Streetwise Professor

I’ve written a little on Russian demographics in the past, usually drawing a retort from DR/Sublime Oblivion.  DR (Anatoly Karlin) has written a long piece where he takes issue with the conventional wisdom that Russia is a dying nation in a downward demographic spiral.    I’m not a demographer, so I can’t present a professional demographer’s review, but I am a social scientist, so can make a few reasoned points on DR’s analysis.

First, overall, what DR has written is a useful summary that emphasizes some things that deserve consideration.  Reading it has raised some questions in my mind about the conventional wisdom (which I am always somewhat skeptical about, being especially dubious of consensus science.)  The analysis of fertility is more thorough, and more convincing than that of mortality, by far, and does provide some reason to believe that the exceedingly black portrayal of Russian birth trends is overdone.  

Second, that said, I come away mostly unconvinced.  That is, I think that although DR’s argument that the pessimism is overdone is supportable, it’s a long way from there to any real optimism about Russia’s demographic future, especially in light of the economic crisis.

A few key points:

• A good deal of DR’s analysis involves pointing out that compared to European and Japanese fertility, Russia doesn’t look that bad.  Well, since it is well understood that European and Japanese fertility are pretty appalling, that’s very cold comfort indeed.  DR says “Russia is becoming part of the rest of Europe with respect to ideas about ideal family size.”  That’s the good news?  The European example is hardly worth emulation.
• Even by these comparisons, Russia doesn’t do that well.  The total fertility rate is at the bottom of the list of countries included in his figures.  Ditto for net female reproduction.  (His discussion of NFR below the graph is very hard to follow, and doesn’t seem to match up with the evidence in the graph.)
• What DR touts as the most accurate measure of long term fertility, the average birth sequence (ABS) does not provide tremendous evidence that a corner has been turned, as DR suggests.  The measure showed little variation, and certainly no systematic improvement in the post-1998 period.  There is a noticeable uptick in 2007.  But one year doth not a trend make.  Especially given that underlying circumstances have changed dramatically for the worse in late-2008 and 2009.  I also note that there is no comparison between this measure in Russia and other countries, whereas there is such a comparison for the other measures of fertility.  This raises questions in my mind.  Why compare TFR and NFR across countries, but not ABS?  
• Not surprising to those who have read DR’s comments here on SWP, his treatment of Russia’s appalling adult male mortality is cavalier, not to say amoral.  “Excessive mortality also disproportionately affects poorer, badly-educated people.”  “It is true that poor health lowers productivity, although by curbing aging it also relieves pressure on pensions.”  Gee, I thought the reason for pensions was so that people could live good lives into old age.  That is, pensions are for people, but DR seems to argue that people are for pensions.  
• These facts remain: (a) if people die at greater rates than they are born, population will decline; (b) Russian death rates are so much higher than the corresponding rates in Europe, Japan, the US and Canada that the “productivity effect” is large (gliding over whether the value of lives should be measured by production); (c) early death, poverty, and lack of education are all affected by individual choices, and nations in which far larger numbers of individuals choose behaviors that increase their odds of dying young and poor must be providing perverse incentives for people to engage in those behaviors–unless DR wants to make some cultural/racial based argument that it’s something inherently Russian.
• DR has to squint very hard to put Russian infant mortality of 8.5/1000 “close to developed world standards of 3-7/1000.”  The latter is a very wide range, and the Russian rate is still 20 percent above the highest of that range. It would also be worthwhile to present statistics on mortality before 5, rates of abandonment/orphaning/fostering.  
• DR asserts that high male death rates have “little direct effects on fertility” because “men don’t reproduce.”  This is a very reductive analysis that elevates a biological fact into a demographic conclusion, thereby ignoring economic aspects of fertility.  Women’s decisions to have children will depend in large part on their assessment of their future life prospects.  A large risk that the father of their children will die prematurely, often of a behavioral choice that also tends to reduce earning potential, will affect decisions to marry, and decisions about fertility, and not for the better.  Maybe DR is right, and playing Russian husband roulette doesn’t affect fertility.  But it is only an unsupported assertion/hypothesis.  He would be better served by investigating that hypothesis, or presenting evidence in support of it.  

DR’s main basis for demographic optimism is based on a hopeful interpretation of survey evidence, and a projection of economic optimism about Russia’s future.  In a nutshell, he argues that survey evidence shows that Russians would  desire, under optimal economic circumstances, to have about 2.5 children per family.  Actual birth rates have been lower, due to seriously suboptimal economic circumstances. But “after a long period of disillusionment, at the end of 2006 more people began to believe that Russia was moving in a positive than in a negative direction.”  Economic circumstances are improving, and are expected to improve further.  As a result (although DR caveats this linkage between the 2007 uptick in TFR/ABS and renewed optimism), it can be expected that Russian fertility will rise as economic conditions will allow the closing of the gap between actual and desired family size.  This will lead to an avoidance of demographic implosion.

Perhaps.  But.  

This is a conclusion based essentially on one year’s increase in TFR and ABS.  Again, one year doth not a trend make.  I would emphasize that the ABS numbers DR reports show no trend at all during the period of time when the Russian economy was growing rapidly.  It declined even in 2006.  In 2007 it did rise sharply.  That is a very weak basis for a conclusion that improved economic circumstances will lead to substantial fertility changes.  

But again.

DR dismisses the possibility that the current economic crisis will undermine this budding confidence, and slow or reverse the 2007 uptick.  Although he acknowledges that the 2008-2009 collapse was sharper than the 1998 one, he takes comfort in the fact that “both state and society have much bigger surpluses to fall back on during the lean times.  As a result, the probability that the crisis will have a significant longterm effect on Russian fertility is extremely low.”

Again an assertion, and a highly dubious one.  The state surplus is being exhausted rapidly.  Don’t believe me?  Ask Kudrin.  Moreover, the surplus is being used to support current consumption and social programs, not to mention the military, and desperately needed long term investments in things like infrastructure are being slashed.  This will not provide the foundation for robust, organic growth not driven by resource rents.  

More tellingly, the crisis is still in its very early stages.  Unemployment is rising rapidly.  Importantly, individual incomes and wages are falling rapidly after years of rather heady growth.  There is an appreciable probability that, as Kudrin himself states, that the economic malaise will be severe and protracted.  This would not be favorable for continued improvements in fertility.

Regardless, the crisis gives the lie to the very narrative of stability and a boundless future upon to which DR attributes the turning of the demographic corner in 2006-2007.  Not to go all Gary Becker on you, but viewing childbearing as an investment, and recognizing that people tend to defer investment when uncertainty rises dramatically, I think it is overoptimistic of DR to dismiss so blithely the potential impact of the economic crisis on fertility (and on mortality, for that matter).  Even if Kudrin’s forecast is unduly gloomy, people will now know that economic risk has not gone away, and even in good economic times, things can turn bad with a vengeance.  We’re certainly learning that in the US.  Given the much more tenuous basis of optimism in Russia, and its tumultuous social, economic, and political history, it would be understandable if the crisis has long term effects on fertility through (a) the persistence of the crisis itself, and (b) its effect on Russians’ perceptions of economic risk.

These are hypotheses, I grant.  But that’s all DR can really offer in support of his optimism.  Put differently, he has a story, and one data point (2007) to support it.  That does not make an extremely convincing case.  

That’s why I’m not convinced.  Plausible economic scenarios–arguably more plausible than DR’s rosy one–the recognition of the possibility that 2007 may be an outlier, rather than a harbinger of a sea change in behavior, and a more thorough analysis of the economic underpinnings of fertility continue to make me far more skeptical of Russia’s demographic future.  

A couple of pieces caught my eye today.  Each discusses the prospects for political unrest in Russia.

The first is by Peter Reddaway in the National Interest.  It makes a point that I’ve been advocating here for well over a year: namely, that the fundamental nature of the Russian state makes it ill-suited to respond to large shocks, and as a result is brittle and subject to collapse.  (Here’s one of my posts that discusses this in detail.)  Here’s Reddaway:

To date, these have been lacking, partly because Putin and Medvedev have somewhat different interests and instincts, partly because the mafia-like clans of Russia’s power elite are seriously divided, and partly because the deeply ingrained vices of “the Putin system” have made personal and clan interests, not Russia’s interests, the ruling class’s priority. None of the clans wants to upset the covert and intricate arrangements of the status quo with an honest debate about the national interest. They are rich, sometimes superrich, with too many secrets to hide about how they acquired their wealth. Usually their business interests conflict with the national interest, to the detriment of the latter. Members of Putin’s main clan—his comrades from the security services in St. Petersburg—are especially determined to hang on to their power and wealth, and may, in the short term at least, have more ways both of influencing Putin and of undercutting Medvedev than do others.

The clans are trying to adapt to the disorienting political system in which there are suddenly two masters and not one. Even though Putin is clearly more powerful than Medvedev, they see that this might change if, say, Putin decides to retire. So maybe it is best to get close to Medvedev in advance, or at least to hedge their bets. On the other hand, maybe Putin will push Medvedev out and resume the presidency, in which case he’d take revenge on them for having sucked up to Medvedev. After a year of this, the uncertainties facing Russia’s rich are as enervating as ever. And with a drop of 70-75 percent in the value of the stock market, the well-off are losing a lot of money and their moods have become sourer still. Thus the risk grows that the bolder clans could start to seek change in the leadership, a potentially disruptive outcome.

If, as seems plausible, the recession and the clumsy tandem structure should make the Putin-Medvedev leadership increasingly erratic, the implications would be many—a deteriorating economic policy, business and bureaucratic groups ever-more aggressive in their demands, regional governors asserting more autonomy, the spread of popular discontent, weakened media censorship and a less predictable Russian foreign policy, to name a few. The future of the leadership would be subject to even-more discussion, maneuvering and plotting than it is already. And the critical public support for the present leaders would start to fragment. This would throw their futures into doubt and could lead to an unstable transfer of power.

This description is similar to the cartel model that I’ve advanced before.  Such systems are ill-suited to change.  This is true for a couple of reasons.  The most important is that they are set up to maintain the status quo.  Rival groups settle on an agreement to divide the spoils.  Importantly, as the stream of spoils is expected to persist over time, it is desirable to avoid haggling and conflict in the future, so the agreement is intended to be enduring.  However,  any such agreement is subject to reneging.  Any major change can be perceived as reneging, and one perceived episode of reneging is often met by retaliatory moves.  Such tit-for-tat behavior can lead to unravelling of the entire agreement.  So, such systems usually attempt to build in constraints on change.  

A famous paper by Marshall and Weingast that discusses the seemingly byzantine nature of Congress explains the complexity of the committee system, seniority rules, and arcane procedures as one means of constraining change in order to enforce deals among Congressmen.  I promise to vote for the dam in your district if you vote for the defense plant in mine.  Next year, however, I might be tempted to lead an effort to cut funding for your dam, especially if I feel that my defense plant is secure.  The earlier promises can’t be enforced in court, so there must be some way of preventing this sort of reneging; otherwise such logrolling deals would never be made as performance could never be relied upon.  

The committee system is one way to do it.  If you sit on the committee that is responsible for dams, and I sit on the one that is responsible for defense appropriations, and importantly, if my committee must approve any change in defense appropriations and yours must approve any change in dam appropriations, I can’t unilaterally renege on my deal, nor can you.  You will shoot down my attempt to renege in your committee, as will I yours in mine.  Weingast and Marshall show how other seemingly inefficient aspects of legislative rules and procedures play similar bargain-enforcing roles.  For example, seniority tends to lead to stability in committee assignments, and to give the most senior legislators greater power in committees.  This creates hystersis in committees that tends to lead to stability in legislative bargains, and resistance to change.  

The important point is that since reneging is change, these rules tend to favor the status quo and to make change difficult.  That is typically for the good in stable situations, but can be disastrous in conditions of discontinuous external change, e.g., a large economic shock.  In Russia’s case, for instance, the representative of one clan argues “We need to respond to this crisis by doing X, a radical departure from our past practice.”  The other clan retorts: “No, you don’t want to do that for the national benefit, you are just trying to get out of our earlier deal and do something that helps you and hurts us.  No dice.”  

That is, since it is so difficult to distinguish reliably between policy/rule/deal changes that are optimal responses to shocks, from those that are opportunistic changes intended to undo previous deals to the benefit of one party and the detriment of others, systems of this sort are typically very rigid and resistant to change.  The choice is usually either between doing nothing, or (in the immortal words from The Godfather), going to the mattresses.  Given the horrific consequences of the latter, the tendency is to do nothing even when it is widely acknowledged that something should be done.  

This is particularly true of highly centralized, state-dominated systems.  In such systems, the relevant bargains are much more extensive and encompassing.   There are few independent agents who can unilaterally act without upsetting the whole structure.  Such systems find it especially difficult to deal with big shocks.  

These systems also tend to undermine elections and court systems that can overturn the status quo.  This further reduces their capacity for change.  Similarly, restrictions on the flow of information also favor stability, but at the expense of reasoned response to exogenous changes such as an economic shock.  

I think these various factors explain the policy gridlock that Reddaway describes.  It also explains the fetishization of stability in Russia, and the deep-seated fear of change.  This is also why incremental change is very difficult in such systems, and hence why when it does come, political change tends to be cataclysmic.  When the external shock is big enough, and the system cannot respond organically and supplely, collapse/chaos/cataclysm is the typical result.  That is, sometimes the rivals feel compelled to go to the mattresses.

Which brings us to the second article, via FT Alphaville:

Risk consultancy Eurasia Group is exploring the “increasing likelihood of radical political disjunctures”, or fat tail events in national-level politics.

Here’s their synopsis:

The combination of lost savings, banking crises and credit crunches, rising unemployment, growing popular discontent with financial and political elites, and the squeeze on government services is dramatically increasing the pressures on political leaders, institutions, and stability in countries all over the world. Governments everywhere are taking steps to counteract the impact of the global crisis with efforts to ward off socioeconomic and political discontent. But countries vary significantly both in their resiliency in the face of the crisis, and in their ability to respond to it coherently and effectively.

The political impact of the crisis is anything but uniform across countries.For differing reasons, we see a great deal of resilience in some of the most important emerging powers, including China, India, and Brazil. But the unprecedented strain on political systems is creating fat tail risks for unexpected political changes in a number of major countries.  In this report, we describe the top ten fat tail scenarios: significant political changes in important countries that would have been almost unthinkable six months or a year ago but are now much more conceivable. In general, these scenarios reflect the interplay between elements of the economic crisis and preexisting tensions, conflicts, and political vulnerabilties. (Emphasis from FT-Alphaville).

Note which BRIC country is missing from the list of “resilient” nations?  B–covered.  I–covered.  C–covered.   R?  Nope, no R.  That’s because Eurasia Group assigns an appreciable 20 percent probability to a Kremlin coup by hardliners.  (Putinophiles–I won’t say Russophiles–may take comfort, however, in EG’s assessment of 15 percent odds of a Ukrainian turn towards Russia.)  

EG’s analysis makes sense in light of what Reddaway writes, and what I’ve mentioned here and elsewhere.  “Unprecedented strain on political systems” is most dangerous in places like Russia, where extreme resistance to change is baked into the cake.  Such resistance is necessary for the system to survive in normal times.  But it can be fatal in abnormal ones.  

I’ve never said that a cataclysm in Russia is a probability 1 event.  I have said consistently that the structure of the system makes it more vulnerable to cataclysm than most other major nations.  The Reddaway and EG pieces take a similar view.

Russia, renowned for its public health prowess, is taking aggressive measures against swine flu:

All passengers arriving in Russia from the United States or Mexico will have their temperatures tested to make sure that they are not carrying a deadly strain of swine flu, Gennady Onishchenko, head of the Federal Consumer Protection Service, said Sunday.  

“All airline passengers from Mexico and the United States will be passing through a contact-free heat sensor,” he said, Interfax rep

Whew.  Glad there’s a “contact free” test.  When I read the first paragraph, I had a vision of a Russian Nurse Ratched standing at the end of the jetway in Sheremetyevo with a thermometer, and NOT one of those nice little electronic oral ones, if you know what I mean.  

Uhm, I mean a temperature may be a necessary condition for swine flu, but it’s hardly a sufficient condition.  My 15 year old had a fever last week.  Pretty sure it wasn’t the swine flu.  Talk about a test tailor-made for false positives.  In other words, a complete waste of resources with virtually no prospect of any benefit.  Unless the whole idea is to discourage foreign tourists, and to deter Russians from traveling abroad.  

But the government’s vigilance does not stop there:

The outbreak also led to a new round of pork bans, Nikolai Vlasov, a deputy head of Russia’s veterinary health watchdog, said Sunday. Effective immediately, uncooked pork from Mexico, California, Texas and Kansas will be stopped at the border because of confirmed swine flu cases there.  

Uhm, again–one can’t contract swine flu from meat:

Here is the C.D.C.’s response to the pork question: “Swine influenza viruses are not spread by food. You cannot get swine influenza from eating pork or pork products. Eating properly handled and cooked pork products is safe.”

Russia has routinely used health justifications to ban imports of agricultural products that compete with domestic producers.  This just seems another transparently opportunistic attempt to exploit health fears to engage in protectionism.

The swine flu is a potentially serious matter.  Thoughtful measures are called for.  The public measures Russia has announced are, to say the least, not thoughtful.  They betray a mixture of xenophobia and economic opportunism.  And, what’s more, they would be more palatable if Russia took a similarly aggressive tack to its own public health dangers (e.g., various outbreaks of bird flu, and especially problems with virulent TB and AIDS).

The signs from The Republic of Georgia are ominous. News reports of exchanges of fire between South Ossetia and Georgia.  An intercepted Nashi provocation.  And most importantly, repeated Russian histrionics over NATO exercises in Georgia.  These exercises were planned prior to last year’s war, and in any event, are basically a glorified staff exercise, rather than serious maneuvers.  But Medvedev has made a big deal out of them:

“This is the wrong decision, a dangerous decision,” Medvedev told a news conference at his state residence outside Moscow.

“Decisions of this kind are aimed at muscle-flexing,” he said. “Such decisions are disappointing and do not facilitate the resumption of full scale contacts between the Russian Federation and NATO.”

Tensions over Georgia have been running high since Georgian President Mikheil Saakashvili’s failed bid to retake the pro-Moscow breakaway region of South Ossetia in August.

Even more ominously, Russia is moving troops to within 25 miles of Tblisi:

Russia has stationed its forces just 25 miles (40 kilometers) from the Georgian capital, in violation of the EU-brokered cease-fire that ended last year’s brief war. And in recent weeks, it has sent even more troops and armored vehicles to within striking distance of the city ahead of street protests against Georgia’s president.

But don’t worry!  They will get a stern talking to!:

The European Union and United States consider Russia to be in violation of the cease-fire signed by President Dmitry Medvedev, which called for troops to pull back to positions held before the war began.

Swedish Foreign Minister Carl Bildt, whose country takes the EU’s rotating chairmanship in July, said this week that the EU has often pointed out to Russia that it is not in compliance and “will continue to point this out.”

Oh, many it won’t be that stern.  “Pointing out” barely makes it to “tepid,” let alone stern  

Pavel Felgenhauer, who correctly predicted the onset of the Russo-Georgian War last year, is convinced that Russia will finish the job this year.  The limp-wristed European, NATO, and yes, American responses to Russia’s increasing pressure, and skirting–and arguably flouting–the cease fire must give Russia confidence that swallowing Georgia will entail little if no political or diplomatic cost, let alone a military one.    

Indeed, Russia’s domestic economic troubles may provide a strong spur to foreign adventurism. I suggested yesterday that Putin was betraying signs of desperation as the economic situation worsens. Fear of unrest, be it among the elite, or the populace at large, always weighs heavily on the minds of autocrats. In such a system, a foreign war can be very useful politically.

The hysterical reaction to the NATO exercises in Georgia cannot be a rational reaction to any military threat posed by the NATO troops, who will be represented by less than a company per nation participating. Nor can it be a rational reaction to any threat that the exercises will bolster the Georgian military sufficiently to pose any threat to Russia.

It could be explained, however, as the reaction of a government that perceives the presence of even small numbers of NATO troops interferes with its timetable to launch a war. If a splendid little war is needed to short circuit domestic discontent, even a delay could be quite costly indeed.

Whatever the reason for the Russian troop movements, the border clash, and the overwrought reaction to what are about the most benign military exercises imaginable do not bode well.

Commentor Sandrew was feeling overlooked because I didn’t pick up on his comment on the Felix Salmon post, a comment that hit the key point in my later response to Salmon.  Here’s his comment:

I think you may be focusing on the wrong transaction costs. To pierce the Coasean retort, one must demonstrate that frictions exist to impede the unwinding of CDS and the transfer of bonds. Pirrong argues that if such transactions are efficient, then the perverse incentives that bond hedging via CDS create can be efficiently diffused.

That said, I’m not convinced that the bond and CDS markets are as well lubricated as Pirrong seems to suggest. To me, the enormity of the CDS market is as much evidence for the presence of significant CDS unwind costs as it is for the popularity of the instruments. If unwinding or novating CDS was so cheap, why did the aggregate notional amounts balloon to umpty-trillion bucks over the course of the past decade?

Sandrew’s comment re the Coasean retort is correct.  Re his second paragraph, well, I don’t really take a stand on how well “lubricated” the CDS market is, except to say that if the empty creditor problem is a really big deal, and the bad incentives resulting from hedged bond positions lead to huge costs, in my view it is likely that the CDS market is sufficiently lubricated to permit market participants to avoid such costs.  I note that re the ballooning of aggregate amounts, etc., when it became apparent that there were large costs associated with failing to close offsetting positions, market participants acted with alacrity and did large amounts of tear-ups through TriOptima, etc.  As a result, notional amounts have fallen dramatically (by about 40 percent if memory serves).  

Thanks for the comment on Salmon’s blog, Sandrew.  You are on point, and get props from me, if belated ones.

So, Sandrew–consider your head patted;-)

Felix Salmon does me the kindness of responding in detail to my post on Coase Meets CDS.  Color me unpersuaded.  

Felix (if I may) strikes the pose of the Practical Man, juxtaposed to his portrayal of me as the Ivory Tower Pointy Head.  It is of course essential to keep the practicalities in mind, but  the Practical Man  (a) is often limited by what has been, and has a difficult time envisioning alternatives, and (b) often lacks a conceptual framework that helps sort through complex situations.  I respectfully suggest that Felix falls victim to both problems.  The comparative advantage of the Ivory Tower Pointy Head is that s/he–I, in this instance–can bring some conceptual order to the complexity.  Indeed, that’s the whole beauty of the Coase Theorem in particular.  By imagining an impractical world, it identifies the key practical aspects of a problem that deserve analytical attention.

Let’s focus on what is the issue at hand, and which Felix doesn’t IMHO adequately isolate, and instead in Practical Man fashion buries in a jumble of other empirically/observationally motivated considerations.  

The issue at hand is: What is the incremental contribution of CDS to the costs of financial distress?  Felix mentions the well-known transactions costs of the bankruptcy process.  But these costs were well known before CDS were a glimmer in some J.P. Morgan banker’s eye.  Relatedly, Felix mentions “very few people trade in [distressed credit]: basically it’s the province of a small number of distressed-debt funds who like to buy the debt cheap and then wade into invariably-arduous litigation.”  True.  But it was true before CDS.  It is true today even for distressed credits on which CDS are not traded, or for which the volume of CDS trading is de minimus.  Relatedly, Felix talks about how “arduous debt renegotiations are.”  True again, but the same remarks hold.  This does not address in any way the incremental contribution of hedged creditors to the arduousness of renegotiations.  So, these remarks are completely off point in responding to the issue at hand.  

The charge before the bar is that by undermining the incentives of hedged creditors to undertake part in value-enhancing pre-bankruptcy restructurings, the costs of these restructurings are higher when some creditors are hedged when they are not.  (Relatedly, it is possible that bankruptcy procedures themselves are higher when some creditors are hedged.)  Discussing the costs of workout and bankruptcy in general says absolutely nothing about this key issue.

When addressing that specific charge, the Practical Realities that Felix mentions are not particularly illuminating, because they are common to all dealings involving distressed credits.  

The relevant issue is the incremental cost of eliminating the putatively perverse incentive arising from hedged trades.  The very liquidity in CDS that Felix touts suggests that this incremental cost is not particularly high; the hedged creditor can reverse the CDS position.  If the creditor does not want to retain the risk exposure associated with the remaining debt that would result after reversing its CDS position, an EFP-style trade (a simultaneous transaction in the underlying credit and the CDS) with a party with an offsetting CDS position, to a first approximation (i.e., abstracting from basis risk) leads to an identical allocation of risk and the elimination of the putatively perverse incentive.  Win win.  Value created that can be shared.

EFP trades have been common features of derivatives markets since their beginnings (though they go by a bewildering variety of names).  Nothing new here.  Nothing complicated here.  Very Practical, in fact.  Practical Men have used them for a long time in many markets.  Nothing Ivory Tower about them.  Indeed, I can say from 20+ years of academic experience that 90+ percent of Ivory Tower finance people have never heard of an EFP.  I learned about it from being in the markets.  

Let’s stipulate that this isn’t being done, at least in quantity.  That means that the costs exceed the benefits.  This could be because the costs are high, or because the benefits are low.  Neither Felix nor any of the other disquisitions on this subject I’ve read present a convincing case that the benefits are high (because the empty creditor problem is particularly pernicious.  The absence of these sorts of trades is also consistent with the benefits of eliminating the empty creditor problem being small.  

Some of the very facts that Felix cites are consistent with the conjecture that the empty creditor problem isn’t that serious because workouts prohibitively costly when this problem is absent.  A lot of firms go into bankruptcy–meaning that pre-bankruptcy workouts are not universal.  Again, this was true before CDS, and is true for firms for which CDS hedging is not that material. This means that the transactions costs of the workout are sometimes prohibitively costly even in the absence of hedged creditors.  Indeed, I would argue that the relative rarity of workouts in situations not complicated by CDS suggests that the incremental contribution of CDS is likely to be small.  

Felix makes some lazy arguments.  About laziness, in fact: “Bondholders have discovered that if they hedge themselves in the CDS market, they can be lazy about such matters.  And there aren’t any easy ways to get a lazy bondholder do hard negotiating work.”  

Again.  If the empty creditor problem–now renamed the “lazy bondholder problem”–is that serious, then laziness is very costly.  There is value on the table that can be used to bribe the lazy to transfer their positions to somebody who is not lazy.  Indeed, the truly lazy can completely wash their hands of everything and pick up some spare change in the bargain.  Sounds tailor made for the lazy.  

There has always been the issue of control rights not being held by those best able to exercise them.  Insurance companies buy corporate bonds not because they have a comparative advantage in participating in workouts, but because the risk-return characteristics of the bonds meets their investing needs.  In the event of an issuer’s financial distress, the insurance company is unlikely to have the comparative advantage in participating in the workout.  The company could–and sometimes does–sell bonds to someone who can exercise the rights more efficiently.  But often it does not.  One reason for doing this is that the rights are not that valuable in the first place–due, in large part, to the arduousness of workouts even in the absence of hedging.  

In the end it’s all about a very basic economic proposition.  A very practical economic proposition that is lived out in markets every day, as it has been for millennia past.  That proposition is that resources flow to their highest value uses.  As modified by Coase, the “highest value use” takes transactions costs into consideration.  Those worrying about the lazy bondholder problem assert that CDS dramatically raise the transactions costs and impede the flow of control rights into their highest value use.  The case is not proven by a longshot.  

Felix objects to my starting the story at the end–i.e., when financial distress looms, rather than when the hedger initiates a CDS trade.  This objection is readily addressed, and indeed, extending the analysis in that direction strengthens my point.

First, that’s the natural starting point in addressing the empty creditor argument, precisely because that’s where Hu and others started it.  

Second, and more importantly, taking this into consideration forces one to consider the effects of CDS in their entirety–something I did in the last paragraph of my post.  The possibility that value will be destroyed due to perverse incentives in the event of financial distress will be priced into the CDS when a hedger initiates a position.  In particular, the costs arising from an inefficient resolution of a financially distressed firm will tend to increase the costs of protection accordingly; the protection seller, anticipating the possibility of making larger payouts in the event of financial distress on the named credit, will price that into the protection.  If consenting adults make the trade nonetheless, it means that the net benefit of the CDS transaction to them is positive even taking into account the possibility of a lazy bondholder problem.  Although it might be desirable to undertake actions that reduce transactions costs in the event of financial distress, there is no justification whatsoever for restricting trading of CDS based on fears of the empty creditor problem.  You may save on some costs, but only by imposing even greater costs in return.  You know that you are imposing even greater costs because you are preventing consenting adults from engaging in trades they deem to be mutually beneficial even given the possibility of the lazy bondholder problem down the road.  

This understanding motivates a very Practical Way of analyzing how to improve the CDS markets.  Focus on reducing the transactions costs of dealing in CDS and corporate bonds.  Avoid measures that constrain the ability of market participants to trade CDS–either to initiate, or reverse positions.  Sadly, to the extent the worries about the empty creditor problem contribute to the CDS are bad meme, they are invoked to support measures that would restrict CDS trading, thereby eliminating some mutually (and socially) beneficial trades.  As an example of the former policy, moves to improve standardization and fungibility would facilitate the development of EFP-style trades in CDS.  (Lack of standardization and fungibility make it costlier to deal with others than with the original counterparty, thereby limiting the possible universe of CDS trades.)  

A couple of final points.  Felix chides my CDS auction speedup proposal because it doesn’t address the pre-bankruptcy workout issue.  I make that very point in my post.  

And finally, Felix states that my original post is a “very long” one.  LOL.  That’s nothing, dude.  Want to see long?  Prowl around the site awhile and you’ll see long!

One of the first things I read this morning was this Itar-Tass statement of Putin’s latest pronouncement:

A gradual inflation slowdown will allow the Central Bank to reduce its rate of refinancing, Prime Minister Vladimir Putin said.

“We can expect the Central Bank to reduce the rate of refinancing,” Putin said at an economic meeting.

Central Bank Chairman Sergei Ignatyev agreed with him.

At the same time, Putin said, “This issue is within the exclusive jurisdiction of the Central Bank Board of Directors.”

“The government should create conditions under which the reduction of the base rates will not be just a symbolic step but will effectively make loans less expensive,” Putin said.

Of course it is in the exclusive jurisdiction of the RCB Board.  Putin said “Jump!” and the Board said “How high, boss?”  So, after I got into the office this morning, and had a chance to catch up on the news, I read this:

The first in a series of interest rate cuts and a minister acknowledged recession could strike much deeper than the government has previously forecast.

Some 1.8 million Russians have lost their jobs in the first three months of the year in a recession that raises the risk of social unrest and presents a major challenge for Russia’s rulers after years of fast growth fuelled by oil wealth.

The 50 basis point cut to key rates, an attempt to support the economy through its deepest crisis in a decade by making commercial loans cheaper, was in line with expectations.

But it came slightly sooner than forecast — most analysts polled by Reuters on Wednesday said the move would come in early May.  

The rationale?  Inflation is coming down.  Really!:

“We believe that we are in a downward trend on inflation and that gives us the basis for lowering interest rates,” the central bank’s first deputy chief Alexei Ulyukayev told Reuters.

“If the macroeconomic situation is favourable, we will continue (to cut rates),” he added.

Sure!  The world famous economist Vladimir Vladimirovich Putin says so:

Just a day after Prime Minister Vladimir Putin said slowing inflation could allow rate cuts, the central bank said it would lower the key refinancing rate to 12.5 percent from 13.0 percent from April 24, and cut the minimum one-day repo rate to 9.5 percent from 10.0. [ID:nLM493897]

After the announcement, deputy economy minister Andrei Klepach said the Russian economy likely shrank a much sharper than expected 9.5 percent in the first quarter and the International Monetary Fund’s forecast for a 2009 Russian GDP contraction of 6 percent was “quite realistic”.

What is the evidence for the slowing inflation?  Certainly not the first quarter of 2009.  Inflation has actually ticked up, and reached almost 50 percent of the government’s forecast for the year in only 3 months.  The story is, apparently, that the leveling of the ruble will reduce import inflation.  But, (a) the level of the ruble is not unrelated to monetary policy, and monetary loosening and reducing interest rates will put downward pressure on the ruble, and (b) the dire budgetary situation will also put pressure on the ruble.

This last concern is particularly acute in the aftermath of the travesty of Putin’s appearing to order the rate cut, and a craven Central Bank reacting immediately to comply.   Monetary policy is all about credibility, and political independence.  I’ve written–as have many other economists, including Hamilton, Meltzer, and others–that the Fed’s actions in the US have raised serious questions about its independence and credibility, and that these could lay the foundation for self-fulfilling inflationary expectations.

The appearance of politicization of Russian monetary policy is now deeply impressed on anybody paying attention.  As this quote from the Reuter’s article states:

Rory McFarquhar, senior economist at Goldman Sachs, noted the proximity of the rate cut to Wednesday’s comments from Putin on inflation. “An unfortunate episode, dispelling any semblance of central bank independence,” he wrote in a research note.

“In the past, the central bank has resisted pressure from Putin on exchange rate policy, but rarely has the ‘jawboning’ been quite as direct as yesterday.”

It is interesting to note that this happy talk about easing inflation also is in direct contradiction with the leader of the expert counsel advising the government on the economic crisis, Vladimir Mau.  He identifies inflation as Russia’s main economic problem.  This suggests a considerable difference of opinion within the Russian government.

So why the haste?  Why the political pressure?  I detect a sense of desperation.  And just why would that be?  Well, maybe this has something to do with it:

The economy plunged by 9.5 percent in the first three months of 2009 and might contract by 6 percent this year, Deputy Economic Development Minister Andrei Klepach said Thursday, painting a bleaker picture than the government had previously forecast.  

The Economic Development Ministry is now reconsidering its forecast of a 2.2 percent drop in gross domestic product for 2009, Klepach said, calling a recent International Monetary Fund forecast of 6 percent “quite realistic,” Interfax reported.  

Klepach declined to give any exact figures.  

Just weeks earlier, Klepach and other government officials had criticized as “overly pessimistic” a World Bank report that predicted GDP would fall by 4.5 percent this year.  

Klepach got into trouble with Prime Minister Vladimir Putin in December for saying the economy would go into its first recession in a decade. Putin said economic growth would continue in 2009, and Klepach later retracted his statement.  

The Economic Development Ministry had predicted earlier this month that the economy would shrink by 7 percent to 8 percent in the first quarter, but Klepach said Thursday that the figure had in fact hit 9.5 percent.  

Klepach said risks for the economy were “higher than expected” because lending and construction had not revived as quickly as the government had hoped.  

“We forecast that lending will grow by 7 to 8 percent, down from the previously expected 10 to 13 percent,” Klepach said.  

He said his ministry has raised its forecast for the average price of oil by $4 to $45 per barrel for 2009 but does not see inflation slowing down from the expected 13 percent for the year.  

Note further evidence of disagreement: contra Putin and RCB, the Economic Development Ministry does NOT see inflation abating.  

Who you gonna believe?  Putin or your lyin’ eyes?  Putin says inflation is declining.  The Central Bank head says Russia is on a downward inflationary trend.  But the most recent data say no such thing.  And many in the government apparently say nothing of the kind either.  This further suggests that the CB move is the result of a political power play engineered by Putin, rather than of a serious consideration of the actual data.

I note as well that this growth forecast from the Russian government is already more pessimistic than the IMF forecast which was more pessimistic than OECD which was more pessimistic than the World Bank, all of which were more pessimistic than previous forecasts.  Need I go on?  

But maybe not pessimistic enough:

The economy in the second quarter, however, is still expected to fall by 8.7 percent to 10 percent, Klepach said.  

Some market players suggested that Klepach’s figure remained too optimistic.  

“The data voiced by the deputy minister show that the economic fall in January was not the bottom,” Rye, Man and Gor Securities said in a research note. “The revival of the economy will not be possible without a significant change in interest rates.”  

Want further signs of desperation?  What about the decision to cease reporting of monthly unemployment statistics, apparently because the news is extremely alarming?:

According to Reuters’ calculations, unemployment hit 11.9 percent in March from 8.5 percent in February, assuming that previous data was unrevised.  

“The shift [in jobless data reporting] could imply a huge leap in March that Rosstat [the State Statistics Service] is seeking to smooth over with this new reporting method,” said Rory MacFarquhar, an economist with Goldman Sachs.

Want more fuel for desperation?  What about Kudrin’s warning that the state reserve funds, painstakingly built up during the seven fat years, will not survive even two lean ones?:

Russia’s vast reserve fund, intended as a cushion against economic downturns, will be completely spent next year as the country battles the crisis, Finance Minister Alexei Kudrin said on Wednesday, Russian website NewsRu.com reports.

“We believe that the reserve fund next year will be practically fully spent,” Russian news agencies quoted Kudrin as saying.

Not vast enough, apparently.

Against this barrage of bad news–virtually all of it from Russian, and Russian government, sources, I might add, not the surmises of stateside professors–desperation is understandable.  Very understandable.  Exploding unemployment.  An apparently hopeless budgetary situation.  An economy that continues to contract far more dramatically than other large economies, which are themselves contracting more rapidly than since the 1930s.  Under these circumstances, it is completely understandable that Putin would be more than willing to trample Central Bank independence underfoot, and demand monetary easing.  Sure, inflation may wreak havoc in the future, but Putin–always a man in a hurry–is focused on the very dire present.  

Indeed, to me Putin’s action in crossing a line that he has avoided heretofore, is a very credible signal of his desperation.  When you got nothing, you got nothing to lose.  

Reading about the bizarre circumstances involving the government’s role in negotiations between the bailed-out auto company and bailed-out banks puts me in mind of a story from the pre-Civil War army about a particularly cussed officer, Braxton Bragg*:

As commander of the company he made a requisition upon the quartermaster–himself–for something he wanted. As quartermaster he declined to fill the requisition, and endorsed on the back of it his reasons for so doing. As company commander he responded to this, urging that his requisition called for nothing but what he was entitled to, and that it was the duty of the quartermaster to fill it. As quartermaster he still persisted that he was right. Unable to resolve the dilemma, Bragg referred the whole matter to the post commander, who exclaimed: “My God, Mr. Bragg, you have quarreled with every officer in the army, and now you are quarreling with yourself.”

With the government on both sides of the bailout–I mean bargaining–table in the Chrysler negotiations, similar absurdities are inevitable.

Every dollar extracted from the banks to help Chrysler is a dollar of bank capital gone.   Given that (a) the banks are arguably insolvent, or teetering on the precipice of insolvency, and (b) the government has effectively guaranteed to recapitalize the banks, this is just robbing Peter to pay Paul.   And you, dear taxpayers, are Peter.

The government’s metastasizing presence throughout the “commanding heights” of the American economy is a recipe for policy incoherence, and intense distributive feuds over rents.   People have been throwing around scare words–socialism, fascism–to describe what’s going on.   For the most part, those terms are unnecessarily provocative and inaccurate.   It is fairer, and far more accurate, to forecast that we are devolving into corporatism.   And corporatism, in my view, would sentence the American (and world) economies to decades of Olsonian sclerosis.

One other quick economic comment.   I wonder if anyone has rerun the Obama deficit projections based on either OECD or IMF growth forecasts, which are considerably gloomier than the Obama assumptions, and even the more pessimistic CBO assumptions.   (This goes for spades in the UK, BTW.)   I would imagine that the already shocking deficit projections would be stupefying.

I read in a Bloomberg piece today that the mortgage backed securities market is 10 percent larger than the US Treasury securities market.   Not for long, folks.   Especially if IMF is right.

* Bragg later became a Confederate general who commanded the Army of Mississippi and the Army of Tennessee.   He was notoriously unsuccessful, except in the area of inspiring hatred among his subordinates.   Grady McWhiney, who wrote the quoted passage, was planning a multi-volume biography of Bragg.   He found Bragg so odious a character that he gave up after a single volume, and let one of his graduate students finish the biography.   Isn’t that what graduate students are for?   To do the jobs their advisors won’t?   [That was sarcastic/ironic, BTW.   Not reflective of my personal views, but a sardonic comment that cuts painfully close to the truth far too often.]

The IMF World Economic Outlook makes extremely dispiriting reading.  Especially for Russia.  The IMF completes the trifecta of major international organizations (after the World Bank and OECD) to revise sharply downwards its prognostication for Russian economic growth.  (SWP paging Bob!  SWP paging Bob!)  Indeed, Russia is the champ, according to IMF.  That is, the IMF reduced its estimate of growth for every country, but the reduction in Russia’s GDP growth forecast was the largest, at -5.3 percent.  Indeed, the IMF’s forecast of Russian growth is lower than its forecast for any country other than Japan for 2009: IMF estimates that Russian GDP will drop 6 percent, compared to Japan’s decline of 6.2 percent.

Russia is also the champ when one compares 2007 or 2008 growth rates to forecast 2009 growth rates.  Whereas Japan’s growth rate in 2009 is forecast to be 5.6 percentage points below its 2008 growth rate, Russia’s 2009 rate is forecast to be 11.6 percent below.  Comparing 2007 and 2009 growth rates implies a difference of 8.6 percentage points for Japan, and a whopping 14.1 percentage points for Russia.  Say that slowly.  Fourteen point one percentage points.  That’s huge.

An article in the Moscow Times should only deepen the sense of gloom.  The article notes that Russian inflation was 5.8 percent in the first quarter.  This is consistent with another SWP prediction that Russia is mired in a deep stagflation.  The acceleration of inflation at the same time the economy is plunging is deeply troubling, and reflects the forces that I mentioned in some earlier posts, namely, the quite reasonable decision by people to exchange rubles for goods.  I doubt the ruble can maintain its rally under such circumstances.  Unbelievably, though, the government is sticking with its forecast of 13 percent inflation for 2009.  Dudes.  You’re like 45 percent of the way there after 25 percent of the year.  Expecting a dramatic slowdown of inflation is very unrealistic, especially given the seemingly entrenched inflationary expectations among the Russian people.

The head of the Kremlin’s anti-crisis task force, Vladimir Mai channels the SWP theme that Russian policy options are extremely limited, especially given the sharp inflation:

“Inflation limits the tools of our anti-crisis policy. Many measures used in the United States and Europe are not available for us. We cannot carry out quantitative easing, we cannot use budget stimulus and we need to maintain high interest rates,” he said.

Mau fears that renewed growth in commodity prices could stall the modernization drive and bring the government back into a complacency mode that characterized the last years of Vladimir Putin’s presidency.

“During an economic boom, it is impossible to carry out a modernization policy,” he said. “If prices for oil and gas are high, there will be no diversification.”

Translation: “We’re screwed.”

The last paragraph is of particular interest.  The political will for modernization and diversification is lacking in times of economic crisis because the government is in survival mode then.  The political will for modernization and diversification is lacking when the economy is strong due to high oil and gas prices because under such circumstances, who needs modernization?  Laissez les bon temps roullez!  Especially for the kleptocrats.    Where’s the Goldilocks spot?  You know, the one that’s just right to facilitate modernization and diversification?  Uhm, somebody will have to get back to you on that one.

For the foreseeable future, if anybody (now who could that be?) uses the words “nano” and “Russia” in the same sentence, my immediate reaction will be to think of the order of magnitude of the probability that Russia will achieve the economic ambitions that harbored a mere six months ago, let alone achieve the fantasy set out in the Russia 2020 pipe dream.

In this environment, Putin’s statements about the economy are delusional.  Beyond delusional.  As are the pursuit of “prestige” projects like Sochi, billion dollar bridges to Godforsaken islands, and large expenditures on new weaponry.

Kudrin may be overly pessimistic in saying that this crisis has set the country back 50 years, but maybe not.   The crisis has derailed for the foreseeable future measures necessary to cope with Russia’s serious long term problems, such as demography and health, and infrastructure.  I hope to write soon on a couple of articles on Russia’s demographic situation, but given that economic growth of the first decade of this millenium led to only a modest decline in Russia’s downward demographic trajectory, there is a serious prospect that the current crisis will eliminate that faint progress, and lead to the return of the apocalyptic trends of the 90s.  Similarly, the prospects for addressing Russia’s serious infrastructure problems are fading fast.  The resulting deterioration in human and physical capital undermines the prospects for long term growth.  Upon consideration, maybe the “stressed” Mr. Kudrin is an optimist.

The Rodney Dangerfields of financial instruments, credit default swaps, are now getting disrespected for impeding workouts of companies teetering on the edge of bankruptcy.  This argument was first flogged by UT law professor Henry Hu last year.  Now, lawyers in General Growth Properties and AbitibiBowater bankruptcies are blaming debtholders who hedged by buying CDS protection on these companies with having little interest in achieving a workout.  Several bloggers, including the estimable Megan McCardle  and the very good (but not quite so estimable, IMHO) Felix Salmon  have expressed similar concerns.  The somewhat supercilious, but usually provocative, Charles Davi takes the opposite view.

I come down on Davi’s side, but for very different reasons.  This is essentially an argument about the effect of the distribution of property rights/ownership.  Those who claim that there are perverse effects of CDS argue that the distribution of ownership has effects on the allocation of resources.  There will be a different allocation if some debt is owned by those who also have CDS positions, than if all debt is owned by the unhedged.  In particular, outcomes will be less efficient, in this view, if some debts are owned by firms that are hedged.

Well, the proper way to begin any analysis of the effects of the original distribution of ownership is with Coase, and the Coase Theorem.  This states, of course, that in the absence of transactions costs, the initial distribution of ownership has NO effect on the ultimate allocation of resources. This result obtains because without transactions costs, the original owners can negotiate mutually beneficial trades that put the resources in their highest value uses.  Indeed, they will trade until the final allocation of ownership maximizes value, regardless of the initial allocation.

This means that any “problem” with the distribution of ownership is a transactions cost problem.  This leads one to (a) attempt to identify the sources of transactions costs, and (b) determine whether there is any change in laws, regulations, etc., that could reduce transactions costs.

In the CDS context, this means that in the frictionless Coasean world, the “empty creditor problem” that arises when creditors are hedged is in fact an “empty problem”–that is, not a problem at all.  It is therefore necessary to evaluate, and do so more carefully than those I have seen weigh in on this subject, whether transactions costs seriously impede value maximizing trades, and if so, what are the most efficacious means of reducing these costs.  

Here’s my argument in more detail:

A completely hedged debtholder (i.e., a party that has purchased protection in an amount equal to his holdings) would appear to have no incentive to behave constructively during the reorganization.   But this means that a potential source of value—the control and legal rights attached to the ownership of the debt security—is not being maximized.   There is therefore a set of mutually beneficial transactions that would leave the insured debtholder no worse off than if he acts in the passive manner that the critics of CDS hedgers suggest, but would result in the efficient exercise of the control and legal rights.   Specifically, another party could purchase the debt from the insured current holder at a price that is satisfactory to the latter, but which allows the purchaser to capture some of value associated with the control rights.   That is, there is a set of transactions that would allow the hedged debtholder to capture some of the benefits of the control rights.

The anti-CDS analysis presumes that there is money left on the table.   The total value of the debt and insurance contracts are higher if the control rights are efficiently exercised.   This creates an economic incentive to structure transactions to ensure that they are so exercised.

The credit protection that hedgers have is not (from a social perspective) an economic asset.   It has zero value because the gain to the buyer is offset penny for penny by a loss to the seller.   This suggests another value enhancing transaction.   The protection seller and the protection buyer could agree to cancel the contract at a mutually acceptable price that effectively splits the value associated with the control rights between them.   This would be mutually beneficial even if the debtholder is overhedged, i.e., has bought more protection than he holds in the debt.    

Another alternative is for the protection seller to buy back the protection and the debt.  The “empty creditor” problem goes away because there is no hedge once this transaction is completed.  The risk profile of the buyers and the sellers is unchanged.  The formerly hedged creditor had no risk exposure after the trade because he was hedged; he has no exposure afterwards because both positions are closed.  (The former statement is something of a simplification.  The “hedged” firm still faces basis risk–a not immaterial consideration, especially of late.  Thus, risk exposure actually goes down for this firm.)  The former protection seller’s risk exposure doesn’t change either.  He was long the debt (via the CDS position) before the trade; he is long the debt itself afterwards.

In other words, CDS critics essentially overlook the Coase theorem, and assume that the allocation of rights is somehow locked in, and cannot be changed by mutually profitable value-enhancing trades.

Of course, transactions costs are not zero in the real world.   It may be costly to find the insured holder of the debt (although insurance sellers could always find their counterparties and commence a negotiation.)   More substantively, different parties may have different—and private—information about the value of the control rights.   Similarly, absent some disclosure requirements, the positions in the debt and protection of each market participant are private information.   This private information can create transactions costs that impede the transfer of the valuable control rights to those who can exercise them most efficiently.

The CDS critics focus on potential problems in negotiations in bankruptcy, or in pre-bankruptcy negotiations between debtors and creditors, and among creditors.  This is a myopic view.  That lawyers (pace the FT piece) advance it is not a surprise, in some sense, because that’s their world.  It is a myopic view because there are many other potential transactions; between protection sellers, buyers, creditors, and third parties that can reallocate the relevant control rights and mitigate the allegedly perverse incentive effects of hedged positions.  If hedges destroy value, by impairing incentives, greedy market participants have an incentive to unwind the hedges to capture that value that would otherwise be destroyed.  These transactions can involve the CDS, the underlying debts, or both.  The world of possible value enhancing transactions does not begin or end at the law firm door, or the steps of the bankruptcy court.  

Thus, at root, as is the case with any asserted inefficiency, the anti-CDS argument is implicitly one about transactions costs.    The anti-CDS  argument holds only if transactions costs materially impede the consummation of value enhancing bargains, but those advancing this argument undertake no analysis of transactions costs, or of ways to reduce them.

To take the skeptics’ view at face value (no pun intended), is to assume that transactions costs are very high indeed.  For the skeptics argue that large amounts of value are destroyed by the empty creditor problem, it must be the case that the transactions costs of circumventing the problem are even larger.  Given the presence of large, sophisticated market participants, this seems something of a stretch.  And indeed, it’s not just the original holders of the debt and CDS that are potential players here.  Hedge funds or vulture funds or others could realize the value opportunity, and structure trades that maximize the value of the control rights.  

The fact that a relatively simple trade–the reversal of an earlier CDS trade, combined with the simultaneous purchase of debt–could eliminate the empty creditor problem suggests that this is much ado about nothing.  The transactions costs of reversing an earlier transaction, in what is effectively an “EFP” (“exchange for physicals,” a commonplace derivatives trade), are not all that high.  Certainly not that much higher–if at all–than the original trade.  

Even if my conjecture that the empty creditor problem isn’t that big a deal, or somebody (or many somebodies) would have engaged in trades to make it go away is incorrect, the debate over how to deal with the issue has been pretty much off point.  It has a sort of “woe is me what are we going to do with these awful CDS” flavor to it.  The more high strung among the critics suggest that trading in CDS should be severely constrained.

A more constructive approach is to identify the sources of transactions costs that are interfering with the efficient reallocation of control rights, and to devise policies to reduce these costs.  (And again, I would emphasize that greedy financial innovators have strong incentives to figure out ways of doing this all by themselves.  If they aren’t doing it . . . maybe the problem isn’t that serious.  Especially since a vanilla EFP will do.)  

This suggests some policy responses that would not entail substantial impediments to (and perhaps the banning) the trading in credit derivatives and the underlying credits.   One policy response is to reduce transactions costs that would arise when a company approaches financial distress, or perhaps declares bankruptcy.   One way to reduce transactions costs would be to reduce the importance of information asymmetries about positions.   Like a poker player, someone who knows his positions and knows that nobody else knows them, can bluff and negotiate in a way that impedes efficient transactions.   This inefficiency can be eliminated, and efficient trading encouraged, by requiring revelation of all positions in the underlying debt, credit protection, and equity of the troubled company at the time of a credit event.   This would facilitate value enhancing transactions between credit protection buyers and sellers by making it easy to identify the economic interests of all parties, and eliminating the ability to bluff about positions and interests in an attempt to extract value from other participants.

Another policy response is to undermine the bargaining power of hedged debtholders, or to remove those with weak or poor incentives from the reorganization process.   This could be done in bankruptcy by reducing the voting and representation rights of debtholders by the amount of the protection they have purchased.   For instance, the holder of $50 million in debt who has purchased credit protection on $25 million, would be treated equivalently to the holder of $25 million of the debt (and the total holdings used to apportion voting and representation rights would be correspondingly reduced.)

The mechanics of settlement of credit derivatives could also be designed to mitigate the perverse incentives that concern the CDS skeptics.   For instance, if payoffs to a credit derivative are determined very soon after the formal declaration of a default or bankruptcy, but before the completion of a reorganization, the concern evaporates.   An ISDA auction soon after a default or bankruptcy would establish prices at which all outstanding credit derivatives on the defaulting firm are settled.   Once this price is determined, the value of outstanding credit derivatives is fixed, and consequently indifference or strategic behavior by the buyers of protection is no longer an issue.   The derivatives effectively disappear, and all that is left is the underlying debt securities, along with their associated control and legal rights, uncompromised by conflicting incentives created by derivatives instruments.   The debtholders then have an incentive to exercise control and legal rights efficiently.*

In summary, Hu and others have identified a potential concern about the adverse incentive effects of credit derivatives, but their analysis is incomplete.   It overlooks an important consideration that should inform any analysis of an asserted inefficiency; namely, the fact that regardless of the original distribution of economic rights, self-interested market participants have an incentive to engage in transactions to allocate these rights to maximize their value.    The skeptics’  analysis presumes that individually and collectively, market participants are not maximizing the size of the economic pie—the value of a firm undergoing a reorganization.   This can only happen if transactions costs materially impede the efficient reallocation of these rights, but Hu and the other critics do not analyze—or even mention—transactions costs, or the potential for consenting adults to make trades that enhance value.   Moreover, since transactions costs may exist in the real world, policy responses designed to reduce these transactions costs deserve serious attention before more draconian restrictions on credit derivatives are contemplated.

Finally, it should be noted that even if credit derivatives do result in some efficiency loss because of their effects on the incentives of debtholders during reorganizations, or the transactions costs that perpetuate these incentives, these costs must be weighed against the benefits of credit derivatives.   Credit derivatives also facilitate the efficient allocation of risk among market participants.   Moreover, credit derivatives play an increasingly important role in price discovery and enhancing the transparency of the credit markets.   These benefits are appreciable, and the phenomenal growth of these instruments is a testament to the magnitude of these benefits.   Any policy response to the problem that the skeptics identify should be crafted so as to preserve these benefits. Thus, a light-touch approach that focuses on reducing transactions costs or modifying the bankruptcy process would mitigate the importance of the CDS skeptics’ concern, without jeopardizing the risk management and price transparency benefits of credit derivatives.