Streetwise Professor

To the post-ISDA reception party at The Supperclub, sponsored by ICAP, that is.  And I didn’t.

Actually, Mama had nothing to do with it.  I am a Poor Richard, early to bed, early to rise kind of guy; healthy (yes), wealthy (well, comfortable), and wise (Streetwise, anyways 🙂 ).  That, plus the 2 hour time difference meant that the party began well after my normal, CT bedtime.  So, while the daring ones were headed to the Supperclub, I headed back to the hotel for some shuteye.

The linked article says suggests that the fin de siecle decadence which I had not seen was not entirely absent.  (This definitely NOT work friendly article suggests that even more strongly.)

All which provides further reason, as if further reason was needed, why I became a professor, rather than a banker.

Update:  A reliable eyewitness tells me that the NYT story was more than a little exaggerated for effect.  The back room was empty, the dominatrix flix were nowhere to be seen, and in the main, it was just “a bunch of geeks dancing.”  And probably talking about Greeks.

According to this morning’s press reports, Dodd and Lincoln have agreed to bolt together their bills.  The Lincoln bill passed by the Senate Ag Committee would become the derivatives title of the Dodd financial “reform” legislation.  Crucially, according to these reports, the no Federal assistance/derivatives dealer spinoff/Volker plan on steroids will become part of the Senate bill.

Perhaps maintaining the spinoff is simply a negotiating ploy.  Republicans are likely to filibuster the bill, because it is not bipartisan.  Negotiations are ongoing.  One common negotiating ploy is to include outrageous clauses, that one can generously sacrifice during negotiations.

But maybe it isn’t.  Maybe Dodd and Lincoln believe in this insanity.  And it is insanity.

I’ve mentioned some of its scary features.  But I haven’t mentioned all of the frightening implications.  Derivatives markets are intended to provide risk bearing capacity and liquidity.  To do so, those making markets must combine trading talent, valuation expertise, and risk capital.  One of the reasons that dealers came to dominate OTC markets is that they were able to offer this combination.  Crucially, their balance sheets provided the risk capital that made traders more willing to deal with them than other  potential counterparties.  Dealers assemble networks of positions backed by their capital.  There are economies of scale and scope.  Prevent financial institutions from backing derivative deals with their balance sheets, and it will be impossible to exploit these economies.

It is interesting to recall that many financial institutions set up bankruptcy remote, separately capitalized, AAA derivatives trading subsidiaries.  But market participants preferred to trade with banks directly, thereby having recourse to the banks’ balance sheets.  That is, the market once upon a time had a choice to trade on something like that contemplated in the Lincoln bill, and consciously chose not to.

The spinoff clause is therefore likely to impair the liquidity and risk bearing capacity of the derivative markets.  (Perhaps, from the perspective of Lincoln and those of like “minds”, this is a feature, not a bug.)  Moreover, it is likely to result in more counterparty risk, as less-well capitalized intermediaries replace the banks.

I’ve focused on the derivatives aspects of the Senate bills, but there’s plenty more to hate in the Dodd bill.  Let me comment just briefly on the resolution aspects.

The $50 billion dollar “bailout fund” has drawn the most attention, and the most fire, but it’s small beer compared to other things in the bill.

Most importantly, as I’ve noted repeatedly, the fundamental source of too big to fail is the inability of the government to commit not to bail out creditors of a failing or failed institution.  Increasing the discretion of authorities responsible for resolution reduces ability to commit.

And the Dodd bill does just that.  It gives the FDIC and the Treasury and the Fed tremendous discretionary authority to make creditors whole on the taxpayers’ dime.  This discretionary authority is almost completely free from any Congressional check.  Moreover, this authority has effectively unlimited access to the public purse.

To sum up:  instead of constraining regulators’ ability to bail out creditors of big financial institutions, the bill expands their discretion; instead of increasing the credibility of commitments not to bail out by limiting access to government funds, the bill undermines credibility by giving the Fed and the executive branch virtually completely discretionary authority to pay as much as they want to the creditors of large financial institutions.

Sure, the bill also mandates greater prudential oversight, but this is unlikely to be sufficient, as a litany of past failures of such oversight should make plain.  That is tapping on the break, while the measures I just described are flooring the gas pedal.

I know it’s tiresome to hear it yet again, but it bears repeating: the source of TBTF is the implicit subsidy to creditors that exists when the government cannot pre-commit credibly not to bail them out.  The Dodd bill basically says in flashing neon:  We Will Bail Out Creditors!!!  Regulatory discretion plus unconstrained access to the Treasury is a recipe for systemic risk.

If, heaven forfend, the Dodd bill passes, keep an eye on the difference in the funding costs of big financial institutions and small ones.  If my analysis is correct, that difference–which is already substantial–will remain wide, and likely grow.

There is of course a conceptual link between the derivatives and bailout provisions.  Big derivatives dealers will take on too much risk, to the extent that they are subsidized via the TBTF features of the bill currently slouching towards passage.  But the right way to address that problem is not to hive off derivatives trading from the banks that get the implicit subsidy.  If they can’t take advantage of the subsidy via derivatives trading, they’ll just take advantage of it some other way.  Believe me, there are an infinite number of ways that smart bankers can exploit the subsidy to the fullest; close off one way, they’ll find another.  The better way to go is to take measures to reduce, and substantially so, the TBTF subsidy.  This the Dodd bill does not do: in fact, it does the opposite.

In some respects, the debate over clearing has been at cross purposes.  Those who advocate clearing, including many in the banking community, often focus on the chaotic events that accompany the default of a large OTC counterparty, such as Lehman or LTCM; advocates of clearing argue that a central counterparty can mitigate the disruptions associated with a large failure.  Those, like me, who are skeptical of mandates (but who are not averse to clearing if freely chosen by market participants, as has occurred in energy, freight forwards, and many interest rate swaps) focus on the incentive and information effects that affect behavior prior to a default.

I confess to being less than clear about the distinction, and therefore think it’s worthwhile to address these issues in more detail.

In essence, the distinction is between ex ante and ex post.  I have focused on the ex ante incentives, whereas others have focused on ex post issues.  Both are important.  (This parallels distinctions that transactions cost economists sometimes draw between agency theory and property rights models, which focus,  on ex ante incentives, and Williamsonian governance theories, which focus on the ex post management of contractual relationships.)

Of course, the ex ante and ex post issues are not unrelated.  Ex ante incentives affect the positions and risks that are undertaken, and hence affect the likelihood of a major default.  Resolution mechanisms affect the cost of dealing with default.  The expected cost of clearing vs. bilateral mechanisms for allocating counterparty risk is, roughly, given by the probability of a major default (which depends on the ex ante incentives) times the cost of such a default (which depends on the ex post resolution mechanism).  It is not evident a priori whether this product is larger under a cleared or uncleared system, hence the grounds for legitimate debate over the merits of clearing.

There is a colorable case that the combination of multilateral netting and the existence of a central counterparty that can coordinate the transfer and replacement of defaulted positions can reduce the cost conditional on a default occurring.  Multilateral netting reduces the magnitude of the positions that need replacing.  This reduces the stress on market liquidity resulting from a default.  Moreover, clearing facilitates the transfer of customer positions to solvent clearing members, thereby avoiding the necessity of replacing these positions via market transactions, further reducing said stress.  Moreover, the information that a CCP possesses about total positions, and its ability to coordinate the hedging/replacement of the defaulted risks can reduce uncertainty and mitigate price impact.  (Although it should be noted that the experience of the CME with the Lehman problem, as documented by the Valukas report, and as suggested by what I have learned from informed sources that the LCH unwind of the Lehman positions was not as breezy as LCH has suggested demonstrate that this is at best a relative statement.)

Some research that grew out of the ’87 Crash sheds light on this last issue.  An interesting paper by Greenwald and Stein (JOB, 1988) shows that normal, continuous trading mechanisms can exhibit poor performance during periods of market stress caused by a large shock to the volume of transactions (especially when this shock is accompanied by an increase in fundamental uncertainty).  In essence, there are execution price risks under these circumstances that create negative externalities.  Potential replacement counterparties are reluctant to trade in these circumstances because of the extreme uncertainty about execution prices during periods of large volume shocks.  This tends to reduce liquidity, which tends to exacerbate the execution price risk.

This means that the uncoordinated replacement of large numbers of defaulted positions by a large number of firms through the use of ordinary, continuous market mechanisms (whether OTC or exchange) can lead to substantial price changes that are not fundamentally driven, but are microstructural in origin.  This can have further knock-on effects, as these (distorted) market prices affect collateral/margin calls, can induce asset fire sales, etc.

Thus, a plausible characterization of a key trade-off between bilateral and cleared structures is: (a) counterparty risks are more efficiently priced and shared in a bilateral setting, and hence moral hazards and adverse selection problems are less acute in that setting; (b) further, hub-and-spoke clearing networks create concentrated points of failure that are more problematic than more distributed (but still concentrated) bilateral networks; but (c) a cleared system reduces replacement cost risks/price impacts conditional on default.

Which raises the question: is it possible to obtain the information benefits associated with bilateral arrangements for some transactions, while mitigating the price impact of an uncoordinated replacement of defaulted positions? Can we have our cake and eat it too?

Put differently, clearing is a bundle of functions including inter alia: (1) the pricing of counterparty risks; (2) the mutualization of losses not covered by collateral; and (3) the management of risk associated with defaulted positions, and the replacement of these positions.  I argue that for many transactions and transactors, bilateral mechanisms are superior for (1) and (2); I recognize that CCPs may do (3) better.  Is there any way to get the benefits of (3), without incurring the disadvantages that CCPs arguably face with (1) and (2)?

I think that this could be possible.  In essence, it would involve pre-commitment to a suspension of normal, continuous trading activities in the event of a default by a large market participant (a dealer, such as Lehman, or a big hedge fund, such as LTCM), and its replacement with an auction-type mechanism.  (This is the essence of the Greenwald-Stein recommendation for “circuit breakers” that replace continuous trading with a call auction.  The key difference is that the Greenwald-Stein circuit breakers are price-contingent, which has some problematic features, whereas what I am proposing is default-contingent.)

ISDA implemented a “Big Bang” auction protocol to facilitate the settlement of CDS positions in the event of the default in a named credit.  Although as I predicted in my post on this subject some years back, this protocol has not eliminated all problems with pricing the debt of defaulted credits (as shown in a recent Markit Magazine article), it has greatly smoothed the process of handling CDS-triggering credit events.  Perhaps something similar could be designed and implemented to deal with a big derivatives default.

ISDA could of course play a central role in shepherding the creation of such a mechanism.  Similarly, regulators, notably the NY Fed, could also play a constructive role, perhaps in both the design and implementation.  I am pretty sure that ISDA would be quite willing to engage in such a cooperative endeavor.

The process would of course be facilitated by the development of robust trade repositories that permit rapid determination of the positions that are defaulted against.  I have supported the creation of such repositories (see my Regulation magazine piece) from the outset.

Just thinking out loud, here are some ideas of a potential structure.

First, a compression round whereby multilateral exposures are netted.  (This would have implications for bankruptcy priorities and bankruptcy law; these implications would have to be weighed carefully and addressed).

Second, an auction round for replacement of positions.  This auction round would follow a disclosure, based on the information in the trade repository, of all the positions, to the potential bidders.

The auction round raises several issues that need to be considered.  Who would be allowed to participate?  Permitting anyone to participate could just be a jump from the frying pan into the fire if some of the winning participants are themselves in dodgy financial condition.  (This is a dilemma that CME faced in its Lehman auction, and likely explains why it limited participation in the auction of Lehman positions).

Another issue is that the number of positions to replaced can be immense, and highly heterogeneous, with many non-standardized contracts.  Perhaps one way to deal with the latter would be to auction off shares of portfolios, e.g., USD interest rate (swap, swaption, etc.) positions; FX positions; equity derivatives; and so on.  This would mitigate cherry picking/adverse selection problems and simplify the bidding.  It would, however, mean the splitting of some individual contracts among multiple counterparties.  (It should be noted, though, that many of the positions would not be cleared or even clearable in any event, so this issue is not eliminated by a clearing mandate.)

Yet another issue is that those assuming positions would be taking on counterparty risk.  Thus, the repository would have to disclose the counterparties to the defaulted contracts to the potential bidders.

So, I realize that there are many thorny operational issues that must be addressed to implement this proposal.  But some would exist under a clearing mandate because not everything would be cleared in any event.  I further realize that FRBNY and the dealer community tried to do some of this on the fly in the “Lehman weekend,” and in LTCM years before.  The Lehman attempt foundered (as Theo Lubke of FRBNY, and several bankers I spoke to, indicated at the ISDA AGM).  But perhaps this is not surprising as extemporizing on the fly in those conditions faces faint chances of success, particularly given the lack of information available to the participants; a pre-planned mechanism that can rely on more complete information is almost certain to work better.  I would also note that in a cleared market something like this will have to be in place in any event.

The logic behind my approach is pretty straightforward.  Whenever things are bundled, the immediate question should be: can efficiency be enhanced by unbundling them?  (A lot of what goes on in finance involves unbundling things and allocating the pieces in a value-enhancing way.)  Sometimes you can’t: so be it.  But sometimes you can.

Clearinghouses bundle counterparty risk pricing, counterparty risk management (including the collateralization mechanism), mutualization, position information collection, and default resolution.  There is no logic that says that those functions have to be bundled.  Repositories can collect and aggregate information, perhaps more effectively than CCPs (because they can incorporate information on non-cleared positions, and information on positions held across CCPs).  CCPs are not always the best at counterparty risk pricing and collateralization mechanics.  Mutualization can have some extremely problematic features.  So why not an approach that unbundles, and allows specialization in these various functions?

Once repositories are created, the development of a robust, coordinated defaulted contract resolution/replacement mechanism would go a long way to improving the efficiency of the OTC derivatives market while permitting it to continue to do what it does best.  This would be an easier process (though not a simple one) than what will be set in motion by the vast expansion of CCPs as contemplated in the pending legislation.  CCPs will have to develop resolution procedures in any event.  Moreover, it is desirable to develop procedures to deal with contracts that are not cleared (which will be the most challenging ones in any event).  But force-fed CCPs will also have to grapple with challenging pricing, risk management, risk sharing, and governance issues as well.  And if there are multiple CCPs, there will have to be some coordination of the resolution procedures.  (If there isn’t there will be trouble.)  So, a mandated and extensive expansion of CCPs will have to solve many more problems than just the resolution mechanism.  So why not just focus on that?

I am sitting in the SF airport, on my way back to Houston after speaking at the ISDA Annual General Meeting.

Wikipedia states that “fin de siecle”

refers to the end of the 19th century, in Europe, France and/or Paris. It has connotations of decadence, which are seen as typical for the last years of a culturally vibrant period (La Belle Époque at the turn of the 20th century), and of anticipative excitement about, or despair facing, impending change, or both, that is generally expected when a century or time period draws to a close.

There was definitely a fin de siecle feel to this ISDA event.  Decadent?  No, but certainly more extravagant that what I am used to.  Anticipative excitement?  Definitely not, but certainly anxiety, bordering on despair, about the impending change facing the OTC derivatives business.

Yesterday, of course, Obama gave a populist speech at Cooper Union in New York, in which he demanded that Wall Street submit meekly to the regulatory proposals racing through the Senate.  Deputy Secretary of the Treasury Neal Wolin carried this message to ISDA.  He gave a hostile, our-way-or-the-highway speech.  I haven’t seen Wolin speak before, so I have no benchmark to compare to, but not only was his speech very sharp-edged, but his body English also communicated a certain hostility.

The audience reaction was as tepid as any I’ve ever seen.  I would probably be exaggerating if I said half the audience gave any applause, and even those clapping were making only the most perfunctory effort.

Mark Brickell, formerly of J. P. Morgan, asked a very provocative question, and one that needed asking.  He asked Wolin whether by forcing things into clearinghouses, weren’t the new proposals creating the ultimate too big to fail institutions, and effectively committing the government to future bailouts?  Wolin’s answer was basically just a flat denial, and did not truly engage the real issue that lay at the heart of the question.

Wolin was also asked about the Lincoln bill’s no Federal assistance provision, which would be the Volcker bill on steroids, requiring not only banks to exit proprietary trading, but customer-facing derivatives market making activities too.  Consistent with other administration voices, Wolin neither endorsed or criticized the measure.  He said something like “there’s a lot in these bills.”  Thanks for that insight.

I was on an academic panel chaired by Chris Culp (Chicago), with David Mordecai (Chicago), and David Mengle (UCLA, which was Chicago West in those days).  Mengle gave a nice talk about close out netting and its essential role in the OTC trading model.  David Mordecai gave a conceptual talk about the broad lessons of the crisis, in which he drew on the insights of Ronald Coase (always a good choice).

I gave the 20 minute Cliffs’ Note version of my case against clearing mandates.  My talk was largely well received, though not by everybody.  One of the things I focused on during my talk was the experience of the 1987 Crash, in which the CME clearinghouse was in serious jeopardy.  Somebody from CME clearing came up afterwards, and was pretty outraged at what I said.  He told me I was “feeding the dealer frenzy.”  No, I am trying to counter the legislative and regulatory frenzy with some back-to-basics analysis of the economics of risk sharing.  He also denied that the CME clearinghouse was in trouble in ’87, which got me a little ticked.  I told him, hey, look, I was there, I lived it, and was told that very specifically by Brian Monieson, a CME board member, in the morning of 20 October, 1987; truth be told, when that was happening this gentleman was in grade school in India.  You can look at contemporary accounts, including the Brady report and the Bernanke article on clearing and settlement during the Crash, and learn the same thing.  You can also look at Tamarkin’s book The Merc.  I was told of the BOTCC problems on the 19th-20th by two well-respected FCMs.  This isn’t a secret.

In various conversations afterwards, many bankers asked me about the ’87 Crash.  For the most part, they were not aware of the history, and were quite interested in it.  (Thanks for making me feel old, guys.)  Several are involved in various clearing efforts today, and found this history quite thought provoking.  That’s a big reason why I make such a big deal out of this.  People are so focused on the last crisis, and preventing a recurrence; regulators and legislators are most guilty of this.  It is important to make people aware that the last crisis was not the first crisis.  That there’s more historical experiences that can inform our current deliberations than what transpired in September, 2008.  The Crash of ’87 is particularly valuable because it gives the lie to the widespread claims about the efficacy of clearing as a solution to systemic risk.

Went to the meeting knowing almost no one, walked away knowing quite a few people.

The reception/dinner last night was a very interesting, almost anthropological experience  Pretty much the sole subject of conversation was the pending legislation; that’s what gave things the fin de siecle feel.  Everyone knows big changes are coming; that a vibrant period is coming to a close; and that the future will be very different.  The only question is: how different?

I think that the prevailing sense is that yes, some regulatory changes are needed and desirable, but that the punitive-for-the-sake-of-being-punitive legislation will be extremely counterproductive.  There was also a sense of despair that their fate was in the hands of those not only with an animus and an agenda, but with only a limited understanding of the way the business really works, and the likely consequences of what is being proposed.

Substantively there was broad agreement that expanded clearing could provide benefits, but that pushing it too far could be a disaster.  (That’s basically my view.  My CME interlocutor might talk to some of his own members to learn that they share similar concerns.)  There was widespread amazement at the exchange trading requirements.  I made a brief comment about the inanity of the Lynch Amendment (which may also be introduced by Sherrod Brown in the Senate) which several people talked to me about; they, as I, cannot believe how anyone would expect that banks are expected to bear counterparty risk by capitalizing a clearinghouse and providing backstop funds without having a commensurate voice or control of the operations of the CCP.

One last note.  The reception last night was held at the Legion of Honor, a beautiful art museum, which has one of the biggest Rodin collections outside of France.  (It also hosts a Cartier exhibit, which reinforced the sense of extravagance.)  The Thinker dominates the entryway to the museum.  On my way out, I looked back at the sculpture.  The sky was crystal clear.  A brilliant half moon hung over The Thinker’s head.  Four stars, in a diamond shape, bracketed the moon.  Quite a sight.

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.

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.

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.

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.

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.

Oi.

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.

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.