Streetwise Professor

This could become a regular SWP feature: Gary Gensler continues to grind out the metaphors in his verbal attack on OTC markets.  The most recent: “[the dealer banks] is also the group that nearly drove us off the cliff.”

Wait a minute.  Just days ago he said: “The dealers collectively nearly burned down the financial system.”  So what is it, are dealers bad drivers?  Or arsonists?  Or, is it that they drove a car off a cliff, and the explosion of the gas tank on impact ignited a conflagration?

I’m so confused.  But I’m also a little disappointed.  Haven’t heard about apples in a while.

I’m also still waiting for an explanation of how dealers qua dealers sped over a cliff, or lit a huge fire, or sped a flaming car over a cliff, and how the regulations Gensler is advocating would address any of those problems.  And no, saying the AIG incantation for the zillionth time doesn’t count.

The Futures Industry Association, a trade group for futures commission merchants and exchanges, has come out strongly in opposition to the CFTC’s proposed energy position limits.  The most interesting thing to me about the FIA letter is the fact that one of the central pillars of its argument is similar to an objection I’ve been raising for some months: specifically, that the CFTC doesn’t have a legal leg to stand on because (a) Congress has authorized the CFTC to impose limits when “it is necessary to diminish, eliminate, or prevent” the “undue and unnecessary burden” of “excessive speculation” that causes “sudden or unreasonable fluctuations or unwarranted changes in the price” of any traded commodity, but (b) CFTC has made no finding that excessive speculation that causes unreasonable price fluctuations exists, or has existed, in energy products.  Indeed, it’s worse than that.  CFTC’s attitude has been “we don’t got to show you no steenking evidence.”  CFTC, and notably Chairman Gensler, have also invoked repeatedly the idea that concentration is a danger that should be controlled through position limits.  But the Commodity Exchange Act is silent on concentration in this context.

The FIA letter is quite blunt: “Substantively in the absence of the ‘necessary’ finding, the CFTC lacks the statutory authority to adopt position limits.”  FIA also states that “[t]he ‘excessive concentration’ and ‘uncontrolled speculation’ themes the CFTC cites are both factually unproven and legally irrelevant.”  The letter states further that the “‘excessive concentration’ focus is misguided.”  I agree with all this, and have said and written as much over the past year (or more).  I further agree with the FIA’s statement that “FIA is not aware of any convincing or even credible evidence that large traders with speculative positions in energy futures markets have trumped fundamentals as the determining factor in energy futures prices.”  (Emphasis in original.)  Again, agreed.

To summarize, like the FIA, I believe that the CFTC position limit proposal is unjustified and legally dubious.  It is unjustified because there is no credible evidence, or logical argument even, that speculation has distorted prices.  It would be nice to make policy on the basis of, you know, evidence, wouldn’t it?  (Isn’t this the administration that said it was going to base policy on science, not politics?)  It is legally dubious because the CFTC’s authority to impose limits is not absolute.  The CFTC can impose limits pursuant to a particular purpose laid out in statute, but the CFTC’s justification for its proposal (a) does not show that its limits are in fact necessary to achieve that purpose, and (b) includes considerations that are altogether absent from the statute.

This is regulatory overreach based on no evidence.  Other than that, it’s great!  Kudos to the FIA for joining me in pointing that out.

A prosecutor in Milan, Italy has filed charges against four banks, alleging fraud in dealing swaps in the Italian city.  There are numerous other allegations of fraudulent marketing of swaps to municipalities, in Italy primarily, but also in the United States (e.g., Jefferson County, AL).

So far, the reporting is a bit sketchy, and in the Milan episode specifically, is driven by the prosecutor’s charges, and the flat (but uninformative) denials of the accused.  This article from FT goes into more detail about the issue generally.

Here’s my initial take.

According to the FT article, many of the municipalities borrowed at a fixed rate with the banks, and then swapped into a floating rate (by entering a receive fixed, pay floating swap).  This was all great and stuff when interest rates were low.  When interest rates rose, not so good.

But that’s a risk you take when you effectively borrow at a floating rate.  To the extent that losses resulting from rising interest rates are the basis for grievances–or legal action–against the banks that offered the swaps, I say tough luck.  You take a risk, and you shouldn’t be able to walk when that risk doesn’t pay off.   You can walk away from an option–but you have to pay money for that privilege.  (Once upon a time, in fact, options were called “privileges.”)  You entered into a swap, which costs nothing up front, and have to take the downside with the upside.

Other aspects of the deals are somewhat cloudier.  Because of options, in fact.  Some of the deals included collar structures (caps and floors).  These are embedded options.  A zero cost collar should have cap and floor strikes such that the values of the cap and the floor offset.  The banks are likely to be better informed about option values, especially given the very long terms on some of these transactions.  Thus, it is plausible, though not proven, that the options were mispriced in favor of the banks.

I am more sympathetic to such a claim, but not oodles more.  It would have been straightforward for a big entity like Milan, and many of the other affected governments, to hire a qualified, independent academic to vet the valuations.  Off the top of my head, I can think of a half-dozen very capable Italian finance academics that would have been overqualified to perform this rather routine exercise.  By spending a couple of thousand Euro in consulting fees, those now complaining could have saved themselves the millions of Euros they’re claiming they lost.  (A hundred million Euros, in the case of Milan.)  You’d think Italians would be able to understand the concept of caveat emptor.  (I don’t know how to say “due diligence” in either Latin or Italian, but the concept is the same in any language.)

There’s also an element of greed involved–and not just by the banks.  (Politicians and bureaucrats can be greedy?  Who knew?)  Many entities apparently renegotiated the deals frequently, and the new deals were priced off-market, but resulted in a cash payment to the municipalities at the front end.  This allowed the politicians to defer uncomfortable spending and tax choices.

But there’s no such thing as free money.  You get more money now, you have to pay more later.  Funny the way that works.  Again, the effective interest rate in the off-market swap vs. up-front cash payment might have been too high.  But again–that’s a fairly straightforward calculation to make, so hire somebody competent to do it.

The most likely explanation here is that nobody covered themselves in glory.  No doubt the banks saw suckers coming.  No doubt the municipalities were short sighted, greedy, and careless.  Funny how those two types seem to find one another, isn’t it?

The situation in Jefferson County, Alabama is somewhat different.  The county borrowed at floating rates through auction rate securities, then swapped that into a fixed rate.  That worked fine until the ARS market blew up, and the yields (and hence the county’s borrowing costs) spiked, and importantly, spiked relative to the floating rate in the swap.  This is a painful lesson in the risks of hedging.  You exchange flat price risk for basis risk.  In this instance, the basis blew out, and the hedger took a beating.

I haven’t followed the ARS debacle that closely (only so many hours in the day), but it seems that the implosion was an unexpected consequence of the unanticipated financial crisis.  It’s quite possible that both the banks and the county didn’t fully appreciate this basis risk.

To sum up, I’d say be very suspicious about sob stories and morality tales from municipalities that have lost money in derivatives deals.  In some cases, they took a risk, and they lost.  In other cases, it is possible that they were in fact overpaying to the banks on the other sides of the deals.  In still other cases, it’s likely that both things were true.  But from what I’ve read these deals weren’t so devilishly complicated that a qualified academic or independent consultant couldn’t have provided an analysis that would have prevented a municipality from entering into bad deals.  The municipalities should have some obligation to undertake due diligence, and letting them off the hook for failing to do so will only raise the costs of legitimate uses of such transactions.

In an uncharacteristically dyspeptic opinion piece on his newsletter, John Lothian concludes that CFTC Chairman Gary Gensler has his eye on something more than Chairmanship of what has long been an also ran among Federal agencies:

There has been talk in Washington, Chicago and in the media that Gary Gensler has ambitions to become the next Treasury Secretary should Tim Geithner’s reputation continue to take a beating and be force out.  It has been written, said and whispered that he is positioning himself for this promotion.  After seeing him in action at Boca, I tend to agree with this assessment.  We have had short-timer CFTC Chairmen before, with ambitions for greater jobs.  One only has to think of Reuben Jeffrey, who was mailing it in as CFTC Chair shortly after being named to the position, or so it seemed at the time.

To which I say: well, yeah.  When asked by a reporter for my appraisal of the CFTC commissioners last August, I wrote that it was pretty clear that Gensler had his eye on Treasury.  It’s only become clearer since then.

And in his campaign, Gensler is willing to say anything–anything–even if it is misleading, or untrue.  Consider what he said in an interview with Jeremy Grant at the FT (available here, for now, anyways): “The dealers collectively nearly burned down the financial system . . . . We know that.”

It is no doubt true that firms that are dealers, namely Lehman and Bear, failed, thereby shaking the financial system to its foundations.  We know that other firms that serve as dealers dealt with AIG (which was not, as commonly understood, a dealer), and that these dealings played some role in AIG’s bailout (exactly what role none of the principals involved will state forthrightly or consistently).  We know that other firms that serve as dealers, such as Citi and BofA and Merrill, were in desperate financial trouble.

But it is misleading, and a non sequitur, to assert that these events justify the kinds of regulation that Gensler is flogging endlessly in purple prose.  For once, I would like Gensler to state specifically what these various dealers did, qua dealers, that put the financial system at risk, and how the proposed regulations would address this behavior.

Again: read the Valukas report on Lehman.  The catastrophic investments that Lehman made involved pretty much everything but its OTC derivatives business (which was in the black to the tune of $21 billion).  Residential real estate, commercial estate, CDOs, private equity, leveraged loans, you name it.  Merrill and Citi and BofA were also torpedoed not by their activities as OTC dealers, but as underwriters of and investors in CDOs and other real estate related investments.

It is a bait-and-switch to say that “dealers” cratered the financial system to justify regulation of dealer activities.  Doing so suggests that it was the OTC dealing activities that were the root of the problem, when they clearly were not.

But, you might argue: OTC derivatives dealing creates interconnections between firms that can communicate financial contagion.  It is definitely true that the events make plain something I’ve flogged myself for well over a year: namely, that balance sheet risk arising from other investments and activities is an important determinant of the default risks posed by any dealer firm.  But it is just this kind of risk that clearinghouses do not and cannot price, nor effectively control.  And it is just this kind of risk that can be spread to big financial firms via their interconnection through a clearinghouse.  Clearing does not make interconnection go away: it reconfigures the interconnections, and does so in ways that can be riskier, not safer.

So, balance sheet risk is arguably a problem, but clearing is quite definitely not the solution; exchange trading and post-trade price transparency are even less relevant to this problem.  Indeed, it can make the balance sheet risk problem worse, and will do so IMHO.

It is, in short, perfectly consistent to excoriate the banks for what they did (and sadly, for what some continue to do) while opposing the proposed regulations of OTC derivatives.  These banks are big, complex, and engage in a wide variety of activities.  Some of the risks that banks ran proved ruinous, or nearly so.  But the OTC  dealing activities are not high on the list of those risks, if they are there at all.  But that doesn’t stop Jeremiah (or is it Ahab?) Gensler.

And a shout out to Stacy-Marie Ishmael at FTAlphaville who joins me in mocking (though she is more gentle in her mocking than me) Gensler’s fondness for metaphors over-the-top, mixed, and just plain wrong*.  But literary merit–not to mention fairness or accuracy–is of little moment when there is a political battle to be fought–or a cabinet post to be won.

* I am still chuckling over the Mrs. O’Leary’s cow Genslerism.  It is the perfect metaphor for him to use.  Like much of what Gensler peddles, the story of Mrs. O’Leary’s cow was a complete myth.

The clearing debate is getting more complicated, with major brokerages/FCMs clamoring to be admitted to OTC derivatives clearinghouses:

MF Global Holdings Ltd., Hexagon Securities LLC and at least 19 other financial firms are pressing regulators to force swaps clearinghouses to lower entry barriers in order to improve competition in a $605 trillion derivatives market dominated by the world’s biggest banks.

Brokers formed an association last month that hired a Washington-based law firm to pursue the issue with lawmakers and regulators, said Mike Hisler, a partner at New York-based Hexagon. They also seek tougher conflict-of-interest laws to ensure that a bank’s derivatives desk doesn’t influence clearinghouse decisions that could shut out new competitors.

There are numerous issues here that cut in different ways, and make policymaking treacherous.  Indeed, these are issues that I have raised in some of my academic work.

One issue is market power.  I’ve shown that in the presence of substantial scale and scope economies (which definitely exist in clearing), a coalition of intermediaries can form a cooperative firm to provide these services that is (a) smaller than optimal, and (b) immune to competitive entry.  The basic idea is that by adding just enough members to ensure that any other competing effort does not have the scale or scope to compete, this decisive coalition (which consists of the most efficient suppliers, e.g., the big dealers) can reap market power rents even if the cooperative itself charges marginal cost prices.  So, it is potentially problematic to permit a clearing cooperative firm to limit membership.

But there is another issue.  The whole idea behind a clearinghouse is to mutualize risk and, hopefully, to reduce systemic risk.  Admitting anybody willy-nilly is contrary to these goals.  Permitting less financially solid, not to say dodgy, entities imposes costs on the more solid ones, unless those risks can be priced effectively.  But, as I’ve argued extensively, clearinghouses typically do not have the information or the incentive to price the balance sheet risks of members properly.  Moreover, since the price setting process will inevitably be political in such an organization, it is likely (for reasons similar to what Peltzman described in his famous JLE ’75 article on regulation) that the prices will transfer wealth from the efficient to the inefficient (i.e., from the low risk to the high risk).  (A median voter-style analysis leads to a similar result.) Thus, open entry is a recipe for moral hazard–and systemic risk.  And hence, more financially solid firms have an incentive to bridle at the prospect of being required to share risk with other entities.

Allowing anybody in also increases the heterogeneity of the membership, which makes governance more costly and cumbersome.

This is just another example of the dilemmas posed by the network-nature of financial markets generally, and clearing in particular.  Scale and scope economies make competition difficult, if not impossible; efficiently scaled-entities are very large relative to the total market, and arguably natural monopolies.  These scale and scope economies can be exploited to exercise market power by limiting entry.  But permitting open entry creates its own difficulties, especially in clearing, because member heterogeneity that is inevitable with open entry, and member heterogeneity can be expected to lead to cross subsidies.  In this context, that means that some risks are underpriced, and riskier firms can expand and the expense of less risky ones.  That hardly comports with the putative objective of forcing more things onto clearinghouses.

In their rush to find a “solution” and the resulting embrace of clearing, regulators and legislators have largely ignored these very real challenges.  Mandating an expansion of clearing, and micromanaging the organization and governance of clearinghouses (as Gensler has advocated, and as the Lynch Amendment does), will involve unintended consequences.  These consequences will almost certainly undermine the ostensible objectives of these initiatives.

Again: Fools rush in.

The Valukas report on Lehman makes for interesting reading.  One of the most interesting things in the report is what isn’t in it: specifically, OTC derivatives.  Given the hyperventilating over the role of OTC derivatives in the financial crisis, this is quite important news.

Yes, OTC derivatives are mentioned, but in only the most perfunctory way.  Valukus concludes that Lehman’s methods for valuing its OTC derivatives was sound, and that alternative valuation methods gave very similar estimates of the value of Lehman’s positions.  Moreover, he notes that Lehman’s OTC derivatives positions were in the money to the tune of $21 billion, which represented only about 3.3 percent of the firm’s assets.  And that’s about it.

It is clear that the OTC derivatives were not the problem with Lehman.  Indeed, they were arguably the only thing that WASN’T a problem with the firm.  The huge losses were in residential real estate-related positions, commercial real estate, private equity, and leveraged loans.

Even the collateral and contagion issues were associated with other activities, notably repo funding.  In this regard, its interesting to note that, unsurprisingly, the mechanism that is often held out as the way of protecting the safety of the system—collateral—is actually what fed the death spiral.

The report also should open some eyes about the other supposed magic bullet—clearing.  Valukas concludes that there is a colorable case against the CME to claw back losses that resulted from the sale at a deep discount of Lehman’s house positions with the CME clearinghouse.  Valukas states, however, that preemption under the Commodity Exchange Act, the immunity of self-regulatory organizations, and the safe harbor provisions of federal bankruptcy law may shield the exchange from these claims.  I don’t know much about the first two things, but based on my knowledge/experience it is very plausible that the safe harbor provisions would apply here.

But that’s not the main thing of interest here.  It is evident that the Lehman bankruptcy posed risks to the CME clearinghouse, and hence its members.  After finding out about the impending bankruptcy, the CME ordered Lehman to trade for liquidation only, but the firm added to its positions over the next couple of days.  Moreover, the exchange failed in its initial attempt to get members to buy Lehman’s positions in bulk; it decided on this approach after concluding that liquidating the positions on the open market would have been extremely disruptive, given their size and the chaotic conditions in the market.  Several days later the positions were auctioned in bulk, but only at a steep discount.  Resolution of the problem clearly stressed the CME.  (There’s nothing in the report about what happened with SwapClear.  It would be interesting to know more about that.)

Note that the CME clearinghouse was at risk while these positions were still held at Lehman.  The risk posed by these positions didn’t magically disappear.  Moreover, note that what sparked the crisis was Lehman’s balance sheet risk, not the risk of its cleared positions.  This is the kind of risk that clearinghouses have little ability to measure, manage, or price.

In the end, the CME worked through the problems, though there were doubtless some sleepless nights.   Yes, the clearing process worked, but so did the OTC market.  The point is that the failure of a big member posed a big risk to the clearinghouse—and hence its members.  Clearing doesn’t make risk go away, or eliminate systemic risk.

In brief, the Valukas report on Lehman does not comport with the received narrative of the crisis, in which OTC derivatives play a central, and malign, role, and in which clearing is the panacea.  The narrative is so entrenched, however, I doubt that the facts will make any difference.  It will be interesting to see whether the Usual Suspects acknowledge this reality.  I am not holding my breath.

Gary “Jeremiah” Gensler continued his assault against CDS, this time from deep in enemy territory, at Markit’s Outlook for OTC Derivatives Markets Conference.  If it were up to Gensler, the OTC Outlook would be terminal.

In the speech, Gensler repeats several of his constant themes, and also adds some more, drafting off the cynical European outrage over sovereign CDS.  All of the tired standbys are here, including arguendo ad AIG (don’t leave home without it!)  but he also uses the shameless “derivatives used to mask Greece’s budget chicanery” argument.

I see.  We’re supposed to trust governments to regulate instruments that governments use to escape commitments they’ve undertaken.  What’s next?  Robert Downey Jr. for Drug Czar?

Gensler calls for regulation of derivatives dealers including capital and collateral requirements.  But siloed regulation of specific instruments makes little sense when these are just one element in the portfolios of complex financial institutions that engage in a wide range of risk taking activities.  A holistic approach by banking regulators is called for to ensure that risks are priced properly and consistently across all the instruments in bank portfolios.  But that wouldn’t give the CFTC a hand in the game, would it?

The CFTC chair also calls for transparency, arguing for something like the consolidated tape in equity markets.  I have no problems with that, having advocated a data hub for energy years ago, and suggesting it for OTC derivatives more broadly more recently.

But Gensler overstates the potential benefits.  He laments the fact that during the crisis there were “no reference prices for particular assets.”  Well, duh.  That’s because they didn’t trade.  And mandating that something trade on an exchange will not magically mean that it will trade at all.  Low volume instruments typically don’t trade on exchange because it’s not worth the cost of maintaining a market that is seldom used.  This isn’t Field of Dreams: just because you build a trading facility, doesn’t mean that people will come to trade everything on it.  Even with an exchange mandate and/or post-trade transparency, many instruments will still lack reference prices on a timely basis because there is no underlying demand to trade them with any frequency.

Which undermines Gensler’s next demand: that derivatives be cleared.  Sufficient trading activity is a necessary condition for clearing to be the best way of allocating default risk (though not a sufficient condition).  In addition, I note, wearily, that Gensler again invokes clearing as a deus ex machina that “guarantees obligations of both parties” and “takes trades off the books of financial institutions.”  Pray tell, where does the risk go?  Who provides the guarantee?  Is there a guarantee fairy?  Do leprechauns guarantee trades with a pot of gold at the end of a rainbow?  (Or is that needed for the Irish banks?)

In this speech, Gensler expands his criticism of CDS to take up the by now standard “no insurable interest argument” against holding “naked” CDS positions: who knew regulators were such prudes?  In a section titled “market manipulation” he regaled his audience with the story of how in the 18th century unscrupulous folk had taken out insurance on ships they didn’t own, which then seemed to have a bad habit of being lost.  This, and related schemes, led to the passage of statutes that required the purchaser of insurance to have an insurable interest.

There is an argument to be made for the efficiency of such rules in some contexts.  In particular, in the specific historical case Gensler discussed, the probability of detection was probably quite small, given the difficulty of proving that a particular vessel sank as a result of foul play (difficult if for no other reason that it was lying at the bottom of the ocean, perhaps with the bodies of its crew).  This meant that ex post deterrence of this conduct was likely very ineffective.  Moreover, there is no compelling benefit of A buying insurance on B’s property or life.

The question is whether this analogy is apt for CDS.  I think not.

First, there are potentially beneficial reasons for naked CDS.  Speculation of this sort can provide valuable information: markets that restrict short sales are typically less informationally efficient than those that don’t, and experimental evidence suggests that short sale restrictions encourage bubbles.  Moreover, market makers may sometimes take naked positions in CDS pursuant to their vital role of providing liquidity.  In addition, holding naked CDS against related positions (e.g., equity positions in the same firm, CDS positions in other firms in the same industry) can be sensible spread trading strategies that ensure that financial instruments are priced appropriately relative to one another.

Second, it is interesting that Gensler cannot point to any particular example in CDS analogous to what apparently happened to ships in the 18th century. He resorts to the “some say” dodge, stating that “some observers . . . contend” that CDS swap protection buyers “may have engaged in market activity to help undermine an underlying company’s prospects.”

Be a man Gary.  If you have evidence of this, let’s hear it.  If not, some say you should shut the hell up.  I would also note that Gensler’s argument can be applied to pretty much any financial instrument.  Owners of puts on a company have an incentive to do thing to undermine that company’s prospects.  What makes CDS special?

CFTC anti-manipulation standards require a finding that a manipulator had the ability to cause distorted prices, took actions that had the effect of causing such a distortion, and acted with the specific intent to do so.  Is Gensler arguing for a different standard for CDS?  Does he have any evidence that most CDS holders, naked or otherwise, have the ability to cause the distortions that Gensler conjectures?  Can he cite specific examples of where this ability to cause was actually exercised to cause the mayhem he describes?  Most importantly, does he seriously believe that such an action could be undertaken without being detected?   This seems an area in which ex post deterrence through enforcement action or private action is best suited, which is quite different from the shipping example that Gensler discusses.  Blanket bans against naked CDS don’t make sense in this context, as they preclude potentially valuable uses of this strategy, while (so far only hypothetically) misuses can be deterred efficiently ex post.

Gensler also trots out the empty creditor problem.  As I argued here and here, the conventional analysis of this issue (advanced most prominently by Henry Hu, and which Gensler essentially repeats) is seriously incomplete because it fails to address the latent Coase Question of what transactions costs preclude voluntary trades resulting in optimal allocation of rights.  Insofar as remedies are concerned, Gensler and I actually agree: he recommends position disclosure and voting in bankruptcy based on economic interest, just as I did last April in the first of the two posts linked above.

The CFTC chair also criticizes the Basel capital rules insofar as they apply to CDS.  I yield to no man in my disdain for these rules, and think that they were a major contributor to the financial crisis (to the extent that they incentivized banks to undertake the same trading strategy of holding large positions in AAA CDOs).  But I think that Gensler, in his Ahab-like obsession with CDS, focuses on a side issue.  Specifically, he criticizes the component of the rules that give capital relief to those who hold CDS as a hedge against other risk exposures.  He wants more restrictive capital treatment of CDS -hedged positions.  He pejoratively states that this treatment means that “a bank can essentially rent another institution’s credit rating to reduce its required capital.”

Well, yeah.  That’s what hedging is all about; an institution is laying off the risk to somebody who bears it at a lower cost. This can be done by selling the underlying instrument, or entering into a hedging transaction utilizing a related instrument.  Sometimes–a lot of the time–the latter is more efficient.   Economically, it makes perfect sense to require less capital against hedged positions.  It would be perverse indeed to do otherwise.

As to specific restrictions, Gensler suggests that “only CDS subject to collateral requirements could be allowed to provide capital relief.”  Perhaps he hasn’t read the most recent ISDA Collateral Market Review (released on March 1), which states that 97 percent of CDS positions are collateralized.

And by-the-way: AIG’s CDS contracts were subject to collateral agreements.

So, Gensler’s specific recommendations are red herrings, even in the context of arguendo ad AIG.

Would it that CDS and OTC derivatives were the only object of Gensler’s control fetish, and desire to swell the authority of the CFTC.  But no.  Not only are there position limits, but Gensler has also set his sights on the market for power firm transmission rights, setting off a turf war with FERC.

Gensler is attempting to put Rahm Emanuel’s “let no good crisis go to waste” dictum into action, exploiting the financial crisis–and importantly, more than twice told tales about the financial crisis–to advance a regulatory agenda that would concentrate tremendous power in his agency.  This agenda is built on fundamentally flawed analysis.  What’s more, the agency that he heads quite clearly has not demonstrated that it has the capability, resources, or expertise to exercise those powers effectively and judiciously.  And I am being very charitable in saying that.  (If you have any doubts, take some time and look through the reports the GAO has written about the CFTC over the years.  It does not make for happy reading.)

I have some novel suggestions, Chairman Gensler.  First, do no harm.  Second, be circumspect about anyone’s abilities–including yours–to micromanage huge, complex markets.

Greece desperately needs people to buy its bonds.  So what does it do?  It excludes potential buyers, specifically hedge funds:

Greece ordered its bankers to exclude hedge funds from a bond offering this week in an effort to punish the speculators it blames for destabilising its debt markets.

The decision came amid growing anger among European leaders over what they see as the role speculators played in undermining the Greek debt market and driving the country towards a possible default.

. . . .

According to people familiar with this week’s €5bn (£4.5bn) Greek bond issue authorities in Athens told banks handling the sale to make sure they did not allocate any bonds to hedge funds or any bodies that might be a proxy, or front, for them.

Uhm, those hedge funds that want to buy are going to result in lower interest rates for Greece.  Excluding them from the primary market can only make things costlier for Greece.  (Although since these folks can buy in the secondary market, the effect of excluding them from an auction might not be that large.)   You don’t punish bearish hedge funds (not that they deserve punishment in any event–see below) by taking a smack at bullish ones.  How assinine.

The Queen of this Greek drama, Prime minister Papandreou is absolutely over the top with his anti-speculative rants:

Greek Prime Minister George Papandreou, drawing parallels with the 1947 fight to contain communism in Europe, called for trans-Atlantic cooperation to combat “unprincipled speculators” who threaten to bring a new global financial crisis.

“Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system,” he said in a speech today in Washington. “An ongoing euro crisis could cause a domino effect, driving up borrowing costs for other countries with large deficits and causing volatility in bond and currency rates across the world.”

Papandreou and other leaders such as German Chancellor Angela Merkel have blamed much of the surge in Greek financing costs on market speculation, rather than its inability to tame the region’s biggest budget deficit. Germany and France are pushing for curbs on “speculators” using derivatives to bet against Greek debt, which will be ready in June, officials in Berlin and Brussels said today.

Papandreou called the market for credit-default swaps a “scourge” that “haunts Greece and all of us.” U.S. and European regulators need to bolster regulations to curtain such activities, he said, or “a small problem could be the tipping point in an already volatile system.”

Puh-lease.  I mean seriously.  What should haunt you, Mr. Prime Minister, is years of profligacy only partially concealed by financial chicanery (enabled, true enough, by some of the very banks against whom you rail today).  If you are facing some sort of financial  Armageddon, it’s the fault of your government and its predecessors, dating back years.  I would say that it was the governments of Greece–and other countries, the US included–that acted with “utter disregard for the consequences on the larger economic system.”

And which are acting with such utter disregard today.  Only more so.

But the shoot-the-messenger histrionics don’t end with Papandreou.  All of Europe’s government leaders are closing ranks to blame everybody but those who actually spent the money they didn’t have and couldn’t pay back.  Here’s Sarkozy:

“If Greece needs them (the measures), we’ll be there,” he said. “Speculators … must know that ‘solidarity’ means something.”

France, Germany and Greece will take a common initiative to fight speculation, and the euro zone’s two biggest economic powers “have decided to do what’s necessary so that Greece is not isolated,” Sarkozy said.

And Merkel:

German Chancellor Angela Merkel said that Greece doesn’t need financial aid, as she turned her focus to restricting the use of derivatives to halt “speculators” from exploiting countries’ budget deficits.

“Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb,” Merkel said at a joint press conference in Berlin yesterday with Greek Prime Minister George Papandreou.

. . . .

“We must succeed at putting a stop to the speculators’ game with sovereign states,” Merkel said. “We can’t allow speculators to be the profiteers of Greece’s difficult situation.”

So the Merkel story is, effectively, that the Greek financial house was all in order, nice white stucco and all, until one day, out of a clear blue Aegean sky, some malicious speculators decided to burn that house down.

What a crock.

It would be more accurate to say that the Greek financial house was used to store gasoline, while the family was busy puffing away on cigarettes (the Greeks being among the greatest smokers in Europe, BTW) and throwing their butts and matches around with abandon.  Some people noticed this, figured out something bad was almost inevitable, and put their money where their eyes were.  Yes, they probably made a few bucks for themselves, but also did the service of accelerating the inevitable fiscal reckoning, not just in Greece, but in Europe as a whole.

Oh, and even Merkel’s own German financial regulator, BaFin, denies that speculation caused the Greek crisis:

German market regulator BaFin said Monday that so far, it doesn’t see any sign of massive speculation in credit default swaps against Greek government bonds, despite some recent press reports suggesting this.

A significant reason behind widening CDS spreads is the increasing demand for insurance against Greek risk, BaFin said in a statement, adding that it closely watches the government bond and credit derivatives markets for selected euro-zone countries.

. . . .

BaFin said data published by the U.S. Depository Trust & Clearing Corporation don’t signal an increase in new open positions and don’t indicate massive speculation. It is true, however, that the gross volume of outstanding CDS contracts for Greek government bonds amount to around $83 billion as of Feb. 12, according to DTCC, more than twice the $41.1 billion a year earlier.

In other words, Papandreou, Sarkozy, Merkel et al are saying: “Don’t bother me with the facts.”  They don’t want to face up to fiscal realities, so they are trying to direct blame elsewhere.

Politics as usual, in other words.  And it is politics as usual that put Europe in this positions in the first place, and politics as usual that will prevent any fundamental change.

I’m just back in Houston from speaking at a conference at the Columbia Law School, titled “The Financial Crisis: Can We Prevent a Recurrence?”  It was probably the best conference I have ever attended.  It was a gathering of a truly talented group of academics (mainly legal scholars, but some economists), practicing lawyers, finance practitioners, central bankers (US and non-US), and government folks, all of whom offered excellent insights on various aspects of the crisis, and policy responses to it.  The organizers, Jeff Gordon of Columbia and Howell Jackson of Harvard Law School, are to be congratulated for putting on a phenomenal event.  It was a privilege to participate.

I spoke on clearing.  (Go figure.)  My remarks were well received, I think.  Robert Pozen of MFS Financial Management said in his remarks that he didn’t agree with a lot of what I had to say, but that any supporter of mandated clearing (which he is) had to take my critique seriously, and address the concerns I’d raised.  Which is quite fair.  I don’t claim to have all the answers, but I think I have good questions, and hope that posing them will contribute to the formulation of better policy.  (I started my talk with Hayek’s quote “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”  I think that some in policymaking circles think they know far more than they do about the systemic implications of clearing, and all I aim to do is what Hayek says economists should do.)

The conference finished up with a session on “Radical Solutions.”  Charlie Calomiris and Luigi Zingales gave very interesting talks that echoed two major SWP themes, namely that too big to fail is the result of governments’ inability to commit credibly not to bail out, and that the ultimate source of moral hazard and the excessive growth of financial institutions is that their creditors are convinced that they will be bailed out, and hence are willing to lend on terms that do not reflect risk.  They offered interesting proposals to address these problems.

One thing that struck me throughout the event is the widespread belief that financial reform efforts are dead in the water.  Some considered that unfortunate.  Others, including yours truly, were not so negative; not that I/we don’t believe that some sort of reform is needed, just that the alternatives on offer are likely to be counterproductive.

Today’s luncheon speaker was Henry Hu, a University of Texas law prof now heading up the SEC’s new Division of Risk, Strategy, and Financial Innovation.  I don’t always agree with Henry–I have criticized his analysis of the “empty creditor” problem, for instance–but he is obviously a thoughtful man who is bringing tremendous energy and enthusiasm to his DC job.  In his talk, he asked the audience to let him know whether they observed any new product or trading strategy that threatened to destabilize the financial system.  That’s fine, but I would also hope that he would be equally alert to regulations or legislation that could have deleterious effects; and be particularly alert to the creation of policies that could encourage the development of problematic strategies and products in direct response to such policies.

Friday’s dinner speaker was Simon Johnson.  I have an extremely mixed reaction.  I share his concern about too big to fail, and the potential for legislative and regulatory capture by the finance industry.  But given that I consider much of the proposed legislation to be counterproductive, unlike Johnson I don’t believe that it is axiomatic that bank opposition to this legislation is an outrage.  His is a very Manichean world view, with big finance as the epicenter of evil, and those who fight big finance as the avatars of goodness.  Not quite that simple, IMHO.

It was weird, to say the least, to hear someone channeling Andrew Jackson in a Brit accent.  He started out talking about TR taking on the trusts, and FDR taking on the banks, but I was thinking that his real hero should be Andy Jack.  Sure enough, a few minutes later he said that the true first opponent of financial oligarchy was Jackson.

Again, I have some sympathies; much of Jackson’s critique was correct, as is some of Johnson’s.  But much of Jackson’s criticism was misguided, and what’s more, the system that he advocated to replace the corrupt Second Bank of the US was plagued by chronic instability and crisis.  Johnson was less than candid about Jackson’s banking legacy: he would only admit that the post-Jackson banking system was “complex.”  But to admit that a previous populist response to concentrated financial power was hardly ideal would undermine Johnson’s populist jeremiad against today’s concentrated financial power.  That failure to confront the possibility that a populist reaction can be destructive undercuts Johnson’s credibility in my eyes.

Johnson’s tone was also extremely off-putting.  It was snide and arrogant.  He came off as a populist provocateur poseur.  Not particularly appealing.  But worth hearing nonetheless.

At the conference, there was a lot of agreement about the underlying causes of the crisis.  There was, however, less agreement about policy responses going forward.  That’s not surprising, but given the caliber of the people at the conference, it does suggest that we are in for a long debate over policy going forward.

And while I was at the Columbia conference, SWP daughter Renee was at a conference at Texas A&M, sitting 10 feet from George H. W. Bush and Barbara Bush.  And someone really important: Chuck Norris.  And she lived!  (He gave the death glare to one of her friends who was laughing too hard at something.)  Nobody quite that famous at Columbia, but it was worth the trip nonetheless.

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

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

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

I only have time for a few comments.

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

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

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

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

This article from Bloomberg hits the nail squarely:

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

. . . .

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

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