Streetwise Professor

April 21, 2010

The Next Derivatives Disaster

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 9:06 pm

Is the legislation currently working its way through Congress.  According to The Hill, Harry Reid wants the Lincoln derivatives bill incorporated into the Dodd legislation (replacing the “place-holder” derivatives title of the Dodd bill).  Great.

There are many bad features in the Lincoln bill.  Arguably the worst (though the competition is stiff!) is the proscription on any “Federal assistance”, including Fed lending, to financial institutions that trade derivatives, including clearinghouses.  Especially when combined with the mandated expansion of clearing, this is extremely dangerous.

Clearinghouses can blow up.  It has happened historically, and it almost happened with disastrous effects during the ’87 crash.  Arguably the only thing that prevented that from happening was the intervention of the Fed.  I strongly suggest that Lincoln, or her staff, read the Brady report on the Crash to get some understanding of that.  Or better yet, read Bernanke’s “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133).  A few telling excerpts:

Let us put aside the possibility of government intervention for the moment. Then there seems to be a potential structural problem with the clearinghouse arrangement. The problem is not that some traders who thought they had a guaranteed contract would end up not being paid off; as we have said, perfect insurance against systemwide shocks is not possible. Rather, the problem is that a shock large enough to exhaust the clearinghouse’s capital and assessment powers would have a serious prospective effect on the ability of the clearinghouse and thus of the futures market itself to function. Presumably, over a period of time reorganization and recapitalization would occur. But in the shorter run the poor functioning or shutdown of the futures market might exacerbate the adverse conditions that precipitated the problem in the first place.

That is, the potential for failure of a clearinghouse–just the potential–can lead to a positive feedback mechanism that worsens the crisis.

Bernanke discusses the essential role of the Fed on 19-20 October:

The malfunctioning of the banking side of the clearing and settlements systems during this period is indisputable. [Emphasis added.]

. . . .

The official reports and other observers generally agree that the Federal Reserve’s attempts to alleviate the crisis were very constructive. On Tuesday morning, October 20, the Fed issued a brief statement: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.” This statement was backed up by three types of actions: First, the Fed reversed its tight monetary stance of the previous weeks and flooded the system with liquidity. Second, the Fed “persuaded” the banks, particularly the big New York banks, to lend freely, promising whatever support was necessary. (The 10 largest New York banks nearly doubled their lending to securities firms during the week of October 19.) Finally, the Fed monitored the situation and took some direct actions where necessary, notably in the case of First Options of Chicago. When that large clearing firm was in danger of defaulting, Fed Chairman Greenspan acted quickly to enable its parent firm, Continental Illinois, to inject funds into its subsidiary; according to some observers, this action may have helped avoid the closing of the options exchange.

. . . .

In retrospect we may ask, what really were the dangers to the integrity of the financial markets posed by the crash? And what were
the benefits of the Federal Reserve’s actions? The technological problems of communications and information availability that plagued the system, while serious, did not in and of themselves threaten to bring down the markets. For the most part, information availability was a critical issue during the crash only in the sense that illiquidity is essentially a problem of imperfect information. (Clearly, though, improvements in these technologies should be made.)

It was the financial problems-the possibility of insolvency by major players-that were potentially the more serious. As we have emphasized, financial problems impaired the market’s functioning in at least two ways. First, concerns about solvency impeded the operation of the payments and clearing systems, contributing to financial “gridlock.” Second, the fear that major brokers, FCMs, or clearinghouses might default created uncertainty about the contract performance guarantee. Both aspects reduced market liquidity and disrupted trading. Conceivably these problems could have forced a market shutdown.

In response to this situation, the Federal Reserve, in its lender-of- last-resort capacity, performed an important protective function. The Fed’s key action was to induce the banks (by suasion and by the supply of liquidity) to make loans, on customary terms, despite chaotic conditions and the possibility of severe adverse selection of borrowers. In expectation, making these loans must have been a money-losing strategy from the point of view of the banks (and the Fed); otherwise, Fed persuasion would not have been needed. But lending was a good strategy for the preservation of the system as a whole.

The principal effect of the loans was to transfer some trader default risk from the clearinghouses and their members to money-center
banks. Under the presumption that the money-center banks were well capitalized, and that in any event their solvency would be guaranteed by the government, this transfer of risk reduced the overall hreat of insolvencies in the system. This allowed the payments process to begin to normalize; it also restored confidence in the clear- inghouse’s guarantee of futures contract performance. The resulting stabilization of the markets served the interest of the banks and the Fed in a wider sense, by avoiding any potential costs that a market breakdown might have imposed on the banking system and the general economy.

In performing its lender-of-last-resort function, the Fed redistributed risks in the system in a socially beneficial way. Conceptually, it
is as if the Fed had provided ex post insurance to the clearinghouse against a shock that it seemed possible would exhaust the insurance capability of the clearinghouse itself. Thus the Fed became the “insurer of last resort.”

What, pray tell, would have happened absent the Fed supplying liquidity to the system?  A disaster.

Note that Bernanke’s analysis recognizes that a clearinghouse’s financial resources are limited.  Would it that those flogging the clearinghouse cure would recognize this, and grapple with its implications in a serious way (as Bernanke did), rather than ignoring this brute fact as they do routinely: no, reflexively.

A dramatic expansion of clearing will increase, in a commensurately dramatic way, the potential for operational and financial failures in the clearing and payment system (like those observed in ’87) during a large price move.  Any policy of mandates MUST acknowledge this, and make sure that mechanisms are in place to address this reality.  By cutting out derivatives, and clearinghouses, from the lender of last resort mechanism, but providing no replacement, the Lincoln bill is courting financial Armageddon.

(Perhaps the Fed would be able to intervene indirectly, by supporting banks and inducing them to support the clearinghouses financially, but constraining the means by which the Fed can supply liquidity to the clearing system increases the likelihood of a failure.)

Bernanke argued in his 1990 article that the Fed has a role in ensuring the integrated banking, clearing, and settlement systems can survive a shock like a stock market crash.  (Again–it is integrated: interconnected.)  Although the Lincoln bill attempts to hive off the derivatives markets from the broader financial system, this is an impossibility.  No, it is worse: it is an absurdity.  The banking and derivatives trading systems are inextricably linked.  Policy must be predicated on that fact.

Maybe the Fed is a flawed institution, but it’s the institution we have.  If Lincoln gets her way, and constrains the ability of the Fed to perform its LOLR function in support of a vastly expanded clearing system, without providing any alternative, she is indeed “reforming” derivatives markets in the worst way.

Will Somebody Please Call Bullshit on Gensler?

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:24 pm

So I don’t have to?  Because it’s getting tiresome.

But it has to be done, so here goes.

Jeremiah’s latest gurgling appears on the oped page of today’s WSJ.  It starts with a non-sequitur, and careens downhill from there.  Gensler tells a story about his role in the LTCM situation, and then claims that to prevent a recurrence, or a repeat of AIG, it is necessary to reduce the “cancerous interconnections” (Jeremiah Recycled Bad Metaphor Alert!) in the financial system by, you guessed it, mandatory clearing.

Look.  This is very basic.  Do I have to repeat it?  CLEARING DOES NOT ELIMINATE INTERCONNECTIONS AMONG FINANCIAL INSTITUTIONS.  At most, it reconfigures the topology of the network of interconnections.  Anyone who argues otherwise is not competent to weigh in on the subject, let alone to have regulatory responsibility over a vastly expanded clearing system.  At most you can argue that the interconnections in a cleared system are better in some ways than the interconnections in the current OTC structure.  But Gensler doesn’t do that.   He just makes unsupported assertion after unsupported assertion.

If you have any doubts about how interconnected a clearing system is with the banks, just look in detail at what happened on 19-20 October, 1987.

Don’t believe me?  Then consider what Ben Bernanke wrote as an academic in his “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133):

A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.  This interconnection exists at several points.  First, banks are operationally a part of the clearing process. Clearinghouses typically maintain accounts at a number of “clearing banks. Member FCMs are required to maintain an account at a minimum of one of these banks and to authorize the bank to make debits or credits to the account in accord with the clearinghouse’s instructions. This facilitates the settling of accounts and the making of margin calls. Note that the bank’s role may exceed simple accounting if, for example, it must decide whether to permit an overdraft on an FCM’s account.

Second, banks are a major source of credit, especially very short-term credit, to all of the parties, including the customers, the FCMs, and the clearinghouse itself. As was noted above, bank letters of credit can in some cases be used as initial margin. Customers and FCMs often rely on bank credit to facilitate the speedy posting of variation margin, and FCMs would typically have to turn to banks to finance payments made necessary by customers’ defaults or slow payment. In equity markets, banks are often the ultimate source of credit for the purchase of securities on credit.

Finally, it should be noted that while, in the conventional language, most margin postings and settlement payments are made in “cash,” these transactions are, of course, not really made in cash but by the transfer of bank deposits. Thus, the smooth operation of the financial market clearing and settlement system is based at all times on the presumption that the banking system is sound and can satisfy demands for withdrawals of funds.

“A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.”  Does it get any clearer?  (No pun intended.)

Ben, would you please drop the “Gentle Ben” demeanor and slap some sense into Gensler?  You actually know something about the subject.  You’re a former educator.  And somebody needs some educatin’.

And consider the implications of a dramatic increase in the scope of the clearing system, including the clearing of many products with unique tail/jump to default risks that have not been cleared before, on the magnitude of the interdependence between the clearing system and the banking and payment systems.  The potential for operational and financial gridlock in the face of a substantial price shock will be greatly amplified if clearing is greatly expanded.

Bernanke goes on to argue that the systemic centrality of the clearing system means that it is highly desirable for the Fed to serve as the “insurer of last resort” to prevent the failure of a clearinghouse or clearinghouses.  So much for Gensler’s assertion that clearing would “greatly reduce . . . the need for future bailouts.”

This is very serious business.  Very serious.  It deserves serious consideration of the real implications of the effects of a vast expansion of clearing.  That consideration must be predicated on an understanding of the real interconnections inherent in a clearing system, not on unsupported and unsupportable denials of the existence of such interconnections.

If the basis for the policies Gensler advocates, and which Congress seems hell-bent on implementing, is a belief that clearing does not entail an intricate web of interconnections (and potentially fragile interconnections) among financial firms, then they are policies built on lies.  And all that a policy based on lies will do is sow the seeds for the next crisis.

Who Made an Incomplete Disclosure?

Filed under: Derivatives,Financial crisis,Politics — The Professor @ 1:35 pm

CNBC reports that a Paulson employee told the SEC that he had met with ACA, and disclosed in that meeting that Paulson was going to be the short in the synthetic CDO:

CNBC has examined documents in which a government official asked Pellegrini whether he informed ACA CDO manager Laura Schwartz about Paulson’s position in the portfolio, named Abacus 2007-AC1.

“Did you tell her that you were interested in taking a short position in Abacus?” a government official asked Pellegrini, referring to the name of the CDO portfolio.

“Yes, that was the purpose of the meeting,” Pellegrini responded.

So, apparently ACA DID say “WTF: Are you buying or selling?”  Funny how that wasn’t in the complaint, huh?  CNBC says that Pellegrini and Schwartz met three times.

If true, this would pretty much torpedo the SEC case, which depends crucially on “Paulson’s undisclosed short interest.”  Will the SEC try to argue that this is irrelevant, because Goldman didn’t disclose it to all buyers?  That would be a stretch.

Happy San Jacinto Day

Filed under: Military — The Professor @ 11:58 am

One-hundred seventy four years ago today, the Texian forces under the command of Sam Houston defeated the Mexican Army commanded by Santa Ana at the Battle of San Jacinto (the site of which is located near Houston, hard on the Ship Channel).  After retreating pell mell before the advancing Mexicans in the “Runaway Scrape,” the Texians turned to fight at San Jacinto.  The Texians caught the Mexicans napping–literally–and launched their decisive attack while the Mexicans were taking a siesta with no sentries posted.  The Mexicans were routed–and apparently many Texians took revenge for previous Mexican atrocities at Goliad and the Alamo, despite Houston’s effort to restrain them.  Santa Ana fled the battlefield, and was captured in disguise the next day.  In May, while in captivity, he signed treaties that gave Texas its independence.

Given that Texas independence led to the Mexican War, and the Mexican War resulted in a clash over the extension of slavery into the territories obtained thereby that culminated in the Civil War, April 21, 1836 must be counted as one of the decisive days in American history.

Further Thoughts on Goldman

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 11:48 am

Let’s look at the basics to try to figure out the real strength of the SEC’s case.

One.  Goldman was marketing a synthetic CDO to potential customers, including ACA.  The customers would be long the credit, and would lose if the reference names declined in value, due, for instance, to unexpectedly high defaults.

Two.  Every synthetic CDO has a protection buyer (who is short the credit) and a protection seller (as above, long the credit).  So ACA and other potential protection sellers knew that there was somebody or somebodies who wanted to short these particular credits.

Three.  The possible motive of the party short the credit are, roughly speaking, hedging and speculating.   The speculator has a view, which may be based on non-public information, or proprietary analysis of public data, or maybe just his horoscope, that the value of these credits will decline.  The hedger may have such a view, but may be risk averse and be willing to sell the credits for less than he thinks they are worth in order to reduce risk exposure.  Most hedgers have mixed motives, and hedge selectively: they are more likely to short the credit when they anticipate a price decline.

These three factors are common to every derivatives transaction.  There is a positive probability that the buyer is trading with someone who has information or a belief that the price will decline.  This potential for adverse selection is a risk the buyer faces in every transaction.

Four.  In most transactions in derivatives and securities markets, brokers have no obligation to disclose the identify of their principal; indeed, they are obliged not to disclose their principal.  That is true even though the identify of the agent might be very pertinent information.  Indeed, market participants try mightily, and spend real money, in order to attempt to learn who is the ultimate counterparty, because that can be informative.  Knowing that, other traders go to great lengths to conceal their identities and their trading–that’s why they use brokers in the first place.  Moreover, the traders who are willing to disclose their identity usually do so because they can demonstrate that they are uninformed.

This means that, in general, the party to a derivatives trade doesn’t know, and doesn’t have the right to know the ultimate counterparty.  (I don’t know, as a legal matter, if they ask, it is illegal for the broker to lie.  My guess is it’s just that “don’t ask, don’t tell” is the rule.)

It also means, in general, that they want to know because the identify of the counterparty can be informative.

The fact that most markets are anonymous, and that brokers are obligated not to disclose the identity of the principal they represent, means that the default policy presumes that the benefits of counterparty disclosure are less than the costs.  One may argue about whether that is the correct judgment, but it is the one implicit in the law.

The one factor that supposedly separates this case from other transactions is that Paulson selected a set of credits to include in the synthetic.  But every buyer of X knows that someone wants to sell X, regardless of what X is.  That is, the always seller chooses what he wants to sell in any transaction.  The fact that Paulson chose the particular names doesn’t distinguish this case from the typical transaction; the adverse selection risk is present in any trade.

Another allegedly distinguishing feature is that Goldman allegedly insinuated that Paulson was a buyer, not a seller.  But still, the actual potential buyers knew that there was somebody who wanted to sell.

The strongest argument that can be made is this.  ACA and the German bank allegedly thought that Paulson was long, based on Goldman’s representations (though Goldman disputes this).  Paulson participated in the selection of the credits to be included.  ACA drew a different inference about what private information Paulson had based on its belief that he was a buyer, than it would had it known he was a seller.  The supposed absence of the seller from the design of the CDO–and hence, the apparent delegation of the decision of what to sell to somebody other than the ultimate seller–plausibly reduced ACA’s estimate of the adverse selection risk it faced.  Thus, ACA entered the deal at a price that was higher than it would have, had it known of Paulson’s true role.

How much higher?  Impossible to say, but “not much” is a plausible answer.  Because, again, at the end of the day that ACA knew that it faced a winner’s curse: there was a real risk that the actual short would only pull the trigger on the deal if it were priced unfairly to ACA.

But the anonymity of most financial transactions, and the obligation of brokers not to reveal their principals, suggest that you have no right to be free of adverse selection risk.  It seems that the case will turn, therefore, on (a) whether it is unlawful to deceive the counterparty about your principal, and (b) whether Goldman did deceive ACA, etc.  Would Goldman have been fine if it had just stuck to “don’t ask, don’t tell”?  Did it, in fact stick to DADT?

It may be difficult to show that Goldman actually and intentionally deceived ACA.  And without that, the transaction is very difficult to distinguish from virtually another other transaction in which the buyer faces the risk of dealing with a better informed seller whose identity it does not know.  With adherence to DADT, it would be hard to justify finding Goldman guilty.

What’s more, it’s not as if Paulson was offstage during this entire drama.  Quite the opposite.  He met several times with the ACA team and actively and personally participated in the selection of the mortgages.  If the mortgages that he was pushing were so bad, you’d think ACA would notice and start questioning his true involvement: “You want all this real garbage in the structure.  WTF: Are you buying or are you selling?”

The SEC faces a tension here.  The harder it tries to argue that the mortgages were really, really, really bad, the more it strains credulity to argue that ACA was duped.  ACA could have observed information related to the criteria that the SEC says in its complaint that Paulson used to select candidates for the pool.  They evidently took a different view of the implications of these criteria than Paulson.  Where’s the material, non-public information about the mortgages themselves that might justify a more traditional case?  If ACA looked at the same information Paulson did, and came to a different conclusion, it is hard to argue that it wouldn’t have entered into the transaction if it had known that Paulson had decided to short the mortgages based on this information.

An interesting possibility is that the SEC finds Goldman guilty, but that damages in a civil lawsuit against Goldman may be small.  Certainly, it will be very difficult to estimate the “but for” price of the deal, i.e., the price that the parties would have negotiated had Paulson’s role been known.  Certainly, the synthetic buyers will try to argue that their realized loss is their damage, because they wouldn’t have entered the transaction if they had known Paulson was on the other side.  But that’s not all that plausible; they might have entered the deal, but at a slightly lower price.  There’s no “curative disclosure” here, so estimating that but for price would be devilishly hard.

A couple of last, broader, policy points.  First, the SEC has been broadening its interpretation of what “material nonpublic information” is.  Depending on how the SEC argues this case, the evidence of actual deceit about Paulson’s role (as opposed to silence), and how it is decided, this case could affect how the materiality of counterparty identity is interpreted.  This could have a big impact on the securities and derivatives industry more broadly, and reduce the anonymity of brokered financial transaction.  Perhaps more troublingly, it could add uncertainty into the interpretation of an intermediary’s rights and obligations to its clients.  Hard cases make bad law, and this one has that potential.

Second, this case is being trumpeted as a perfect illustration of why sweeping new regulation is needed.  Indeed, the White House and the Democrat Party are using this as a fund raising plug: they started with this campaign a mere 30 minutes after the complaint came down.  But, if Goldman’s conduct is actionable under the current law, how can that conduct demonstrate the need for more laws and regulations?

That said, all is not well on Wall Street, obviously.  But this case is a distraction from the main issues, notably too big to fail.  The current legislative proposals are not encouraging in this regard.  This Goldman case is factually and legally ambiguous morality play that diverts attention from the central issues, and which could result in the passage of much legislation and the implementation of much regulation that is irrelevant to the main issue, and ultimately destructive.

April 19, 2010

A Clarification on the Adoption Issue

Filed under: Politics,Russia — The Professor @ 10:34 pm

Given some of the feedback I’ve received on the adoption post, it’s evident I was not sufficiently thoughtful, and gave too much weight to my very limited personal brush with Russian adoption (which did leave a big impression on me, but which was far too superficial to provide the basis of any broad conclusions).  So I think it’s necessary for me to clarify, and to provide some different perspectives.

First, to me the biggest tragedy is the large number of Russian kids who need good homes and loving parents who may see their opportunity thwarted by cynical politicians exploiting what happened with the 7 year old who was sent back by himself.  As R notes in her extensive comment, the narrative being spun by the Russian authorities is almost certainly deeply deceptive.  And even if the specifics of this story were as the Russian government represents, extrapolating from this one episode is as inappropriate as my extrapolation from the observations on a single flight from Moscow.  Indeed, far more inappropriate, because my opinions don’t really affect anybody’s lives, but the Russian government’s actions have the potential to harm innocent children and those who want to provide them better lives.

Second, contrary to the impression I left in my post, the effect of these adoptions is almost certainly highly positive on balance.  R’s experience is one example.  Some friends in Chelsea, Michigan adopted 4 Russian children in the early-90s and have given them wonderful lives full of love.  And my friend Mike S. sent along this inspiring story which you really should read.

I regret that by over-emphasizing a single personal anecdote I left a misleading impression about something as complex as international adoption, and specifically Russian adoption.  I should leave that subject to people who know more about it.  I should have just focused on what were my main points: (a) that it is wrong for the Russian government to seize upon a single human tragedy to score political points in a way that could create many more tragedies, and (b) would that the Russian government showed as much outrage at the suffering of Russian kids at the hands of Russians–including in the first instance agents of the Russian state–as it has over the hapless woman in Tennessee, and turn that outrage into constructive action.

Other Than That, How’s the Bill, Mizz Lincoln?

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 2:11 pm

Very bad.

Problem one is obviously the ban on “Federal assistance” to any “swaps entity” where “Federal assistance” includes a Fed loan.  It is ironic, and disturbing, that (a) the bill mandates extensive clearing, and thereby makes swaps clearinghouses a central pillar of the financial system, but (b) denies these entities the ability to access liquidity via the Fed.  This goes against the recommendations of Duffie et al in their policy piece for the FRBNY, the European Commission, and now the IMF:

Hence, those [CCPs] deemed to be systemically important should have access to emergency central bank liquidity.  However, any such emergency lending should be collateralized by the same high-quality liquid securities as those typically posted against monetary policy operations. Also, it should not be done in any way that might compromise the central bank’s monetary policy or foreign exchange policy operations. [IMF, Making the OTC Derivatives Markets Safer (April, 2010), p. 20.]

In short, Lincoln’s bill goes against the advice of virtually all those who have analyzed the implications of clearing mandates–including strong supporters of these mandates.

During periods of market stress, and ESPECIALLY in cleared markets, the demand for liquidity increases dramatically.  Firms need liquidity to meet margin calls in response to big price moves.  CCPs that can borrow on behalf of their members can facilitate this process.  Denying these entities access to central bank liquidity facilities is a major mistake, and will in effect make the markets like they were prior to the formation of the Fed in 1913.  Can you say “Panic of 1907”?  I knew you could.

And even allowing CCPs to access liquidity facilities, while denying swap dealers from the same option–effectively requiring banks to hive off derivatives dealing activities–will cause problems.  If the idea is to reduce systemic risks arising from counterparty risk, it is desirable to ensure that market participants, including derivatives market participants, have access to liquidity during periods of market stress.  A firm experiencing a liquidity shock, due, for instance, to a big collateral call, but which is solvent, would be forced by this provision into fire sales or defaults that would exacerbate systemic risks.  It would do so by threatening to transform liquidity shocks into crises.

Lincoln’s bill evidently mistakes a bailout for the exercise of lender of last resort functions.  The latter, if Bagehot’s basic framework is followed, eases liquidity crises by lending freely against good collateral.  (The Fed’s promise to do so in October, 1987 almost surely saved the CME and CBT clearinghouses during the crash).  A bailout transfers wealth from taxpayers to the claimants of an insolvent firm.  Lincoln’s provision threatens to turn liquidity shocks into full-blown crises.

In some respects, Lincoln’s confusion is understandable.  After all, the Bernanke Fed has clearly blurred the line between Bagehot-esque lender of last resort activities and bailouts.  That’s a serious issue, that should be addressed.  But Lincoln’s approach would be a very bad way of doing that.

The bill’s end user exemption is extremely, extremely limited.  That’s also a problem, for reasons I’ve discussed before.  What’s particularly amazing is that the end user exemption is basically limited to commodity producers and consumers (although firms like J. Aron or Morgan Stanley that handle physical commodities are expressly excluded from the exemption).  That means that a firm, say IBM or Merck that uses currency or interest rate swaps would not be eligible for the exemption.


The bill also extends position limits to the OTC market.  More pain, without gain.

The proposal requires trading on either exchanges or swap execution facilities, and precludes voice brokerage.  It mandates pre-trade price transparency, and “real time” price reporting.  I’ve commented extensively on these ideas in the past, and find them no more reasonable now than I have before.

About to jump on a plane, so I will add more later.  One last thing.  The bill envisions a massive expansion of responsibilities for the CFTC.  To be honest, the CFTC does not have the capabilities to handle its current responsibilities, let alone the new and extremely complex ones it would have under the bill.  This is a setup for future regulatory failure, in a situation where the regulation is much more pervasive–and systemic. Regulators failed before. They will fail again. The likelihood of failure will be higher, and the consequences of failure more catastrophic, when regulatory responsibilities are expanded greatly and foisted onto an agency that is ill prepared to handle them. Even if the CFTC is funded much more generously, it will face daunting challenges in scaling up, and obtaining the expertise it needs to do a much expanded job. This is a train wreck ready to happen.

OK.  Time for one more thing, something that the bill doesn’t do.  Manipulation is a potential problem in derivatives markets, and existing law and regulation has proved problematic (at best) in deterring it.  I’ve advocated for years that a statutory fix is required, and this bill (or the Frank bill, or the Dodd bill) would present opportunities to do that, but they don’t.  So we have a bill (bills, actually) that does many things it shouldn’t and doesn’t do something it can and should.  Great.

April 18, 2010

Throwing Like a Girl: An Update

Filed under: Politics,Sports — The Professor @ 9:16 pm

I was watching the tube with one eye a couple of days back, when an Obama PSA came on.  He was exhorting men to “be a dad.”  I’m all for that.  No arguments here.  But what I found humorous and interesting, in light of his pitching performance, was the first item in his exempli gratia: “Play catch.”  That was either ironic, or Freudian.

Political Posturing at its Worst

Filed under: Politics,Russia — The Professor @ 9:06 pm

There’s been quite a bit of fussing and fuming from Russia over the sad story of a Russian boy adopted by a Tennessee couple who was sent back home alone.  It is pretty clear that the woman involved was in way over her head, and showed very poor judgment.  However poor her judgment, it is no justification for the histrionics and hyperbole emanating from the highest levels of the Russian government.  It is a human tragedy, not an affair of state.

In 2005, returning on a trip to Moscow, there must have been a half-dozen Russian kids traveling with their adoptive parents.  Most of the kids were old, as adopted kids go.  Most of the parents were old too, as adoptive parents go.  It was pretty clear that each was the last chance for the other, and that the odds of it working out well were not too good.  Most of the kids were in distress, and most of the adoptive parents were at a loss at how to handle it.

My Russian seat-mate (now a close friend) was clearly affected by the scenes, and I was troubled.

The Tennessee story is no surprise to me, then, given what I know, what I’ve read, what I’ve observed, and what I’ve learned from friends (including a family that adopted 4 Russian children in the early-1990s).  Indeed, the only thing that surprises me is that it doesn’t occur with greater frequency.

I might give the outrage of Medvedev and Lavrov more credit, if they were to show the same level of umbrage at the treatment of Russian children in Russian institutions by Russians, or at the social conditions that produce such tragedies.  The appalling conditions in Russian orphanages are quite well known, as is the fact that many who live there are not orphans, but abandoned by their mother, or mother and father.  The cynical and mercenary nature of the adoption business in Russia (even by the fairly dreary standards of these things) is also an open secret.

But it’s so much easier to demonize an unprepared, overwhelmed American woman than to come to grips with the conditions that resulted in a troubled boy being placed with someone incapable of handling him.  You can play the patriotism card, criticize the damned Americans, and relieve your conscience of any thought of your own responsibility.  That’s cheap sensationalism and grandstanding that exploits the tragedy of a damaged Russian boy and a well-meaning but overwhelmed American woman.

Yes, Russian can muster moral outrage, and stop adoptions by Americans.  Just how, pray tell, will that help all those institutionalized Russian kids facing a future which the word “bleak” does no justice?  Indeed, I find the posturing about this sad episode, in the face of the myriad tragedies about which not a word will pass the lips of anyone in power in Russia, to be more than a little nauseating.  It is an evasion of responsibility, and exploitive political posturing.  In a word: disgusting.

Goldman in the Dock

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 8:57 am

I have several reactions to the SEC’s fraud complaint against Goldman.

First, some of the more sensationalist reporting emphasizes that Goldman was short the RMBS structures that it was selling to its customers.  (Yeah, it’s the NYT, basing its opinion on reporting by Wretched Gretchen Morgenson, so take it for what it’s worth–meaning not much.) Well, that’s true, but Goldman was also long.  After all, it was the counterparty, the protection seller, to Paulson’s CDS.  It then entered into offsetting transactions.  Goldman was essentially a conduit of risk between other financial firms and Paulson.  Note paragraph 66 of the complaint, which indicates that Goldman paid most of the $840 million it received on short positions in the  Abacus deals to Paulson.

This means that Goldman took on substantial counterparty risk, which is also revealed in the complaint.  Although the complaint does not spell out the exact transactions in detail, it appears that ACA Capital sold hedges on the Abacus deal, and that the risk that ACA Capital would not be able to perform was assumed (for 17 basis points) by ABN.  In the event, ACA Cap could not perform, and ABN’s purchaser, RBS, ended paying off on the protection (to Goldman).

This is related to something I blogged about last year (which attracted Jim Chanos’s attention).  Specifically, as a market maker both long and short credits, Goldman was vulnerable to default by its counterparties on its long positions.  That’s why AIG’s impending demise was so threatening to Goldman.  AIG owed collateral to Goldman, and Goldman owed collateral to its counterparties.  If AIG had failed, Goldman likely would have failed too.  That still seems to me to be the key issue that is often overlooked in discussions of the AIG bailout, and Goldman’s stake in that bailout (which it vociferously denies–too vociferously, IMO).

As to the specifics of the complaint, yes, I’m sure that ACA Management, and the ultimate buyers of the Abacus deal would have liked to know Paulson’s true role in the transaction, and his true economic interest.  And it appears that Goldman was deceptive in its representations about Paulson’s role.  Whether that’s enough to secure a judgment is debatable, however.

It’s worthwhile to note that it is unlikely that Paulson had material, non-public information about the mortgages at issue. He certainly had a view, based on his analysis of the market.  But, according to the complaint itself, that view was based on the analysis of what is most likely public information:

In late 2006 and early 2007, Paulson performed an analysis of recent-vintage Triple B RMBS and identified over 100 bonds it expected to experience credit events in the near future. Paulson’s selection criteria favored RMBS that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.

All that information was available to ACA Management, and to the ultimate buyers.

Paulson had a view on what was going to happen in the mortgage market, and desired a structure that would pay off substantially if that view was correct.  At the time others did not take the same view, even when looking at the same information.  That said, one would have been wise to take pause at buying this stuff had they known that Paulson had such a strong view on the market.

One curious thing in the complaint.  Typically annoying investment banker jerk Fabrice Tourre (who seems to have stepped out of a Tom Wolfe novel) is the only named defendant.  Didn’t oodles of people at Goldman have to sign off on this deal?  Why aren’t they named?  That seems to suggest a certain weakness in the case.

The self-styled “Fab” is a natural target primarily because of his big mouth–or more precisely, his lurid emails.  Emails like this are catnip to reporters–and prosecutors.  But any prosecutor who makes such correspondence the keystone of his case is taking a huge risk, as the recent Bear Stearns cases illustrate clearly.  The emails should be used like the cherry on the sundae–not the entire dessert.  To make the case, the SEC will need more substantive evidence about Goldman’s actions–including the actions of others beyond Tourre, including any putative adults in legal.  Yes, it’s hard for juries to follow.  Yes, it’s boring.  But that’s the hard work that must be done to secure a conviction.

One last comment.  The timing of the complaint is quite interesting, coinciding with the administration’s big push for financial regulatory “reform” and its identification of this as a major winning issue.  It could be just that–a coincidence.  But maybe not.

Moreover, it is cases like these that build the narrative that is used to justify the need for wide-reaching regulation, most of which relates to matters far removed from the specifics of any particular case.  That extrapolation is dangerous (extrapolation always is), and almost always results in bad policy.

Much of the regulation introduced in the 1930s was built on similar narratives, that were similarly removed from the specifics of the laws and regulations.  The Goldman story is most resonant of the stories of bank perfidy in marketing corporate and sovereign securities in the 1920s; this narrative was an important part of the justification for Glass-Steagall.  But as much recent research has shown, the empirical evidence does not support the view that banks systematically profited (and screwed their clients) by keeping good loans and palming off the bad ones through the securities markets.  No doubt that happened at times, but the evidence doesn’t support the broader narrative that this was the rule, rather than the exception.

But the new narrative that parallels that of the 1930s is well established, and the Goldman complaint will only cement it in place.  And this may turn out to be the most socially costly aspect of Goldman’s actions.  These actions will help advance laws and regulations that pose considerable risk of doing far more harm than good.

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