Streetwise Professor

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

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

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

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

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

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

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

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

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

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

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

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

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

I knew that the Commodity Futures Modernization Act (CFMA) was a powerful piece of legislation, but I was unaware just how powerful.  It apparently has the ability to alter the space-time continuum, and affect events even prior to its passage.  How did I learn this?  From a letter signed by senators Feinstein, Cantwell, Snowe and Dorgan to Chris Dodd.  (I haven’t been able to find a copy online.)  The senators state:

As you know, in 2000 Congress made the mistake of exempting energy from commodities regulation in the Commodity Futures Modernization Act.  This exemption, known as the “Enron loophole” led directly to the Western Energy Crisis.

Uhm, compromise language that was ultimately incorporated into CFMA passed the House on 14 December, 2000, and was introduced into the Senate on 15 December.  A conference committee hashed out differences, and the bill was ultimately signed into law (by Bill Clinton) on 21 December, 2000.

Meanwhile, the California/Western energy crisis had been building throughout 2000.  Power prices first spiked in May, 2000.  The first blackouts were in June, 2000.  San Diego Gas & Electric made allegations of market manipulation in August, 2000.  FERC rejected California’s request for a price cap on–wait for it–15 December, 2000.  The peak prices observed during the entire crisis occurred in December, 2000.

In other words, the energy crisis was well underway long before the passage of the CFMA, and reached its crescendo at the very time that the bill was being passed, and well before it could have, let alone did, affect one transaction in energy or anything else.  Since cause must precede effect, for these senators to say, in the very opening paragraph of their letter, that the Act “led directly” to the crisis is complete and utter bilge.

What’s more the underlying causes of the crisis are well known, and had nothing to do with the matters addressed in the CFMA, and everything to do with the wretched market design put in place by the California legislature.  Indeed, to the extent that derivatives were involved at all, it was the legislature’s ban on the ability of CA utilities to enter into long term purchase deals or hedging contracts that exacerbated the crisis.

Insofar as Enron is concerned, its actions (e.g., Death Star, Fat Boy, Ricochet) were designed to exploit flaws in the market design (particularly the design of the Power Exchange–PX–and differing price caps across markets).  They had nothing to do with the kinds of things addressed in the CFMA.

(I would also add that the exemptions in the CFMA were not quite so broad as the senators suggest in their letter.)

So, the senators got off to a very bad start.  What about other matters raised in the letter?  Well, better, but not much.

The basic thrust of the letter is to argue against providing end user exemptions from clearing requirements, or treating end users more liberally generally.  The essence of their argument is that systemic risk is unpriced, and that clearing internalizes this externality.

This represents just another example of clearing as deus ex machina that magically addresses systemic risk concerns.  The authors of the letter, like many others who have discussed the subject, assume that (a) counterparty risks are not priced properly in OTC markets, and (b) central counterparties will do a better job at pricing counterparty risks.  As I’ve written extensively, neither claim is necessarily true, nor even plausible.

The letter commits another factual gaffe when it claims that there was a “systemic failure caused by the Enron bankruptcy.”  Certainly counterparties lost money as a result of the Enron bankruptcy, but there was no systemic failure, particularly if one defines “systemic failure” to mean a contagion effect.

The Enron failure did not cause a major upset in the energy markets.  The implosion of the merchant energy sector occurred some months later.  The key event was the SEC’s announcement that it was investigating Dynegy’s accounting on 25 April, 2002.  Subsequent to that time, merchant energy stocks declined by about 90 percent in value, and other companies went bankrupt (e.g., Mirant).

But this wasn’t a systemic contagion event.  Instead, it was the result of a widespread recognition that the energy trading boom was overdone, that profitability estimates were probably inflated, and profit projections would not be realized due to overbuilding of capacity and other reasons.  That is, every firm in the sector was overvalued, and when the market reached that conclusion, they all fell  in value.  There was a common shock, and the affected firms fell in common.  That implosion would have occurred, clearing or no.

This point about confusing contagion effects (in which the demise of one big firm induces financial distress in otherwise healthy firms to which it is connected) and simultaneous collapses of multiple firms caused by a common shock is quite important, and gets too little attention.  The common shock in the recent financial crisis was real estate price declines, communicated to large financial institutions through their holding highly correlated positions in real estate price sensitive investments.  That’s different than a contagion resulting from the bad decisions or bad luck of one firm bringing down others just through contractual connections.

We can barely expect such more discriminating analysis, alas, from senators who are either completely ignorant of the legislation that they write about, or who don’t understand the basic fact that cause must proceed effect.

Update (3/1/10): SWP daughter #1 wonders if a silver DeLorean and a wild haired professor were seen in the vicinity of either Congress or California when the CFMA passed.

Matt Leising and Shannon Harrington have been on a roll lately.  Today, they report that big buy side firms are resisting Fed calls to clear a targeted percentage of their deals:

The biggest credit-default swaps investors oppose targets for clearing trades as regulators attempt to curb risk in the $25 trillion market.

Pacific Investment Management Co., BlueMountain Capital Management LLC and AllianceBernstein LP are among asset managers and hedge funds that won’t agree to specific goals before the Federal Reserve Bank of New York’s March 1 deadline requiring them to outline the industry’s next steps to move swaps through clearinghouses, according to people familiar with the matter who declined to be identified because the talks are private.

. . . .

The asset managers, while backing efforts to broaden the use of clearinghouses, want assurances that cleared trades would be protected under bankruptcy laws, the people said. They’re also concerned they may be saddled with collateral costs that are double or triple what they’re paying now because they could lose benefits now granted by prime brokers that give credit for offsetting trades, the people said.

For example, hedge funds and other asset managers often will perform trades that seek to profit from price dislocations between index contracts and swaps on companies included in the index. Prime brokers typically will demand collateral on the net amount at risk from offsetting trades.

Tying Up Cash

If one leg of the trade were required to be cleared, while the other contracts aren’t eligible, fund managers may be forced to increase the amount they have to post, tying up cash, the people said.

This is ironic because the best economic case for clearing is that reduces counterparty risk for end-users.  For instance, the classical futures clearinghouse reduces customer default losses (but doesn’t necessarily eliminate them) that could result from the failure of a brokerage firm by shifting the liability to the clearinghouse, and thus, to the other brokerage firms that are members of the clearinghouse.  Note that the Chicago Board of Trade has always argued that no CUSTOMER has lost money as the result of a default; the CME now makes a similar claim.  Thus, if anybody should be clamoring for clearing, it is customers.

But, as the article notes, this doesn’t come for free.  In particular, the article notes that clearing, especially through single-instrument clearinghouses, can eliminate scope economies (achieved, for instance, through netting and cross margining), thereby inflating costs.

So it can be reasonable for customer firms to resist clearing even though if it benefits anybody, it is most likely to benefit them.

Dealer firms have agreed to clear a large fraction of some inter-dealer trades (e.g., CDS trades).  In other markets (e.g., interest rate swaps) banks have elected to clear a decent proportion (around 50 percent) of inter-dealer trades.  But in many respects, inter-dealer clearing offers fewer potential risk sharing advantages than customer clearing (that shifts risks from customers to the dealer-members collectively).

In bilateral markets, there is extensive inter-dealer trading; this creates performance risk between dealers.  Clearing basically does the same thing.  It can reduce some exposure, through multi-lateral netting, but as Duffie and Zhao have shown, and as I have shown, this gain is reduced, and at times non-existent, because clearing can reduce bilateral netting opportunities across a portfolio of instruments.  Thus, the exposure reductions may be limited, especially if the clearinghouse handles only a narrow range of the instruments that dealers trade.  But even if there is some exposure reduction, a lot of what inter-dealer clearing does is to share the same risk among the same players.

The way this risk is allocated can differ somewhat; in particular, it is possible that risk exposures through clearing are less concentrated than the bilateral inter-dealer exposures in non-cleared markets.  But dealers have incentives to limit concentration on their own, and do so through exposure limits and credit limits with each counterparty.  Moreover, dealers have the ability to use their own information to choose these limits in bilateral dealings, whereas the clearinghouse cannot rely on this information.  Thus, clearinghouse members may have exposures that are less concentrated than their bilateral exposures, but they still may be worse off because they take more exposure with some counterparties via the clearinghouse than they would voluntarily take in a bilateral market.  That is, concentrations in bilateral markets are endogenous, and high concentrations can be sensible, based on counterparty risk evaluations.

The resistance of some sophisticated buy side firms to clearing should be another hint to regulators and legislators that mandated clearing is not necessarily a good thing.  If those who, if anyone, would be the biggest beneficiaries of clearing, decide it’s not worth the candle, that strongly suggests that the total benefits are illusory.

Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives.  (Indeed, I think I’ll start referring to him as “Jeremiah.”)  I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.”  Lo and behold, what do I read in today’s FT:

US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.

I personally find it very disturbing that I can channel Gensler’s thinking.

The substance of the oped is more Gensler same-old, same-old.  Clearing is again the deus ex machina of his sermon:

Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Uhm, just who backs that guarantee, Jeremiah?  Could it be the very same derivatives dealers?  Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?

Arguendo ad AIG makes its stock appearance (see the first quotation).  George Stigler once wrote that data is not the plural of anecdote.  What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data.  What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed.  First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were.  Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing.  Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.

Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis.  He provides no evidence whatsoever–other than the tired AIG trope.  This is a complete misreading of the history of the crisis.  If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.

Gensler also makes some assertions that are categorically incorrect.  For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.”  It is, in fact, well known that excessive transparency can reduce liquidity.  There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.

More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.

I could go on and on, but I’ll let it rest here for now.

If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights.  He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire.  (At least he spares us the apple story.)  (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value.  He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg.  But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)

(And another parenthetical about the metaphor overload: is cancer “interconnected”?  Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)

Perhaps this remarkable performance is actually good news.  Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.

And that lack of success is not surprising.  Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business.  But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.

But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.

In a matter of personal interest:

The U.S. Supreme Court rejected an appeal by Pacific Investment Management Co., clearing the way for a lawsuit seeking more than $600 million for the company’s alleged manipulation of the price of Treasury futures contracts on the Chicago Board of Trade.

The justices today let stand a federal appeals court ruling that said traders could press their suit against the company as a class action. Pimco, manager of the world’s largest bond fund, argued unsuccessfully that many of the investors in the class actually would have made money had the market manipulation taken place as alleged.

The lawsuit, filed in 2005, accuses Pimco of cornering the market for contracts on 10-year Treasury notes during May and June 2005. Pimco allegedly used its holdings to drive up the price for traders who had sold short — that is, contracted to sell notes on a specified later date — and needed to cover their positions.

And that’s all I have to say about that.  Here, anyways.

My original take on the CFTC energy futures position limits was that they were sufficiently generous so as to not represent much of a constraint on most market participants.  Upon further thought, I concluded that the “crowding out” provisions that would (a) limit swap dealers to double the spec limit, and (b) preclude those benefitting from the hedge exemption from speculating, or acting as swap dealers are landmines that could inefficiently constrain the operations of the futures markets as risk shifting and price discovery tools.

Christopher Doering of Reuters picked up on this phrase, and found others concerned about the same issue.  In effect, the rule will segment the market, creating ghettoes for hedgers, swap dealers, and speculators.

There are good economic reasons to believe that some hedgers might be able to compete effectively as swap dealers, or can speculate in addition to hedging.  (Indeed, as Working pointed out eons ago, hedging is really just speculating on price relationships.)  Moreover, some swap dealers might have hedging needs, or can efficiently supply speculative capital to the market.  The 2x limit on swap dealers is also problematic.  Why 2x?  Why not 3.14159x?  This limitation could constrain the ability of some swap dealers to achieve efficient scale, and may indeed have the perverse effect of shifting business to less well capitalized market participants.

What is truly scary is the “rationale” for this limit offered by that noted industrial organization economist, and expert on scope economies, CFTC commissioner Bart Chilton:

CFTC Commissioner Bart Chilton, a strong proponent of position limits, was unapologetic, arguing exemptions have given too much flexibility to players without stakes in the physical commodity.

“There should be zero patience for trading on your own book, if you have an exemption,” Chilton told Reuters, defending the new proposal as a safeguard against the impact of large traders roiling markets by making risky bets for their own accounts.

“Perhaps, if our proposal goes into effect, some will have to choose a business model,” he said. “Are they a speculator, a swaps dealer or a hedger? Part of the problem we have had over the years is that some wanted to be everything to everybody.”

Loaded with deep economic insights, that.  “There should be zero patience for trading on your own book, if you have an exemption”: a purely conclusory, unsupported, assertion.  Hedgers with substantial physical market information are often the most profitable speculators.

“Part of the problem we have had over the years is that some wanted to be everything to everybody.”  What does that mean, even?  Given the nature of information and information flows, it is quite understandable that there are complementarities between speculative, physical, and customer-facing (e.g., swap dealing) trading functions.  This is a highly competitive market, and one would expect that if there are complementarities that reduce costs, one would observe–as we do–some firms exploiting them.

Siloing physical market, speculative, and customer-facing activities precludes market participants from exploiting any complementarities.  If the complementarities didn’t exist, specialized firms would dominate in practice.  The success of multi-function firms in a competitive environment suggests that these combinations offer efficiencies.  There are no obvious regulatory constraints (e.g., price controls, rate of return regulations) that are (inefficiently) encouraging the evolution of integrated, multi-function firms.

Regulators throughout the government–in the US, but elsewhere too–are repeatedly substituting their judgments regarding efficient market structure for those of the participants in highly competitive markets.  Moreover, like Commissioner Chilton, their rationales for their judgments are often shockingly superficial, not to say ignorant, and fail to engage let alone answer fundamental economic questions.  It would be nice, if at least sometimes, regulators flogging particular proposals to change market structures could provide a coherent critique of why incumbent market structures are inefficient, and how the proposed regulation would remedy these inefficiencies–without introducing even worse ones.

The House financial regulation “reform” bill passed last year includes the Lynch Amendment, which puts limits on the ownership of central counterparties/clearinghouses by financial intermediaries.  I blogged about this a bit.  The essence of my argument was that although there are potentially competitive concerns arising from dealer control of CCPs, there must be an alignment between economic interest and ownership structure.  Whoever bears the default risk is going to demand an influence over the governance of the CCP.  If you expect the big banks to bear the risk, they are going to require some control over the operations of the clearinghouse.  If you deny them this control, you have to find somebody else to bear the risk.  Competitive concerns are best addressed through anti-trust tools.

Sad to say, the “thinking” behind the Lynch Amendment has jumped the Atlantic, and the European Parliament is contemplating a similar restriction on dealer ownership:

Derivatives dealers should not be allowed to own stakes in central counterparties (CCPs) or their risk management systems – and CCPs should not be allowed to compete with each other, according to advice from the European Parliament’s committee on economic and monetary affairs (Econ).

The (anonymous) reactions of a European banker are spot on, and echo my earlier analysis:

“It’s ludicrous. Clearing houses were mutual organisations. They were originally mutually-owned and their job is to mutualise risk, so to say that users shouldn’t have any influence or ownership of governance or direction – it just betrays complete ignorance of what the function of a clearing house is and how a clearing house can be built and become operational,” says one head of market structure at a European bank.

. . . .

“It is our money in the default fund of the clearing house. For dealers to have some kind of oversight or some kind of say in the functioning of the clearing house is entirely reasonable. We’re not going to support a clearing house if we’re not satisfied with the risk management processes it operates. To think that the smart way to make this all happen is to remove the big dealers from the process is just dumb,” says the head of market structure.

“Complete ignorance.”  “Just dumb.”  That’s about right.

There’s a very simple choice here.  If you don’t want banks to exercise control over a clearinghouse, don’t look to them to bear the default risk.  If you want them to bear the default risk, you’ll have to give them considerable influence, and arguably de facto control.  And if you choose the first alternative, you need to answer: who is going to bear the default risk, and what price are they going to charge to do so?  And if you’re worried about competition, you should worry that the price this non-bank-owned CCP is going to charge, because it will almost certainly have market power.

The Lynch Amendment and its proposed European cousin both reflect a fundamental misunderstanding of just what clearing is about.  It is a risk allocation mechanism.  Which immediately should raise the question: who is going to bear the risk?  Clearing is not a risk fairy that makes risk disappear.  Those that bear the risk will almost certainly demand an active role in the organization that measures and manages it.  So if you make a governance and ownership choice, you’ve ruled out some risk allocation choices.  Our Solons, and Europe, apparently haven’t figured that out; they haven’t provided any idea on whom they expect to bear the risk, and are mandating or threatening to mandate models that have seldom, if ever, been tried in practice.  Which is very scary.

Like Claude Rains in Casablanca (which was on Turner Classic Movies yesterday), the Germans and others are Shocked! Shocked! that Greece used swaps priced off the market to borrow, for all intents and purposes.  For all purposes, that is, but one: accounting for the public debt to determine its adherence to European Monetary Union requirements.

Except that it wasn’t a secret at all.  Risk wrote about one of these deals back in 2003. S&P issued a note describing these types of deals in 2002.   The New York Times reports that there were many of these deals, from the very outset of the European experiment:

For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.

. . . .

But with the help of JPMorgan, Italy was able to do more than that. Despite persistently high deficits, a 1996 derivative helped bring Italy’s budget into line by swapping currency with JPMorgan at a favorable exchange rate, effectively putting more money in the government’s hands. In return, Italy committed to future payments that were not booked as liabilities.

The NYT also reports that these types of deals were a subject of fierce debate among European finance ministers going back to 2000.

In other words, nobody in government finance has any more reason to be shocked about these transactions than Captain Reynaud had to be shocked about gambling going on at Rick’s.

Some of the debates that are going on about the probity of these deals reminds me of discussions of who is to blame for drug addiction: the addict (Greece, for instance), or the pusher (e.g., Goldman, Morgan, Deutsche Bank, etc.):

“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.

In other words, politicians were being politicians, and bankers were being bankers, and they were engaged in mutually beneficial transactions.  The difference being, of course, that there are other people–millions of other people–who will pay costs.

If forced to choose, I guess I’m have a less favorable view of the politicians, for two reasons.  First, they never cease to tell us how morally superior they are, whereas bankers are for the most part (not universally) less sanctimonious.  Second, the politicians are ultimately violating a responsibility that they are entrusted with, whereas the bankers are actually carrying out their responsibilities to their principals.

But this is really all a side issue.  The central issue is what to do about Greece, and ultimately, the other countries that are at risk to following it over the edge.

I tend to lean towards what John Kemp writes in Reuters:

Most commentators have concentrated on the need for the EU to bail out Greece. But in reality any rescue would be another subsidy for excessive-risk taking by the country’s bankers and the institutions that have sold credit default swaps (CDS) on Greek debt.

Forcing the country into an austerity programme and arranging an emergency loan from other EU members or the IMF would ensure the bankers got their money back (again), but inflict years of misery on the country’s households and businesses.

If market discipline is ever to be re-established after the boom and bailouts of the last five years, it is imperative creditors face the real prospect of making losses if they extend large loans and fail to price the risk on them properly. The sellers of CDS insurance must face up to making real payouts in return for all the premiums they pocket.

Bailing out Greece would be wrong. Not because it would harm the eurozone’s credibility, but because it would reinforce the rampant moral hazard in financial markets. It would perpetuate the inequitable and politically unacceptable situation where structuring fees are retained by the banks as private profits while credit losses are socialised and passed onto taxpayers.

Greece would do everyone a favour by declaring a moratorium and forcing a rescheduling. The country faces years of misery in any case. The threat of being shut out of capital markets rings hollow. But by triggering losses on these derivative transactions and a credit events under the CDS it would help ensure a much more prudent approach in international banking markets.

Bailing out Greece so everyone can pretend the country can remain “current” on its loans when it patently cannot would simply deepen the moral-hazard crisis. If market discipline is ever to be re-established (something which everyone agrees is desirable) then at some point creditors must take a loss. Greece is a good place to start.

Yes.  As I discussed in an earlier post, it is the lenders–the creditors–that are ultimately the source of moral hazard.  If they are convinced that they will be bailed out, they will continue to feed the bad habits of profligate borrowers, including sovereigns.  Bailing out Greece, or others, will just increase expectations of future bailouts, and we’ll be in a sort of moral hazard Groundhog Day. Only it won’t be quite so funny.

Spain’s intelligence service, Centro Nacional de Inteligencia (CNI), is investigating “speculative attacks” against the country (via the CDS market), and Europe generally (via the currency market).  This article in El Pais tells the story.  Based on my shaky Spanish, it seems that Zapatero is blaming “Anglo-Saxon” speculators and journalists and pundits with conspiring against Spain, and the European project generally.

The speculators are indeed out in force, and there is a game of chicken between them and the European governments individually and collectively.  But the speculative attack is driven by the shaky finances in the Eurozone, and especially in Greece, Spain, Portugal, and Ireland.  The politicians have created the opportunity through profligate fiscal policies, and it is more than a little rich to hear them take umbrage at the markets holding them accountable.

If you chum the waters, Mr. Zapatero et al, why are you surprised when the sharks appear?

One of the tales about derivatives clearing, told repeatedly by Timmy! Geithner and Gary Gensler is that the clearing fairy magically makes counterparty risk disappear.  The reality is that it doesn’t make it disappear: it just moves it around.  And not necessarily in a better way, as members of the CME clearinghouse clearly understand.

Many of these members are extremely leery of the CME’s plan to clear CDS.  This week, according to Bloomberg and DJ (not online, fortunately), big brokers Newedge and MF Global came out forcefully against the CME proposal precisely because they fear that clearing CDS will allocate the risk their way, and their customers’ way:

Newedge USA LLC, the largest U.S. futures broker, and MF  Global Holdings Ltd. are urging the U.S. to prohibit CME Group Inc. from using customer funds to back credit-default swap  trades alongside futures transactions in its clearinghouse.  The brokers said the lack of an underlying frequently traded contract for credit-default swaps, such as a future based on the swaps, made it too difficult to price the derivatives for risk-management purposes, according to a Feb. 4 joint letter the companies sent to the Commodity Futures Trading Commission.

“We do not believe it would be appropriate for the commission to now require futures customers to effectively cross guaranty CDS risk, however remote some may suggest the likelihood of a cleared CDS default to be,” the firms and CME Group members wrote in the letter. “MF Global and Newedge are not satisfied that the risks to futures customers’ funds and to our own guaranty deposits — risks we never signed up for — may adequately be assessed or contained.”

The Newedge/MF Global broadside gives the lie to other clearing fairy tales: namely, that contractual standardization is sufficient to make instruments appropriate for clearing, and that clearinghouses magically create transparency.  To the contrary, clearinghouses consume transparency/information: they need liquid markets with active price discovery to work effectively, and contractual standardization is not sufficient to ensure such liquidity.

Note their concern that risks may not be adequately assessed.  This requires information  about pricing and risk characteristics.  This information is hard to come by for many CDS, particularly single-name CDS.  Moreover, dealers may have better information than a clearinghouse.

In other words, clearing is not magic.  It doesn’t make risk disappear.  At best, it reallocates it.  Moreover, it can actually create problems, rather than mitigate them, when the clearer lacks the information to price the risks properly.  Newedge and MF Global, and before them Thomas Peterffy, the FIA, and Penson’s Chris Heymeyer, recognize that.  When will those who want to mandate clearing as broadly as possible figure it out?