Streetwise Professor

The Rodney Dangerfields of financial instruments, credit default swaps, are now getting disrespected for impeding workouts of companies teetering on the edge of bankruptcy.  This argument was first flogged by UT law professor Henry Hu last year.  Now, lawyers in General Growth Properties and AbitibiBowater bankruptcies are blaming debtholders who hedged by buying CDS protection on these companies with having little interest in achieving a workout.  Several bloggers, including the estimable Megan McCardle  and the very good (but not quite so estimable, IMHO) Felix Salmon  have expressed similar concerns.  The somewhat supercilious, but usually provocative, Charles Davi takes the opposite view.

I come down on Davi’s side, but for very different reasons.  This is essentially an argument about the effect of the distribution of property rights/ownership.  Those who claim that there are perverse effects of CDS argue that the distribution of ownership has effects on the allocation of resources.  There will be a different allocation if some debt is owned by those who also have CDS positions, than if all debt is owned by the unhedged.  In particular, outcomes will be less efficient, in this view, if some debts are owned by firms that are hedged.

Well, the proper way to begin any analysis of the effects of the original distribution of ownership is with Coase, and the Coase Theorem.  This states, of course, that in the absence of transactions costs, the initial distribution of ownership has NO effect on the ultimate allocation of resources. This result obtains because without transactions costs, the original owners can negotiate mutually beneficial trades that put the resources in their highest value uses.  Indeed, they will trade until the final allocation of ownership maximizes value, regardless of the initial allocation.

This means that any “problem” with the distribution of ownership is a transactions cost problem.  This leads one to (a) attempt to identify the sources of transactions costs, and (b) determine whether there is any change in laws, regulations, etc., that could reduce transactions costs.

In the CDS context, this means that in the frictionless Coasean world, the “empty creditor problem” that arises when creditors are hedged is in fact an “empty problem”–that is, not a problem at all.  It is therefore necessary to evaluate, and do so more carefully than those I have seen weigh in on this subject, whether transactions costs seriously impede value maximizing trades, and if so, what are the most efficacious means of reducing these costs.  

Here’s my argument in more detail:

A completely hedged debtholder (i.e., a party that has purchased protection in an amount equal to his holdings) would appear to have no incentive to behave constructively during the reorganization.   But this means that a potential source of value—the control and legal rights attached to the ownership of the debt security—is not being maximized.   There is therefore a set of mutually beneficial transactions that would leave the insured debtholder no worse off than if he acts in the passive manner that the critics of CDS hedgers suggest, but would result in the efficient exercise of the control and legal rights.   Specifically, another party could purchase the debt from the insured current holder at a price that is satisfactory to the latter, but which allows the purchaser to capture some of value associated with the control rights.   That is, there is a set of transactions that would allow the hedged debtholder to capture some of the benefits of the control rights.

The anti-CDS analysis presumes that there is money left on the table.   The total value of the debt and insurance contracts are higher if the control rights are efficiently exercised.   This creates an economic incentive to structure transactions to ensure that they are so exercised.

The credit protection that hedgers have is not (from a social perspective) an economic asset.   It has zero value because the gain to the buyer is offset penny for penny by a loss to the seller.   This suggests another value enhancing transaction.   The protection seller and the protection buyer could agree to cancel the contract at a mutually acceptable price that effectively splits the value associated with the control rights between them.   This would be mutually beneficial even if the debtholder is overhedged, i.e., has bought more protection than he holds in the debt.    

Another alternative is for the protection seller to buy back the protection and the debt.  The “empty creditor” problem goes away because there is no hedge once this transaction is completed.  The risk profile of the buyers and the sellers is unchanged.  The formerly hedged creditor had no risk exposure after the trade because he was hedged; he has no exposure afterwards because both positions are closed.  (The former statement is something of a simplification.  The “hedged” firm still faces basis risk–a not immaterial consideration, especially of late.  Thus, risk exposure actually goes down for this firm.)  The former protection seller’s risk exposure doesn’t change either.  He was long the debt (via the CDS position) before the trade; he is long the debt itself afterwards.

In other words, CDS critics essentially overlook the Coase theorem, and assume that the allocation of rights is somehow locked in, and cannot be changed by mutually profitable value-enhancing trades.

Of course, transactions costs are not zero in the real world.   It may be costly to find the insured holder of the debt (although insurance sellers could always find their counterparties and commence a negotiation.)   More substantively, different parties may have different—and private—information about the value of the control rights.   Similarly, absent some disclosure requirements, the positions in the debt and protection of each market participant are private information.   This private information can create transactions costs that impede the transfer of the valuable control rights to those who can exercise them most efficiently.

The CDS critics focus on potential problems in negotiations in bankruptcy, or in pre-bankruptcy negotiations between debtors and creditors, and among creditors.  This is a myopic view.  That lawyers (pace the FT piece) advance it is not a surprise, in some sense, because that’s their world.  It is a myopic view because there are many other potential transactions; between protection sellers, buyers, creditors, and third parties that can reallocate the relevant control rights and mitigate the allegedly perverse incentive effects of hedged positions.  If hedges destroy value, by impairing incentives, greedy market participants have an incentive to unwind the hedges to capture that value that would otherwise be destroyed.  These transactions can involve the CDS, the underlying debts, or both.  The world of possible value enhancing transactions does not begin or end at the law firm door, or the steps of the bankruptcy court.  

Thus, at root, as is the case with any asserted inefficiency, the anti-CDS argument is implicitly one about transactions costs.    The anti-CDS  argument holds only if transactions costs materially impede the consummation of value enhancing bargains, but those advancing this argument undertake no analysis of transactions costs, or of ways to reduce them.

To take the skeptics’ view at face value (no pun intended), is to assume that transactions costs are very high indeed.  For the skeptics argue that large amounts of value are destroyed by the empty creditor problem, it must be the case that the transactions costs of circumventing the problem are even larger.  Given the presence of large, sophisticated market participants, this seems something of a stretch.  And indeed, it’s not just the original holders of the debt and CDS that are potential players here.  Hedge funds or vulture funds or others could realize the value opportunity, and structure trades that maximize the value of the control rights.  

The fact that a relatively simple trade–the reversal of an earlier CDS trade, combined with the simultaneous purchase of debt–could eliminate the empty creditor problem suggests that this is much ado about nothing.  The transactions costs of reversing an earlier transaction, in what is effectively an “EFP” (“exchange for physicals,” a commonplace derivatives trade), are not all that high.  Certainly not that much higher–if at all–than the original trade.  

Even if my conjecture that the empty creditor problem isn’t that big a deal, or somebody (or many somebodies) would have engaged in trades to make it go away is incorrect, the debate over how to deal with the issue has been pretty much off point.  It has a sort of “woe is me what are we going to do with these awful CDS” flavor to it.  The more high strung among the critics suggest that trading in CDS should be severely constrained.

A more constructive approach is to identify the sources of transactions costs that are interfering with the efficient reallocation of control rights, and to devise policies to reduce these costs.  (And again, I would emphasize that greedy financial innovators have strong incentives to figure out ways of doing this all by themselves.  If they aren’t doing it . . . maybe the problem isn’t that serious.  Especially since a vanilla EFP will do.)  

This suggests some policy responses that would not entail substantial impediments to (and perhaps the banning) the trading in credit derivatives and the underlying credits.   One policy response is to reduce transactions costs that would arise when a company approaches financial distress, or perhaps declares bankruptcy.   One way to reduce transactions costs would be to reduce the importance of information asymmetries about positions.   Like a poker player, someone who knows his positions and knows that nobody else knows them, can bluff and negotiate in a way that impedes efficient transactions.   This inefficiency can be eliminated, and efficient trading encouraged, by requiring revelation of all positions in the underlying debt, credit protection, and equity of the troubled company at the time of a credit event.   This would facilitate value enhancing transactions between credit protection buyers and sellers by making it easy to identify the economic interests of all parties, and eliminating the ability to bluff about positions and interests in an attempt to extract value from other participants.

Another policy response is to undermine the bargaining power of hedged debtholders, or to remove those with weak or poor incentives from the reorganization process.   This could be done in bankruptcy by reducing the voting and representation rights of debtholders by the amount of the protection they have purchased.   For instance, the holder of $50 million in debt who has purchased credit protection on $25 million, would be treated equivalently to the holder of $25 million of the debt (and the total holdings used to apportion voting and representation rights would be correspondingly reduced.)

The mechanics of settlement of credit derivatives could also be designed to mitigate the perverse incentives that concern the CDS skeptics.   For instance, if payoffs to a credit derivative are determined very soon after the formal declaration of a default or bankruptcy, but before the completion of a reorganization, the concern evaporates.   An ISDA auction soon after a default or bankruptcy would establish prices at which all outstanding credit derivatives on the defaulting firm are settled.   Once this price is determined, the value of outstanding credit derivatives is fixed, and consequently indifference or strategic behavior by the buyers of protection is no longer an issue.   The derivatives effectively disappear, and all that is left is the underlying debt securities, along with their associated control and legal rights, uncompromised by conflicting incentives created by derivatives instruments.   The debtholders then have an incentive to exercise control and legal rights efficiently.*

In summary, Hu and others have identified a potential concern about the adverse incentive effects of credit derivatives, but their analysis is incomplete.   It overlooks an important consideration that should inform any analysis of an asserted inefficiency; namely, the fact that regardless of the original distribution of economic rights, self-interested market participants have an incentive to engage in transactions to allocate these rights to maximize their value.    The skeptics’  analysis presumes that individually and collectively, market participants are not maximizing the size of the economic pie—the value of a firm undergoing a reorganization.   This can only happen if transactions costs materially impede the efficient reallocation of these rights, but Hu and the other critics do not analyze—or even mention—transactions costs, or the potential for consenting adults to make trades that enhance value.   Moreover, since transactions costs may exist in the real world, policy responses designed to reduce these transactions costs deserve serious attention before more draconian restrictions on credit derivatives are contemplated.

Finally, it should be noted that even if credit derivatives do result in some efficiency loss because of their effects on the incentives of debtholders during reorganizations, or the transactions costs that perpetuate these incentives, these costs must be weighed against the benefits of credit derivatives.   Credit derivatives also facilitate the efficient allocation of risk among market participants.   Moreover, credit derivatives play an increasingly important role in price discovery and enhancing the transparency of the credit markets.   These benefits are appreciable, and the phenomenal growth of these instruments is a testament to the magnitude of these benefits.   Any policy response to the problem that the skeptics identify should be crafted so as to preserve these benefits. Thus, a light-touch approach that focuses on reducing transactions costs or modifying the bankruptcy process would mitigate the importance of the CDS skeptics’ concern, without jeopardizing the risk management and price transparency benefits of credit derivatives.

Last month Senator Maria Cantwell (Duh-W) announced two pieces of legislation to ”  help prevent future energy price bubbles and market manipulation“:

The first, S. 672, which she introduced on Mar. 24, would give the Federal Energy Regulatory Commission authority to issue cease-and-desist orders against manipulative schemes in progress. The US Securities and Exchange Commission and Commodity Futures Trading Commission already have this authority, she noted.

She said the bill also would make FERC able to freeze the assets of any entity suspected of market manipulation. It would give the commission authority to temporarily change or suspend power rates for up to 30 days during an energy emergency caused by market manipulation. And it would have any potential natural gas refund accrue from the time FERC brought a case (an approach currently used in electricity markets, according to Cantwell) instead of when it actually proves it.

“It will allow FERC to act more like a cop catching a robbery in progress instead of trying to piece together what happened at a crime scene after the fact,” she said.

Yes, we are expected to nod and trust the formulation of rules regarding the operation of our vast, and enormously complex financial markets to the likes of Senator Cantwell, who is apparently rather ill-informed about ordinary policing activities, let alone about the relevance of the possibility that cops may now and again interrupt an armed robbery at the Quickie Mart (Apu! Duck!) to the determination of the efficient way to reduce the frequency of manipulation and “excess speculation” in energy markets.  

First off, the premise of Cantwell’s analogy is wildly inaccurate.  Just how often do cops intervene while felonies are in progress?  Virtually all police work is done after the crime has been committed.  Cops respond to the calls of victims, or alarm calls, and in the vast majority of cases arrive after the perpetrators have fled.  Then begins the arduous process of “trying to piece together what happened at a crime scene after the fact.”  That’s exactly what cops spend most of their time doing.  Either Senator Cantwell watches way too much TV, or not enough.

Second, even if one were to grant that cops have the authority to intervene in crimes in process, and sometimes utilize that authority, that does NOT imply that this is the best way to fight market manipulation.  The law and economics of the trade-off of prevention vs. deterrence is very well understood.  (Steve Shavell wrote a very thorough article on the subject in the JLE in the early-90s.)  Deterrence–piecing together what happened after the fact, and imposing sanctions on those found to have committed harms–works best exactly in conditions like those that characterize a market manipulation.  Specifically, a real manipulation is readily detectable after the fact.  As Judge Easterbrook has written, “an undetected manipulation is an unsuccessful manipulation.”  Moreover, manipulators are typically not judgment proof.  That is, they are typically quite wealthy, and can afford to pay fines or other punishments equal to the harm they inflict.  Those that aren’t judgment proof are the firms whose manipulations failed spectacularly, and ruined the perps financially.  From a deterrence perspective, that isn’t a big deal, because fining successful manipulators can make the payoff to manipulation negative in every state of the world (fines when your manipulation succeeds; financial ruin when it doesn’t).  These are the conditions that make deterrence preferable to prevention.

Indeed, information considerations strongly favor ex post deterrence (as I argue in my 1996 book on manipulation).  Manipulations often unfold very quickly.  Moreover, the most distinctive effects of manipulation, such as the collapse in prices that follows the end of a corner (the “burying the corpse” effect), are virtually unmistakable after the fact, but cannot be observed while the corner is in progress. As a result of this fact, and others,  regulators necessarily have far less information about whether prices are distorted while a manipulation is in process, than after the fact.  Due to this information disadvantage, both “false positives” (intervening when a manipulation is not in reality occurring) and “false negatives” (failing to intervene in a real manipulation) are more likely when one attempts to act during an alleged manipulative event, than to wait and impose damaging sanctions after the manipulation is over.  Indeed, given that a mistaken intervention in a market would be extremely disruptive, false positive interventions are very costly.  That is, mistakes are much more likely, and the costs of mistakes are higher, when regulators attempt to intervene in real time, rather than to deter manipulation through the imposition of penalties.  (Moreover, private actions by those harmed by manipulation also have a strong deterrent effect, can rely on the superior information available after the fact, and can also fill the deterrence gap when regulators fail to act even after the end of a manipulation, as is too often the case.)  

Moreover, the costs of ex post deterrence only need be incurred when a manipulation has actually occurred, whereas maintaining a “police force” and surveilling every market is quite costly, and these costs must be incurred even when no manipulation is occurring.  

In other words, Cantwell is only 180 degrees off.  But it was one of her better days, I’m told.  

A couple of other entertaining thoughts.  First, the article states:

FERC would welcome this additional authority, according to one of the hearing’s witnesses, Anna Cochrane, acting director of the commission’s enforcement office. “Congressional action to give the commission cease-and-desist authority for violations of the [Federal Power Act] and [Natural Gas Act] and the ability to freeze assets of entities that violate the market manipulation rules would give the commission the same enforcement tools that both the SEC and CFTC have long possessed. In addition, authority to temporarily suspend market rules on file under the FPA when necessary to protect against potential abuse of market power could be useful,” she said in her written statement.

Imagine that.  A government agency that would “welcome . . . additional authority.”  Shocking.

Second, the article notes that CFTC and SEC have this authority.  With respect to market manipulation, it is seldom used.  

More humor:

Cantwell said the second legislation the hearing would examine would establish an office within EIA to collect and analyze information from physical and paper oil markets. This would improve EIA’s ability to predict future energy prices and help regulators police markets more effectively, she said.

In his written testimony, McCullough said no federal agency has been directed to investigate and explain last year’s extraordinary crude oil price changes despite oil’s arguably being the US economy’s most important commodity.

“The inability of the federal government to fully investigate oil price behavior in 2008 is fundamentally a data problem. Perhaps it is not a coincidence that oil is the most opaque of our nation’s energy supplies. The transparency legislation that you are discussing today is a step in the right direction because it will expand EIA’s ability to track oil inventories within the US by owner,” he said.

Sure.  EIA will be just dandy at forecasting energy prices.  And how is EIA, which has no enforcement authority, supposed to coordinate with CFTC and FERC (and perhaps soon, the FTC, when it puts its oil manipulation rule into effect), which do?  

“McCullough,” by the way, is Robert McCullough, Jr.  He is one of several people, e.g., Michael Masters, who routinely testifies before various House and Senate committees on energy market speculation and manipulation issues, and just as routinely parrots exactly what Cantwell, et al, want to hear.  The regular presence of this tiresome cast of courtiers, who IMO have little if any demonstrated expertise, and who routinely make idiotic arguments unsupported by logic or evidence, make the hearing process look like Kabuki theater, or a show trial.  It’s not intended to raise issues, find facts, sift evidence, or air serious disagreements.  Instead, it’s purely a theatrical production, with a pre-scripted outcome, intended to convey the impression of investigation, inquiry, and debate.

In the scheme of things, manipulation should be one of the easier things to regulate and deter in financial markets.  Nonetheless, Congress and various alphabet soup regulatory agencies (GFA, CEA, SEC, FERC, and probably soon, FTC) have made a complete botch of it for going on 87 years now.  (Yeah, I know.  But I’m feeling generous today.)  Yet we’re supposed to have confidence that that same Congress and same array of regulators (plus some more) have the knowledge, competence, and incentives to legislate and regulate much more complex and arcane aspects of the operation of the financial markets (e.g., clearing, “excess” speculation, product design).

Just remember the three big lies.  The check is in the mail.  I’ll respect you in the morning.  And the biggie: I’m from the government, and here to help you.

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OK, that’s hyperbole.   But my work in the case in Josef A. Kohen, Breakwater Trading LLC and Richard Hershey v. Pacific Investment Management Co. (“PIMCO”) was the focus of some attention in the argument heard before a 7th Circuit panel headed by the formidable Judge Richard Posner.   Here’s an MP3 of the hearing. Defendant PIMCO had appealed class certification in the case, and the hearing related to the question of whether Judge Guzman’s (the trial judge) decision to certify should stand.

Listening brought back memories of my grad school days, specifically the Economics of Legal Organization Workshop at Chicago.   Posner, Stigler, Becker, Telser, Peltzman and other heavyweights would sit in the first row.   Usually the speaker would utter perhaps two sentences, and then one of the front row crowd, and often Posner in particular, would jump in with a question expressing extreme skepticism, criticism, or incredulity.   That’s what happened to PIMCO’s lawyer.   Two sentences, and up pipes Judge Posner with a very, pointed, shall we say, question.

I’m biased, and an amateur observer of these sorts of things, but overall I think it went pretty well for the good guys.

The WSJ has a long article based on an exclusive interview with your fave and mine, Igor Sechin.  It is full of the usual his-lips-are-moving whoppers, but this one stunned even me, even as predisposed as I am to snort at pretty much anything old Eyegore has to say:

And he was quick to point out that Russia became a major oil exporter in the 1970s in response to demand in the West amid the Arab oil embargo. “Now they tell us, ‘You have Dutch disease, you’re a resource economy.’ But you yourselves asked us to be that way,” he said.

Sorry, but WTF is he talking about?  Yeah, the USSR was just eager to please the US and the West in the early-to-mid 1970s.  We said “jump”, and Brezhnev said “how high, boss?”  

Please.  The Soviets exported oil because (a) there was money in it, (b) they needed a lot of money, given that the rest of the economy was going to hell (especially the agricultural sector, which couldn’t feed the country), and (c) they had absolutely nothing else to sell that anybody wanted.  

What is it about Russians that they are responsible for absolutely nothing?  It’s always “The Devil (i.e., America) made me do it!”  They are wanna be Masters of the Universe, but everything is out of their control.  Sheesh.

Here’s another one from Putin’s Pinnochio:

Mr. Sechin is Moscow’s point man for warming relations with the Organization of Petroleum Exporting Countries. But he said Russia, the largest oil producer outside the cartel, isn’t ready to accept membership in the group, despite its pleas.

“It would be irresponsible for Russia to join OPEC because we can’t directly regulate the activity of our companies,” he said, as nearly all are privately owned.  (Emphasis added.)

Spare me.  

First, Russia taxes oil exports.  It is perfectly feasible for Russia to regulate the activities of its companies indirectly through the oil export duty mechanism.  Russia can achieve any level of exports it wants by adjusting the duty.  And it has been adjusting it–downwards, thereby encouraging oil exports.  (Maybe Sechin was quite deliberate in including the word “directly” in his answer, knowing quite well that this is an irrelevance, given the ability of the government to control exports via the tax mechanism, without directing companies to do anything.)  

Second, “nearly all are privately owned”–except the one that is by far the biggest, Sechin’s own Rosneft.  And, does he really expect us to believe, with Khodorkovsky in the dock, Mechel’s CEO Igor Zyuzin contemplating what Putin meant about “sending a doctor” (and given Russian healthcare, that is a frightening prospect), BP-TNK’s Dudley fleeing the country, etc., that if Putin or Medvedev told the owners/managers of these “privately owned” companies to cut exports, that they wouldn’t salute and ask “how much?”  

Sechin repeated his call to segment and “gasify” the oil market:

Mr. Sechin called for a gradual but major overhaul of the international oil trade, adding tight regulation and longer-term supply contracts, eliminating “economically unjustified intermediaries” and reducing speculation. Russia is the world’s No. 2 crude exporter.

Russia doesn’t like open markets and price discovery.  It likes market segmentation and backroom deals.  

In the add insult to injury category, Sechin uttered these Orwellianisms:

Mr. Sechin hailed  BP  PLC’s TNK-BP Ltd. joint venture in Russia as a sign of Russia’s openness to foreign investment in the sector. But he singled out secretive Siberian giant OAO Surgutneftegaz as “Russia’s best private oil company.”

Investors have criticized Surgut for refusing to release international-standard financial accounts or details of its ownership structure.

Surely, from Sechin’s perspective, black hole Surgutneftegaz is indeed the ideal energy company.  And yes, the whole BP-TNK fiasco is just a shining illustration of how an Investor’s Paradise has risen from the ashes of the former Worker’s Paradise.  Orwellian, like I say.

I actually appreciate the fact that Sechin has become much more open.  By speaking publicly, he reveals his utter mendacity, and in so doing, provides a revealing glimpse at the equally mendacious regime in which he serves.

News reports state that Geithner supports mandatory central clearing of OTC derivatives transactions.   His testimony is not quite so blunt, but could be interpreted that way:

Fourth, we should establish a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market, moving the standardized parts of those markets to central clearinghouse, and encouraging further use of exchange-traded instruments.

I have argued against such a mandate here (“skinny” version), and here (“supersized” version).   Geithner is not specific about the organization of a clearinghouse, and in particular about the scope of products each would clear, but Darrell Duffie has argued that a specialized CDS clearinghouse would increase risk.   I’ve also laid out many of my arguments (that eventually showed up in the papers linked above) here on SWP–just type in “clearing” on the search bar if you’d like to find them.

Given the barrage of words I’ve already hurled at the subject, I’ll limit myself here to a bullet point list of the problematic issues:

• Risk pricing.   Dealers are likely to have better information about counterparty risks arising from the nature of the specific instruments, and especially from the balance sheet risks of counterparties.
• Netting is not necessarily a social benefit.   It redistributes wealth (in the event of a default) to clearinghouse members and from the other creditors of a defaulter, e.g., buyers of the defaulter’s commercial paper, its securities lending counterparties.   It is not immediately obvious that this allocation of counterparty risk is welfare improving.
• Clearing concentrates counterparty risk and redistributes it among the members.
• This concentration is especially problematic since derivatives counterparties have recourse to a dealer’s entire balance sheet in the event of a default.   In a CCP, recourse is limited to the capital of the CCP, plus any additional “good to the last drop” obligations of members to contribute additional capital in the event that the CCP funds are exhausted.   These funds appear small to the potential loss in the event of a major default.   As an example, CME clearinghouse can tap into $6 billion of capital if margins don’t cover a default loss.   (This includes CME stock deposited by clearinghouse members, valued at its current price too, which would likely fall in the event of a major default.)   The size of ICE Trust’s Guaranty Fund (the backstop monies that would be available in the event that margins don’t cover a defaulter’s obligations) is not publicly known (at least I have not been able to track down that number).   ICE has committed $10 million, with a commitment to raise it to $100 million.   I think members are obligated to kick in $20 million to the fund, but that could be scaled as position sizes increase.   I have not seen any indication that there will be “Maxwell House” (H/T Lucio) features in ICE Trust.   Anyways, we’re talking less than $1 billion here.
• CCPs have a more rigid, mechanical collateralization mechanism.   This could be a feature, but it could also be a major bug in times of systemic stress.   CCPs require posting of collateral in cash or close substitutes, sometimes intraday, and no later that the opening of business of the next day.   Dealers can be more flexible with collateralization, extending credit, or accepting a wider range of collateral.   Large market moves create large demands for cash in a CCP structure.   This can contribute to a liquidity crisis.   Note in October, 1987, many banks were unwilling to extend credit to fund margin calls.   Fed action alleviated a collapse of CME and CBT clearinghouses, but the margin induced demand for liquidity nearly led to a systemic collapse.   (Bernanke actually wrote a paper on this in the 1991 RFS).

I have seen no evidence that any of these points have been given serious vetting by the powers that be.

In Britain, a Bill of Attainder was a private bill in Parliament which imposed a punishment on a specific person, or group of people, without any trial.  Their abuse was so notorious, that they were specifically proscribed in the US Constitution.

Perhaps there are legal nuances that distinguish the many of the legislative and administrative proposals being bandied about to strip AIG employees of bonuses (some already paid) from Bills of Attainder, but there is plenty of family resemblance.

I say again.  There are legal provisions under which contracts can be modified (e.g., bankruptcy). If they apply here, then by all means proceed.  Unlike the attainder-like proposals ricocheting around Capitol Hill, these mechanisms embed various procedural protections, require rigorous fact-finding, and can draw upon a variety of precedents.  All of these reduce the likelihood of legal error.  If these do not apply, then let’s speak no more about it.

And by all means, every one of the Capitol Hillbillies that has been running his or her mouth on the subject should STFU.  As should pretty much everybody in the administration.  The grandstands are closed.

One sentiment (I won’t dignify it with the words “thought” or “idea”) that I’ve heard is that since the government now owns AIG, it can do whatever the hell it wants.  Uhm, no.  A firm is a nexus of contracts, and if you acquire it, you acquire the entire bundle.  Not just the contracts you feel like living up to.

But the ownership issue does raise a set of questions relating to the bailout, and the “logic” behind it.

The story of the bailout in a nutshell goes: AIG did massive trades without having to post any collateral, due to its sterling credit rating.  (Given the UK’s current condition, that phrase may be obsolete.)  However, the mark-to-market losses on its derivatives and securities lending business became so large that the company’s credit rating was cut to below investment grade, triggering huge collateral calls.  The mark-to-market hole was so deep firm couldn’t make these calls, and fearing a meltdown, the Treasury stepped in.  The bulk of the cash it supplied the firm went to meet collateral calls to various counterparties.

Now, if these counterparties viewed the government-owned AIG as being backed by the full faith and credit of the US government, there would be no need to post collateral.  The fact that government cash went out the door to meet AIG’s collateral requirements means either (a) counterparties don’t view AIG’s credit as good as the Federal government’s, or (b) the AIG bailout is really a disguised lending program for the counterparties, or (c) the government is clueless.

Now, insofar as (a) is concerned, there is good reason to believe that even in government hands that AIG’s credit is bad, and it poses a substantial risk of default.  After all, the government has a limited liability equity stake.  It can still walk away.  Given that fact, perhaps the counterparties are operating under the motto “In God We Trust.  All Others (including Uncle Sam) must pay cash.”  Presumably, the howling over the bonuses only encourages those now holding AIG collateral to think that keeping their hands on that cash is a far better alternative than to rely on the hope that the government will come through when the contracts at issue actually must payoff.  (Whether it should is another issue.)

This illustrates one of the absurdities in keeping AIG in its current Living Dead state.  If the government really intends to guarantee that AIG’s obligations will be paid off (in order to avoid a systemic crisis) then it can do so without having any cash go out the door as collateral to ease the fears of jittery counterparties.  The government could provide an explicit guarantee of the contracts in question.  It could novate the trades, and substitute itself for AIG as the counterparty.  (Or perhaps the Fed could do this.)

Now, from a mark-to-market perspective, either would be a wash.  The liability is worth what it is worth.  But they would not require the government to pony up tens of billions in cash to provide to counterparties.  Just like AIG’s counterparties effectively extended credit to the firm by allowing it to hold underwater positions without collateral, the government should be able to do the same thing.

Indeed, if Treasury and the Fed really believe what they’ve been saying since the crisis broke in the late summer, the mark-to-market loss on the position is far greater than the present value of the loss that the AIG portfolio is expected to suffer.  After all, Bernanke and others have argued that the market prices of these positions are artificially depressed as a result of the lack of liquidity, and the potential for fire sale liquidations of troubled assets.  So, according to this logic, if Treasury (or the Fed) took these positions onto its books, the eventual cost to the taxpayers would be expected to be smaller than the current mark-to-market loss–and hence smaller than the amount of government cash paid to counterparties as collateral.  (Of course, if this is right, then eventually some of that collateral will be paid back as liquidity improves and market prices rebound as a result.  But, since the government doesn’t own 100 percent of AIG, it will only capture a fraction–80 percent, if memory serves–of that rebound.   But note that this means that the government could potentially face the risk that the counterparties would not pay back the collateral.   Which raises another question: is this truly collateral, held in a particular account, not commingled with the counterparty’s funds?)

This all raises questions in my mind as to why the government is persisting with this indirect way of absorbing the risk on the AIG positions.  If the powers that be consider it essential that the government absorb this risk because (a) AIG cannot, and (b) doing so is necessary to maintain the stability of the financial system, then why do it in a way that (c) requires a lot of cash, and (d) incurs the agency costs and other frictions that arise when working through a firm with incentives that are not necessarily well-aligned with those of the taxpayers.

Thus, I hold open the possibility that there is an ulterior motive for the convoluted structure of this intervention.  The difference between the intervention as it is, and the alternatives I’ve sketched above, is that the existing structure puts a lot of cash in the hands of large financial institutions, whereas the alternatives would not.  It effectively monetizes the mark-to-market values of the positions these institutions had with AIG.  This suggests that the reason for doing it this way is that it effectively extends credit to these institutions.

But, this just kicks the can down the road.  If these institutions need injections of government credit, why not do it in a more straightforward, transparent manner?  Or is this indirection part of the plan, an effort to conceal the liquidity needs of these institutions?

I dunno for sure.  What I am pretty sure of is that the “collateral” narrative does not make a lot of sense.

Oliver Williamson, the premier transactions cost economist, coined many neologisms and succinct phrases.  One of them is “selective intervention.”  This concept means that managers cannot credibly commit to utilize discretion to intervene only when this is economically efficient.  The inability to commit to use discretion efficiently is, in Williamson’s view, one of the factors that limits the size of firms.  It is also why imposing ex ante constraints on decision makers can enhance efficiency even though these constraints are costly ex post.  It is, in brief, why rules are frequently superior to discretion.  

The outrage over the AIG bonuses provides a particularly acute illustration of the dilemmas that arise with selective intervention.  (The UK has screened a similar soap opera in recent weeks, involving the pension of RBS’s Sir Fred Goodwin.)  Assume arguendo (a common Williamsonian trope) that revoking the AIG bonuses is an efficient use of government discretion.  Can any financial institution, or any business for that matter, be assured that if it accepts government assistance, that the government will use its discretion to intervene to change contracts or alter management decisions only when efficient?  Or, would it be more reasonable for said institution or said business to conclude that policymakers acting according to political, rather than economic, calculus, will frequently abuse their discretion, and implement politically popular but inefficient decisions?  

Given the sums at stake in the ongoing financial crisis, the selective abrogation of contracts, no matter how outrageous they appear ex post, is likely to result in costs that dwarf the hundreds of millions in bonuses due to the employees of AIG Financial Group.  In particular, it would likely lead to a dramatic increase in the difficulty of negotiating workouts or recapitalization or restructuring of other troubled financial institutions.  Delays in such measures could have immense real costs.  Costs, by the way, that would fall on everyone, as taxpayers but also just as economic agents (due to the adverse effects on the overall economy).  Moreover, the uncertainty associated with the use of discretion can impair private decision making and investment.  (Why make an irreversible investment when a subsequent exercise of government discretion could lead to its effective expropriation?)  This again imposes substantial costs across the entire economy.  

Under these circumstances, there is a strong case to be made for relying on rule-based, rather than discretionary, responses to the distress of large financial institutions.  If the government, as the residual claimaint of AIG, has a legitimate legal justification for eliminating or reducing the AIG bonus payouts, there are established legal rules and procedures for achieving that outcome.  And no, this doesn’t mean Spitzer-like granstanding and armtwisting by Andy Cuomo.  It means a methodical pursuit of redress through real courts, not through the court of public opinion.  

It also means that there should be a strong preference for existing, rule-based mechanisms, such as FDIC receivership and bankruptcy procedures.  

This episode provides a very illuminating illustration of the costs associated with the ad hoc (read, discretionary)  way in which the government has addressed the financial crisis.  At its very outset, there was some justification for this, as there was room for serious doubt that existing rule-based institutions were capable of dealing with unprecedented crises in real time.  But 6 months have passed since Lehman and AIG, 9 or so since Fannie and Freddie, 12 since Bear.  The new administration has been in place for 3, and its senior financial policy team since the election.  Given these experiences, and the time that has lapsed, we should be far further along in creating a legal and regulatory structure for addressing large, troubled financial institutions.  Instead, we seem to be pretty much where we were a year ago.  

To the extent possible, this should cleave to existing precedents in bankruptcy law, and in FDIC procedures and regulations.  These things are messy, no doubt.  (Having been involved in several bankruptcy cases as an expert, I have first hand experience with this.)  But they are messy in a somewhat predictable way, and in a way that limits the potential for abuse of discretion.

At cynical moments (and I have many, if you haven’t noticed;-) I wonder if this is a feature, not a bug, at least from the perspective of those in government.  To them, discretion is a good, not a bad.   Sovereigns always bridle at the restrictions of law, precedent, and procedure, even though these often lead to substantial increases in wealth and efficiency.    

The bonus fiasco also shows the problematic rationale for the entire AIG bailout.  It is clear that the Treasury and Fed felt compelled to support AIG, rather than let it implode, in order to protect its counterparties, who happened to be large, systemically important financial institutions (e.g., Goldman).  But supporting these institutions indirectly, by funneling money through AIG, rather than in a more direct way, has created a huge agency problem.  AIG has become, in effect, the government’s agent in maintaining the solvency of other large financial institutions.  But AIG and its managers have their own agendas, and their interests and incentives are not well aligned with those of the other large financial institutions, or with the taxpayers who are ultimately on the hook in this arrangement.  Using AIG as a conduit for taxpayer financial support to other institutions has added substantial friction to the process.

It would be far more efficient to take AIG out of the middle of this process of channeling billions from taxpayers to financial institutions.  This would require novating AIG’s trades.  Maybe the government should become the counterparty.  Or, it could novate the deals to other institutions and provide credit support.  Or it could negotiate closeouts, perhaps requiring the in-the-money counterparties to take a haircut.  All of these alternatives pose challenges, but it is almost certain that these challenges entail lower costs than the agency costs incurred using AIG as a conduit to keep its counteparties whole.  In other words, cut out the middleman.

A constant theme of my Russian commentary is that the absence of a rule of law; the insecurity of contractual and property rights; and the abuse of discretion by a state only weakly bound by procedural checks and balances; have all contributed to that nation’s economic dysfunction.  No doubt one can make an argument that this or that Russian state intervention was efficient, but there is no doubt that the vast scope of state discretion has been detrimental to Russian economic development.  Similarly, a strong argument can be made that the AIG bonuses are unconscionable, and inefficient in light of current information.  But as in Russia, the cost of weakening the rule of law in general, and contract rights in particular, will far exceed the benefits of a legally dubious discretionary intervention.  

As in many situations, we face a choice of evils.  Given the essential role of the rule of law in binding Leviathan, in my mind the far greater evil is an erosion of the security of property and contract rights.  We don’t want a nation where government officials can threaten to send corporate executive to the doctor for having the temerity to do something that offends the Sovereign.  Several hundred million dollars is a lot of money.  But it pales in comparison to the amount that would be lost by undermining contracts and the rule of law.

The passage of a couple days since Treasury Secretary Timothy “Eraserhead” Geithner’s speech on the planless plan to heal the banking system has led me to the conviction that it was not just stupid and damaging (to Geithner, the administration, but most importantly the country), but it was just plain strange.  Passing strange.  Certainly Geithner and Obama, who didn’t want to “steal [Geithner’s] thunder” (no need to worry about that!), should have known that the release of the Treasury Term Paper would be an economic and political disaster given  the buildup for the speech, and the market’s near frantic desire for some indication that some resolution was in sight.  So why did it happen?

The speech was delayed one day as it was.  But the anticipation was so great that Geithner could not wait any longer.  So, even though he had nothing concrete to deliver, he was compelled to say something.  

Which raises the question: Why didn’t he have anything after Treasury had been working on things for months, and presumably the transition team had made the banking situation a priority?  (Remember Obama announced Geithner’s nomination days after the election.)  They had to have something much more detailed than what Geithner presented.  

This all leads me to believe that there is a vicious political battle over the banking plan going on at the very highest levels of the administration.  Note there were myriad leaks in the days running up to Geithner’s speech (most likely emanating from Geithner or his minions) to the effect that the Treasury Secretary had beaten back attempts by White House political types (Axlerod was named specifically) to impose much more draconian restrictions on the banking system.  But the fact that Geithner did not announce a credible, detailed plan means that even if Axlerod and his allies did not prevail, neither did Geithner.  In other words, there is a stalemate.  I don’t see any other way to explain why Geithner would essentially appear naked before a watching world.  

One of the President’s jobs is to break stalemates between his subordinates.  It is clear that Obama has not done so in this instance.  Given the gravity of the situation, that is a serious failure.  

And here is my most troubling concern.  Banking has long been considered one of the “commanding heights” of the economy.  (That’s Lenin’s term, which he used when defending a retreat from hardline Bolshevism in the New Economic Policy; he rationalized the tactical withdrawal by saying that the party still controlled the commanding heights, including the banks.)  Government power over the banking system gives it incredible power over the broader economy.  Hardcore political types (e.g., Axelrod, many people in Congress) no doubt understand the tremendous political and economic advantages to be gained by retaining pervasive government control over the banks.  (To paraphrase Rahm Emanuel, a banking crisis is a terrible thing to waste.) Just think how popular Fannie and Freddie were in Congress.  They were beholden to Congress and did its bidding accordingly.  Think of a quasi-nationalized banking system as Fannie and Freddie on ‘roids.  That would be a leftist/statist politician’s dream.  

So, one explanation of what is going on is that elements in the White House and the Congress want to exploit the crisis to strengthen their control over the banking system.  Treasury and the banks themselves are pushing back.  There is now a stalemate, and Obama has not intervened to break it.  This is very dangerous.

It is a matter of particular concern that politicization of the banking system and the capital markets is self-reinforcing.  Politicization can occur because the dire straits in which the banking system finds itself make it dependent on government support.  But this government support comes at a price, in terms of investment and lending decisions driven by political considerations, rather than economic ones.  Such decisions do further damage to the financial condition of the banks, perpetuating their dependence on the government.  

Maybe this is unduly alarmist, but I find it hard to explain otherwise why the administration was unable to unveil a more complete and credible response to the banking crisis.  It also comports with the leaks about the behind-the-scenes struggles between the more Bolshi elements of the administration and the finance/technocrat types.  

Whatever the cause, this limbo is unacceptable.  And if we are in limbo because of an internecine struggle, it is incumbent on Obama to intervene forcefully to put and end to it, and decide.  

He won, after all.  He told us so.  Well, with winning goes the duty to make the hard choices and live with the consequences.

There’s an old joke that the Founding Fathers should have ended the Bill of Rights after the first five words of the First Amendment.   The lunacy surrounding derivatives regulation suggests that there is more than a little wisdom in that witticism.  

The House Ag Committee first mooted a proposal that would have limited the trading of credit default swaps to hedgers (only those long bonds could buy protection; only those short bonds could sell it).  That proposal met with snorts of derision and bellows of outrage from many quarters (including hereabouts, where I voiced both), so committee chair Peterson soon backtracked on that.  Then it was reported that the bill would permit the CFTC to summarily stop trading in CDS products.  As I was quoted in Bloomberg, that was an improvement, but it was still horrible.  So, channeling Maxwell Smart, Rep. Peterson said “Check that.  Would you believe that what I really meant was that CFTC could stop trading in CDS by those without positions in the underlying security only on companies that were subject to an SEC short sale ban.”  

Given that the SEC short sale ban was arguably one of the most idiotic public policy moves of recent memory (and the competition is very stiff in that category, sports fans), House Ag’s new position appears to be that the CFTC has the authority to imitate the moronic moves of a thoroughly discredited agency.  Great.

The bill’s future is extremely uncertain.  You might think that’s good news, but the reason for its tenuousness just gives rise to other concerns.  Barney Frank is moving to get control of the bill shifted to his committee.  Yes, the Barney Frank who should not be allowed within several galaxies of any responsibility for regulation of anything related to the financial system.  The Barney Frank who, if he had a scintilla of shame (I know, I know), would have retired to a hermitage in the aftermath of Freddie and Fannie.  One can only imagine the mischief and mayhem he can create given control over derivatives market regulation.

Congress shall pass no law.  Sounds good to me.  But it will.  And, as the old saying goes, no man’s life, liberty, or property are safe while the Legislature is in session.  That mordant remark was never truer than today.

“Stimulus” package or no, the economy will not resuscitate until the financial markets, and especially the banking system, are stabilized and recapitalized.  Several alternative approaches are on the table.  In this post, I’ll give my appraisal of each.  Sad to say, the leading candidates are the least attractive, in my view, and the most appealing ones have received little traction.  

The four alternatives are (in order from most awful to least bad):

• Nationalization
• Government guarantees
• Bad bank (with a SWP twist–call it “Humpty Dumpty Light”)
• Bad bank on steroids (“Full Monty Humpty Dumpty”)

Nationalization would involve a government takeover, for some indefinite period, of banks.  Equity holders and bondholders would be zeroed out.  When this option is proposed, it is often said, in a soothing fashion, that the seized institutions will eventually be privatized.

The government (in the US) already has a regime for nationalization: the FDIC can seize banks under certain conditions.  The nationalization proposals being mooted would go beyond this.

Nationalization has one advantage–no bailout of shareholders of the seized institutions (and the bondholders as well).  But it has two major disadvantages, namely: the likely politicization of resource allocation decisions, and soft budget constraints.  Together, this combination is quite dangerous.

Nationalized banks would certainly be under pressure to make lending decisions based on political criteria.  Like FNMA and FHLMC?  Like the CRA?  You’ll love nationalized banks!  Want Barney Frank and Chris Dodd exerted disproportionate influence over how capital is allocated in the US?  Nationalization is for you!

I don’t believe that Fannie and Freddie and the Community Reinvestment Act were the sole, or even the primary causes of the financial crisis.  But they were definitely major contributory factors.  Pressures on financial institutions to achieve political objectives, primarily in housing, contributed to the perverse lending practices that culminated in the subprime meltdown.  

With nationalized banks, these pressures would be felt in all aspects of lending, not just housing.  The banks would become levers that politicians pull to favor influential constituents, and to engage in industrial policy.  

The resulting loans would, almost certainly, be far likelier to default than loans issued based on economic criteria by profit maximizing banks.  That’s where the “soft budget constraint” comes in.  Nationalized banks in financial difficulty would almost certainly receive government financial support, further eroding market discipline and enabling continued extension of credit to bad, but politically favored, risks.

And here’s where soothing promises that nationalized banks will be privatized “as soon as possible” become meaningless.  It may never be possible, as bad loans multiply on nationalized banks’ balance sheets.  Nationalized banks will become the financial equivalent of roach motels–we can get in, but we can’t get out.  

My verdict: nationalizing is Really REALLY Bad.  

As to guarantees: an improvement, but not much of one.  Government guarantees on (some) of the assets on bank balance sheets is equivalent to the Feds writing a massive put.  There are many details to be worked out: What is the maturity of the put?  Who has the right to “put” the assets to the guarantor, and under what conditions?  Is the put on the entire portfolio, or are there multiple puts on multiple portions of each bank’s portfolio?

I’ll put those non-trivial, but secondary, issues aside to focus on other more problematic ones.  Most notably, what is (are) the “strike price” of the put(s)?, and what consideration will the guarantor (the government) receive in return?  

If the guarantee on is something approaching the par (or even book) value of toxic assets on bank balance sheets, the “put” is deep in the money.  That is, it is likely that the market value of the assets is far below the guaranteed level, and therefore it is almost inevitable at some point the bad assets will be “put” to the government, in exchange for the government writing a check for an amount far exceeding the value of the assets.  

If the guarantee is set at a level approximating the current market value of the assets, however imprecisely determined, the option will be at-the-money.  Short options create a short volatility exposure to the option writer, and this exposure is greatest when the option is approximately at the money.  Therefore, making the guarantee approximately at-the-money creates a substantial volatility exposure to taxpayers.  If volatility goes up, the value of the guarantee goes up as well–costing taxpayers money.

If the government receives no consideration for the guarantee, it is a huge subsidy to the financial institution receiving it.  Puts are valuable.  A government guarantee extended gratis to the financial institution is therefore a subsidy to the bank’s shareholders and bondholders.  This value can come from the “moneyness” of the option or the “time value.”  If the guarantee is deep in the money (i.e., the guarantee is at a level far above the market value of the assets), the intrinsic value of the option is large; this intrinsic value will flow to the bank’s current shareholders and creditors.  Even if the strike price of the option the government provides is approximately equal to the market value of the guaranteed assets, the time value is large.  With an at the money option, the guaranteed bank has a “heads I win, tails I don’t lose” position.  If the assets tank further, the government bears the cost as guarantor; if the assets rise in value, the bank can pocket the gain.  This one sided exposure is also valuable, and this value flows to the bank’s current shareholders and lenders.  This value is highly sensitive, moreover, to the volatility of the underlying assets.  

Recognizing this, in recent interventions the government has received consideration in exchange for the guarantee.  For instance, it has received stock.

Receiving the upside on the guaranteed assets is equivalent to buying them outright.  Receiving the upside is equivalent to having a call on these assets.  Writing a put and buying a call is equivalent to a forward contract–a commitment–to buy the assets at the guaranteed value.

Receiving stock gives the government an upside not just on the covered assets, but on the bank’s other assets as well.  But it also gives the government–that is, the taxpayers–an exposure to the downside on the non-guaranteed assets.  

The idea behind the guarantee, presumably, is to shift the uncertainty about the value of toxic assets to the government.  This, in theory, should make it easier for banks to recapitalize; if the government bears the losses on the toxic assets, private investors in the banks need not fear nasty surprises if the value of these assets turns out to be lower than anticipated.  

I don’t like the guarantee approach for a variety of reasons.  

First, there is a high likelihood that it will serve as a stealth bailout of the existing stock and bondholders of the troubled banks.  That is, the value of the put will far exceed the value of the consideration received.  This will represent a transfer from the taxpayers, to the current shareholders and bondholders.  It may facilitate the attraction of new private capital, but there are ways to do this without bailing out the incumbent suppliers of capital.  

The fact that this approach can facilitate a “stealthy” bailout probably explains its political attractiveness. When announcing the guarantee, politicians can say “we didn’t bail out the banks and their shareholders because we didn’t write a check.”  The honest statement would be “we didn’t write a check today, but we promise to write one sometime in the future.”  If the value of the put is greater than the value of the consideration, shareholders and bondholders are happy, because they receive a windfall.  Put differently, the more popular a guarantee is, the more skeptical I become.  It will be most popular when it (a) provides a large stealth subsidy, and (b) allows politicians to escape accountability for the subsidy.   So, if politicians and bankers unite in enthusiasm for guarantees, be afraid.  Be very afraid.  

A second problem with the guarantee is that I am skeptical that it will markedly improve the ability of banks to recapitalize.   Potential investors will reasonably fear that any commitments that the government makes today are not credible.  As guarantor, and as part owner, the government will potentially find it very tempting to expropriate new investors sometime in the future, perhaps by reneging on the guarantee in whole or in part, or imposing additional conditions or restrictions, or by using the threat of such actions to force the banks to engage in politicized (but uneconomic) loans.  Just as a guarantee can be a stealth bailout, it can be a stealth quasi-nationalization.  The government as guarantor and owner will have a major influence on a bank’s operations going forward, and can use that to harm the interests of new investors.  This means that although the guarantee may reduce one kind of risk–the risk of fluctuations in the value of toxic assets–it adds another–political/expropriation risk.  

For instance, let’s say that performing on the guarantee turns out to be very expensive, because the strike price on the assets is far above their eventual value (either because that value is over-estimated today, or because their value falls further.)  The political pressure to scale back on the guarantee, or change its terms, will be immense.  You can just envision the political posturing.   New investors in banks would lose if this were to happen.  Foreseeing this possibility, they may be very reluctant to invest today.

A potential investor in an institution guaranteed and partially owned by the government would not be likely to take the promise that “we’re from the government and we’re here to help you” to the bank, as it were, and invest in it.  

Given all this, in my view the guarantee approach could both subsidize existing shareholders and scare off new shareholders.  As a result, it is highly likely to be just an extremely expensive waystation on the road to nationalization.

So, color that one really bad.

Another proposal on offer is the bad bank.  Strip out the bad assets, and put them in a separate institution.  Again, many devilish details.  

Most bad bank proposals envision that the government would pay for the bad assets.  This raises all of the difficulties associated with determining the price.  Too high prices, and there is a transfer of wealth from taxpayers to existing shareholders and bondholders.  Too low prices, and the reverse occurs, and the already weak capital position of the banks is eroded further.

My twist on this is to adapt something from my Humpty-Dumpty proposals.  Put all the bad assets in a separate corporation, and rather than giving the contributing banks cash, give them stock in the new company.

The valuation issue still exists–since the assets are heterogeneous and hard to value, it will be impossible to make sure that every bank receives stock in the new company that is worth exactly the same amount as the assets it gives it.  Here, however, the valuation errors are shared in the banking system.  Some banks win, some banks lose, but there is no possibility of systematic transfers (one way or another) between taxpayers and the banks’ owners and lenders.  

Moreover, as I argued in my Humpty Dumpty proposal, the equity in the new company would be marketable, and almost certainly more valuable than the sum of the current values of the individual assets.  This is true partially because some of the toxic assets would be various CDOs and other claims with various offsetting optionalities that make them very hard to value.  These offsetting options positions would be eliminated, leaving the simpler, easier to value (not easy–easier) assets underlying the CDOs.  The equity would be more liquid than the underlying assets, and liquidity can enhance value.  Thus, it is highly likely that this mechanism alone will mitigate the capital problems that banks face because the equity that they receive will typically be higher than the value of the assets that they give up.  

Perhaps most importantly, the equity in the bad asset repository could trade in the market and produce a transparent, relatively informative price.  Exchanging a dog’s breakfast of assets that cannot be valued for a homogeneous claim (equity in the bad asset repository) with a transparent price makes it much easier to value the banks, and to determine which are insolvent and which are not.  This will facilitate the resolution of the problems in the banking industry by the FDIC, for instance.  It will also make it easier for potential new investors to appraise their value, and thus they will be more willing to invest, and to pay more, for new equity stakes in the banks.  

So, my verdict is: Bad bank without the issuance of publicly tradeable equity in the firm holding the bad assets–not a good idea because of the daunting valuation issues.  Bad bank with issuance of such equity–a definite improvement over either nationalization or a guarantee.  

But, it is possible to go further, and do the full Humpty Dumpty.  The proposal I’ve just sketched out gets the bad assets off US bank balance sheets, but the bad assets are also held by hedge funds, foreign banks, and others.  If the bad bank option is limited to US banks, the ability to undo complex structures such as CDOs, CDOs squared, etc., will be incomplete.  Since a major benefit of hiving off the bad assets is the ability to compress hard to value derivatives with complex embedded optionality back into less complex, more easily valued underlying securities, this limitation to US banks will also limit the scope of these compression benefits.  

As I argued in the original Humpty Dumpty posts, obtaining the maximum benefit would require putting all of the toxic assets, including all of the outstanding CDOs, etc., in the single bad bank.  This would require participation by hedge funds, foreign banks, and other investors.  

You might think that it would also be legally impossible–how can you make a foreign bank exchange its holdings of CDOs on US subprime mortgages for equity in the bad bank?  I think that there’s a (draconian) legal way around this.  To the extent that the cash flows on the bad assets originate in this country, the US could require that the cash flows from all of the assets underlying the toxic assets that would go into the bad bank be directed to that bank, and that the bad bank would retain all such cash flows, but would also exchange equity to those presenting bona fide claims on those cash flows.  In essence, by holding the cash flows hostage, the government/bad bank would provide a very strong incentive for anyone, hedge fund, foreign bank, whoever, to exchange their claims on these cash flows for equity in the bad bank.  Any valuation errors in determining how many shares would be received for each asset would be shared within the world financial markets, would not lead to a direct transfer between financial institutions and taxpayers (in either direction), and could be structured so as not to favor one set of asset owners over another.    

Draconian, yes.  But nationalizing a set of bad assets (or the cash flows on these assets) is less draconian than nationalizing the banks in their entirety or extending guarantees.  The government would also not obtain an ownership stake in financial institutions, or such a huge financial stake that it could more extensively politicize the financial markets. Nationalization and guarantees also would not enhance price discovery and liquidity–Humpty Dumpty would.  

It’s likely that even if this approach were implemented, some banks would be found to be insolvent.  But that’s a feature, not a bug.  First, by improving the transparency of bank balance sheets through the exchange of untraded and untradeable assets for the tradeable equity in the bad bank, Humpty Dumpty would help identify which banks are insolvent, and by how much.  This will reduce the potential for type I and type II regulatory errors (failing to intervene when the bank is insolvent, intervening when it is not).  Also, if (as is almost certainly the case) the traded equity in the bad bank is worth more than the sum of the value of the assets if they remain on the bank balance sheets, on average bank capitalization will rise.

To sum up a very long post: Some variant on the bad bank is, in my view, the best way to go.  People have soured on the bad bank idea because of the belief that it requires exchanging the bad assets for cash, thereby raising difficult valuation issues that will inevitably transfer wealth between taxpayers and bank stock and bond holders.  This problem can be avoided if the bad assets are paid for with equity in the bad bank.  Valuation problems will occur, but the transfers will be contained within the group of firms contributing the bad assets.  Moreover, exchanging heterogenous, hard to value assets for a homogeneous claim on a super-portfolio of these assets will produce a variety of benefits.   This approach will be more efficacious, the more complete the participation in the program.  Achieving more complete participation will require more draconian, and hence politically difficult, measures.

Nationalization and guarantees present far more acute problems, in my view.  Both will politicize the process of capital allocation.  That will destroy value, and transfer wealth.  Guarantees can serve as subsidies.  Moreover, I doubt that any system of guarantees can be made credible against political reneging or renegotiation in the future.  In anticipation of this, private investors will be reluctant to recapitalize guaranteed banks, perceiving them to be nationalized banks in waiting.

So, create a Big Bad Bank by exchanging bad assets for its stock.  A Big Bad Private Bank.  The bigger, the better.  Clean out the Augean Stables.  Create a market for the unmarketable, and minimize the government’s role in the operation of these financial institutions and the financial markets.  The greater and more enduring the direct government involvement in this process, the worse the outcome, in terms of politicized capital allocation and massive transfers of wealth.   Once all the King’s horses and all the King’s men put Humpty Dumpty back together, they should get the hell out of the way and let him do his thing.  It ain’t perfect, but it’s a damn sight better than the other appalling alternatives on offer.