Streetwise Professor

NASDAQ has decided to cancel–bust–trades made between 2:40 and 3:00 PM ET if they were at prices more than 60 percent away from the market price prior to 2:40.

Very bad idea.

The orders executed at these prices were almost certainly stop orders.  Old fashioned stop orders.  The kind that have been destabilizing for years, not some newfangled HFT thing.  When stops are hit, they reinforce the price movement that triggered them.

Busting these trades therefore encourages the use of a particularly destabilizing type of order.  If the idea is to reduce the amount of positive feedback in the system, this will have the exact opposite effect.

There is still no definitive understanding of what triggered the selloff.  The P&G story seems bogus–the slide started before that.  Yes, algorithmic trading or program trading of some sort was probably involved.  Let’s try to think of the most likely trigger.

A big index futures sale that really moved the futures price would have triggered sell orders in stocks generally, first in the index component stocks, then in other stocks (as correlation or pair algorithms kicked in). The main effect of algorithms would have been to speed the transmission of the initial shock.  The question is: what would have caused a big index futures trade?  An error?  (CME says its system worked fine, and Citi denies it was involved in any erroneous trade, as had been rumored.)

There are no answers right now, but the methodology for providing the answers should be pretty straightforward, and ironically, the very accurate time sequencing and record keeping made possible by electronic trading will greatly ease the process of implementing that methodology.   Look which markets moved first.  Look at the orders that were associated with those moves.  Then trace the effects from there.  Knowing where the event started, the basics of algo trading strategies makes it straightforward to hypothesize how the shock wave should have traveled.  One can then test those hypotheses to see whether in fact these strategies accelerated the decline.

There are also reports that many HFT traders withdrew from the market when things got crazy.  This isn’t surprising, really.  That’s what market makers do.  (Remember the stories of NASDAQ market makers not answering their phones–or making markets–during the ’87 Crash.  Or clearing firms yanking their locals off the floor on that day.)  This is very consistent with the Greenwald-Stein story of how a big volume shock can lead to higher execution risk which causes a decline in liquidity which in turn makes the market more volatile.  That is another feature inherent in continuous markets, human or automated.  HFT firms that make markets won’t behave that differently than human market makers.  They’ve just embodied the logic in the market makers’ heads into computer code.

Another thing that is consistent with the Greenwald-Stein story is the report that the NYSE liquidity circuit breakers exacerbated problems.  Greenwald-Stein recommended that in the event of a major disruption, the market transition from continuous trading to an auction market.  That’s what NYSE did.  But this apparently resulted in orders being redirected to other execution venues.  The circuit breaker deprived the market of NYSE liquidity for a time, and the wave of orders stressed liquidity in other venues.  But one of the points that was made clear in the aftermath of the ’87 Crash is that circuit breakers have to be coordinated.  Tripping a circuit breaker in one market but not the other can make things worse, not better.

One thing that is not really consistent with G-S is the rapid rise in prices after the plummeting fall.  Indeed, the rise is in some ways more remarkable than the fall.  It is almost vertical, with the Dow moving up more than 4 percent in less than 15 minutes, with most of that distance covered in about 10.  This suggests that value buyers jumped on the opportunity, and drove up prices.  In G-S, the execution risk keeps the value buyers away.

Thus, another important question is: who were these value buyers?  Mightn’t they have been algo/HFT traders?  If so, it is imperative than any rule changes or regulations implemented in response to this event do not cripple those using negative feedback strategies.

I am probably asking for too much there, as the tendency to lump traders into big categories is very strong, and the ability and willingness to make careful distinctions virtually absent.

And it is highly likely that stop order traders who almost certainly exacerbated the price decline will not receive proper scrutiny, and indeed are likely to be pitied as victims; busting trades is consistent with that narrative.  That would be a real pity, and would betray a failure to understand what kinds of orders and trading strategies are destabilizing.  Stop orders should be taxed, if anything, and those using them don’t deserve pity–or mulligans.

One of the arguments in favor of mandated clearing is that (a) CCPs require initial margin to collateralize trades, and (b) many OTC deals do not.  Requiring collateralization, the argument goes, reduces the default risk associated with derivatives.

Even assuming this argument is correct, it does not imply that clearing reduces the risk of failure of a financial firm, or the risk that its failure will have destabilizing spillover effects.  This is because the argument fails to address the equilibrium responses of affected firms.

In essence, collateralization reduces the credit/leverage in a derivatives transaction.  But if firms are forced to reduce leverage in one set of transactions, they can increase it in others.  Indeed, you’d expect this to happen.  If a firm has a given debt capacity, or a given target leverage, it will almost certainly respond to a mandated reduction of leverage in one set of transactions by using the debt capacity/target leverage freed up in this way by increasing leverage elsewhere.  For instance, it could borrow the initial margin amount.  (This is done, to some degree already for cleared transactions.)  A reasonable approximation of the first order net effect of mandated collateralization of some deals is that the firm’s leverage will not change much.  Yes, all else equal more collateral means less leverage, but all else is not equal.

Of course, the firm can’t be made better off by the imposition of a constraint.  Revealed preference implies that the firm is at most indifferent to forced changes to its capital structure, but likely prefers the freely chosen allocation of debt/credit capacity between derivatives transactions and other deals.  For instance, it may be cheaper to obtain credit/leverage through derivatives than through an on balance sheet loan.  (That’s the essence of my argument as to why end users may object to being forced to clear.)  But it is almost certain that firms subject to the clearing mandate will adjust their capital structures in ways that mitigate the impact of the mandate on their overall leverage and counterparty risk.  This is likely especially true for large financial firms that have many substitute funding sources.

Nor is it obvious that the form of the leverage will change all that much.  Even if you believe that the leverage implicit in derivatives trades, when combined with bankruptcy rules, encourages counterparties to run, it is likely that reducing that kind of leverage will encourage substitution into a form of debt that is similarly vulnerable to runs.  Runs are damaging to firms.  That’s why they can be a disciplining device.  By choosing its capital structure, a firm chooses a probability of a run.  This choice must be considered maximizing in some respect.  If you force a reduction of the use of one kind of credit that is vulnerable to runs, firms are likely to substitute towards another form that results in a probability of a run that is close to the original, maximizing choice.

This means that increasing derivatives collateralization will not substantially reduce the likelihood a firm will become bankrupt, or vulnerable to a destructive run.  Its main effect will be to redistribute the losses consequent to such a bankruptcy.  Derivatives counterparties may suffer smaller losses (due to multilateral netting and its effect on priority, and to lower leverage in derivatives deals due to greater collateral), but other counterparties will suffer commensurately greater losses.  As I’ve argued before, a priori one cannot conclude that this reallocation of default losses is more efficient than the one that results from the voluntary contracting decisions of the agents.  (Also note that the derivatives counterparties would often be the counterparties to the offsetting leverage increasing transactions.)

Put differently, the first order effect of clearing, whether through netting or increased collateralization is to change priority, not the amount  of leverage (and hence the risk of bankruptcy/default/run).  Its primary effect is redistributive.  It is not evident, moreover, that this effect is socially beneficial.  If there are externalities due to credit (arising from systemic risk, for instance), why should a credit exposure implicit in a derivatives transaction create a more harmful externality than a credit exposure inherent in some other transaction?

The amount of leverage, rather than the contractual means by which firms add leverage, is arguably the fundamental underlying concern.  Attempting to control leverage at the capillaries by regulating some transactions is pointless: leverage needs to be regulated at the heart.

This means that the most important steps should be to eliminate subsidies to leverage, whether through the tax code or subsidies to debt implicit in TBTF/bailouts.  The next most important measure is capital requirements and liquidity requirements, although I am much more dubious of their efficacy as they are, in essence, price controls set by (relatively) ignorant third parties which can be gamed by the much more knowledgeable parties that are supposed to be constrained by them.  Set the prices wrong and the cure can be worse than the disease; given the information imbalances, the prices are almost certainly wrong.  (The financial crisis, and the contribution of the Basel rules to it, provide a cautionary tale.)

This is another example, as if another was needed, as to how superficial analyses of the effects of clearing mandates create a false sense of security, and thereby encourage complacency.  They don’t fix a problem: they just move it around.  The cat won’t sit on a hot stove again, but in its obsession to avoid the stove it risks stepping in the rat trap.

Harvard’s Mark Roe has an oped in today’s WSJ where he opines that clearing is NOT the “magic bullet” for systemic risk.  I definitely agree with that conclusion, as readers of SWP certainly know.

Several of Mark’s arguments echo the ones I’ve been making for the past two years.  First, they can create a moral hazard, and there is room to doubt that they have the requisite information to price counterparty risk properly:

The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that’s not my problem because the clearinghouse pays me anyway. The clearinghouse weakens private market discipline. [That’s the moral hazard point.]

Still, if the clearinghouse is as good or better at checking up on your creditworthiness as I am, all will be well. But one has to wonder how good a clearinghouse will be, or can be. [That’s the information point.]

Second, they can create a systemic risk:

Moreover, if trillions of dollars of derivatives trading goes through a clearinghouse, we will have created another institution that’s too big to fail. Regulators worried that an interconnected Bear or AIG could drag down the economy. Imagine what an interconnected clearinghouse’s failure could do.

AIG needed $85 billion in government cash to avoid defaulting on its debts, including its derivatives obligations. Could one clearinghouse meet even a fraction of that call without backup from the U.S.? True, we could have many clearinghouses, each not too big to fail—but then maybe each would be too small to do enough good.

The Senate bill would allow a clearinghouse to grab new collateral out from failing derivatives-trading banks to cover old, but suddenly toxic, debts the banks owe to the clearinghouse. This could harm other creditors and cause the firm to suffer a run. Nevertheless, to protect itself in a declining market, a clearinghouse would have to make those big collateral calls. That’s good if it protects the clearinghouse. But it’s bad if it starts a run on a weakened but important bank.

. . . .

Clearinghouses can help manage some systemic risk if they’re run right. If not, they can become the Fannie and Freddie of the next financial meltdown.

Third, by allowing multi-lateral netting, clearing gives derivatives counterparties priority over other creditors, a point I first made back in ’08.  This is systemically ambiguous.  There is no guarantee that the derivatives counterparties are more systemically important, or more vulnerable to contagion, than other claimants.  For instance, reducing the payoffs that the buyers of a big intermediary’s short term paper obtain in the event of a bankruptcy by reshuffling priority imposes bigger losses on these creditors.  In the Lehman case, these creditors included money market funds who had bought Lehman commercial paper; the threat of a run on the money market funds led the Fed to guarantee them.

Where Mark and I part company is on bankruptcy treatment of derivatives.  He believes that all aspects of the bankruptcy code that give priority to derivatives counterparties should be eliminated.  Although I (see above) concur that changing priorities can be problematic, I also believe that treating derivatives exactly the same as other debts is problematic too.  Indeed, I think that there is a good argument for several of the safe harbor provisions.

I’ve been planning to write an extended post on this issue, and still hope to, so I’ll just summarize here.  First, the bankruptcy rules allow derivatives counterparties to seize collateral, whereas other creditors are stayed, meaning they cannot do so.  The reason this makes sense is that whereas in traditional debt the amount of exposure is limited to the face amount of the borrowing (plus interest owed), the exposure is potentially unlimited in derivatives.  Derivatives traders use collateral to limit their exposure; staying them would expose them to unlimited risk.

Second, the rules allow termination and close out netting of defaulted derivatives positions.  Without such termination and netting, (a) a defaulter’s counterparties would be locked into positions that generate unhedgeable risk, and (b) could expose such counterparties who have winning and losing positions with the defaulters to having to pay the bankrupt’s estate on the losing positions and not getting much back on the winning ones.  This is particularly problematic in a dealer model in which dealers tend to run matched books (or close to it).  With termination and close out netting, their exposure is related to their net positions.  Without it, it could be as large as their gross positions, which are a multiple of their net.  The dealer market maker model would not be sustainable under these conditions.   No doubt there would be various work arounds, but these are likely to be very costly and impede greatly the ability of the market to serve its risk transfer functions.

So Mark and I would agree that dictating CCPs is a bad idea; we would disagree on the advisability of wholesale changes in the treatment of derivatives in bankruptcy.

I know that Mark also shares my concern about the psychology that underlies the fixation on clearing mandates as the panacea to systemic risk.  There is a palpable obsession with “solving” the systemic risk problem.  Clearing has been seized on as this solution.  Groupthink has taken over, and there is virtually no questioning or critical analysis of clearing as it is, as opposed to clearing as people wish it to be. There is this rather unsettling similarity to a cult; it is like clearing is the space ship that will take the believers to a better place.  Or to a belief that there is a magic pill or painless diet that will cause one to lose weight and keep it off.  The thought is comforting.  It’s easy.  This makes people unwilling to ask uncomfortable questions.

This desire to “solve” systemic risk in one step is especially troubling because it bears the seeds of the next crisis.  The thing that is most likely to breed complacency is a belief that a problem has been solved.  As Mark, and I and others, have argued, clearing is not a foolproof solution, but has its own risks.  Overlooking those risks is a very dangerous thing.

The European Commission is pushing for foreign currency derivatives to be cleared.  This is also a bone of contention here in the US.

It is interesting that those advocating clearing, and also exchange trading, have not attempted to explain the very pronounced cross sectional variation in trading and clearing practices across markets, and the time trends in particular markets.  Virtually all FX derivatives trading is OTC (with currency futures being the hair at the end of the tail of the dog).  The large bulk of linear interest rate derivative trading is OTC (even though the Eurodollar futures and similar markets are immense, they are dwarfed by the even more immense OTC interest rate swaps).  Equity derivatives and interest rate option trading is more evenly split between OTC and exchange.  Moreover, whereas in recent years a good portion of interest rate swap business has migrated to clearing naturally (accounting for about 50 percent of the interbank business), no OTC FX business is cleared.  A decent amount of OTC equity business is cleared.  A considerable part of OTC energy trading in the US is cleared–and was trending in that direction starting from about 2003 without anybody from the government telling market participants to do it.

The lack of clearing in OTC FX is pretty interesting, inasmuch as counterparty risk on an FX swap of a given amount and tenor is greater than that of a corresponding interest rate swap because principal is at risk in the former, but not the latter.  If clearing is such an economical way of allocating counterparty risk, why is it almost completely absent for products in which that risk is pronounced?  Similarly, due to the jump-to-default feature in CDS, these products pose large counterparty risks, but they weren’t cleared either until the dealers came under pressure to do so.  So, the instruments that arguably pose the greatest counterparty risks were not cleared voluntarily.

It would be nice of those who have the Olympian insight to dictate how markets should be structured could explain how they are structured.  If the European Commission is right, then the participants in the FX derivatives market are wrong.  Why?  And why should FX market participants choose a different mix of execution and counterparty risk allocation methods than participants in interest rate swaps and equity and energy derivatives?  Especially since there’s more than a little overlap between the participants in these various markets.

This is an interesting economic puzzle, the solution to which might, just might, be somewhat illuminating.  It might just shed some light on the economic trade-offs involved in clearing.  Just a guess.  But in the haste to prescribe–to dictate–market structure, our legislative and regulatory betters couldn’t be bothered to understand.  They just know.  So everybody should just shut up and get with the program.

The debate over “rules vs. discretion” was a centerpiece of disputes over monetary policy during the 1960s-1980s.  One of the most important contributions to this debate was by John Taylor, who devised an eponymous rule for monetary policy.  A rule that Greenspan and Bernanke flouted, and in so doing, contributed mightily to the financial crisis.

Taylor has an article about rules vs. discretion in today’s WSJ.  It is not about monetary policy, but rules vs. discretion in the resolution of large financial institutions that have failed, or are teetering on the brink of failure.   Taylor comes down firmly on the side of rules:

You do not prevent bailouts by giving the government more power to intervene in a discretionary manner. You prevent bailouts by requiring adequate capital based on simple, enforceable rules and by making it possible for failing firms to go through bankruptcy without causing disruption to the financial system and the economy.

Taylor’s argument is that the capriciousness of a system that gives regulators tremendous discretion gives rise to destabilizing uncertainty.  A rule-based system is more predictable, and more stable.

I too have argued for limiting discretion, though on somewhat different grounds.  My concern is that discretion, especially when there is a possibility that that discretion can be used to commit government funds (or even funds eventually contributed by other financial firms) in order to bail out creditors creates moral hazard.  Political economy considerations will almost certainly favor bail outs; concentrated, politically connected creditors will exert greater influence than diffuse taxpayers.  The prospect for bailouts reduces the cost of credit, which encourages excessive leverage, excessive risk taking, and  insufficient monitoring.  Which, in turn, makes failure more likely.

Although Taylor’s argument and mine on discretion are different, they are complementary.  I have not seen an even mildly persuasive argument in favor of discretion.  Thus, whereas the Chapter 11F bankruptcy option that Taylor advocates (as does George Schultz, one of the only US Treasury Secretaries I wouldn’t swap for Kudrin) is languishing, the discretion-heavy Dodd bill advances apace.

A constant theme here at SWP, in my public speaking, and in my academic work has been the lack of serious thought underlying the financial bills currently slouching through Congress.  These markets are complex (in the usual sense of the word, and the more technical meaning of complex systems characterized by emergent orders and rich feedbacks).  Any major changes will have effects that are almost impossible to predict: and it is quite likely that the legislative effects will be quite different from those intended by its framers.  Or, as I put it in a policy paper for Cato that I just finished (first draft, anyways):

There is a “fire, ready, aim!” feel to many of the policy proposals emanating from Capitol Hill and the administration.  Prescription precedes understanding.  To evaluate the costs and benefits of clearing mandates, this order must be reversed.

The implicit judgment underlying the regulation is that the received structure is fundamentally defective, but there is no explanation as to why that is so.  There is no stepping back to ask: “Could there be an economic rationale for the arrangements that have emerged from the decisions of myriad economic agents?”  There is no grappling with the Coase question: no serious attempt to identify the source of transactions costs that could lead to the massive “market failure” that the advocates of major changes believe exists.

As I’ve said before: fools rush in where angels fear to tread.  Without understanding what is broke, and what isn’t, how can you fix it?

I am reminded of the time I was helping my grandfather fix a tractor.  I had the wrenches out and was ready to just start unbolting stuff.  He said: “Wait just a God damn minute.  Why don’t we try to figure out why it isn’t working first?  If you just take the damned thing apart it will be well and truly broken.”

Is it too much to ask the denizens of the 202 area code to wait a God damn minute and figure out what in the financial system didn’t work and why, before they well and truly break it in ill-considered efforts to “fix” it?

Well at least I have some company in my misery.  Today’s New York Times, of all things, has an article that highlights the foreboding of several other finance scholars:

Others simply argue that it is premature to pass sweeping legislation while so much about the crisis remains unclear and so many inquiries are in progress.

“Until we understand what the causes were, we may be implementing ineffective and even counterproductive reforms,” said Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology. “I understand the need for action. I understand the need for something to be done. But what I expect from political leaders is for them to demonstrate leadership in telling the public that we need to proceed about this in a much more deliberate and rational and thoughtful way.”

. . . .

The most basic critique comes from Professor Lo and others who say that Congress is moving too quickly. The origins of the crisis remain a subject of intense controversy. Investigations continue to unearth surprising information. The Financial Crisis Inquiry Commission, a bipartisan panel created by Congress, is not scheduled to report until December. Why not wait, they ask, until the targets are clearer?

Exactly.  The article quotes others, including Lawrence White of NYU who almost sputters with indignation at the failure of any of the bills to address Fannie Mae and Freddie Mac at all.  But what would you expect from Barney Mae and Chrissy Mac?  Or is it Fannie Frank and Freddie Dodd?  Regardless, addressing that issue would raise the most embarrassing questions, like: WTF are the people who bear tremendous personal responsibility for one of the most costly aspects of the crisis–and what is arguably a key underlying cause of the crisis–doing in charge of “fixing” the system instead of donning sackcloth and squatting on a pile of ashes, begging abjectly for forgiveness?

In another misery-loves-company moment, from a truly unexpected source, Sheila Bair and the FDIC have come out against the derivatives spinoff provision of the Lincoln bill:

Federal Deposit Insurance Corp. Chairman Sheila Bair is opposing a Senate measure that could cut off privileges to banks like Goldman Sachs Group Inc. and JPMorgan Chase & Co.that don’t segregate swaps trading units.

Bair, in an April 30 letter to Senate Banking Chairman Christopher Dodd and Agriculture Committee Chairman Blanche Lincoln, said the proposal championed by Lincoln would create “weakened, not strengthened, protection of the insured bank.”

“If all derivatives market-making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less-regulated and more highly leveraged venues,” Bair wrote. “Even pushing the activity into a bank holding company affiliate would reduce the amount and quality of capital required to be held against this activity.”

Not that Bair has gone the SWP full monty: she still favors the Volcker rule and mandatory clearing.  But at least she recognizes the completely insane and ill-considered, unlike Shapiro and Gensler.

But will any of these Cassandra-esque warnings, from Bair or from academics, make a difference?  Sadly, almost certainly not.  This whole endeavor is operating on a strictly political timetable, and is driven by a strictly political considerations.  It is the centerpiece of the Democrats’ attempt to salvage something from the upcoming elections.  And as such, thoughts about the economic rationale or consequences are irrelevancies.

It has been reported that Federal prosecutors are considering the possibility of a criminal indictment of Goldman Sachs.  It is early yet, but it’s worthwhile to contemplate what the consequences of this action would be.

In 1988, Drexel Burnham Lambert faced the prospect of RICO charges arising from the Milken issues that would have effectively destroyed the firm.  The company plead nolo to avoid that death sentence, but it was mortally wounded and imploded months later, with moderately unpleasant consequences for the financial markets (including the derivatives markets).  The mere prospect of a Treasury Department ban on its participation in Treasury auctions due to one of its traders having squeezed the T-note markets (arguably a less severe sanction than anything associated with criminal charges) caused a run on Salomon Brothers that almost destroyed the firm; only Buffett’s frantic efforts saved the firm.  (That article is an interesting read.  I smiled at the part where Buffett was talking on a payphone.  Was it that long ago?)

Goldman’s stock was down hard on the news, and its CDS spread widened.

Criminal charges against the firm raises a significant risk of a run (specifically, a withdrawal of short term credit) that could threaten the firm.  Goldman is well-capitalized, and in a decent liquidity situation, but not so soundly financed that it is inconceivable that it could fail. Similarly, Buffett’s connection to the firm provides an economic cushion, and perhaps just as importantly, a political one.

It must be remembered that these situations are highly non-linear, due to the substantial feedback and the existence of multiple equilibria.  Runs can be self-fulling.  If enough creditors believe the rest will run, they will run, which will cause others to run, etc.  That is, ironically given that firms like Goldman have been accused of commencing speculative attacks against whole countries, such firms are actually acutely vulnerable themselves to such attacks.

Again, Buffet’s presence here may be crucial: if lenders believe that he will inject additional capital into the firm, they will be less likely to run.

Bottom line: even a criminal charge against the firm is unlikely to be fatal, but the risk of a non-linear, unstable, destructive response is not out of the question.

And given the centrality of Goldman to the financial system, it going non-linear could cause a destabilizing, non-linear response in the broader markets.  If Goldman defaults on derivatives, the scramble to replace the positions would have large price, volatility, and correlation effects that can set off their own non-linear feedbacks.  Similarly, the effects on the credit markets would not be pretty to watch.  The world financial system is still very fragile.  It is not recovered from the 2008 cataclysm, and it is under considerable stress from the European mess.  In this environment, feedbacks can be particularly destabilizing and destructive.

Which raises interesting political issues.  Are the Treasury and the Fed engaged in contingency planning to deal with the potential for Goldman distress arising from criminal charges?  I am sure this is a particularly delicate issue: is Justice in contact with Treasury and the Fed about these issues, either to keep the financial authorities aware so they are not caught by surprise, or for consultations about the substance of the charges?  If they are in contact, is it two way, or is it just a matter of Justice briefing Treasury or the Fed?

This is particularly delicate given the political toxicity of banks in general, and Goldman in particular.  Anything that smacks of giving Goldman a pass will cause a non-linear political effect.  But actions (or lack of actions) that contribute to or do not mitigate a shock to the financial system could be devastating both economically and politically.

These are not palatable choices, and that makes it very difficult to assess what course will be followed.  This uncertainty is exacerbated because “the government” is not a unitary thing.  Multiple independent decision makers have the power to take actions that would have serious effects.  Even a mis-statement by a press spokesman can have cataclysmic consequences.  (Remember the incautious statement by a spokesman for the East German government that set off the train of events that caused that government to collapse?)  All of this uncertainty contributes to the risk of destabilizing responses.

On a more philosophical level, this issue creates some interesting dilemmas.  Recall the intense reaction to the Supreme Court’s decision in the Citizens United case?  Many commentators, especially on the left, were outraged at the Court’s treatment of corporations as “persons” for certain purposes.  My intuition here is that the same folks would likely be outraged if the government did not pursue criminal charges against Goldman.  Would they experience any cognitive dissonance at their denial of the personhood of corporations as a matter of principle, and their insistence that the corporation be prosecuted as a criminal–criminality a behavior undertaken by individual persons?

Of course, you might ask whether I would feel any cognitive dissonance about not prosecuting Goldman.  To which I reply: legal personhood encompasses a bundle of characteristics, rights, and obligations.  Considerations of efficiency and justice suggest that is desirable to endow corporations with some of the individual pieces of this bundle, but not others.  There are trade-offs involved, and its is wise to eschew categorical, all-or-nothing choices, and instead make a pragmatic judgment about the legal rights and protections of corporations.  Yes, corporations are like persons in some respect, but not necessarily in all respects.  The problem is that lawyers tend to think in categories, not trade-offs, and this leads to difficulties.

Insofar as the specifics are concerned, the key issue is the incentive effects that charging the firm criminally would have.  The prospect of the large losses that could result from criminal charges would certainly provide a greater incentive for upper management to monitor and discipline the actions of their subordinates; that’s the whole idea behind vicarious liability.  But this effect could also be achieved by prosecuting the individual managers responsible for oversight of underlings that engage in criminal acts.

Moreover, the prospect of a non-linear response to the charges (let alone a conviction)  means that the cost of the criminal sanction is likely hugely disproportionate to the harm, and hence have an excessive deterrent effect.

Furthermore, many innocent individuals would be harmed by a crippling or destruction of Goldman–its innocent employees in the first instance, but myriad other individuals as well.

Finally, given that (a) these crimes, if they occurred, are economic in nature, (b) the cost of the harm can be approximated with some accuracy, and (c) Goldman is sufficiently wealthy as not to be judgment proof from the economic harm that resulted from its actions or lack of action, a strong case can be made that civil action, including third party actions by those injured, is more efficient than criminal prosecution.

Back in 2008 I wrote a few posts on the Porsche corner of VW stock.  The FT has posted the amended complaint in the securities fraud and manipulation lawsuit filed by VW shortsellers.  It makes for very interesting reading.

It is clear that if the basic facts in the complaint are correct, that this was a garden variety corner.  A very intense one, due to the nature of stock markets.  Whereas in commodities additional deliverable supplies are usually available at some price above the competitive level, the strictly finite supply of stock in a company makes the relevant supply curve effectively vertical, which means that the only thing that limits how how the price of the cornered instrument can go is the cost that shorts incur from defaulting on their obligations.  As I mentioned in one of the earlier posts, this event was like the great stock corners of the old days, most notably the 1901 Northern Pacific corner.  In this case the price shot up nearly five-fold, something that would be extremely unlikely in a commodity corner.

Porsche’s strategy was pretty straightforward.  It owned 50 percent of VW stock.  20 percent was in the hands of the German state of Lower Saxony, which was unlikely to sell.  Index funds (who could not sell their shares because of their need to match indices in which VW was a component) owned more than 5 percent.

Porsche stated publicly that it had no intent of gaining a controlling 75 percent stake in the company, but bought calls and sold puts on shares representing 25 percent of the company.  This long call-short put strategy created a synthetic forward contract on VW stock.  It did so knowing that if its long position equaled 75 percent, given index funds’ and Lower Saxony’s positions of greater than 25 percent, any short seller would not be able to obtain stock to make delivery, and would be cornered.

The sellers of the synthetic forward hedged their exposure by buying shares; they bought shares from short sellers who believed that the stock was overpriced, based in part on comparisons to the prices of other, related stocks.

Porsche concealed its efforts by engaging in the options transactions with a variety of different counterparties, making it difficult for anyone to understand what the company’s total position was.

According to the complaint, a decline in the price of VW stock caused by the financial crisis caused problems for Porsche; its puts moved into the money, imposing a substantial financial burden on the company.  So it decided to spring its trap, and the price of VW stock skyrocketed from about 200 Euros/share to nearly 1000.  For a brief time, VW had the world’s largest market cap.

All in all, a very straightforward and compelling story.

The complaint makes a big deal out of the fact that Porsche’s VW options were not, as some contemporary press reports claimed, cash-settled.  Instead, they required the call option seller to deliver shares upon exercise.

This isn’t that critical.  VW could have manipulated even if the options were cash settled.  Just the means of manipulation would have differed.

With delivery settled options, Porsche could effectively determine the price of VW stock by choosing the number of options to exercise, and hence the number of shares of stock to buy (X shares, say); this would have determined the number of shares that the shorts would have had to come up with at the time of exercise.   This, in turn, would have determined the demand for the stock and hence its price.  Porsche could have profited by selling the remaining options at a value reflecting the inflated stock price.

But if the options were cash settled, VW could have achieved the same result by buying stock in competition with the shorts scrambling to cover.  If they bought X shares on the open market (i.e., the same number of shares acquired by exercise of the physically settled options), shorts would have faced the same supply curve for shares, and would have driven up price to the same level.  Porsche would have profited by the cash settlement of its options at the same price.  Thus, VW could have achieved the same outcome regardless of whether the options were cash settled or not.  (One caveat: perhaps regulations constrained open market purchases differently than the exercise of options.)

Regardless, this is about as classic an example of a corner as you will see in this day and age.  Which makes it all the more amazing that German financial regulator BaFin did a great Sergeant Schultz impersonation, and saw nuthink!  nuthink!, both during and (even more amazingly) afterward.  Another stellar moment in the regulation of market manipulation–and a clear demonstration of why private action by the victims of a manipulation is the most effective deterrent against this form of opportunistic behavior.

Jeremy Grant wrote a piece on the no Federal assistance of clearinghouses section of the Lincoln bill in today’s FT.  He noted that both Gensler and SEC head Mary Shapiro came out in support of this provision.  He also argued that their position is quite wrong.

That Gensler is wrong is no surprise; I’ve thrown out watches that were right more often than he is.

Gensler and Shapiro are jumping on the “no bailout” populist bandwagon.  Now I also oppose bailouts, but one of my main criticisms of this section, and the arguments raised in its support, is that they confuse the operation of the Fed as a lender of last resort against good collateral, and a true bailout which uses taxpayer money to protect creditors. It is a crucial distinction, and one that Gensler and others apparently either don’t understand or are deliberately ignoring.

I noted in my earlier post on this subject that Bernanke’s Fed has certainly created confusion by pushing the LOLR concept beyond all previous limits.  But that’s reason to put limits on the Fed generally; it’s not a reason to cut off CCPs and other crucial derivatives intermediaries from access to even legitimate LOLR functions.  Section 106 throws out the baby with the bath.  It prevents creditor saving bailouts, but also does not permit systemically stabilizing use of LOLR powers.

The IMF supports central bank lending to CCPs backed by good collateral.  The Europeans recognize it too: note that some European CCPs, notably Eurex and LCH.Clearnet SA (the French part of LCH.Clearnet) have access to the ECB.

It’s important to recognize fundamental distinctions.  The Lincoln bill doesn’t.  Nor do its cheerleaders, Gensler and Shapiro.  This failure will have serious consequences if the provision becomes law.

It’s also interesting to note that on Monday Gensler refused to come out one way or another on the provision. In fact, he was so evasive that he even acknowledged that he was not answering the question.  What changed between Monday and Wednesday, when he said he supported the Lincoln provision?  Orders from on high?  Or a calculation on the direction of the political winds?  (Note that I exclude reasoned consideration of the economic issues from the possible explanations.  Why waste time on sets of measure zero?)

[Added bonus from the last link: Gensler Metaphor Alert!:

“Just like a street light protects you from dark and dangerous highways, we need something to protect us from the dark and dangerous market that is right now is OTC derivatives,” Gensler said.

Ever notice that Gensler appears to be really, really afraid of the dark?]

One last interesting story.  Senator Judd Gregg blew a gasket, accusing Gensler of a power grab:

CFTC Chairman Gary Gensler answered questions about the bill and its impact at the committee’s “mark-up” of the bill last week, which Gregg called an “affront” and a “pretty heavy sign” that he was leading the charge on the reforms.

“It’s trying to consolidate as much power as possible … in-house, and give the chairman of the CFTC basically massive authority over this market at levels never seen before,” Gregg said.

Gregg said Lincoln’s proposals, the bulk of which Dodd has agreed to merge with his bill once debate begins, are meant to penalize large players in OTC derivatives whose risky trades have been blamed for part of the recent financial crisis.

“I thought I’d woken up in Argentina in 1950,” Gregg said, describing his reaction to the Lincoln proposal.

“That bill is essentially a document that is written by people who do not believe in markets, do not believe in capitalism, and hate profit, and basically see … government as being the correct arbiter of almost anything that has to do with markets,” Gregg said.

Though I take pretty much anything any senator has to say with a huge grain of salt, I have to say that Gregg is pretty much on the money.  Yeah, the don’t cry for me Argentina thing is hyperbole, but the fact that the entire legislative effort is driven by people who do not believe in markets is spot on.  As is the assertion that Gensler is engaged in a massive power grab.

The sad things are that (a) he’ll probably succeed, (b) his agency is completely incapable of responsibly and effectively exercising those swollen powers (especially with Gensler at the controls), and (c) (a)+(b)=a future crack up that is appalling to contemplate.

Blanche Lincoln has expressed uncertainty as to whether the no Federal assistance clause in her bill will survive to become law.  (Here’s hoping, though the Republicans caved–I’m shocked!, shocked!–at holding up the Dodd bill which Steve Bainbridge rightly calls “evil.”)  Perhaps one reason for her uncertainty is that some anonymous Fed staffers threw some “comments” on the bill over the transom.  (Which raises the questions: why do these staffers feel the need to be anonymous?  Why hasn’t the Board, or Bernanke, taken a stand on this?) (We know with probability 1 that SWP’s cogent critiques had nothing to do with Lincoln’s uncertainty!)

Echoing my original take, the comments trashed the dreaded section 106:

1. Section 106 should be deleted.

a. Lending to financial market utilities. Section 106 would prohibit any federal assistance to swap dealers, major swap participants, swap exchanges, clearinghouses and central counterparties.  This would appear to override the provision of Title VIII that would allow the Federal Reserve to provide emergency collateralized loans to systemically important financial market utilities, such as clearinghouses and central counterparties, to maintain financial stability and prevent serious adverse effects on the U.S. economy.

i. As systemically important post-trade “choke points” in the financial system, it is imperative that these utilities be able to settle each day as expected to avoid systemic problems and allow for a wide range of financial markets and institutions to operate.  The failure of a systemically important utility to settle for its markets would not only call into question the soundness of the utility as a critical market infrastructure but could also create systemic liquidity disruptions for one or more  markets and potentially other financial market utilities.  The increased importance that Title VIII places on central counterparties and central clearinghouses to reduce risk in the financial system necessitates ensuring that short-term secured credit is available to these utilities in times of stress.

b.  “Push–out” of bank swap activities. Section 106 would in effect prohibit banks from engaging in derivative transactions as an intermediary for customers or to hedge the bank’s own exposures.

i. Title VI, which includes the so-called Volcker rule provisions, better addresses the problem of risks from derivatives activities by prohibiting any bank, as well as any company that owns a bank, from taking speculative, proprietary derivative positions that are unrelated to customer needs.

I would disagree only to the extent that I think the Volcker rule is inane too.

The interesting question is where this insanity came from.  In the months leading up to the announcement of the Lincoln bill, mandatory clearing was always on the table; mandatory exchange or exchange-like trading was constantly discussed; but the no Federal assistance provision was never broached.  How can it happen, so late in the day, that such a momentous provision, fraught with the potential for massive consequences (that are almost impossible to forecast with any precision), can appear in a piece of legislation like a bolt from the blue?  The cavalier attitude on display here is frightening.

I have another question, related to the consequences.  During the Crash of ’87 clearinghouses didn’t have direct access to Fed assistance.  Nor do they now, for the most part.  But the Fed clearly provided liquidity support in 1987 that although not directed to CCPs or FCMs directly, indirectly supported them.  The Fed flooded the system with liquidity, and “persuaded” (the quotes are in Bernanke’s article about the event) banks to take the liquidity and lend it to securities firms and FCMs to make sure that they would be able to meet margin calls.  The Fed also permitted Continental Bank to inject capital into First Options, which probably saved OCC; Continental, I believe, received Fed liquidity.

Would it be legal for the Fed to do provide the same indirect support under Section 106?  It seems ambiguous.  The Fed’s actions in 1987 were clearly undertaken with the intent of saving clearinghouses, and had this effect.  Do we really want lawyers (or judges) trying to figure out whether such indirect assistance is legal when the financial system is on the brink?  Or will the fear of such a constraint lead to the kind of backroom dealing and cover-ups that occurred during and after the AIG bailout?  (And which, by the way, may get Timmy! in the legal crosshairs of the TARP Inspector General.)

Has anybody in the Senate even thought about this?

You know, when you play chess, or plan military strategies, you have to think several steps ahead.  You have to play “what if?”  I believe, with almost metaphysical certainty, that nobody who will be voting on this has done so.  More often, they are looking back, and learning false lessons about the past, or ignoring potentially informative experiences, or just engaging in pointless political posing and posturing.  Which bodes very ill for the next future, and the next crisis–when, and not if, it occurs.

Which is just one reason why Congress is the biggest systemic risk.