Streetwise Professor

The Greek crisis (or, more generally, the EuroSov crisis) is leading to increasingly shrill calls to line up short sellers–and especially “naked” CDS buyers–against the wall for summary execution.  Among the shrillest is this piece by Wolfgang Munchau (sorry about the missing umlauts):

I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer.

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece”. Using CDSs to destabilise a government was “counter-productive”, he said. Unfortunately, it is legal.

I only have time for a few comments.

• Like Wretched Gretchen Morgenson (whom I adamantly will not link to, not wanting to corrupt impressionable minds), Munchau lumps together CDS and other kinds of derivatives, namely currency and interest rate swaps that oh-so-pure European governments used to conceal their debts.  Is he ignorant?  Is he duplicitous?  Does it matter? It is incorrect, and it is misleading.
• He trots out the tired “CDS are insurance-insurance law prohibits buying insurance without insurable interest-so we should ban naked CDS purchases” argument.  Beware misleading analogies.  Try to understand the particular reasons why, in general, an insurable interest is required to by life insurance on, say, Wolfgang Munchau or fire insurance on his dwelling.  Moral hazard, for instance: Wolfgang’s life and home could be in some jeopardy if this were allowed.  Of course, resources could be devoted to investigate anything untoward that happened to Mr. Munchau, thereby deterring such abuse, but this is costly, and it is difficult to see any social benefit at all from permitting others to bet on Mr. Munchau’s longevity or the reliability of the wiring in his home.
• Which brings us to Mr. Munchau’s most important point: that there is NO social benefit associated with naked CDS.   He says:
  

  It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

• Not a single social benefit?  All speculators agree on this?  That’s a pretty strong assertion, which is just that: an assertion, offered with little argument and less evidence.  I agree that it is unlikely that the social benefits and social costs of speculation do not align with the private benefits and private costs.  For instance, a good deal of speculation is rent seeking activity, where individuals expend resources to collect information which they trade on in order to receive a transfer from some less-informed sucker.  But that’s different from saying that speculation has no benefit whatsoever.
• In particular, the information that is embedded in prices by informed speculators can lead market participants to make better decisions, or more timely ones.  This was no part of the speculators’ intentions, but it is a benefit of speculation nonetheless. To the extent that speculation leads to a speedier, and more credible, revelation of the wasteful profligacy of spendthrift governments (or banks, or corporates), the sooner and more effectively this waste can be curbed.  For instance, if you think corporate fraud is wasteful (think Enron), you should also think that short sellers that detect it and profit from it and lead to its ultimate revelation are providing a valuable social benefit.
• Again, there’s no clean alignment between the individual incentives of speculators and the benefits of their activities, but that’s quite a different thing from saying that there is no benefit at all.  And as Mr. Munchau’s article demonstrates, there’s a real choice involved since it’s impossible to quantify the costs and benefits of any particular speculative trade: you either ban it or let it go (with, perhaps, rules against purely opportunistic activity, such as spreading false information to enhance the value of a speculative position).
• Mr. Munchau has absolutely no data on how much CDS purchasing is naked.

Muchau’s outrage is shared by virtually every government in Europe.  Spare me.  This is clearly shooting the messenger.  As James Carville noted long ago, the bond market (and now, the CDS market), disciplines governments, and they don’t like it one bit.

This article from Bloomberg hits the nail squarely:

Blaming derivatives for governments’ financial problems is like faulting the “mirror for your ugly face,” according to analysts at Citigroup Inc.

. . . .

“We would do better to spend our time addressing the defects the mirror shows than blaming the mirror,” Citigroup analysts led by Michael Hampden-Turner in London wrote in a note to investors. “After all, banning mirrors does nothing at all to make the world a prettier place.”

Damn right.  Nobody likes market discipline, especially governments.  But they’re the ones who usually need it the most.  Hence we should resist cynical, self-interested calls to terminate CDS speculators, and instead pay more attention to the message they are sending about the unsustainability of fiscal policies in Europe, and around the world.

The Russians have got their Jockskis in a bunch (I know, so what else is new?), this time over the US plan to base missile defenses in Romania, and perhaps Bulgaria and the Black Sea.   Two particular aspects of the US-Romanian announcement frosted the Russians.

The first is that Russia found out about the deal through the press.  To which I say: (a) if that’s really true, perhaps the FSB is going the way of Russian Olympic sports if it can’t get advanced information about something like this from former satellite countries, (b) Russia is hardly noted for consulting with us on its diplomatic and military moves, and (c) given that Russia would no doubt have responded to any advance warning by pulling out all the stops to torpedo the deal, the administration was quite right in keeping it under wraps and announcing a fait accompli.

The second is the fact that the Russian Foreign Ministry spokesman Nesterenko (any relation to Blackhawk legend Eric Nesterenko, the Man from Flin Flon?) used the word “unilateral” more than once in his denunciation of the agreement.  What this means is that Russia expects to be not just consulted, but deferred to, on any military agreement involving sovereign nations in what it fancies to be its sphere of privileged interest.  For refusing to countenance a Russian veto, the administration is to be congratulated.  (You can stop rubbing your eyes–yes, I complimented the Obama administration not once but twice in a single post.)

The Aegis/Standard missile systems in the western Black Sea pose even less of a threat (meaning zero threat) to Russian ICBMs than did the aborted Czech-Polish BMD sites.  (Though they could be used against some Russian IRBMs–interesting, that.)  Which means that the hyperventilating by the Russian FM and military about the threat to its nuclear deterrent is just so much baloney.  What really gets them is the thought that their former vassals would have the temerity to exercise their own sovereignty without even a by-your-leave to Russia.  This is also the case with the Russian apoplexy over the basing of Patriot missiles in Poland.

Which leads me to say again: if you have nothing attractive to offer, what do you expect?  Flies, sugar, gall, remember?

This is important as a potential counter to Iran, and as a statement to the eastern Europeans that they are not being left to the tender mercies of Russia.  I would have preferred that this missile defense initiative would have been undertaken in addition to the Czech-Polish BMD initiative.  But something is better than nothing.  And again, the sites are important in and of themselves, but they have a broader importance in bolstering shaky nerves in eastern Europe, as argued in this Wess Mitchell and Robert Kron oped:

North Central European allies have been concerned by marked increases in Russian revisionist rhetoric and behavior (remember Georgia?). They have been alarmed by the perception of U.S. disengagement, embodied by the Obama administration’s decision to abandon plans for a ground-based Ballistic Missile Defense (BMD) system anchored in Central Europe. Their calls for “strategic reassurance” have sparked a debate in NATO about the security needs of the region, centering on the question of whether Polish and Baltic-State threat assessments vis-à-vis Russia are accurate.

This is the wrong question to be asking. Lost in the debate is the detrimental effect that insecurity among Central European allies has on the Alliance and U.S. national interests–irrespective of the nature and extent of Russian capabilities and intentions. This state of affairs is ultimately unhealthy for theUnited States, the Atlantic Alliance and European integration.

. . . .

Washington need not adopt a policy of confronting Russia to assuage its regional allies, but would be wise to take action now, or risk allowing allied concerns to fester and pay the costs down the road.

That is, this is about more than missile defense and Iran per se.  Which is why the Russians are so apoplectic about it.  And which is why the administration should continue to proceed, Russian tantrums and all.

I wonder when the next tu quoque deal with Hugo Chavez or Nicaragua will be announced.  Maybe they’ll have to wait until Hugo can get the lights back on.

AEI’s Peter Wallison’s opinions on matters related to the financial crisis and financial regulation are highly and positively correlated with mine.  He has an excellent oped in today’s WSJ which echoes my views on the real source of moral hazard and too-big-to-fail: namely, bailouts don’t directly distort the incentives of bank executives and equity holders, but they do seriously distort the incentives of those who lend to banks:

The same failure to understand the power of moral hazard is what makes the administration’s call for a resolution authority most inapt and troubling. Although the administration has argued, and some in Congress believe, that moral hazard and too-big-to-fail would be curbed by a resolution authority, the opposite is true. Both would be enhanced.

This is because the principal danger of moral hazard—the key to its adverse effects on private decision-making—is its impact on creditors and counterparties. The fact that shareholders and managements will lose everything in a government resolution is largely irrelevant. What really matters are the lessons creditors draw about how they will be treated. And it is clear creditors will be treated far more favorably in a government resolution process than in a bankruptcy.

To understand why this is true, consider the administration’s reasons for preferring a government resolution process. The claim is that large, interconnected firms will drag down others when they fail. The remedy for this is to make sure their creditors and counterparties are fully paid when the takeover occurs. That’s why the Fed made Goldman Sachs and others whole when it rescued the insurance giant AIG. It’s also what distinguishes a government resolution process from a bankruptcy, where a stay is imposed on most payments to creditors when the bankruptcy petition is filed.

Creditors will realize that by lending to large companies that might be taken over and resolved by the government, their chances of being fully paid are better than if they lend to others that might not. Thus a resolution authority will enhance moral hazard not reduce it—and as creditors increasingly assume that large firms will be rescued, the too-big-to-fail phenomenon will grow, not decline. In the end, a resolution authority becomes, in effect, a permanent Troubled Asset Relief Program.

Exactly so.  The effects of this can be far-reaching.  For instance, it can make it rational for banks to take on excessive leverage.  Moreover, it can distort the types of leverage banks use; it tends to favor short-term debt and fragile capital structures, because it is that kind of debt that provides the greatest systemic risk, and hence is most likely to induce the government to ride to the “rescue.”

On these lines, note that the widespread belief that the government stood behind Fannie and Freddie debt allowed these entities to grow immense and highly leveraged.  Funny, isn’t it, that even though F&F are gulping down government money in quantities that make AIG look like a piker (another $15+ billion last quarter for Fannie, with NO end in sight), that this goes largely unnoticed, and draws nothing of the outrage that the AIG bailout does?

Wallison also expresses skepticism about the importance of contagion and interconnection in driving the financial crisis:

Then there is the proposal to give a government agency the authority to take over and “resolve” failing financial firms. Here, the administration has pointed to the chaos that followed the bankruptcy of Lehman Brothers in September 2008. To prevent that kind of breakdown, the administration says all large and “interconnected” financial firms in crisis should be dealt with by a government agency, rather than by a judge in bankruptcy proceedings.

The term “interconnected” is important here. It implies that when one large firm fails it will carry others down with it, causing a systemic crisis. But that is clearly not the lesson of Lehman. Although the company went suddenly and shockingly into bankruptcy, none of its large financial counterparties failed. The systemic significance of “interconnectedness” proved to be a myth.

There seems to  be a tendency to attribute any simultaneous implosions among financial firms to a contagion effect.  I think it is more plausible, however, that the observed correlation in distress reflected correlations in investment strategies across financial institutions, making them simultaneously vulnerable to a common shock.  In the event, it was exposure to real estate prices.

Look at the week or so beginning September 7, when the Feds took over Fannie and Freddie, followed by the Lehman collapse and the AIG bailout.  All of these were heavily exposed to real estate prices.  The most heavily damaged survivors, Citi, Merrill, and BofA most notably, also had big exposures.  Before them, it was Bear.  It wasn’t a single bad firm dragging healthy ones to which it was interconnected down with it; it was an epidemic of financial sickness caused by exposure to a single, common pathogen that simultaneously brought many firms low.

It is important to understand the relative importance of contagion and correlated solvency shocks in contributing to the crisis.  Most of the proposed “solutions” seem motivated by a belief that the crisis was a chain reaction made possible by excessive interconnectedness.  If this diagnosis is wrong, the prescriptions are likely to be either useless, or positively harmful.  The same is true with the diagnosis of the true source of moral hazard underlying TBTF.  Unfortunately, as Wallison suggests, we seem to be misguided here as well.  This doesn’t bode well for avoiding the next crisis.

My testimony at trial (in Chicago) in Trading Technologies v. eSpeed was quoted in the Court of Appeals for the Federal Circuit’s decision on the case.  I testified on behalf of TT.  The good guys won, at trial, and before the Federal Circuit.

The underwriters of the Rusal IPO have declined to exercise their “greenshoe option” to buy additional shares.  Surprise, surprise, surprise.

My dad told me that he’d seen a CNBC interview with some Congressmen advocating a law to prohibit the government from bailing out financial firms.  It is hard to get excited about this watching what’s going on in Europe.  The Maastricht Treaty expressly proscribes bailouts of member countries, but there are all sorts of plans under consideration to do just that for Greece, while avoiding a direct government-to-government bailout.  These schemes would utilize various cutouts, such as having German banks buy Greek government debt, and the German government providing guarantees to the banks.

As I’ve written before, the difficulty with too big to fail is the inability of governments to commit credibly not to bail out.  The Europeans recognized this problem, and attempted to write language in the EU founding treaty that would commit the members not to bail out others who are failing.  But where there’s a will–or, more accurately, a lack of will to adhere to commitments–there is a way.  This is why TBTF is so intractable, and why we should be wary of any claims that this legislative measure or that here in the US will make the problem go away.

I say only somewhat facetiously that what is needed to prevent TBTF is a financial doomsday machine, a la Herman Kahn/Dr. Strangelove, that would automatically impose a prohibitive cost on any government that attempts to bailout.  Short of that, with mere humans in charge, credible commitments are nearly impossible.