precedence, for this moment, and for all moments into the foreseeable future. A system predicated on the unchallenged supremacy of the state will never credibly concede autonomy to individuals or individual companies. In such a system, and under such an ideology, every interest and every individual must bow before the state–but property rights are a bulwark against the state, and so are inconsistent with the fundamental character of the system. Thus, strengthening of property rights is not in prospect, and consequently, a strong, independent “national financial centre” is a pipe dream.

A couple of thoughts regarding clearing, both important and overlooked, methinks.   They’ve been on my mind for awhile, and I have a moment to get them off.

First, the issue of systematic risk.   The chairman of The Clearing Corp, Goldman’s Michael Dawley has stated that a central counterparty for CDS contracts would reduce systemic risk.   The article in which Dawley is quoted does not go into detail as to how a CCP would reduce systemic risk.   Presumably, by regularizing procedures and centralizing information, it would mitigate operational risks that could metastasize into systemic ones.

But let me interject a note of skepticism.   Systemic risk presumably arises because of an externality.   Private contracting decisions can lead to outcomes that jeopardize the financial and payments systems.   Damage to the payments system, for instance, can impose immense costs on individuals not parties to the original contracts that were the source of the contagion.   It is the existence of this externality that means that private contracting decisions, notably, decisions regarding the amount of risk to incur, may be suboptimal.

Such costs are external to the parties to CDS contracts in a bilateral OTC market, and are almost certainly external to a CCP, especially one owned and governed by large dealers.   That is, creating a clearinghouse does not internalize the externality that is the source of systemic risk.   Indeed, if a CCP prices risks badly (due to asymmetric information, for instance), it might actually exacerbate systemic risks.

I therefore conclude that the formation of a CCP is not sufficient to reduce substantially systemic risk, and that expectations or representations that it will (beyond the effect of reducing operational risks) are overly optimistic.

Second, consideration of the balance sheet risks in OTC markets led me to think about balance sheet risks for exchange clearinghouses.   The brokerage/FCM industry has evolved dramatically over the past decades, and now clearinghouse membership is dominated by the big banks, whereas at one time the clearing business was less concentrated, and less dominated by huge integrated financial institutions.

As I’ve written in posts about OTC clearing, these huge, integrated financial institutions have opaque balance sheets that carry a great deal of risk that is difficult for third parties to evaluate.   As clearing members, they expose exchange clearinghouses to their balance sheet risks.   Moreover, exchange clearinghouses don’t attempt to evaluate this risk (almost certainly because they lack the information to do so), and certainly don’t price it.

Thus, the evolution of the clearing business has arguably increased exchange clearinghouses’ vulnerability to balance sheet risks.   Given the potentially disastrous implications of a clearinghouse failure (and it’s not outside of the realm of possibility–both CME and CBT clearinghouses came within an ace of failure on 10/20/87), this is something that deserves some attention, but which has not heretofore.

he FT has an interesting article about how changes in the bankruptcy code in 2005 made it easier for firms in derivatives transactions to settle trades and demand additional collateral from their counterparties. According to the article, this made it easier for counterparties to demand additional collateral from Bear and Lehman when these companies began to experience trouble, and this accelerated their demise.

The article is wrong, though, on one thing. It says:

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

The more important issue was that settlements and collateral obtained 90 days or less prior to a company’s declaration of bankruptcy could be deemed a “preference.” The bankruptcy trustee could sue the counterparty of the bankrupt firm to “to recover from creditors payments made shortly before the bankruptcy filing where the payment gave the creditor more than other, similarly situated, creditors would get through the bankruptcy process. ” Thus, if a firm settled an outstanding derivative contract with a firm that eventually went bankrupt within 90 days of the settlement, and received a $1 million payment from the eventual bankrupt pursuant to the settlement (e.g., the parties agreed to close a trade that was underwater from the perspective of the eventual bankrupt), the trustee could sue and claw back the entire $1 million. The firm that had obtained the money in the settlement is then put in the same boat with the rest of the bankrupt’s creditors. Treating settlements and collateral demands as a preference increases the default risk exposure of parties to derivative contracts.

There has long been a safe harbor provision in the bankruptcy code that protected settlements on forward contracts from preference claims. (I’ve worked as an expert in several cases involving forward contract settlements in bankruptcy.) The 2005 bankruptcy code broadened the safe harbor protections to cover explicitly instruments (e.g., swaps) and market participants; prior to this time, it was a matter of uncertainty whether certain kinds of swaps and other derivative contracts would fall under the safe harbor protections. Thus, the change to the bankruptcy code clarified ambiguities in the code, and reduced the legal risks of engaging in derivatives trades.

It is certainly the case that absent the risk of preference claims, derivatives counterparties are more likely to demand that financially shaky trading partners settle contracts that are assets to the financially sound company, and liabilities to the troubled one, or to demand additional collateral from the troubled company. This creates the potential for “runs” on shaky derivatives dealers. Counterparties want to be first in line to get more cash (either from settlements or collateral) from firms that might go under.

Although it seems that runs are a bad thing, the Diamond-Rajan articles on financial fragility show that runs can serve as a disciplining device for financial intermediaries who supply liquidity. Intermediaries supply liquidity. They take funds from lenders, and invest them in higher returning projects. The financial institution has an information advantage in engaging in this information intensive intermediation, however, that allows it to act opportunistically. Absent some form of market discipline, the information advantage allows the intermediary to hold-up the suppliers of funds. Diamond-Rajan show that runs are a disciplining force, and absent such discipline, the opportunism problem results in suboptimal creation of liquidity.

Many aspects of derivatives contracting in OTC markets, including credit triggers that require the immediate liquidation of contracts or the ability to call for additional collateral in the event of a credit downgrade by a party to a derivatives contract encourage run-like behavior. Although there is not an exact analogy between derivatives contracting, and the lending/financing intermediation that Diamond-Rajan model formally, derivatives dealers do supply liquidity to the derivatives market, and especially in more specialized contracts do have an information advantage in dealing with their counterparties. The Diamond-Rajan logic therefore suggests that it may be necessary to subject the dealer to the risk of runs to discipline opportunism. Thus, the fragility of derivatives dealers, so graphically illustrated by recent events, may be efficient, as unsettling (no pun intended) as that conclusion sounds.

Diamond and Rajan argue that measures intended to reduce the likelihood of runs on financial institutions can actually reduce the efficiency of financial markets by raising the cost of disciplining liquidity suppliers. This higher cost of enforcing contracts leads to a smaller supply of liquidity. Thus, in their models, eliminating runs is a bad thing, not a good one, as intuition might suggest.

If this logic extends to derivatives contracting, it has implications for the appropriate regulation of derivatives dealers. I conjecture that the logic can be so extended, but this deserves some formal modeling. Add that to the pile.

I wrote an extended reply to DR’s comment regarding sovereign debt credit spreads, but (a) I had been planning on writing something regarding the price of risk more generally, and (b) the subject is of broad importance, so I’ll expand upon those thoughts in this post.

Credit spreads are essentially a price. Given a set of promised cash flows, the higher the credit spread, the lower the market price of those cash flows. Thus, if you had Russian and Brazilian debt with the same promised cash flows, a higher spread for Russia implies that the Russian debt sells for less.

This can occur for two reasons, the first of which gets the most attention, the second of which is the focus of this post.

The first reason relates to the size of cash flows. On debt instruments, realized cash flows differ from promised cash flows due to defaults. Therefore, the lower price of Russian debt could arise because market participants estimate that Russia is more likely to default than Brazil, and/or, in the event of a default, bond holders will receive fewer cents on the promised dollar from Russian bonds than Brazilian bonds.

The second reason, which is somewhat harder to grasp, is that market participants can apply different discount rates to different securities. In particular, finance theory tells us that you should discount riskier cash flows more heavily than less risky ones. All else equal, greater risk leads to greater discounting to lower price, which leads to higher spreads. Thus, Russian spreads could exceed Brazilian spreads because market participants discount Russian cash flows more heavily due to greater risk.

This raises the question: What is risk? Finance theory tells us that risks that are diversifiable should not be priced, that is, they should not affect the discount rate. This is because if the risk is diversifiable (also known as “idiosyncratic”) investors can eliminate it by holding highly diversified portfolios.

A diversifiable risk is one that affects one investment and that investment alone, and which is uncorrelated with the risks on other investments. For instance, the possibility that a particular company achieves a technical breakthrough is diversifiable, as is the risk that a particular company is hit by a product liability suit, or has a particularly good or bad management. Diversification eliminates these risks because in large portfolios, the law of large numbers means that the bad luck in one company is likely to be offset by good luck in others.

A systematic risk is one that cannot be diversified away. Typically, it is a risk that is driven by overall economic activity, that is, by the state of the overall economy. The overall economy affects all investments to some degree or another, and can’t be diversified away. We have many companies and countries, but only one economy.

Different assets have different sensitivities to overall economic activity. “Cyclicals” is an investment buzzword for companies that perform very well when the economy does well, but do very poorly when the economy is in recession. Some stocks (e.g., healthcare) are often considered to be non-cyclical because the demand for the services of these companies is not as sensitive to overall economic activity as are industries more dependent on discretionary income, such as automobiles and housing.

In brief, investments with performance that is highly dependent on overall economic activity tend to be discounted more heavily. People want investments that pay off when times are bad, and are willing to give up payoffs when times are good. Investments that are highly dependent on the overall economy are sunshine friends–they do well when you don’t need them as much (as your other investments are also paying off), but do poorly when you really do need them to pay (because all your other investments are doing poorly then too.)

Oil provides a very interesting illustration, and a link to the discussion of Russian credit spreads.

Historically, oil has had negative systematic risk. That is, oil prices tended to go up when the economy was doing badly, and go down when the economy was doing well. That meant that if you bought oil, it would pay off handsomely when you really need good payoffs–when your other investments are doing badly.

One explanation for this negative systematic risk is as follows. Supply shocks have historically been an important source of major oil price movements (think of the 1973 and 1979 oil shocks, the supply glut of 1986, and Gulf War I). Unexpected reductions (increases) in oil output raised oil prices and hurt the overall economy. The decline in the overall economy led to stock price declines. Thus, if supply shocks are major drivers of oil prices, you would expect a negative association between stock price and oil price movements.

Things are different now. At present, demand shocks are the major drivers of oil prices. Anticipations of a recession, and likely a severe, worldwide recession, have led to reductions in the expected demand for oil. This is why oil prices have declined of late. Moreover, the anticipation of a recession has caused stock prices to tank too.

Nowdays, the prices of oil and stocks tend to move in the same direction, and exhibit a relatively high correlation. You tell me what happens to the price of oil, and I can tell you (at least directionally, and with some precision as to magnitude) what has happened to the S&P or the FTSE. The price of oil is now a hostage to overall economic activity, as is the stock market. As a result, oil has gone from exhibiting low or negative systematic risk, to exhibiting high and positive systematic risk.

This can help explain Russia’s particularly high credit spreads relative to other BRIC countries, and why Russia has a higher credit spread that Iceland, even (though not as high as basket cases Pakistan, Argentina, and Ukraine.) It also contributes to the oft-noted fact that Russian stocks appear very “cheap” (as measured by price/earnings ratios, for instance) compared to other stocks.

The Russian economy is highly dependent on oil. In particular, government revenues are highly dependent on oil prices. Since oil has significant systematic risk, this means that securities (debt and equity) that are tied to the Russian economy have high systematic risk.

Moreover, the political factor risk factor plays here. It is becoming increasingly clear that the government is willing to spend a lot of money to cover the foreign currency borrowings of Russian companies. The largest borrowers, moreover, are energy companies. Their need for help will be greater, the lower the price of oil. Hence, the lower the price of oil, the faster Russia will burn through its reserves, the weaker its financial position will be, and the higher the likelihood of a default (de jure or de facto, a la 1998).

In essence, due to the close tie between oil prices and its economic fortunes, it makes sense that Russian spreads are very high. The country faces a triple-whammy. (That’s the technical finance term for it.)

First, default is more likely, and recovery rates are lower, the lower the price of oil. If oil prices remain low, Russia is more likely to blow through its reserves bailing out favored firms and defending the ruble. Furthermore, with low oil prices, government finances erode. All of these factors raise the likelihood of default on government debt. Thus, the probability of default is higher, and the recovery conditional on a default lower, the lower the price of oil.

Second, due to the high systematic risk associated with oil prices, cash flows highly dependent on oil prices are discounted more heavily. This includes government debt, private debt, and the equity of Russian companies, especially those in the energy sector, but not limited to that sector (e.g., consumer goods producers and retailers and construction firms are also vulnerable due to the link between their sales in Russia and the price of oil.) Russian investments, including government debt, are likely to do very badly when oil prices are low. Since the price of oil is likely to be low when overall economic activity is low, this poor performance is especially costly to investors, leading them to discount Russian investments more heavily.

Third, the factor I mentioned in The Price of Political Risk, namely the greater susceptibility of the Russian state to disorder when oil prices are low, exacerbates these problems. The low oil price stresses the weak institutions, and which contributes to pressures to spend reserves. It also increases the probability of popular unrest, government infighting, clan warfare, and in the extreme, political chaos and collapse.

So, the facts that (a) the Russian economy, and perhaps more importantly, its public finance and the demands on its public purse, are heavily dependent on the price of oil, and (b) in current market conditions oil-sensitive investments bear substantial systematic risk, imply (c) investments in Russian government or private debt, or Russian equity, have been especially hard hit by the credit crisis. Moreover, (a) and (b) imply that Russian investments will exhibit exceptional sensitivity to oil prices. So much for an island of stability and tranquility.

If you’ve been following the markets lately, you’ll observe that Russian stocks and US and European markets have been moving in the same direction (up on the same days; down on the same days), but that the movements in Russian stocks have been far more violent. (One consequence of this is that since markets overall are down in recent weeks, Russian markets have fallen more.) This is consistent with the foregoing that suggests that due to the oil price connection, Russia exhibits very high systematic risk. Moreover, the very low P/E ratios of Russian stocks are also consistent with this analysis.

Although the Russian market experience is a particularly interesting, this analysis demonstrates a very important point that is missed too often. It has application, for instance, to the ongoing financial crisis and the collapse of mortgage securities prices. This very interesting paper by Coval, Jurek, and Stafford argues that CDOs (and other tranched securities) exhibit very high systematic risk by the very nature of their structure. CDOs invest in multiple instruments, and therefore are highly diversified. What’s left is all systematic risk. What’s more, per C-J-S, this systematic risk is very high because of (a) the fact that the underlying investments are very sensitive to overall economic activity, and (b) the optionality (and hence embedded leverage) in the structure of the instruments.

For instance, the highest tranches of CDOs are likely to payoff when the economy does well. Defaults occur when the economy is doing badly. Thus, low payoffs on these instruments occur when the value of consumption is greatest. This means substantial systematic risk.

C-J-S note that rating agencies only modeled default probabilities and recoveries when rating these instruments, and did not take into account their high systematic risk. The investment grade credit ratings were therefore a very misleading indicator of the risk of capital gain or loss on these instruments.

In sum, finance theory tells us that systematic risk matters. Different instruments have different systematic risks. Russia’s dependence on oil prices and the structure of CDOs both create substantial systematic risks that the market discounts heavily.

As C-J-S note, too often people focus only on the cash flow projections, and pay too little attention to the discounting. (That’s what the rating agencies did in the CDO market.) Seemingly anomalous pricing may well reflect specific systematic risk characteristics of the instrument being priced. (Ignoring this is why arguably why Bernanke thinks that CDOs on bank balance sheets should be worth a lot more. His public statements have seemed to focus on the cash flow projections, rather than the discounting assumptions.) Thus, when evaluating the pricing of a particular instrument, you need to ask: in what states of the world are the cash flows going to be low? Are they going to be especially low during those periods when the cash flows on most other investments are low too? If the answer to that question is “yes”–you need to discount heavily.