Streetwise Professor

Hate to say I told you so, but . . .

Today Treasury Secretary Henry Paulson confirmed what pretty much everybody had figured out: The Treasury will not buy troubled assets under the TARP program. TARP monies have gone primarily to buying equity stakes in banks.

Paulson said “[o]ur assessment at this time that [the purchase of troubled assets] is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other uses of TARP resources, in helping to strengthen our financial system and support lending.” In other words, don’ t hold your breath.

Back in September I expressed extreme skepticism at the theory underlying the TARP program, and questioned many of the proposed implementation schemes. I was not alone. Paulson just validated these judgments.

With TARP funds running low, Paulson is now resorting to investment banker-speak to plead for private capital infusions to complement TARP investments in banks: “We are carefully evaluating programs which would further leverage the impact of TARP investments by attracting private capital through matching investments.” “Leverage the impact.” Yuck. English, please.

This communicates an air of desperation. It’s no surprise that the market was down about 5 percent today in the aftermath of Paulson’s remarks.

This whole fiasco reveals that government recapitalization of banks is a necessary, but not a sufficient condition, to restore stability to the financial system. It is also imperative to clean up banks’ balance sheets by addressing the toxic asset problem. Laurence Kotlikoff, Perry Merhling, and Alistair Milne made a similar point on an FT blog last month but I do not believe that their plan for the government to insure the “AAA” rated CDO tranches on banks’ books goes nearly far enough. This will restore the value of some collateral, but not all of it. Moreover, it will not kickstart the price discovery and revaluation process that is necessary throughout the entire system. It also represents a substantial additional taxpayer funding commitment.

So. . . I keep coming back to Humpty Dumpty. Go ahead. Call me obsessive. I can handle it. I know it’s radical, but nothing else on offer gets to the heart of the matter. That dark heart is the complex optionality in all of the stuff churned out by Frankensteinian financial engineers. If that complexity is not undone, these assets will continue to contaminate balance sheets from sea to shining sea–and beyond.

I ran the idea by someone in a position to do something about it. I was forthright about the pitfalls of the idea–the difficulties in valuation and the extraordinary powers involved. He basically patted me on the head, and told me to go back to the ivory tower, saying that these problems made the plan a non-starter. Fair enough. I understand that response.

But that was October 18th. Four weeks have past. TARP is in a shambles. The Treasury has committed billions, and is running out of ammunition. The AIG bailout has been bailed out. The line of mendicants asking for handouts is stretching as far as the eye can see. Although certain indications from the inter-bank market suggest that the extreme panic has subsided, the renewed swoon in the stock market, led by crashing bank stocks, makes it painfully clear that the situation is still fraught with danger, and that the direct government injections of cash has not solved the crisis. Something more is needed, and soon.

Humpty has numerous virtues which, in my view, more than outweigh its defects. To repeat:

• It does not require a commitment of taxpayer funds, and does not subject the taxpayers to adverse selection.
• It will facilitate the restructuring of mortgages.
• It will improve the liquidity of troubled assets by destroying the complex optionality that saps liquidity. This will increase asset prices, and thereby increase bank capital.
• It will improve the transparency of bank balance sheets by replacing heterogeneous, impossible to value securities with a homogeneous claim that will almost certainly trade much more easily and efficiently than the existing troubled assets. This improved transparency will reduce the difficulties that private lenders and investors face in valuing banks, which will in turn reduce frictions in the inter-bank market and facilitate the re-capitalization of banks. It will also help the government identify which banks are in greatest trouble, and respond accordingly.

If Paulson wants to attract private capital to banks to complement government investments, it is imperative that potential investors know what they are investing in. This requires a quantum improvement in the accuracy of the valuations of the assets on bank balance sheets. He has just admitted that TARP as originally conceived won’t do that. Humpty has the best shot to do so. Without aggressive action to attack the troubled asset problem, Paulson’s call for additional private capital will be a pitiful plea that falls on deaf ears.

Yes, Humpty Dumpty poses serious challenges. But in my view it is, to paraphrase Churchill, the worst way to deal with troubled assets, except for all others that have been tried or proposed from time to time.

I truly admire Natasha de Teran’s reporting on derivatives markets. Her work is head and shoulders above everybody else’s. If you are interested in these markets you should read her in efinancialnews (registration required).

Yesterday Natasha gave some very nice coverage to my work on clearing. She does a very good job at condensing the avalanche of words I’ve written on the subject on SWP into a concise, accurate, and readable summary. Moreover, she adds a couple of very illuminating stories that provide excellent real world (and near real time) illustrations of some of the pitfalls I’ve been writing about.

Thanks again, N. Hopefully this will increase the visibility of some of the concerns I’ve raised as the CDS clearing express train roars down the tracks. (Matt Leising of Bloomberg tells me that there is an MOU in place to give the Federal Reserve primary regulatory authority over a CDS clearinghouse, and that President Bush will announce this at as part of a plan to be announced at a gathering of world leaders to discuss the financial crisis later in the week.) Rushing ahead without giving adequate considerations to these issues could lay the groundwork for greater problems in the future.

* Apologies to the Rocky and Bullwinkle Show. And Natasha de Teran has nothing in common with Natasha Fatale. Especially the accent;-)

Given the difficulties that some folks have had getting access to the article, here it is:

OTC clearing as a cure-all could be OTT
Natasha de Terán
10 Nov 2008

The promotion of clearing as a cure-all, tax on and apology for the over-the-counter derivatives industry is a neat one – but history demonstrates it may not act effectively as any of those things, and specialists worry it could do far worse.Regulators, when caught on the back foot, habitually rush to put out directives and convince lawmakers to rubber-stamp them at the double. Frequently such measures are ill-thought-out, delivering little more than a short-term injection of credibility and a longer-term expansion of their authority.

The participants, in this case the banks, will counter that their markets are self-correcting and that alternatives of their own devising will better assuage any regulatory concerns. Often their principal concerns are to protect their vested interests and preserve the status quo.

And when, between these poles, merchandisers – in this case the exchanges – spring up claiming to have devised tools to resolve this conundrum and boasting that their particular version is superior to those of their rivals, it is the profit motive that is generally their paramount concern.

As a result, and although all of the above groups’ claims about OTC clearing have some weight, they should be seasoned with healthy doses of scepticism. For when an experienced academic, with acknowledged expertise and no skin in the game, weighs in with serious concerns about the proposed rules, the participants’ interpretation of them and the suitability of the apparatus on offer, it is time to sit up and pay attention.

Craig Pirrong, a finance professor and director of the energy institute at the University of Houston, has spent his career studying derivatives markets, exchanges and clearing houses. Recently he has been giving a lot of thought to the issue of over-the-counter derivatives clearing – and he is far from convinced that rushing to clear OTC business is going to help anything. Worse, he worries that it could cause serious problems.

At the risk of being too simplistic, his principal concerns could be boiled down to one issue: that of information asymmetries.

First, he worries that clearing members could have better information about the price of OTC risks than a central counterparty that clears them. When the CCP’s insurance of OTC risk is underpriced, they will avail themselves of it, and when it is overpriced they will not.

This will result not only in an incomplete insurance of OTC risk, but – in the extreme – it will make the risk-sharing device altogether inefficient.

Second he worries that clearing members might have better information about the balance sheet risks of other OTC players and be able to react more quickly to any real or perceived deterioration in their balance sheet strength than CCPs.

This is because the broad spread of members’ business activity with each other should afford them greater insight into their relative balance sheet strengths than a CCP would have. Also, CCPs do not typically charge for balance sheet risks. Instead, they determine criteria for membership based on capital levels, and then set thresholds for collateral postings based on the risks of the instruments the members hold in the CCP. That means that any two given members with the same portfolio, but potentially vastly different balance sheets, will post the same amount of collateral.

On the rare occasions when CCPs do attempt to address this balance sheet issue, they cannot use the soft and hard information mix that OTC counterparts rely on. Instead they must use transparent rule-based mechanisms, typically requiring members with lower credit ratings to post more initial margin than those with higher ratings. If this crisis has shown anything, it is that those ratings are nothing better than rudimentary laggard indicators of balance sheet risks.

Given the above, it is worth considering two things: where exchanges get their information from to price risks and what a counterparty active in both cleared and uncleared OTC markets might do about the perceived deterioration of another’s balance sheet strength.

First, pricing information. Clearing houses manage price risks by looking to liquid, transparent datapoints. In futures and options markets, they can do this easily by looking to the prices on listed markets. In the case of interest rate swap risk, such as that managed by LCH.Clearnet’s SwapClear, the pricing is based on a large number of liquid, observable prices that can be derived from multiple data points.

But when CCPs start clearing OTC credit derivatives risks, they will have much more limited data: they will have to base their assumptions on a smaller number of less liquid, less transparent variables and derive their pricing from just a few sources. In stressed scenarios they might not be able to mark to market at all. Instead they will be marking to model.

Second, what might a clearing house member do in the event they suspect that the balance sheet of other OTC counterpart and clearing house members is being unduly stretched? They could cease trading with that counterpart, they could require that the counterpart post surplus collateral to cover this risk, or they might continue trading with the counterpart but require all the OTC trades be novated to the CCP.

In doing so, they would be parking the unsavoury risk at the clearing house and buying “cheap” insurance from it.

Unlikely? Consider this. In the last few days before the Lehman Brothers collapse, two different behaviours were evidenced in the cleared OTC marketplace.

In the repurchase agreement market, a large dealer refused to take Lehman’s name even though the trade was going to be novated to LCH.Clearnet’s repoclear facility. The trader’s decision was predicated on the belief that Lehman’s counterparty risk was too bad to take.

Not only did he therefore not want to carry it himself, but also he didn’t believe that he should oblige others to share it with him.

In the swap market, another dealer is meanwhile alleged to have attempted to offload to LCH.Clearnet’s Swapclear facility a legacy portfolio of interest rate swap trades that he had on with Lehman. At that time LCH.Clearnet would have been more than aware of Lehman’s risks and would have been able to make an informed decision about whether the assumption of new risks reduced or added to the sum of Lehman’s risks.

In the event, the swap issue proved immaterial since the swap portfolio was not novated to the CCP, but this second incident clearly demonstrates the difficulties that might arise from information assymetries and the potential for abuse of risk-sharing mechanisms. Worse is this: if the actions of the swap trader were known to the repo trader, the latter’s incentive to behave prudently and shun the profit motive in favour of the co-operative’s greater good would have been eliminated.

Thus it is easy to see how the use of a CCP could encourage a wholesale adoption of this worst practice kind of behaviour – taken to the extreme, why would OTC market counterparts ever need to bother who they deal with if someone else is managing it and others insuring it?

Pirrong is a great advocate of clearing and he is also a supporter of derivatives, but his concerns about mixing the two into a ready-made soup are considerable. More OTC clearing could include the potential for excessive and irresponsible risk taking, the mispricing of risk and the exploitative use of information asymmetries.

Natasha tells me that the editor did some fine surgery with a chainsaw (my characterization), lopping off the last 400 words, hence the rather abrupt ending. But you all should get the drift.

I know there are very few new things under the sun . . . but although I’ve read a great deal about clearing, I don’t think that I’ve seen anyone point this out: The main benefit commonly attributed to a central counterparty (CCP)–netting–effectively gives derivatives counterparties a priority in bankruptcy that they would not otherwise possess. As a result of the effective change in priority, the initiation of clearing transfers wealth from CCP members’ other creditors to their derivatives counterparties (who include CCP members.) That is, in dollar terms, formation of a CCP is not a positive sum game (although it can be from the perspective of the CCP members), but a zero sum game. CCP members win at the expense of the other creditors of their members.

This has important implications. Advocates of centralized clearing argue that netting reduces systemic risk by reducing the cost of replacing defaulted derivatives positions. In a bilateral market, counterparties must replace all of the defaulter’s out-of-the money positions; with a CCP, they replace only the net positions. Since replacement is costly (as the counterparties lose in-the-money positions and replace them with new ones of zero value), netting reduces the losses counterparties incur, thereby reducing the likelihood that the counterparties will in turn default; that is, netting reduces the susceptibility of the market to a “daisy chain” of defaults.

Or does it? What about the other creditors? Netting eliminates an asset: the dealer’s in-the-money derivatives positions that are net against some or all of its losing positions. Without netting, both derivatives counterparties and other creditors would have a claim on this asset. With netting, the asset disappears, meaning that the other creditors cannot use it to satisfy their claims against the bankrupt dealer. Thus, netting favors derivatives counterparties at the expense of other creditors.

This means that holding the dealer’s position constant, netting engineers a transfer of default loss, not a reduction of total default loss. It only does so when one considers only derivatives counterparties, and ignores the defaulter’s other creditors.

This has implications for systemic risks. Perhaps netting reduces the possibility that a dealer’s default will cause derivatives counterparties to default, but it increases the likelihood that its other creditors will face financial distress, and perhaps bankruptcy. The defaulter’s other lenders may include banks, hedge funds, money market funds, commercial paper investors, and so on. These lenders may also be systemically important, in the sense that their financial distress can have ripple effects, or trigger a cascade of subsequent defaults.

It is therefore by no means obvious that the ultimate effect of the formation of a CCP is a reduction in systemic risk exposure. Netting redistributes the wealth effect of a default. Unless derivatives counterparties are uniquely systemically important, netting can actually worsen systemic risks.

These points can best be illustrated by an example. Large dealers typically buy and sell the same contract in large quantities. For instance, a dealer may buy 1000 contracts and sell 500 of the same contract to different counterparties. This dealer has a net exposure of 500 long contracts.

In a bilateral market, the offsetting 500 contracts are not eliminated by netting. This has several implications. First, a firm with offsetting positions often has to post collateral on the both the purchased and sold contracts, even though some of those contracts offset (thereby resulting in no market risk exposure.) Since collateral is costly (because it requires the dealer to hold liquid instruments with lower yields than alternative investments), the firm incurs a cost on the offsetting positions that could be avoided if these positions were netted out. Therefore, given the positions held by market participants, the formation of a CCP that nets positions economizes on collateral.

Second, as shown by Jackson and Manning (2006), the lack of netting increases the costs of replacing defaulted positions. Consider a dealer in a bilateral market who is long 1000 and short 500 contracts. Assume that the dealer defaults when the long positions are a liability to him, and the corresponding 1000 short contracts are an asset to his counterparties, and his 500 short positions are an asset to the dealer. The counterparties must replace the contracts at the prevailing market price (at which the short positions they enter have zero values, and hence are neither asset nor liability.) This is an economic loss to the victims of the default, which is reduced by whatever they realize from their claim on the assets of the defaulter, which will be less than what they are owed. It is important to recognize that these replacement costs are incurred on the entire gross position of 1000 contracts.

In contrast, in a cleared market, replacement costs are incurred only on the 500 net positions. Thus, clearing and netting reduces the losses that the defaulter’s counterparties incur to replace the defaulted positions because fewer positions (and sometimes no positions) must be replaced.

It should be noted that this “benefit” from netting is in fact a transfer, rather than a true cost savings. In the absence of netting, the non-offset in the money positions (in the example, the dealer’s 500 short contracts) are an asset to the defaulting firm. This asset can be used to pay the defaulter’s creditors, including derivatives counterparties and others. Netting reduces assets and liabilities by an equal amount; netting reduces the claims against the defaulter’s assets, but reduces the assets by an identical amount. Thus, the total loss suffered by creditors does not change, although the allocation of the loss is likely to change.

In the context of the example, without netting shorts holding 1000 contracts must share with all the other creditors the defaulter’s remaining assets, including the defaulter’s 500 short positions. With netting, in contrast, shorts holding only 500 contracts must share with all the other creditors the defaulter’s remaining assets, which do not include the 500 netted short positions. Thus, in effect, netting gives derivatives counterparties a priority claim to one of the defaulter’s assets–his winning derivatives positions–assets that they would have to share with other creditors absent netting.

An extension of the example illustrates these points. Assume that in a default, the 1000 contracts cost the counterparties $1 billion to replace, and hence the defaulter’s 500 short contracts are worth $500 million to the defaulter in the absence of netting. The defaulter has other assets of $700 million, and other liabilities of $1 billion. In a bilateral setting, the defaulter has assets of $1.2 billion, and liabilities of $2 billion. If the defaulter’s assets are split pro rata among the derivatives counterparties and the other creditors, the victims of the default receive $600 million, and hence lose $400 million. Other creditors also receive $600 million and lose $400 million.

With netting, the derivatives counterparties have a claim of $500 million ($1million on each of the 500 contracts that do not net out), and the defaulter’s assets are $700 million because netting reduces both assets and liabilities by $500 million. Pro rata division of the defaulter’s assets results in a payment of $233.3 million to the derivatives counterparties, meaning they lose $266.7 million. The other creditors receive only $466.7 million and lose $533.3 million. Thus, although netting makes the derivatives counterparties better off, it makes the other creditors worse off by the exact same amount.

Thus, netting effectively transfers wealth in a default from a defaulter’s other creditors to its derivatives counterparties. In the example, netting redistributes $133.3 million from other creditors to the derivatives counterparties. Reductions in replacement costs therefore do not reduce social costs, unless some frictions, related perhaps to systemic risks, imply that giving one set of claimants priority enhances wealth. I discuss this issue further below.

In sum, netting by a CCP benefits its members by (a) reducing collateral, and (b) reducing replacement costs. The important part of that last sentence is “its members.” It is important for two reasons. First, this is a private benefit that these firms will presumably take into consideration when evaluating the net benefits to them of cooperating to create a CCP. Second, since one of the benefits to a CCP’s members is actually a transfer from other creditors, dealers may have an excessive incentive to form a clearinghouse. This makes the absence of a CCP all the more peculiar–and supports the possibility that other costs, such as those arising from asymmetric information, exceed the private benefits of netting received by CCP members.

Netting can also affect systemic risk by affecting the scale of dealer trading activities. To the extent that that the introduction of a CCP reduces the costs dealers incur at the margin to engage in derivatives trades, dealers will trade more. By accumulating bigger positions, they can pose a greater systemic risk.

Netting can affect marginal cost in at least two ways.

First, netting reduces costly collateral. Lower collateral costs induce greater trading activity. (In the 1920s, opponents of central clearing at the CBT argued that bilateral trading encouraged “conservatism”–i.e., less trading–because it imposed higher collateral costs which restrained trading activity.)

Second, reductions in replacement costs could have a similar effect. Here the analysis is more complicated, however. Holding the terms of the dealers’ other liabilities constant, a reduction in replacement costs due to netting encourages dealers to trade more. However, the dealer’s creditors will certainly respond to the implicit reduction in their seniority resulting from clearing by adjusting the terms on which they supply capital to the dealers. Increasing the scale of trading activity increases the default costs other creditors incur. If creditors price capital appropriately, and charge the firm an additional dollar for each additional dollar of default cost they absorb as a result of an expansion in dealers’ trading activity, the dealers will internalize the cost of the transfer, and reductions in replacement costs will not distort their incentives to trade. Given the complexity of dealer balance sheets and the difficulty in evaluating total derivatives exposure, however, it is possible that other creditors will not fully recognize the implications of an expansion of a dealer’s trading activity, and underprice capital as a result. This would encourage the dealer to expand trading activity excessively, as the costs of this expansion are borne by other creditors.

To the extent that lower collateral requirements and replacement costs encourage dealers to trade more, reductions in dealer default exposures that result from clearing will be smaller than one would estimate holding positions constant. Larger positions increase default losses, offsetting in part or in whole the effect of clearing on default losses per trade.

In sum, it is clear that the distributive effects of clearing have not been widely appreciated–if they have been recognized at all. Netting via clearing effectively gives derivatives counterparties a priority claim on some of a dealer’s assets–the portion of a dealer’s positions that are offset by other positions. In a bilateral market, all creditors, not just derivatives counterparties, would have a claim on that asset. This redistributes the burden of a default from derivatives counterparties to a defaulter’s other creditors. Netting is therefore effectively a zero sum game, not a positive sum game. Moreover, the losers may not be members of the clearinghouse, which could distort the incentives to create a CCP. Furthermore, the systemic effects of this redistribution are ambiguous. Imposing additional losses on other creditors could put them into financial distress, even while it eases financial distress from derivatives counterparties. Financial distress by these creditors could also pose a systemic risk.

Thus, the debate over the formation of a CCP should be framed very differently than it has been heretofore. The appropriate question is: Should derivatives counterparties receive a priority claim on a defaulter’s assets? That is, should derivatives counterparties receive priority over a defaulter’s other creditors? The answers to these questions are not immediately obvious.

A couple of thoughts regarding clearing, both important and overlooked, methinks.   They’ve been on my mind for awhile, and I have a moment to get them off.

First, the issue of systematic risk.   The chairman of The Clearing Corp, Goldman’s Michael Dawley has stated that a central counterparty for CDS contracts would reduce systemic risk.   The article in which Dawley is quoted does not go into detail as to how a CCP would reduce systemic risk.   Presumably, by regularizing procedures and centralizing information, it would mitigate operational risks that could metastasize into systemic ones.

But let me interject a note of skepticism.   Systemic risk presumably arises because of an externality.   Private contracting decisions can lead to outcomes that jeopardize the financial and payments systems.   Damage to the payments system, for instance, can impose immense costs on individuals not parties to the original contracts that were the source of the contagion.   It is the existence of this externality that means that private contracting decisions, notably, decisions regarding the amount of risk to incur, may be suboptimal.

Such costs are external to the parties to CDS contracts in a bilateral OTC market, and are almost certainly external to a CCP, especially one owned and governed by large dealers.   That is, creating a clearinghouse does not internalize the externality that is the source of systemic risk.   Indeed, if a CCP prices risks badly (due to asymmetric information, for instance), it might actually exacerbate systemic risks.

I therefore conclude that the formation of a CCP is not sufficient to reduce substantially systemic risk, and that expectations or representations that it will (beyond the effect of reducing operational risks) are overly optimistic.

Second, consideration of the balance sheet risks in OTC markets led me to think about balance sheet risks for exchange clearinghouses.   The brokerage/FCM industry has evolved dramatically over the past decades, and now clearinghouse membership is dominated by the big banks, whereas at one time the clearing business was less concentrated, and less dominated by huge integrated financial institutions.

As I’ve written in posts about OTC clearing, these huge, integrated financial institutions have opaque balance sheets that carry a great deal of risk that is difficult for third parties to evaluate.   As clearing members, they expose exchange clearinghouses to their balance sheet risks.   Moreover, exchange clearinghouses don’t attempt to evaluate this risk (almost certainly because they lack the information to do so), and certainly don’t price it.

Thus, the evolution of the clearing business has arguably increased exchange clearinghouses’ vulnerability to balance sheet risks.   Given the potentially disastrous implications of a clearinghouse failure (and it’s not outside of the realm of possibility–both CME and CBT clearinghouses came within an ace of failure on 10/20/87), this is something that deserves some attention, but which has not heretofore.

he FT has an interesting article about how changes in the bankruptcy code in 2005 made it easier for firms in derivatives transactions to settle trades and demand additional collateral from their counterparties. According to the article, this made it easier for counterparties to demand additional collateral from Bear and Lehman when these companies began to experience trouble, and this accelerated their demise.

The article is wrong, though, on one thing. It says:

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

The more important issue was that settlements and collateral obtained 90 days or less prior to a company’s declaration of bankruptcy could be deemed a “preference.” The bankruptcy trustee could sue the counterparty of the bankrupt firm to “to recover from creditors payments made shortly before the bankruptcy filing where the payment gave the creditor more than other, similarly situated, creditors would get through the bankruptcy process. ” Thus, if a firm settled an outstanding derivative contract with a firm that eventually went bankrupt within 90 days of the settlement, and received a $1 million payment from the eventual bankrupt pursuant to the settlement (e.g., the parties agreed to close a trade that was underwater from the perspective of the eventual bankrupt), the trustee could sue and claw back the entire $1 million. The firm that had obtained the money in the settlement is then put in the same boat with the rest of the bankrupt’s creditors. Treating settlements and collateral demands as a preference increases the default risk exposure of parties to derivative contracts.

There has long been a safe harbor provision in the bankruptcy code that protected settlements on forward contracts from preference claims. (I’ve worked as an expert in several cases involving forward contract settlements in bankruptcy.) The 2005 bankruptcy code broadened the safe harbor protections to cover explicitly instruments (e.g., swaps) and market participants; prior to this time, it was a matter of uncertainty whether certain kinds of swaps and other derivative contracts would fall under the safe harbor protections. Thus, the change to the bankruptcy code clarified ambiguities in the code, and reduced the legal risks of engaging in derivatives trades.

It is certainly the case that absent the risk of preference claims, derivatives counterparties are more likely to demand that financially shaky trading partners settle contracts that are assets to the financially sound company, and liabilities to the troubled one, or to demand additional collateral from the troubled company. This creates the potential for “runs” on shaky derivatives dealers. Counterparties want to be first in line to get more cash (either from settlements or collateral) from firms that might go under.

Although it seems that runs are a bad thing, the Diamond-Rajan articles on financial fragility show that runs can serve as a disciplining device for financial intermediaries who supply liquidity. Intermediaries supply liquidity. They take funds from lenders, and invest them in higher returning projects. The financial institution has an information advantage in engaging in this information intensive intermediation, however, that allows it to act opportunistically. Absent some form of market discipline, the information advantage allows the intermediary to hold-up the suppliers of funds. Diamond-Rajan show that runs are a disciplining force, and absent such discipline, the opportunism problem results in suboptimal creation of liquidity.

Many aspects of derivatives contracting in OTC markets, including credit triggers that require the immediate liquidation of contracts or the ability to call for additional collateral in the event of a credit downgrade by a party to a derivatives contract encourage run-like behavior. Although there is not an exact analogy between derivatives contracting, and the lending/financing intermediation that Diamond-Rajan model formally, derivatives dealers do supply liquidity to the derivatives market, and especially in more specialized contracts do have an information advantage in dealing with their counterparties. The Diamond-Rajan logic therefore suggests that it may be necessary to subject the dealer to the risk of runs to discipline opportunism. Thus, the fragility of derivatives dealers, so graphically illustrated by recent events, may be efficient, as unsettling (no pun intended) as that conclusion sounds.

Diamond and Rajan argue that measures intended to reduce the likelihood of runs on financial institutions can actually reduce the efficiency of financial markets by raising the cost of disciplining liquidity suppliers. This higher cost of enforcing contracts leads to a smaller supply of liquidity. Thus, in their models, eliminating runs is a bad thing, not a good one, as intuition might suggest.

If this logic extends to derivatives contracting, it has implications for the appropriate regulation of derivatives dealers. I conjecture that the logic can be so extended, but this deserves some formal modeling. Add that to the pile.

I wrote an extended reply to DR’s comment regarding sovereign debt credit spreads, but (a) I had been planning on writing something regarding the price of risk more generally, and (b) the subject is of broad importance, so I’ll expand upon those thoughts in this post.

Credit spreads are essentially a price. Given a set of promised cash flows, the higher the credit spread, the lower the market price of those cash flows. Thus, if you had Russian and Brazilian debt with the same promised cash flows, a higher spread for Russia implies that the Russian debt sells for less.

This can occur for two reasons, the first of which gets the most attention, the second of which is the focus of this post.

The first reason relates to the size of cash flows. On debt instruments, realized cash flows differ from promised cash flows due to defaults. Therefore, the lower price of Russian debt could arise because market participants estimate that Russia is more likely to default than Brazil, and/or, in the event of a default, bond holders will receive fewer cents on the promised dollar from Russian bonds than Brazilian bonds.

The second reason, which is somewhat harder to grasp, is that market participants can apply different discount rates to different securities. In particular, finance theory tells us that you should discount riskier cash flows more heavily than less risky ones. All else equal, greater risk leads to greater discounting to lower price, which leads to higher spreads. Thus, Russian spreads could exceed Brazilian spreads because market participants discount Russian cash flows more heavily due to greater risk.

This raises the question: What is risk? Finance theory tells us that risks that are diversifiable should not be priced, that is, they should not affect the discount rate. This is because if the risk is diversifiable (also known as “idiosyncratic”) investors can eliminate it by holding highly diversified portfolios.

A diversifiable risk is one that affects one investment and that investment alone, and which is uncorrelated with the risks on other investments. For instance, the possibility that a particular company achieves a technical breakthrough is diversifiable, as is the risk that a particular company is hit by a product liability suit, or has a particularly good or bad management. Diversification eliminates these risks because in large portfolios, the law of large numbers means that the bad luck in one company is likely to be offset by good luck in others.

A systematic risk is one that cannot be diversified away. Typically, it is a risk that is driven by overall economic activity, that is, by the state of the overall economy. The overall economy affects all investments to some degree or another, and can’t be diversified away. We have many companies and countries, but only one economy.

Different assets have different sensitivities to overall economic activity. “Cyclicals” is an investment buzzword for companies that perform very well when the economy does well, but do very poorly when the economy is in recession. Some stocks (e.g., healthcare) are often considered to be non-cyclical because the demand for the services of these companies is not as sensitive to overall economic activity as are industries more dependent on discretionary income, such as automobiles and housing.

In brief, investments with performance that is highly dependent on overall economic activity tend to be discounted more heavily. People want investments that pay off when times are bad, and are willing to give up payoffs when times are good. Investments that are highly dependent on the overall economy are sunshine friends–they do well when you don’t need them as much (as your other investments are also paying off), but do poorly when you really do need them to pay (because all your other investments are doing poorly then too.)

Oil provides a very interesting illustration, and a link to the discussion of Russian credit spreads.

Historically, oil has had negative systematic risk. That is, oil prices tended to go up when the economy was doing badly, and go down when the economy was doing well. That meant that if you bought oil, it would pay off handsomely when you really need good payoffs–when your other investments are doing badly.

One explanation for this negative systematic risk is as follows. Supply shocks have historically been an important source of major oil price movements (think of the 1973 and 1979 oil shocks, the supply glut of 1986, and Gulf War I). Unexpected reductions (increases) in oil output raised oil prices and hurt the overall economy. The decline in the overall economy led to stock price declines. Thus, if supply shocks are major drivers of oil prices, you would expect a negative association between stock price and oil price movements.

Things are different now. At present, demand shocks are the major drivers of oil prices. Anticipations of a recession, and likely a severe, worldwide recession, have led to reductions in the expected demand for oil. This is why oil prices have declined of late. Moreover, the anticipation of a recession has caused stock prices to tank too.

Nowdays, the prices of oil and stocks tend to move in the same direction, and exhibit a relatively high correlation. You tell me what happens to the price of oil, and I can tell you (at least directionally, and with some precision as to magnitude) what has happened to the S&P or the FTSE. The price of oil is now a hostage to overall economic activity, as is the stock market. As a result, oil has gone from exhibiting low or negative systematic risk, to exhibiting high and positive systematic risk.

This can help explain Russia’s particularly high credit spreads relative to other BRIC countries, and why Russia has a higher credit spread that Iceland, even (though not as high as basket cases Pakistan, Argentina, and Ukraine.) It also contributes to the oft-noted fact that Russian stocks appear very “cheap” (as measured by price/earnings ratios, for instance) compared to other stocks.

The Russian economy is highly dependent on oil. In particular, government revenues are highly dependent on oil prices. Since oil has significant systematic risk, this means that securities (debt and equity) that are tied to the Russian economy have high systematic risk.

Moreover, the political factor risk factor plays here. It is becoming increasingly clear that the government is willing to spend a lot of money to cover the foreign currency borrowings of Russian companies. The largest borrowers, moreover, are energy companies. Their need for help will be greater, the lower the price of oil. Hence, the lower the price of oil, the faster Russia will burn through its reserves, the weaker its financial position will be, and the higher the likelihood of a default (de jure or de facto, a la 1998).

In essence, due to the close tie between oil prices and its economic fortunes, it makes sense that Russian spreads are very high. The country faces a triple-whammy. (That’s the technical finance term for it.)

First, default is more likely, and recovery rates are lower, the lower the price of oil. If oil prices remain low, Russia is more likely to blow through its reserves bailing out favored firms and defending the ruble. Furthermore, with low oil prices, government finances erode. All of these factors raise the likelihood of default on government debt. Thus, the probability of default is higher, and the recovery conditional on a default lower, the lower the price of oil.

Second, due to the high systematic risk associated with oil prices, cash flows highly dependent on oil prices are discounted more heavily. This includes government debt, private debt, and the equity of Russian companies, especially those in the energy sector, but not limited to that sector (e.g., consumer goods producers and retailers and construction firms are also vulnerable due to the link between their sales in Russia and the price of oil.) Russian investments, including government debt, are likely to do very badly when oil prices are low. Since the price of oil is likely to be low when overall economic activity is low, this poor performance is especially costly to investors, leading them to discount Russian investments more heavily.

Third, the factor I mentioned in The Price of Political Risk, namely the greater susceptibility of the Russian state to disorder when oil prices are low, exacerbates these problems. The low oil price stresses the weak institutions, and which contributes to pressures to spend reserves. It also increases the probability of popular unrest, government infighting, clan warfare, and in the extreme, political chaos and collapse.

So, the facts that (a) the Russian economy, and perhaps more importantly, its public finance and the demands on its public purse, are heavily dependent on the price of oil, and (b) in current market conditions oil-sensitive investments bear substantial systematic risk, imply (c) investments in Russian government or private debt, or Russian equity, have been especially hard hit by the credit crisis. Moreover, (a) and (b) imply that Russian investments will exhibit exceptional sensitivity to oil prices. So much for an island of stability and tranquility.

If you’ve been following the markets lately, you’ll observe that Russian stocks and US and European markets have been moving in the same direction (up on the same days; down on the same days), but that the movements in Russian stocks have been far more violent. (One consequence of this is that since markets overall are down in recent weeks, Russian markets have fallen more.) This is consistent with the foregoing that suggests that due to the oil price connection, Russia exhibits very high systematic risk. Moreover, the very low P/E ratios of Russian stocks are also consistent with this analysis.

Although the Russian market experience is a particularly interesting, this analysis demonstrates a very important point that is missed too often. It has application, for instance, to the ongoing financial crisis and the collapse of mortgage securities prices. This very interesting paper by Coval, Jurek, and Stafford argues that CDOs (and other tranched securities) exhibit very high systematic risk by the very nature of their structure. CDOs invest in multiple instruments, and therefore are highly diversified. What’s left is all systematic risk. What’s more, per C-J-S, this systematic risk is very high because of (a) the fact that the underlying investments are very sensitive to overall economic activity, and (b) the optionality (and hence embedded leverage) in the structure of the instruments.

For instance, the highest tranches of CDOs are likely to payoff when the economy does well. Defaults occur when the economy is doing badly. Thus, low payoffs on these instruments occur when the value of consumption is greatest. This means substantial systematic risk.

C-J-S note that rating agencies only modeled default probabilities and recoveries when rating these instruments, and did not take into account their high systematic risk. The investment grade credit ratings were therefore a very misleading indicator of the risk of capital gain or loss on these instruments.

In sum, finance theory tells us that systematic risk matters. Different instruments have different systematic risks. Russia’s dependence on oil prices and the structure of CDOs both create substantial systematic risks that the market discounts heavily.

As C-J-S note, too often people focus only on the cash flow projections, and pay too little attention to the discounting. (That’s what the rating agencies did in the CDO market.) Seemingly anomalous pricing may well reflect specific systematic risk characteristics of the instrument being priced. (Ignoring this is why arguably why Bernanke thinks that CDOs on bank balance sheets should be worth a lot more. His public statements have seemed to focus on the cash flow projections, rather than the discounting assumptions.) Thus, when evaluating the pricing of a particular instrument, you need to ask: in what states of the world are the cash flows going to be low? Are they going to be especially low during those periods when the cash flows on most other investments are low too? If the answer to that question is “yes”–you need to discount heavily.

LaRussaphobe pointed me to this interesting post from the Conde Nast MarketMakers blog.* The post discusses credit spreads for BRIC countries (Brazil, Russia, India, China). These credit spreads measure the creditworthiness of the sovereign debt on each of these countries. The higher the spread, the bigger the market’s estimate of a default (and/or the greater the market’s estimate of the loss conditional on default.)

You will note that as the credit crisis has exploded since late-August, all of these spreads have blown out, meaning that the market estimates that their risks of default have exploded. And surprise, surprise, surprise (cue Gomer Pyle voice), guess whose risk exploded most? Your favorite country and mine, Vlad’s paradise, that island of tranquility in troubled economic times.

In a nutshell, the market has deemed Russia the junkiest of the junky BRIC sovereign credits. And to think, this is the spread on government debt, the government that is sitting on $500 billion. Think of the market’s assessment of the credit risk of the “private” borrowers, eg Deripaska, Fridman/Alfa, Gazprom, Rosneft who are queuing up hat-in-hand to get charity from that government. Well, perhaps one reason for the wide spread is that market participants estimate that the $500 billion will be largely blown bailing out the oligarchs to keep strategic “crown jewels” out of the hands of the cursed foreigners.

Excellent MarketMaker blogger Felix Salmon expresses surprise at Russia’s poor performance relative to Brazil: “So the fact that it’s now 500bp wide of Brazil is kinda crazy. After all, they’re both mainly commodity plays, and their stock markets have both been devastated. But the credit markets show a huge distinction between the two countries which isn’t easily visible elsewhere.”

Not crazy to me, Felix. You’ve focused on just the economics (“both mainly commodity plays”) and missed the political risk angle. My conjecture is that the differential spread is the market price of political brittleness, weak institutions and property rights, corruption, and the absence of a rule of law. Now, Brazil is hardly Adam Smith’s vision of a classical liberal state, but it is miles ahead of Russia in that regard. Trying times test institutions, and times are now tough. The credit swap market is putting its money on the proposition that the current strains will overwhelm Russia’s political, legal, and economic institutions. That as a result, (a) the $500 billion plus that Russia has amassed in the seven fat years is at extremely high risk of disappearing down ratholes, leaving little behind to pay sovereign debtholders, and (b) the prospect that the gravy train is ending will spark political turmoil and infighting that threatens political stability in Russia, and sovereign debtholders hate political instability.

There are numerous stories on the web that help flesh out that story. Indeed, there are too many to mention, so I’ll just pick a few. First, this piece by Robert Skidelski in today’s FT:

Russia carries a heavy burden of political risk. This is the real economic legacy of the Putin years. Mr Putin does not understand the need for a degree of consistency between economic and foreign policy: or rather the reconciliation he has sought has been based on Russia’s energy windfall. If this has now ended, as seems likely, the key assumption of his politics – that Russia can use its energy power to boost its world power without paying much attention to the sensitivities of anyone but the Russian electorate – has been destroyed.

Russia needs to scale down its geopolitical ambition to its real weight – that of an emerging economy with only 3 per cent of the world’s gross domestic product and a quarter of America’s living standard. Also, it desperately needs to develop its human capital. The Putin era is over but Medvedev’s has not begun. This is the real Russian crisis.

(The last bit on human capital doesn’t relate to the political risk theme, but it does agree with what I’ve been arguing–not without opposition, to be fair.)

Then there’s this report describing how Russia is riding roughshod over the rights of minority foreign investors to save an oligarch (Mikhail Prokhorov) by rigging the game to allow him to escape his obligation to buy out minority investors at the price that he paid to acquire a controlling interest in power generator TGK-4. That’s not something you do when you’re thinkin’ ’bout tomorrow. If you are thinking about the future, you don’t want to do something that so damages your reputation with foreign investors. But reputation is about the future, if you are in sauve qui peut mode, it’s all about today.

One last gem, this one from the WSJ. VEB has extended a $4.5 million dollar to Rusal and Deripaska. But the rules said that the VEB assistance was limited to $2.5 billion. Rules? We don’ need no stinkin’ rules:

With the $4.5 billion Rusal loan, VEB appears to have made an exception to internal rules that limit lending of more than $2.5 billion to any one borrower. Norilsk, a major platinum producer, is considered strategic by Russian authorities. Without commenting directly on Rusal, Mr. Dmitriev said in an interview on a state-run news channel that the bank’s board — where Prime Minister Vladimir Putin is chairman — has the authority to make exceptions.

I’ll bet he does.

Both the Rusal and TGK-4 “exceptions” are only the most flagrant illustrations of the complete lack of any stable, rule-driven (and hence predictable) governance. Instead, they show that winners and losers are determined arbitrarily as a result of the exercise of influence and the exchange of political favors. They demonstrate that the system is one of personalized rule, with Putin exercising the ultimate power like the Godfather dispensing his favor on the lucky few. The Rusal exception also shows that Putin is willing to pay up to keep the “crown jewels” in Russian hands. That means that with various Russian companies owing well over $500 billion in foreign debt, there is a high risk that Russia’s reserves will be spent keeping control of these companies in Russian hands–another political decision, and one that just might be in the interest of connected people in the government. (BTW, it’s pretty sad that in the 2000s that an aluminum company is a country’s crown jewel. Think anybody in the US thinks that about Alcoa?)

In short, these episodes illustrate perfectly, Felix, why Russia trades at a 500 bp premium to freakin’ Brazil, of all places.

* I can just picture commentor David, and his fellow gang members (he does admit that he is a member of a group, and I have received emails from others expressing similar views), sitting somewhere in Poland or points east, saying “OMG, I just KNEW IT! Pirrong and LaRussaphobe ARE card-carrying members of a vast anti-Russian conspiracy!!!” You can change your drawers now, Dave, but I’m sorry that I’ll have to disappoint you. LR sent me an email, from the same email address that’s on her website, [email protected]. She signed it Kim. No hint of her/his/it super-secret identity. The email reads, in its entirety (excepting the salutation and signature, and the MarketMakers link that I’ve posted above): “Can’t make heads or tails of this, thought you must be able to.” Pretty loose association, don’t you think? Or, maybe that was code. But I never got my decoder ring, so I’m at a loss. And, to my disappointment, there’ve been no PayPal alerts telling me that money has been sent to me from shadowy sources to compensate me for my work for the conspiracy. Guess I’ll have to try harder.

For a brief, not-so-shining moment, Volkswagen became the largest company by market capitalization in the world. How, you might ask, in the face of a crashing car market, could that be possible? In a word: SQUEEZE.

Numerous hedge funds went short VW shares, only to find out to their dismay on Sunday that Porsche had acquired a far larger long position than anyone expected. The scramble to cover short positions caused the price to rise from about 300 Euros to 1275 Euros. Just like the crude oil episode a little over a month ago, this bears all the hallmarks of a squeeze.

Porsche claims no responsibility, and in a statement that echoes many others that manipulators have made over the years, blames the shorts: “It added that it ‘denies all responsibility for these market distortions and for the resulting risks to which the short sellers have exposed themselves.'” It further said, “Short sellers [are] responsible for extreme price movements in Volkswagen.”

Sorry, kameraden, but (a) you are the large long, and (b) such price movements occur only if the large long inefficiently restricts liquidations of its outstanding positions in the underlying and derivatives. Note that the price came down substantially–but not to their pre-squeeze levels–when the company announced it would sell 5 percent of VW shares, doubling the float in the stock. This indicates that the company’s liquidation decisions affect prices–that it is a price maker, not a price taker.

The German regulator, Bafin, is investigating. It will be interesting to see how this turns out.

In an earlier post I surmised that behomoth hedge fund Citadel was playing balance-of-power politics, working with the banks and against the CME by supporting the upstart ELX futures exchange, and working with the CME and against the banks in a CDS clearing venture.   In each case, Citadel was allied against the incumbent, dominant player (CME in futures, and the banks in the CDS market).

It appears that Citadel has decided this is not a viable strategy, and that it can’t play both sides against the middle.   According to a Bloomberg story by Matt Leising (not yet online), Citadel has resigned its ELX board seat.   Though it will still retain an ownership stake, it will no longer promote the ELX venture.

Presumably the deciding factors were (a) Citadel’s assessment of the likely success of the two ventures, and (b) its estimate of the profit potential of each.   One inference is that Citadel decided that the CME clearing venture is likely to succeed, and potentially in a big way, and that ELX is a much more iffy proposition.

There is definitely a case to be made for both propositions.   Although I’ve identified some hurdles that CME must overcome to make the CDS clearing venture go, most of the reporting I’ve read suggests that the exchange has the inside track.

Overall, I think this is another signal that the banks’ dominance in derivatives has been eclipsed.   Not only are their stock prices low, but their political stock is low as well.   Citadel is a savvy player, and its choice is a lot more credible statement about the current landscape than anything that I, or any other observer, can put forward; they are putting their money on the table.

Just a few of today’s dropping shoes:

• S&P lowered its outlook on Russia.
• Gold and foreign currency reserves fell $15 billion in the last week due mostly to the central bank’s attempts to defend the ruble–and the ruble continued to decline.
• The cost of debt insurance on Russian government bonds rose 135 basis points, to US Treasuries plus 769 bp.
• Sberbank shares fell 10 percent (they are now worth far less than $1, and have fallen more than 80 pct this year). MICEX suspended trading on the shares–the shares of the bank that the government has provided extensive support.
• Credit default protection on Russia’s pride, Gazprom, rose 188 bp to 15.6(!) percent.
• CDS protection on Sberbank rose to 13.4 percent.

I could go on, but you get the picture. Yet, at least in the domestic media, Putin and Medvedev continue their Alfred E. Neumann (What? Me Worry?) routine. It is very, very, sad. And it makes the probability of a blowup all the more likely.