Streetwise Professor

In the aftermath of the financial crisis, CFTC head Gary Gensler believes that OTC derivatives markets need regulation in the worst way, and that he’s just the man to do it.  Gensler testified in front of Congress, and presented an outline of his ideas for regulation of the OTC markets.  It is now clear how Gensler was confirmed in his post, despite his involvement (salutary, in my view) in the (wrongly, in my view) widely excoriated Commodity Futures Modernization Act:  he agreed to push all the derivatives policy nostrums emanating from Capitol Hill.

There is enough here for several posts, and I’ll probably do just that, time and travel schedule permitting.  The Cliffs Note version is: I disagree with just about everything, and think that most of the arguments raised in the letter are wrong, when they’re not retarded.  (Can you say that anymore?)  Actually, that’s not quite right.  There are NO arguments in the letter to speak of.  Just a series of unfounded assertions on which Gensler erects a set of far-reaching policy proposals.  The Monty Python “Argument Sketch” goes to Washington.

Today I’ll focus on the issue that constitutes the most important part of Gensler’s letter: clearing.  It presents a cartoonish version of what clearing does, and grotesquely misstates the economic implications of clearing.  Gensler presents clearing as a panacea, a silver bullet, that will banish systemic risk.  Based on this distorted depiction of the costs (none) and benefits (incalculable) of clearing, Gensler recommends that virtually everything be cleared, and that non-cleared product be subjected to intense scrutiny.

Gee.  If it’s such a great idea, why didn’t anybody think of it before?  That’s the first clue–and it’s a big one–as to why Gensler’s advocacy (which, admittedly, just echoes Geithner’s and Congress’s) is almost certainly based on fantasy rather than fact.  

Gensler’s most grotesque distortion is to assert that bilateral markets are too interconnected, and that cleared markets would be less so:

One of the lessons that emerged from this recent crisis was that institutions were not  just “too big to fail,” but rather too interconnected as well.   By mandating the use of  central clearinghouses, institutions would become much less interconnected, mitigating  risk and increasing transparency.   Throughout this entire financial crisis, trades that  were carried out through regulated exchanges and clearinghouses continued to be  cleared and settled.  

Where do I start? First, clearinghouses CREATE interconnections, albeit different ones than in the OTC market; clearinghouses formalize a specific and extensive form of interconnection between systemically important market participants, and their customers. They are a means of SHARING default risks, and determining the allocation of losses from default. Sharing means a connection.  By definition.  The members of the clearinghouse share the risks of default. The clearinghouse members and their customers are therefore interconnected, and the failure of one has financial implications for the financial health of others. Moreover, the central clearing structure can actually lead to greater concentration of risk than occurs in the bilateral market, and result in less capital being available to absorb default losses.  That is, the particular interconnections in a cleared market can be more systemically threatening than those in a bilateral one.  It is false, misleading, and borders on the fraudulent for Gensler to claim that clearinghouses make markets “much less interconnected.” It is false, false, FALSE.  

Clearing changes the nature of the interconnection.  It is incumbent on advocates of the imposition of clearing to demonstrate that this change is an improvement.  Gensler doesn’t even begin to try to do so.  He just misleadingly asserts the issue out of existence.  Out of such sloppiness, bad policy is made.

The last sentence of the quoted paragraph is also misleading. First, other than the AIG trades (which I’ll get to in a minute), products OUTSIDE the regulated exchanges and clearinghouses also continued to be traded and settled. Lehman’s collapse did NOT lead to a cascade of failures, for instance. Second, the distribution of products traded on exchanges and in the OTC markets is not determined exogenously, so the comparison is not a fair one. Where things trade and the institutions of trading are endogenously determined by the actions of market participants. In my academic work, I argue that some products are suited for clearing, some not, and that trading patterns reasonably reflect those differences. Therefore, a comparison of the performance of cleared and non-cleared markets does hold everything equal. The stuff that is cleared is basically the easier stuff–hence you would expect fewer problems there.  

I’ve heard this argument about how well futures and options clearinghouses worked during the crisis several times now.  Every time I’ve heard it, those advancing it have failed to consider the possibility that this comparison is superficial and incomplete, and it ignores the fact that despite all of the hyperventilating, bilateral markets continued to work too.  

And for those with short memories, I suggest a look at the near death experience of the CBT and CME clearinghouses on 20 October, 1987, and the problems with COMEX clearing on Silver Tuesday in March 1981 (when the Hunts imploded) and during the mid-80s, to get a better understanding of the potential frailties of cleared markets, and how they can actually create systemic risks.  

I would also submit that many of Gensler’s proposals actually would lead to increased interconnectedness. For instance:

Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing.

Extending the membership of clearinghouses by government fiat means that more firms are members of the clearinghouse–and hence interconnected to the failure of any other member. So much for reducing interconnection.

I would also note that Gensler completely overlooks that mandating open access to clearing will increase the heterogeneity of the membership of these organizations, which will have important implications for their governance. In my work on exchanges I note how heterogeneity greatly complicates governance, tends to impede decision making, leads to divisive political infighting, and on and on. (The paper I am presenting in Florence focuses on the effects of heterogeneity of the membership of financial cooperatives like exchanges and clearinghouses affects their governance.)  

Now, I have also shown in my academic work that membership limitations can also be used to turn the clearinghouse into a cartel. But nonetheless, it is very dangerous to blithely dictate the membership policies of such systemically important institutions without even the slightest consideration of how these diktats will influence governance–and how governance might affect policies relating to margining, capital, risk management, and systemic risk. Governance matters, and the heterogeneity of membership that Gensler’s recommendations would create would inevitably affect the politics of exchange governance, and the efficiency of clearinghouse operations.  Not that Gensler–or anybody else flogging this policy–even acknowledges the governance implications.

(I would further note that the possibility that the members of a clearinghouse can effectively use this institution to operate a cartel undermines arguments that anti-competitive motivations underly dealers’ refusals heretofore to clear many products. This provides further support for my argument that there are other costs associated with clearing, namely costs relating to asymmetric information, that outweigh the private benefits that clearing can provide the members of the clearinghouse.)

Gensler brings up AIG to justify his arguments. This, in my view, is the modern financial equivalent of arguendo ad Hitlerum: invoking AIG to justify any policy without a full and fair discussion of just how that proposed policy would have affected AIG’s behavior or the market, is irresponsible and usually reflects a lack of thought. It, like arguments ad Hitlerum, is an appeal to emotion rather than fact and analysis.

Sadly, Genlser’s invocation fits that characterization:

By novating contracts to a central clearinghouse coupled with effective risk management practices,  the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades.

Wrong again, Mr. Gensler. This seems to suggest that a clearinghouse makes default risk Disappear!, like some amazing magician. No. It does not. It redistributes the risk. As I showed in It’s a Wonderful Life: AIG Edition, (a) it is highly unlikely the products AIG traded would have been cleared in any event, and (b) if they had, it is unlikely that clearing would have materially mitigated the implications of an AIG collapse, and indeed could have made it worse.  This is related to the interconnection point.  Once AIG blew up, the members of the clearinghouse would have been on the hook just as its bank counterparties were.  And guess what?  The members of the clearinghouse would likely have been the same bank counterparties.  

There is no acknowledgement in Gensler’s prepared testimony of even the possibility that clearing may be inappropriate for some products, and that requiring clearing of these products may result in greater costs than benefits.  Indeed, the fact that clearing has not succeeded for numerous products, and has not even been attempted for some, raises quite clearly (no pun intended) the possibility that the costs indeed exceed the benefits.

Think of it this way.  By recommending a mandate, Gensler (and others like Geithner who have taken similar positions) is asserting implicitly the existence of a market failure.  The key word is “asserting.”  He is not specifically identifying what that market failure is, and how his proposal corrects it.  Why, if clearing is so socially beneficial, has it not been adopted?  What market failures, what transactions costs, are preventing the adoption of this socially optimal arrangement?  If it is not possible to present a coherent, plausible, and evidence-backed case for the existence of such a market failure, the presumption should be that the market knows better than Mr. Gensler, and that market participants have adopted one set of institutional arrangements for some products and another set for other ones because costs and benefits differ across products and users.  Mr. Gensler apparently believes one size fits all.  The market has been acting as if it believes something very different.  Why is the market wrong?  It may be–but it is incumbent on Gensler and others to make the case.

This implicit assertion of market failure pervades the Gensler letter.  His recommendations to dictate how instruments are traded, with a decided preference for exchange trading, represent another example.  We see invocations of transparency and other Motherhood-and-Apple-Pie virtues to justify dictating market structure, with no serious discussion as to why market participants have apparently chosen suboptimal arrangements.  I will hopefully return to this part of the proposal soon.    

The Gensler testimony also suggests–though it is somewhat ambiguous on this score–that the government will establish margin requirements on all derivatives trades.  One could also read the letter to mean that it will require clearinghouses to set prudent margin requirements.  Either alternative is problematic to the extent that the government and the clearinghouse–but especially the former–are unlikely to have better information for setting these requirements for some products than some private market participants.  This is problematic–as is the possibility that a government regulator or a clearinghouse may be subject to political pressures that lead it to set margin requirements based on rent seeking considerations, rather than prudential ones.

I could go on, but it’s late.  Suffice it to say that Gensler is predicating a massive change in the regulation of financial markets based on a set of implicit assertions.  He is implicitly asserting the existence of a plethora of market failures.  Not one of which does he demonstrate by thorough argument or evidence, beyond the ritual incantation of the Ghost of AIG.  He does not even identify what the market failures are.  This is the stuff that public policy disasters are made of.   If there are market failures that need fixing, it should be straightforward to identify what they are, and to show how the proposed policy will improve the allocation of resources by reducing the severity of these market failures.  

But Gensler doesn’t even try to do that.  That shouldn’t be sufficient, but given that Gensler is primarily serving as Charlie McCarthy to Congress’s Edgar Bergen, sadly it will be more than enough.

I like Jeremy Grant of the FT, and his colleague Gillian Tett is a media darling right now, flogging her book on the financial crisis.  But in their article on the Geithner derivatives proposals (along with Aline van Duyn), they laid an egg.  They repeat the conventional wisdom on clearing, and the supposed benefits of forcing OTC trading onto exchanges.  Actually, it would be more accurate to say that they repeat the conventional ignorance on the subject.

They say that on exchanges “[t]rades are then ‘cleared’ on a central platform, which completes a deal even if one counterparty collapses.”  Similarly, they say that in OTC markets, “[t]hat means in many cases there is no centralised system to monitor prices or deals nor any third party to ensure a trade is completed if a counterparty fails.”  These quotes suggest that counterparty risk does not exist in a cleared market like it does in an OTC market.  This is wrong, because the clearinghouse can fail.  More to the point, given the size of the position of a defaulting party, clearing only affects the allocation of losses, not their total amount.  Now, this allocation can be superior, but not necessarily so.  But I grind my teeth at the suggestion that clearing magically makes default risk disappear.  

This also has implications for systemic risk.  In a cleared market, the default risks are borne in the first instance by clearinghouse members, who are typically systemically important banks.  Clearing can actually concentrate and increase the counterparty risks that these systemically important banks bear.  This point is seldom made, but it is important.  Grant, Tett and van Duyn overlook it altogether.  

Most egregiously, they say this:

The proposals Mr Geithner, Ms Schapiro and others have unveiled try to tackle these problems in four ways. First, they demand all “standardised” derivatives are  centrally cleared to remove counterparty risk, even if they are not traded on an exchange.  [Emphasis added.]

No. No. No. NO!  Clearing DOES NOT REMOVE COUNTERPARTY RISK.  The three FT reporters should be sentenced to write that sentence over and over again on a blackboard, Bart Simpson-like, until they get their minds right.  Moreover, to atone for this, the FT should be required to devote an entire front page consisting entirely of “CLEARING DOES NOT REMOVE COUNTERPARTY RISK” in headline-sized type.  

Again.  Clearing redistributes the losses arising from counterparty default.  It does not remove it, or make it magically disappear.  What’s more, it does so in a way that can reduce efficiency, and increase systemic risks.  

Sheesh.  Grant et al state: “A public debate about derivatives is long overdue.”  I agree.  It would be nice if that debate would be based on a thorough, fact-based, understanding of the actual tradeoffs involved in clearing and exchange trading.  Instead, this article just recycles the same old bromides.  

The article does the service of quoting this gem by new SEC head Mary Shapiro (which I had wanted to call attention to when I saw it last week, but got distracted):

As Mary Schapiro, chair of the Securities and Exchange Commission, says: “OTC derivatives, particularly credit derivatives . . . contributed to the financial mess we are cleaning up today.”

Just how did they contribute?  Yes, like the Treasury letter, you can point to the OTC posterchild, AIG, but that would be incredibly dishonest (as it was when Treasury did it).  It is dishonest because the type of contracts AIG traded would never be cleared, and never traded on exchanges, and hence would be/have been unaffected by the Treasury proposal.  But although credit derivatives have been accused over and over again of contributing to the financial crisis, the type of products that would be affected by the Treasury proposal are conspicuous by their absence from any honest accounting of culpability for the crisis.  

This only goes to show that Mary Shapiro’s replacing of the execrable Chris Cox has not increased the intelligence or market knowledge at the SEC.  And that is a very scary thought.

I was quoted in today’s WSJ:

Companies could try to skirt the regulations by creating new contracts that are similar but not identical to clearable trades.

“People will see where the lines are…[and] devise products that fall outside the scope of this particular regulation and that particular regulation,” said Craig Pirrong, a finance professor at the University of Houston.

The Treasury Department says that clearinghouses need to ensure that “customized OTC derivatives are not used solely as a means to avoid” clearing.

Regarding the sentence following my quote.  As I noted in my post on the proposed Treasury regulations, the clearinghouses are not in a good position to monitor the use of non-cleared products, due to their lack of information, and perhaps more importantly, their conflict of interest in seeing more business come their way.  Although the WSJ article accurately characterizes the Treasury’s position, so much the worse for Treasury.  It suggests a serious failure to think things through.

If they decide to prevent the use of customization to circumvent the clearing requirement, as it almost certainly must if the clearing mandate is to survive, Treasury and Congress will require a regulator to enforce the circumvention ban.  This would require an incredibly intrusive regulator, evaluating the design of every contract, and the intent behind it.  I can state almost categorically that no regulator has or will have the information, expertise, or ESP required to do this.  Moreover, this will just throw us back into the days of pre-CFMA requirement that all “futures” be traded on exchanges.  Not a good thing.  This created regulatory uncertainty, legal ambiguity, and served to protect the interests of exchanges.  One can only imagine the Talmudic inquiries that would be involved in determining whether a particular derivative is, or should be cleared, or was designed to escape a clearing mandate.

Regulators–or clearinghouses serving as their agents–should not be in the position of intervening so intrusively in the contracting decisions of derivatives markets participants.  Such intrusion will raise transactions costs, and interfere with the efficient allocation of risk in the marketplace.  What’s more, there is no reason to believe that this interference will reduce systemic risk.  Indeed, it could well increase systemic risk.

I’ve written about the hard-to-explain behavior of oil prices and stocks.  But oil isn’t the only commodity around, so I thought it would be worthwhile to look at some others to see whether their behavior may shed light on which version of the “green shoots” theory their behavior supports–the green shoots of a recovery in output, or the money-is-green version that the price rises are a harbinger of inflation.

The best data on prices and especially stocks for industrial commodities is available for non-ferrous metals.  Here are the comparisons (all data from the LME):

• Copper 3/2/09.  Cash: $3329, 3 Months: $3355, Stocks: 530,875 MT.
• Copper 5/13/09.  Cash: $4507, 3 Months: $4530, Stocks: 373,750 MT.
• Lead 3/2/09.  Cash: $1160, 3 Months: $1166, Stocks: 60,750 MT.
• Lead 5/13/09.  Cash: $1450, 3 Months: $1440, Stocks: 73,500 MT.  
• Nickel 3/2/09.  Cash: $9602, 3 Months: $9607, Stocks: 99,378 MT.
• Nickel 5/13/09.  Cash:  $12450, 3 Months: $12545,  Stocks: 111,648 MT.
• Primary Aluminum 3/2/09.  Cash: $1270, 3 Months: $1310, Stocks: 3,243,900 MT.
• Primary Aluminum 5/13/09.  Cash: $1428, 3 Months: $1521, Stocks 3,880,325 MT.
• Tin 3/2/09.  Cash: $11,047, 3 Months: $10702, Stocks: 9,140 MT.
• Tin 5/13/09.  Cash: $13,890, 3 Months: $13,615, Stocks: 13,405 MT.
• Zinc 3/2/09.  Cash: $1078, 3 Months: $1104, Stocks: 355,500 MT.
• Zinc 5/13/09.  Cash: $1430, 3 Months: $1475, Stocks: 322,025.

Note that the prices of each commodity have risen.  Depending on the metal, the rises have been between about 15 percent and 40 percent.  For some of the metals, spreads have narrowed.  For instance, the contango in copper has decreased, as has that of lead (which has gone from contango to backwardation).  For aluminum, however, the spread has widened, as it has for zinc (though not in percentage of the spot price).  

Interestingly, lead, nickel, tin, and especially aluminum stocks have increased; stocks for copper and zinc have decreased, especially the former.  Aluminum is of special interest, as this is a major industrial commodity, and is highly sensitive to industrial uses (e.g., in autos).  

Overall, the story is quite mixed.  Copper suggests bullish fundamentals: a sharp rise in price and a pretty steep fall in stocks.  But, overall, the stocks data give no evidence of a near term strengthening in demand that would explain the price rises across all metals.  Note the rise in aluminum price and the contemporaneous nearly 20 percent increase in stocks.  Hardly a signal of a rebound in industrial demand.

There are two interpretations consistent with the data: (1) spot demand remains low, but demand is expected to pick up in the future, and (2) real spot demand remains low, future real demand is expected to remain in the doldrums, but prices are being buoyed by expectations of a possible inflationary burst (i.e., the money is green version of green shoots).  

Even the copper data, and perhaps data from the oil market, are potentially consistent with (2).  It is widely reported that China is stockpiling copper and oil.  Indeed, some of the copper stocks decline may be a mirage as copper is merely being transferred from LME warehouses to Chinese strategic stockpiles that are invisible to the market, rather than being consumed.  This could reflect a Chinese substitution of dollars/dollar denominated assets into real assets such as copper (and perhaps oil) due to their fears about the US dollar and inflationary pressures in the US.  That would be consistent with the inflationary expectations story, and indeed, a channel by which these expectations influence current prices.

If I had to choose between (1) and (2)–between an anticipated increase in future real demand and an anticipated increase in nominal demand due to inflationary pressures–I guess I would choose (2).  Suffice it to say that although I’m not metaphysically certain as to which explanation is right, the data do not contradict the inflationary expectations story.  Moreover, the future demand/spot demand story is not that convincing.  Anticipation of future demand should lead to an increase in current demand, but that is not being reflected in stocks.  

With stocks largely signaling weak real demand (especially when one considers that the copper stock drawdown may not reflect an actual increase in copper consumption), but prices rising, there is a very good chance that metals prices are in fact a harbinger of inflation.  In his speech at the Atlanta Fed conference on Tuesday, John Taylor suggested that the Fed may not have much time before it has to decide whether to switch gears and fight inflation.  The metals data support that suggestion.  Indeed, if China’s actions in the copper market reflect a substitution of real stuff like the red metal for dollar denominated nominal claims, rather than a real need for the commodity, the time for choosing may be coming much more quickly than is conventionally believed.

Just sayin’.  Or, perhaps I should rephrase that: Just the metals market sayin’.  Listen up, Chairman Bernanke.

Not like they would, but anyways . . .  

The Treasury Department today released a letter on “Regulatory Reform Over-The-Counter (OTC) Derivatives” [sic–“in”? “for”? “of”?].  There are a few good ideas in it, but on balance the bad far outweighs the good.  

The centerpiece of the proposal (which has received a warm welcome from Congressional powers like Barney Frank and Collin Peterson) is to mandate clearing for “all standardized OTC derivatives.”  “Standardized” is not defined, but the letter suggests how this will be determined: If a clearinghouse offers to clear it, it’s standardized: “For example, if an OTC derivative is accepted for clearing by one or more regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.”  

On Tuesday, I gave a presentation at the Atlanta Fed conference where I reiterated my argument–which debuted here on SWP–that mandating clearing is a bad idea.  Even for standardized products (my argument nowhere depends on standardization, except to the extent that there is some correlation between standardization and the magnitude of information asymmetries), it is quite possible that information costs are higher in cleared markets than in bilateral markets.  For particular transactions, involving particular transactors, it is possible that information costs are lower in a bilateral trade.  These lower information costs can make it efficient NOT to clear such deals; for other trades, in the same or similar instruments, clearing may be more efficient.  

In a nutshell, there is no basis for the presumption that the costs of clearing are lower than the costs of bilateral trades.  Moreover, I have not seen a credible argument showing that the social benefits of clearing exceed the social costs, but the private benefits are smaller than the private costs; such a showing would be necessary to justify a mandate  for clearing.  At the Atlanta Fed conference, Ed Kane of Boston College (the moderator of my session) argued that the safety net arising from deposit insurance and the implicit promise to bail out too big to fail banks could lead to such a circumstance.  I do not see the economic basis for this conclusion.  Moreover, there have been cases in the past–namely at the CBOT in the 1920s and the LME in the aftermath of the Tin Crisis–where exchanges resisted government pressure to adopt clearing even though there was no safety net that could have caused a divergence between private and social costs/benefits.  

As I said at the Atlanta Conference, my issue is not with clearing per se.  It is with who decides what gets cleared.  Chuck Vice from ICE (no, I did not make that up;-) had chided me after my talk where I cast doubt on the virtues of clearing for some products and participants by saying “I thought you were my friend, Craig.”  I replied: “I am your friend, Chuck.  If you (i.e., ICE) build a clearing system, and market participants come–as happened in energy–more power to you.  That’s great.  What I’m worried about is the ‘We’re from the government and here to help you’ problem.”   By substituting its judgment–an ill-informed judgment IMHO–for the judgment of market participants who (a) have better information on the costs and benefits, and (b) have skin in the game, and hence an incentive to make the right decisions (though since information and incentives are imperfect, they will some times make decisions that an omniscient agent would not), the Treasury risks reducing efficiency. This is a serious risk, in my view.

I have yet to hear any indication from the Treasury, Congress, or the Fed that the issues relating to information costs, and the implications thereof for the benefits of clearing have been acknowledged, let alone addressed.  Since information costs are an essential determinant of the efficiency of any risk transfer mechanism–which is what clearing is–this is a serious omission that undermines any presumption that the proposal is based on a thorough consideration of the relevant considerations.  

Some other issues.  First, the Treasury letter is framed in a very dishonest way.  It starts by saying “[a]s the AIG situation has made clear, massive risks in derivatives markets have gone undetected . . . even if those risks had been better known, regulators lacked the proper authority to mount an effective policy response.”  As its first proposed policy response, it recommends mandatory clearing of standardized products.  But the AIG products were highly non-standardized, and it is extremely unlikely that these products would ever be clearable.  But by linking clearing with AIG, the letter suggests that the former would have prevented the latter.  Nothing in any of the proposals would have had any effect on any of the AIG deals.  This linkage is dishonest, in my view; a classic bait-and-switch.  If a firm did something like that in a securities prospectus, the SEC would nail it.  Similarly, if somebody did something similar in an infomercial, FTC would be all over them.  

Second, the standardization issue will raise no end of difficulties.  It will create an incentive for parties who recognize that the costs of clearing exceed the benefits to enter into non-standard transactions.  The letter says somebody must “ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.”  The subject of the sentence is “CCPs.”  So, are we to believe that CCPs are to investigate bilateral transactions, and make a judgment on the motives for such deals?  There is a real conflict of interest here, as the CCP has the incentive to force business its way, and look at all non-standardized deals with suspicion.  (I should also note that if the dominant CCP is a member-owned entity dominated by banks, they may influence things in the other direction.)  More likely, the regulator will be required to make such judgments.  So, CFTC (or whomever ends up being the regulator) is supposed to put itself in the heads of transactors, and decide what their motives are for a particular trade?  This is a recipe for litigation, conflict, and most importantly, legal uncertainty.  

This will raise all of the issues that created problems under the Grain Futures Act and the CEA.  Those laws required “futures” to be traded on exchange, but allowed cash market contracts to be traded bilaterally.  So, what is a future?  What is a cash market contract?  Who knows?  In part, the answer depended on the economic purposes of the transactions.  Same now with the “standardized” vs. “non-standardized” distinction.  Such distinctions are recipes for dispute, and invitations for financial engineering to circumvent the clearing requirement.  The possible implications for legal certainty are particularly disturbing.  

Third, the letter emphasizes the role for “robust margin requirements.”  There is no recognition that margining can actually contribute to systemic risks, and that the rigid types of margining that CCPs perform may be particularly susceptible to this problem.  Margin calls can induce liquidations that move prices away from equilibrium values, and set off positive feedback mechanisms that destabilize the market.  Similar problems can arise in OTC markets, but the greater flexibility in these sort of arrangements, including the ability to utilize a broader range of collateral, can mitigate the problem there.  It is by no means clear that rigid CCP-style margining reduces systemic risk; it can increase it in some circumstances.  

On the issue of margins, I was interested to hear Chuck Vice (of ICE–I just like saying/writing that;-) say that ICE Trust took an “agnostic view” of the credit risk of member firms in setting margins, and therefore would charge everyone the same margin level that would be sufficient to cover the likely loss on a particular position during an extreme market move.  Bug or feature?  Chuck thinks feature.  I think bug.  Different members pose different default risks (just look at disparities in CDS spreads among the members of ICE Trust), and this would suggest the optimality of different margins–that is done in the OTC market.  One size fits all doesn’t fit everybody when people are of different sizes.  In the OTC market, parties can customize collateral levels to reflect risks, and this has virtues.  

Back to the Treasury letter . . .  

Another pernicious proposal is that the CEA be amended “to authorize the CFTC and SEC to impose . . . . The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.”

Again, this is the GFA/CEA redux–like those laws, this proposes to force a subset of all trades onto centralized exchanges, or electronic trade execution systems that are very exchange-like.  The reason for such a mandate is not stated.  Nor do I think it exists.  What externality is being internalized?  At what cost?  What is the basis for substituting the government’s judgment as to how trades should take place for the judgment of the transactors themselves?  

This is certainly a boon for the CME, and arguably ICE.  And shazaam, their stock prices took off after the release of the letter.  Who would have thought?  

Again, as under pre-CFMA CEA/GFA, the on-exchange/off-exchange distinction will lead to dispute, litigation, and legal risk.  

One could argue that exchanges are more transparent, and that transparency is a benefit.  However, other parts of the letter–namely, the requirement that all trades (including non-standard ones) be reported to a trade repository made available to regulators, and the development of a price reporting system–address the transparency issue.  Indeed, these are better ways to address transparency concerns than either clearing or forced exchange trading.  I said just that in my FRB Atlanta presentation, and in my academic writings on the subject.  Exchange trading may be sufficient to produce price transparency, but it is not necessary.

The transparency proposals are something I support.  Indeed, I view those as something of a vindication, as I was advocating such measures in energy markets in the 2003-2004 period.  The Data Hub lives!  

One issue with post-trade price and position transparency is the effect it will have on liquidity.  JP Morgan’s Eric Beinstein raised such concerns in his talk at the Fed conference.  This was a big deal with London dealers in the stock market, who feared that premature disclosure of trades would make it more difficult for them to lay off positions that they took on from customers.  Therefore, it may be advisable that some reporting delay be permitted.  

The letter also addresses market manipulation, fraud, and other abuses: “The CEA and securities laws should be amended to ensure that the CFTC and the SEC have . . . . Clear and unimpeded authority . . . to police fraud, market manipulation, and other market abuses.”  This is a red herring.  Relatedly the letter says that “under current law [OTC markets] are largely excluded from or exempted from regulation.”  This is wrong if it is meant to refer to exemptions from the manipulation or fraud provisions of the CEA.

CFTC already has authority to police manipulation of “any commodity traded in interstate commerce” and this clearly would extend to OTC swap markets as currently constituted.  Even the much (and wrongly, in my view) maligned CFMA did not exempt any market from the anti-manipulation or anti-fraud provisions of the CEA.  So, why is this language in the proposal?  Ignorance?  

More unfortunately, the letter recommends giving regulators the ability to set position limits on OTC market positions.  As I’ve written  in my book on manipulation, and often on SWP, position limits are an inefficient way to combat manipulation and fraud.  Ex post action is a better way.   CFTC should be better able to do this with better information about positions, so position limits are not advisable.

The problem, though, is not with CFTC’s powers or information.  It is with its willingness and ability to use them.  CFTC’s record in anti-manipulation litigation is hardly glorious.  Moreover, the legal precedents–especially CFTC decisions like in re Indiana Farm Bureau and in re Cox & Frey–have seriously undermined the deterrent force of government and private ex post litigation.  Treasury and Congress would do much more to improve deterrence by writing legislation to clarify manipulation law to undo the pernicious effects of these decisions.  Without doing that, Treasury is fooling itself when it says (in Geithner’s letter to Harry Reid, linked at the bottom of the link above) that  “With CCPs, trade repositories, and other market participants providing the CFTC and SEC with a complete picture of activity in the OTC derivatives markets, they should be able to detect and deter all such market abuses [emphasis added].”

As if.

Information is NOT the binding constraint.  When a manipulation is suspected, the subpoena power is sufficient to obtain the requisite information–and it is usually the efficient way.

I repeat: The binding constraints are (a) the intellectual confusion inherent in existing manipulation precedents; (b) the intellectual confusion at CFTC and other regulatory agencies when it comes to manipulation; and (c) the vague language defining manipulation in the relevant statute, which is ultimately the source of intellectual confusions (a) and (b), and which stemmed quite clearly from Congress’s own intellectual confusion.  I have been saying this since 1994.  So, don’t listen to me.  I’m used to it.  But don’t fool yourselves into believing that you will reduce manipulation efficiently through position limits and the collection of more information that is mis-used because of a failure to understand the economics of manipulation.

The letter also recommends actions to ensure that derivatives are not marketed to unsophisticated parties.  I have not analyzed this issue in detail, but it is my sense that this is another area in which ex post litigation, including private actions (including class actions) would be a preferable way to handle the problem.  Trying to write rules to determine ex ante who is, and who isn’t, sufficiently knowledgeable to enter into derivatives trades is extremely problematic.  I also worry about the incentive this provides for people to take risks, and then attempt to back out of losing contracts by claiming that they were duped.  Maybe they were, but I think there should be a pretty high standard of proof required to support such a finding.

In sum: There are a few good ideas in the Treasury proposal.  Very few.  The biggest, most important proposals are wholly misguided, in my view.  They reflect, again in my view, (a) a shockingly incomplete analysis of the relevant economics, (b) an unjustified and unsupported presumption that regulators’ and legislators’ judgments are superior to those of private transactors, and (c) a failure to identify market failures that the proposed regulatory changes would fix.

John Taylor of Stanford gave a very nice keynote speech at the FRB Atlanta Conference on Financial Crises & Innovation.   It was a very different speech than Bernanke’s, and much more critical of government as a cause of the crisis, and a potential source of systemic risk in the future.   Indeed, Taylor listed three major sources of systemic risk going forward that have been featured prominently on SWP as well:

·           Massive expansion of US government indebtedness.  Interestingly, Taylor said that “[t]here is certainly no  stimulus effect from such deficits, and they put a very heavy burden on the not so distant future.”  

·           A dramatic expansion of the Fed balance sheet, and serious questions about the credibility of any Fed promise to withdraw liquidity from the system, thereby leading to a substantial threat of inflation.

·           An undermining of the rule of law, primarily illustrated by the administration’s heavy-handed efforts to subvert bankruptcy law and debt contracts in the Chrysler case, as well as actions on executive compensation and forcing out CEOs.

I couldn’t agree more, obviously.   I think these are all major threats.   The first in particular is becoming greater by the day.   The second will become more acute as the Fed proceeds with various initiatives to acquire securities, thereby ballooning its already bloated balance sheet into the trillions, and as political pressures to avoid doing anything that could abort a recovery bias the Fed towards ease even if and when inflationary pressures become manifest.   The last is a new development, and it bears attention to see whether the government takes any further steps along this path.

Taylor’s overall theme was that massive government failure is a real possibility, and that government is a major source of systemic risk.   Agreed.   This is a message that bears repeating over and over again as regulatory and legislative nostrums are pushed in the coming months.

At today’s session, AEI’s Vincent Reinhart made a point that I’ve also emphasized on SWP.   I’ve said that the biggest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression, and passed useless or counterproductive legislation as a result.   Reinhart said, in a similar vein, that the most important thing going on today is the battle over the narrative as to what caused the financial crisis, because that narrative will determine what policies are adopted going forward.   He stated that the narrative of the Great Depression was wrong, and that as a result the regulatory and legislative response was wrong too.   He fears that the emerging dominant narrative is similarly misguided, and will lead to similarly damaging results.

Taylor’s talk was an attempt to counter the conventional wisdom narrative, and advance a counter-narrative.   Sadly, I think that this is an uphill battle indeed.   But, as Reinhart says, it is a battle that needs to be fought.

As I was getting on the plane to come back home, a reporter sent me an advanced copy of a letter that Geithner has sent to Congress outlining plans for regulation of the OTC derivatives market.  That letter embodies a particular narrative that I believe is particularly, and perniciously, in error.  This illustrates the relevance of Reinhart’s point.  I will deconstruct that letter in detail tomorrow, time permitting.  

Other than the price, that is.  The excellent Izabella Kaminska continues her fascinating coverage of the relation between oil prices and fundamentals at FTAlphaville. Izabella provides additional data on the continuing accumulation of oil and product inventories in the face of rising prices, and links to a Goldman Sachs analysis thereof.  

A positive co-movement between inventories and prices is an anomaly in the standard theory of storage model.  In that model, an negative demand shock (or a positive supply shock) leads to (a) a decline in price, and (b) an increase in inventories.  

I have devised a model (the ideas for which I first explored on SWP) in which you can get a positive covariation between prices and inventories due to stochastic fundamental volatility.  The basic idea is that when fundamental uncertainty goes up, people increase precautionary inventory holdings.  The only way to do this is to bid up price in order to reduce consumption and increase production.  

Although I think that this model can explain some market behavior (such as in the post-hurricane period 2005-2006), it doesn’t seem to fit the current episode.  If anything, fundamental uncertainty is declining of late.  Stock prices have been rallying.  The volatility indices (e.g., the VIX) have been declining.  

Here’s an alternative explanation.  Traditional models posit Markovian processes for (net) demand shocks.  This means that current demand shocks imply a distribution of future demand.  Moreover, the models are typically stationary, meaning that a given current demand shock leads to a smaller change (in the same direction) in expected future demand.  In these models, the distribution of future demand changes only if current demand changes.  

An alternative model (which is hard to implement formally) incorporates “future” shocks that are distinct from current shocks.  (A Fama-French JF paper on metals prices from 1988–if I recall the year–explores this idea.)  That is, information may arrive today that has no implications for current demand or supply, but does has implications for future demand or supply.  So, for example, if new information arrives that suggests the economy will be better in 6 months than than had been previously anticipated, a rational economic response is to add more to inventory in anticipation of higher future demand.  Expected future prices rise due to the bullish future information, and in conditions of full inventory, the cost-of-carry relationship causes current prices to rise too.  (Indeed, holding current demand constant, the higher price induces lower consumption and higher production, which allows the accumulation of additional inventory.)  

This is pretty close to the Goldman-Sachs story.  Goldman also argues that if oil storage facilities fill up, the connection between future prices and spot prices will break down.  In the context of the model, if the marginal cost of storage becomes very steep, the increase in future demand leads to a rise in the future price, but a much smaller rise in the spot price; it is too costly to accommodate the future demand shock by adding even more to inventory due to the very high and rapidly rising cost of storage.  Thus, current inventory (and hence current consumption) do not respond to the future demand shock; since consumption doesn’t respond, spot prices don’t change either.  

Note that the nature of the “future shock” (to steal the name of an old book) is not specified here.  It could be a real shock or a nominal one.  That is, it could be that information arrives that suggests that real demand will increase in the future, or that only nominal (money) demand will increase.  That is, inflation is expected to increase.  This could lead to increases in nominal spot and futures prices, even in the face of stagnant or declining real demand.  

One piece of evidence that could bolster this interpretation is that nominal Treasury yields are beginning to rise.  The 30 year auction yesterday was something of a disaster, and 10 and 30 year yields are rising. Indeed, over the past week when oil prices have been rising, the breakeven rate (the difference between 10 year nominal T-note rates and the corresponding TIPS yield) has increased from about 1.41 percent to 1.58 percent.  Not a big deal, but the direction is interesting.  

So, the oil market could be a “green shoot” signaling an impending recovery of demand.  One not quite here yet, but on the horizon.  Or, it could be a “green” shoot in the sense that (a) money is green, and (b) per Milton Friedman, inflation is always and everywhere a monetary phenomenon.

Today is the 110th of Hayek’s birth.  Reading a couple of items in the FT brought to mind one of Hayek’s most trenchant observations.  Specifically, Hayek was extremely suspicious of the use of the word “social” as a modifier.  He viewed it a a meaningless appendage at best, a means of undermining (or intimidating the exercise of) independent thought at its worst.  Hayek believed that the positive connotations of the word “social” were used to justify profoundly illiberal, and at times oppressive, actions and policies.

The s-word is cropping up a lot in discussions of the Chrysler bankruptcy, and the administrations attempts to strongarm those standing on their contractual rights.  One example:

“The financial interests of investors may conflict with what the government is trying to do from a social perspective,” says Steve Persky, managing director of Dalton Investors, a Los Angeles-based hedge fund that specialises in distressed debt.

And another:

The message that all the constituencies involved in Chrysler must share in the pain originated in the White House. “The government played a very strong hand,” says the person representing one agent bank. “All the senior lenders got the short end.

“The government had one eye on the social element and one eye on not abrogating contracts, but can you reconcile these two goals?”

Translation: “social perspective” and “social element” mean policies intended to benefit one group of individuals at the expense of another, but that the beneficiaries are called “society” and the victims of the redistributive policy are by implication “anti-social.”  I can’t think of a better example of Hayek’s warnings about the use of “social.”

No, the 60,000 Chrysler workers are not “society.”  They are a politically favored group.  And no, the senior creditors are not “anti-social.”  They are individuals and firms whose contractual rights are being threatened.

Indeed, the insinuation that the deprivation of a small number of individuals’ contractual rights is somehow necessary to achieve larger benefits for “society” turns reality on its head.  By undermining the security of contract to benefit a small, politically favored interest group, these actions will reduce the wealth of Americans–and indeed people around the world–by a far larger amount than it will increase the wealth of the Chrysler workers and retirees.  It will raise capital costs and transactions costs throughout the entire economy, making most of us far poorer (except, perhaps, for lawyers and lobbyists).   The rule of law and contractual rights are essential to the production of wealth, and to economic growth.  Undermine these, and less wealth will be generated, today and in the future.  

And, to provide some perspective on how the word “social” is used to rationalize robbery, here’s a wonderful quote from Obama’s Book Club buddy, Hugo Chavez, rationalizing the expropriation of oil services firms who actually had the temerity to demand payment for services rendered (can you believe?):

“Tomorrow we’ll start recovering the goods and assets that will now belong to the state — social property as it always should have been,” Mr. Chávez said in a televised speech Thursday. “Mr. Man on the moon, cover your ears because the cries of anguish from the bourgeoisie will reach all the way to the moon.”

We’re not Venezuela or Russia yet, by any means, when it comes to undermining property rights.  We still have independent courts.  But the administration’s (and Congress’s) disregard for property rights, and its willingness to run roughshod over them to benefit certain political constituencies promoted to the rank of “society” is an ominous precedent.

As is the other news in the second FT article quoted above.  Namely, the use of big banks dependent on the government to serve as the enforcers of the government’s will:

But whatever the final ruling, the talks last week illustrated that four banks, led by JPMorgan, which acted as agent for the loan, were acting to advance the government’s agenda, according to people familiar with the talks. The core lenders, which also included  Morgan Stanley,  Goldman Sachs  and  Citigroup, have all taken taxpayers’ money through the troubled assets relief programme.

The efforts of Mr Lee at JPMorgan, which originally had $2.7bn of Chrysler debt, were supported by the three other agent banks, Citi, with about $900m in face value of loans, Morgan Stanley and Goldman Sachs with well under $600m each. Mr Lee declined to comment.

The four banks divided up the work of contacting other creditors, with each calling those with whom they had the strongest relationships, the people familiar said.

In some cases, the large banks were lenders to smaller Chrysler creditors, in others, they had sold them the Chrysler debt. “There was a lot of high drama stuff,” recalls one creditor. “There was a lot of we will never do business with you again kind of talk.”

That can be standard in the tough negotiations over the fate of troubled borrowers. But in this case, there was another element. In an illustration of how dramatically the financial world has changed during the financial crisis, bankers from the agent banks say they felt under pressure from the US government.

This is the kind of abuse of effective government control over large financial institutions that has led me to oppose nationalization as a means of addressing bank insolvencies.  We again seem to have the worst of both worlds: the government gives every impression of being captured by the major banks when it comes to dealing with insolvency (I hope to write about the stress tests in a bit), but exerts pressure on them to divert resources to its favored constituents.  And perhaps this is the disturbing quid pro quo: the banks get the opportunity to gamble themselves out of trouble, and in exchange, assist the government in undermining contracts so as to benefit its favored interests.

Like I’ve said.  These things don’t average out: being too nice to the banks on some things and leaning on them in others is to commit two errors that compound, rather than offset.  (Like the old lawyer joke: “I’ve won cases I should have lost.  I’ve lost cases I should have won.  Therefore, on average, justice has been served.”  No.  It’s been dis-served twice.)

To close the circle, this quote from an article about science prizes illustrates perfectly Hayek’s warnings about the low and dishonest rhetorical use of the word “social”:

“I hate these inducement prizes and their language of social benefit,” says University of Pennsylvania prize scholar James F. English, author of “The Economy of Prestige: Prizes, Awards and The Circulation of Cultural Value.” “It’s a cover for what they are really about, which is getting attention. I don’t think that kind of small-scale frantic prize-chasing investment is the best way for us to solve big problems.”

Different context, to be sure.  But a wonderful illustration of Hayek’s point that when you hear the word “social” being used, be very, very careful.  There is a very good chance you’re either being played–or intimidated into silence.

Commentor Sandrew was feeling overlooked because I didn’t pick up on his comment on the Felix Salmon post, a comment that hit the key point in my later response to Salmon.  Here’s his comment:

I think you may be focusing on the wrong transaction costs. To pierce the Coasean retort, one must demonstrate that frictions exist to impede the unwinding of CDS and the transfer of bonds. Pirrong argues that if such transactions are efficient, then the perverse incentives that bond hedging via CDS create can be efficiently diffused.

That said, I’m not convinced that the bond and CDS markets are as well lubricated as Pirrong seems to suggest. To me, the enormity of the CDS market is as much evidence for the presence of significant CDS unwind costs as it is for the popularity of the instruments. If unwinding or novating CDS was so cheap, why did the aggregate notional amounts balloon to umpty-trillion bucks over the course of the past decade?

Sandrew’s comment re the Coasean retort is correct.  Re his second paragraph, well, I don’t really take a stand on how well “lubricated” the CDS market is, except to say that if the empty creditor problem is a really big deal, and the bad incentives resulting from hedged bond positions lead to huge costs, in my view it is likely that the CDS market is sufficiently lubricated to permit market participants to avoid such costs.  I note that re the ballooning of aggregate amounts, etc., when it became apparent that there were large costs associated with failing to close offsetting positions, market participants acted with alacrity and did large amounts of tear-ups through TriOptima, etc.  As a result, notional amounts have fallen dramatically (by about 40 percent if memory serves).  

Thanks for the comment on Salmon’s blog, Sandrew.  You are on point, and get props from me, if belated ones.

So, Sandrew–consider your head patted;-)

Felix Salmon does me the kindness of responding in detail to my post on Coase Meets CDS.  Color me unpersuaded.  

Felix (if I may) strikes the pose of the Practical Man, juxtaposed to his portrayal of me as the Ivory Tower Pointy Head.  It is of course essential to keep the practicalities in mind, but  the Practical Man  (a) is often limited by what has been, and has a difficult time envisioning alternatives, and (b) often lacks a conceptual framework that helps sort through complex situations.  I respectfully suggest that Felix falls victim to both problems.  The comparative advantage of the Ivory Tower Pointy Head is that s/he–I, in this instance–can bring some conceptual order to the complexity.  Indeed, that’s the whole beauty of the Coase Theorem in particular.  By imagining an impractical world, it identifies the key practical aspects of a problem that deserve analytical attention.

Let’s focus on what is the issue at hand, and which Felix doesn’t IMHO adequately isolate, and instead in Practical Man fashion buries in a jumble of other empirically/observationally motivated considerations.  

The issue at hand is: What is the incremental contribution of CDS to the costs of financial distress?  Felix mentions the well-known transactions costs of the bankruptcy process.  But these costs were well known before CDS were a glimmer in some J.P. Morgan banker’s eye.  Relatedly, Felix mentions “very few people trade in [distressed credit]: basically it’s the province of a small number of distressed-debt funds who like to buy the debt cheap and then wade into invariably-arduous litigation.”  True.  But it was true before CDS.  It is true today even for distressed credits on which CDS are not traded, or for which the volume of CDS trading is de minimus.  Relatedly, Felix talks about how “arduous debt renegotiations are.”  True again, but the same remarks hold.  This does not address in any way the incremental contribution of hedged creditors to the arduousness of renegotiations.  So, these remarks are completely off point in responding to the issue at hand.  

The charge before the bar is that by undermining the incentives of hedged creditors to undertake part in value-enhancing pre-bankruptcy restructurings, the costs of these restructurings are higher when some creditors are hedged when they are not.  (Relatedly, it is possible that bankruptcy procedures themselves are higher when some creditors are hedged.)  Discussing the costs of workout and bankruptcy in general says absolutely nothing about this key issue.

When addressing that specific charge, the Practical Realities that Felix mentions are not particularly illuminating, because they are common to all dealings involving distressed credits.  

The relevant issue is the incremental cost of eliminating the putatively perverse incentive arising from hedged trades.  The very liquidity in CDS that Felix touts suggests that this incremental cost is not particularly high; the hedged creditor can reverse the CDS position.  If the creditor does not want to retain the risk exposure associated with the remaining debt that would result after reversing its CDS position, an EFP-style trade (a simultaneous transaction in the underlying credit and the CDS) with a party with an offsetting CDS position, to a first approximation (i.e., abstracting from basis risk) leads to an identical allocation of risk and the elimination of the putatively perverse incentive.  Win win.  Value created that can be shared.

EFP trades have been common features of derivatives markets since their beginnings (though they go by a bewildering variety of names).  Nothing new here.  Nothing complicated here.  Very Practical, in fact.  Practical Men have used them for a long time in many markets.  Nothing Ivory Tower about them.  Indeed, I can say from 20+ years of academic experience that 90+ percent of Ivory Tower finance people have never heard of an EFP.  I learned about it from being in the markets.  

Let’s stipulate that this isn’t being done, at least in quantity.  That means that the costs exceed the benefits.  This could be because the costs are high, or because the benefits are low.  Neither Felix nor any of the other disquisitions on this subject I’ve read present a convincing case that the benefits are high (because the empty creditor problem is particularly pernicious.  The absence of these sorts of trades is also consistent with the benefits of eliminating the empty creditor problem being small.  

Some of the very facts that Felix cites are consistent with the conjecture that the empty creditor problem isn’t that serious because workouts prohibitively costly when this problem is absent.  A lot of firms go into bankruptcy–meaning that pre-bankruptcy workouts are not universal.  Again, this was true before CDS, and is true for firms for which CDS hedging is not that material. This means that the transactions costs of the workout are sometimes prohibitively costly even in the absence of hedged creditors.  Indeed, I would argue that the relative rarity of workouts in situations not complicated by CDS suggests that the incremental contribution of CDS is likely to be small.  

Felix makes some lazy arguments.  About laziness, in fact: “Bondholders have discovered that if they hedge themselves in the CDS market, they can be lazy about such matters.  And there aren’t any easy ways to get a lazy bondholder do hard negotiating work.”  

Again.  If the empty creditor problem–now renamed the “lazy bondholder problem”–is that serious, then laziness is very costly.  There is value on the table that can be used to bribe the lazy to transfer their positions to somebody who is not lazy.  Indeed, the truly lazy can completely wash their hands of everything and pick up some spare change in the bargain.  Sounds tailor made for the lazy.  

There has always been the issue of control rights not being held by those best able to exercise them.  Insurance companies buy corporate bonds not because they have a comparative advantage in participating in workouts, but because the risk-return characteristics of the bonds meets their investing needs.  In the event of an issuer’s financial distress, the insurance company is unlikely to have the comparative advantage in participating in the workout.  The company could–and sometimes does–sell bonds to someone who can exercise the rights more efficiently.  But often it does not.  One reason for doing this is that the rights are not that valuable in the first place–due, in large part, to the arduousness of workouts even in the absence of hedging.  

In the end it’s all about a very basic economic proposition.  A very practical economic proposition that is lived out in markets every day, as it has been for millennia past.  That proposition is that resources flow to their highest value uses.  As modified by Coase, the “highest value use” takes transactions costs into consideration.  Those worrying about the lazy bondholder problem assert that CDS dramatically raise the transactions costs and impede the flow of control rights into their highest value use.  The case is not proven by a longshot.  

Felix objects to my starting the story at the end–i.e., when financial distress looms, rather than when the hedger initiates a CDS trade.  This objection is readily addressed, and indeed, extending the analysis in that direction strengthens my point.

First, that’s the natural starting point in addressing the empty creditor argument, precisely because that’s where Hu and others started it.  

Second, and more importantly, taking this into consideration forces one to consider the effects of CDS in their entirety–something I did in the last paragraph of my post.  The possibility that value will be destroyed due to perverse incentives in the event of financial distress will be priced into the CDS when a hedger initiates a position.  In particular, the costs arising from an inefficient resolution of a financially distressed firm will tend to increase the costs of protection accordingly; the protection seller, anticipating the possibility of making larger payouts in the event of financial distress on the named credit, will price that into the protection.  If consenting adults make the trade nonetheless, it means that the net benefit of the CDS transaction to them is positive even taking into account the possibility of a lazy bondholder problem.  Although it might be desirable to undertake actions that reduce transactions costs in the event of financial distress, there is no justification whatsoever for restricting trading of CDS based on fears of the empty creditor problem.  You may save on some costs, but only by imposing even greater costs in return.  You know that you are imposing even greater costs because you are preventing consenting adults from engaging in trades they deem to be mutually beneficial even given the possibility of the lazy bondholder problem down the road.  

This understanding motivates a very Practical Way of analyzing how to improve the CDS markets.  Focus on reducing the transactions costs of dealing in CDS and corporate bonds.  Avoid measures that constrain the ability of market participants to trade CDS–either to initiate, or reverse positions.  Sadly, to the extent the worries about the empty creditor problem contribute to the CDS are bad meme, they are invoked to support measures that would restrict CDS trading, thereby eliminating some mutually (and socially) beneficial trades.  As an example of the former policy, moves to improve standardization and fungibility would facilitate the development of EFP-style trades in CDS.  (Lack of standardization and fungibility make it costlier to deal with others than with the original counterparty, thereby limiting the possible universe of CDS trades.)  

A couple of final points.  Felix chides my CDS auction speedup proposal because it doesn’t address the pre-bankruptcy workout issue.  I make that very point in my post.  

And finally, Felix states that my original post is a “very long” one.  LOL.  That’s nothing, dude.  Want to see long?  Prowl around the site awhile and you’ll see long!