Streetwise Professor

My most recent clearing post explored the possibility that the formation of a clearinghouse for OTC derivatives is efficient, but that distributive considerations and collective action problems have heretofore prevented its formation. In this post, I consider the possibility that the costs of formation of an OTC clearinghouse (for CDSs, for instance) exceed the benefits.

A central counterparty (CCP) is a default risk sharing mechanism. In a typical CCP setup, a group of intermediaries who trade on their own account and as agents for customers share default risk among themselves. If a customer defaults, the intermediary through whom that customer clears bears the loss. The risk sharing mechanism kicks in only if the one of the CCP member firms defaults.

Two factors drive the default risk that the CCP members share. The first is the riskiness of the instruments that are cleared. The second is the riskiness of the balance sheets of the member firms. A default occurs only if (a) a member firm incurs a loss on its position(s), and (b) this loss exceeds the value of the other assets (net of liabilities) that the firm can draw upon (e.g., sell) to cover this loss. Thus, the members of a CCP take on an option-like exposure, where the option is a complex one with a payoff that depends on multiple factors, namely, the prices of the instruments cleared and the values of the other assets and liabilities in each member’s portfolio.

Recent events (though not in the context of a CCP) indicate that both sources of risk are important in determining the likelihood of default. Lehman and Bear Stearns defaulted on their derivative obligations not because of losses incurred on these derivatives, but because of losses incurred on other investments (primarily mortgage securities). In contrast, AIG collapsed because the huge losses on derivative positions overwhelmed the capital on its otherwise healthy balance sheet.

To operate effectively, any risk sharing mechanism must price risks appropriately. Mispricing of risks provides perverse incentives. If the default risk posed by a particular member of a CCP is underpriced, that member will trade excessively, thereby imposing excessively large risks of loss on the other members.

It should be noted that in practice CCPs typically do not charge different members different fees to reflect differential risks. That is, there is no “experience rating” of clearing fees. Instead, CCPs price risk indirectly by choosing collateral (margin) levels and capital requirements. Since the CCP is effectively a risk sharing mechanism, where the risks are not priced directly and “premiums” do not flow from one member to another, a CCP ideally sets collateral and capital levels so that the expected default cost is the same across all members. By doing so, there are no wealth transfers across members. Failure to do so leads to a transfer of wealth from one set of members to another.

Even though CCPs do not price default risk through insurance premia, as a convenient shorthand I will refer to the pricing of default risk by the CCP, with the understanding that this pricing is indirect through the setting of collateral.

Information asymmetries challenge any risk pricing/insurance mechanism. If the insured (i.e., a clearing member) has better information about his risks than the insurer (i.e., the CCP), he will trade too much and hold positions that are too big when his information indicates that the insurance is underpriced, and trade too little and hold positions that are too small when his information indicates that the insurance is overpriced. Asymmetric information problems usually result in incomplete insurance of risks. In the extreme, information asymmetries and the associated adverse selection and moral hazard problems can make risk sharing inefficient altogether.

In the context of a CCP, asymmetric information about the instruments traded and the balance sheets of the dealer firms that trade them–and who would be the members of a CCP–impedes the sharing of default risk. The severity of these information problems can vary by instrument, and by the nature of the firms that intermediate the trading of these instruments. An examination of CDSs in particular, and more exotic derivatives in general, strongly suggests that asymmetric information about both risks is likely to be acute. This tends to reduce the net benefit of introducing a CCP for these products, and may make this net “benefit” negative, especially when the costs of establishing and operating a CCP are considered.

First consider the issues relating to the risks of a particular type of instrument. To price risk, a CCP uses information on (a) the risk-return characteristics of this instrument, and (b) the current price/value of the instrument. Given the current value of the instrument, and holding the (true economic) capital of a member firm constant, the likelihood of default depends on the probability distribution of returns on the instrument and the size of the position. Therefore, margin setting/risk pricing depends on information regarding the price behavior of the instrument. Moreover, information about the current price of the instrument is important. A CCP uses an estimate of market price to adjust collateral. Using an incorrect price leads to an incorrect estimate of the gain or loss on a position, and therefore to an incorrect determination of the risk exposure, and relatedly, the collateral level.

For homogeneous, linear, traditional instruments traded in liquid, transparent markets, a CCP is likely to have information on these variables that is nearly as good as, and perhaps better than, that in possession of its members. For an actively traded instrument (e.g., S&P 500 futures), transactions are numerous and observed, so positions can be marked to current value with no difficulty. Moreover, extensive historical data is readily available to calibrate risk models, and “rocket science” modeling is not necessary to estimate these risks. Thus, for such instruments, centralized clearing is unlikely to face severe adverse selection problems, and risks can be priced correctly. One would expect to observe central clearing for such instruments–and one does.

Things are quite different for exotic instruments. These instruments are traded less frequently, and so current market price information is harder to come by. Indeed, at times, there may be no transactions, so it is necessary to “mark-to-model” rather than “mark-to-market.” Moreover, sophisticated modeling is necessary to quantify and understand the risks of these instruments.

This pricing complexity is likely to be an important issue for credit derivatives, especially on individual names. The products are relatively new. Often they are not traded in high volumes in liquid transparent markets. Marking to market is not a trivial exercise as a result. Moreover, understanding the risks of these things is difficult. This is particularly true for portfolios of these instruments, due to the potential for default dependence between different instruments (i.e., the unconditional risk of default of a single instrument is not sufficient to determine the risk posed by a CCP member with positions in multiple instruments; you need to know about the correlations across instruments, and these dependencies are especially tricky to model and calibrate with credit products).

Big dealer firms specialize in developing models designed to quantify and characterize these risks. Moreover, these dealers expend resources to develop the data to calibrate and test these models. They have strong incentives to develop good models, as with better models they can manage their own risks better, and perhaps generate higher trading profits. Therefore, it is highly, highly likely that for a product like CDSs, dealer firms that engage in proprietary trading of these instruments will have better models and better information than a CCP.

To reiterate something I’ve said in previous posts, this is not to say that these models are great in some absolute sense. The key issue in risk sharing is asymmetry, which depends on the relative quality of information. If a CCP member has a better model than the CCP, there is an information asymmetry problem, even if the former’s model is, well, pretty bad. As I’ve said before, the one eyed man is king in the land of the blind.

(For an illustration at the problems associated with third party’s attempts to evaluate the risks of heterogeneous, complicated, non-linear derivatives, consider the rating agencies’ disastrous experience with CDOs, and monoline insurers.)

Thus, in my view, it is almost certainly the case that for exotic derivatives, and for CDSs in particular, dealer firms that make markets in these products have much better information about their values and risks than would a CCP. This creates the potential for adverse selection, which reduces the benefit of default risk sharing through a CCP.

It should also be noted that big dealer firms that (a) are the primary intermediaries in exotic derivatives and CDS products, and (b) would be the members of any OTC derivatives clearinghouse, are very complex financial firms with relatively opaque balance sheets. They are in the business of providing information intensive intermediation, through their loans, investments, and trading. As a result of this information intensity, it is challenging for third parties to appraise their balance sheets, and quantify the risks associated with those balance sheets. It is certainly the case that the intermediaries (banks and investment banks and in some cases insurance companies) have better information than third parties about the value of the assets and liabilities on their balance sheets, and the risks of those assets and liabilities–including the correlations between those asset and liability values and the values of derivatives positions on its books.

This means that if a CCP’s members are complex dealer firms engaged in information intensive intermediation, the potential for asymmetric information about balance sheet values is acute.

Put these two things together, and it is evident that the formation of a CCP to clear exotic products, including credit derivatives, and which has big financial institutions with complex balance sheets who supply information intensive intermediation, faces far more daunting challenges than a CCP clearing “vanilla” products and which has simpler firms has members. The pricing of risk is almost certainly far more difficult, and more importantly, the potential for information asymmetries is far greater. Thus, adverse selection problems would almost certainly be far more acute if the big dealer firms formed a CCP to share default risks for credit derivatives and other exotic products.

This suggests caution is in order in moving towards a CCP structure in CDS products in particular. Myriad regulators, market participants, commentators, and legislators have seized on central clearing as the panacea for these products. There has been little–if any–recognition in the public debate of the special challenges that these kinds of products and the institutions that trade them would impose on a central clearing mechanism. Thus, it is quite possible that a CCP has not been adopted for these products is not due to the selfishness of dealers who fear that clearing would increase competition for them, but instead reflects a sober appraisal of the greater costs of sharing default risks for these products.

A couple of other points are worth noting. First, traditional CCPs typically do not vary risk pricing (i.e., collateral levels) to reflect the balance sheet risks specific to each member firm. CCPs typically set collateral levels based on the risks of the instruments held in each member’s portfolio of cleared products, and two members with the same portfolio would post the same collateral even if their balance sheet risks are quite different. CCPs do impose some constraints on balance sheets, but normally through capital requirements that are simply a function of collateral levels. For instance, the CME clearinghouse sets minimum member capital equal to a multiple of the member’s margin level. Importantly, it does not vary capital requirements or collateral levels based on assessments of the balance sheet risks of member firms. Thus, in most CCPs balance sheet risks are not priced.

This may not be a big problem when CCP members are relatively simple–and relatively homogeneous–firms with relatively simple and transparent balance sheets. Many futures commission merchants and securities firms that are clearing members fit this characterization. Some are subsidiaries of complex, broad-based intermediaries, but from the perspective of the clearinghouse, the relative simple balance sheets of the actual member firms are what matters.

If big banks and investment banks continue to dominate intermediation of CDS and exotic derivatives, the members of any clearinghouse for these products will inevitably be firms with complex, opaque balance sheets, for which asymmetric information is likely to be quite acute. Simply adopting futures and options CCP practices will not be adequate for this business. Moreover, I have serious concerns that the difficulties in assessing and pricing balance sheet risk will seriously impair the effectiveness of a CCP for credit derivatives.

The second point is that it is incorrect to say that default risks are not shared among dealers in a bilateral OTC structure. Dealers trade with dealers. I daresay that big dealer firms had the biggest exposures to Lehman, Bear, and AIG. Inter-dealer trade means that default risks are shared among the dealers who would be the members of a clearinghouse even in a formally bilateral market.

This has an important implication. Specifically, the choice between a “bilateral” and “centrally cleared” market structure is a choice between different ways of sharing default risks among dealers (and between dealers and customers); it is NOT a choice between interdealer sharing and no interdealer sharing.

Thus, it is imperative to analyze the comparative costs and benefits of these alternative sharing mechanisms. This is a multi-faceted problem, but I will focus on one issue, one that I think is of primary importance.

In a CCP structure, the CCP is responsible for evaluating the balance sheet and product specific risks of each member firm. That is, there is a centralized risk evaluation and risk pricing mechanism. In contrast, in a “bilateral” market, each dealer firm makes individualized assessments of the product specific and balance sheet risks posed by each counterparty. Moreover, since dealers trade with one another, each dealer assesses and monitors the counterparty risks of each of the other dealers.

Centralized monitoring has one clear benefit–there is no duplicative monitoring. Each dealer is evaluated once. In contrast, in a bilateral market, each dealer assesses and monitors every other dealer, meaning that for N dealers there are 2 to the power N monitoring costs incurred.

However, decentralized monitoring likely has a substantial benefit when complex financial institutions trading complex products are involved. These firms interact with one another in many markets, and have various sources of hard and soft information about the balance sheet risks of its counterparties. This information is almost certainly superior to what a clearinghouse is likely to collect. Moreover, since due to the complexity of the balance sheets of the big dealer firms, any individual firm’s assessment of the balance sheet risks of another is likely quite noisy. Multiple signals should be more precise than a single one. Therefore, monitoring by multiple counterparties generates information that is likely to be collectively far more precise than the information collected by any one. If this information can be aggregated in some way, multiple counterparty risk assessments in a bilateral market can be far more efficient than a single risk assessment by a CCP. (The mechanism for aggregation is a complicated subject in itself. Dealers will make inferences from the actions of others. If dealer A cuts back on trading with B, or decides not to trade with B altogether, dealers C, D, etc., will make inferences about A’s information regarding B’s performance risk. One issue that deserves study is whether this aggregation method encourages information cascades that can lead to inefficient outcomes.)

Furthermore, dealers in bilateral markets can–and do–charge counterparty-specific prices for balance sheet risk. Specifically, they require different counterparties to post different amounts of collateral, where variations in collateral levels across counterparties reflect both product-specific risks and the particular balance sheet risks of each counterparty.

(Member-specific collateral levels in a CCP setting would also put tremendous stress on the governance of a clearinghouse. Each member would have an incentive to influence the CCP to impose higher collateral requirements on competitors. Heterogeneity puts stress on collective/cooperative bodies such as clearinghouses. Even though institutional mechanisms such as the non-profit form can mitigate heterogeneity-driven rent seeking in such organizations, it cannot eliminate it, and these rent seeking costs are typically greater when members are heterogeneous.)

This analysis raises the question of whether it is efficient to bundle the trading of these instruments with the supply of information intensive intermediation. Big banks and investment banks with opaque balance sheets (due to the information intensity of their various financing and trading activities) pose greater balance sheet risks than would simple, “vanilla” intermediaries that specialize in trading these derivatives and eschew other activities.

But we don’t see such simple, vanilla, boutique intermediaries. I think that for a variety of reasons this makes sense, as there are likely scope economies between trading things like CDSs and offering other forms of financial intermediation. After all, banks specialize in evaluating credit risk, and the resources and skills used to do this in lending and underwriting can be put to use in valuing and assessing the risk of derivatives, and most particularly, credit derivatives. Moreover, there are scope economies in modeling and risk evaluation. Thus, I think a strong case can be made that bundling of intermediation of complex derivatives (and especially credit derivatives) with the supply of other information intensive financial intermediation activities is efficient.

In sum, before charging ahead with a CCP for credit derivatives and other exotic products, it is worthwhile to step back and ask why this hasn’t happened before now. Sure, it may reflect inefficient strategic behavior by dealers and collective action problems. But it may be the result of high costs of centralized risk sharing for complex products traded by firms who supply information intensive intermediation, and therefore have somewhat inscrutable balance sheets and balance sheet risks.

I have serious reservations about the efficiency of a CDS clearinghouse consisting of big banks/investment banks. Balance sheet risks are a big deal when such firms are involved, and traditional CCPs have not priced these risks (or have priced them in a very, very crude way.) Moreover, the risks of the instruments themselves will be difficult for a CCP to quantify. Indeed, sometimes it will be difficult for the CCP just to determine the market value of these instruments. (Which is why firms like Markit are included in CDS CCP proposals.) Given the instruments, and the firms trading them that would be in a clearinghouse, risk pricing will be extremely difficult, and beset by asymmetric information problems. To me, it is by no means clear that centralized assessment, pricing and sharing of position and balance sheet risks is more efficient than decentralized, “bilateral” assessment, pricing and sharing of these risks.

This argument may seem somewhat Panglossian–to some it may appear that I am suggesting that we live in the best possible world, and intervention to change performance risk sharing mechanisms is therefore unwarranted. I would disagree with that characterization. Suffice it to say that starting from the basics of risk sharing economics, and analyzing the specifics of credit derivatives and other exotic products, a strong argument can be made that a bilateral OTC market structure is efficient relative to alternative structures, including a CCP-based system. To put things in legal terms, I should think that the burden of proof should lie on those who implicitly or explicitly assert that the existing market structure is inefficient compared to a realistic alternative.

And I will close by noting that some practitioners with skin in the game share reservations similar to those I have expressed here. This Bloomberg article by Matt Leising quotes “electronic trading pioneer” Thomas Peterffy’s objections to the CME’s proposal to clear CDS products. Long time Chicago broker Chris Hehmeyer (CEO of FCM Penson GHCO) is also “balking at” this initiative. Peterffy “doubts that the exchange will be able to determine CDS pricing because they trade infrequently.” Although neither Peterffy nor Hehmeyer (or David Rutter, also quoted in the article) mention the very different balance sheet risk posed by big CDS dealers, I wouldn’t be surprised if that’s a concern as well. Though they aren’t quoted as saying so, these gentlemen have to realize that when the big dealers clear CDS products, the other members of the clearinghouse–firms like theirs–not only bear the risks associated with the CDSs, but also the risks associated with subprime, or CDOs, or whatever happens to be floating the banks’ boats at the moment. This cannot be a comforting thought.

So, before we rush in to create a CDS clearinghouse, it behooves us to examine carefully the risks of doing so. Not all instruments and not all intermediaries are created equal. Some are well-suited for the sharing of default risk through a central clearing mechanism. Others are more problematic. Credit derivatives are among the most problematic of all. Creating a central counterparty without a full assessment of the unique challenges that these products pose is itself a risk–a risk of a train wreck somewhere down the line when the mispricing of default insurance encourages excessive risk taking, and a member (or members) of the clearinghouse defaults. Conditional on the probability of default, a central counterparty is probably the efficient way to bear risk. But if the CCP prices risk wrong, it could increase the probability of default and actually create more problems than it solves.

Do I know this will happen for certain? No, I don’t. But I do think there is considerable basis to conclude that it is a serious possibility. So before venturing down the CDS CCP road, it would be advisable to (a) give this issue serious attention, and (b) design the CCP to mitigate these problems.

In the midst of the credit crisis, it has become conventional wisdom that OTC derivatives, especially credit derivatives, should be centrally cleared. Like Dudley Dooright, the central counterparty (CCP) will come in and save the day. Given that this idea is supported by many people who had probably never heard of clearing until quite recently, there is room for doubt that these high expectations are grounded in a firm understanding of what clearing is and what it entails.

I will explore various aspects of OTC clearing in several posts, of which this is the first.

The motivation behind these posts is a simple question: If clearing is so obviously wonderful,why has it not been adopted before this?

I think there are two answers to this question, answers which are not mutually exclusive. The first is that clearing would be welfare enhancing, but as a result of some collective action problem it has not been implemented. The second is that there are costs and benefits to clearing, that these costs and benefits vary by product, and for some products, the costs exceed the benefits.

The public policy implications of the two alternatives are obviously quite different. The first provides a justification for robust government intervention: the second does not. I think that both factors have an element of truth. This implies that there is a basis for government involvement, but that considerable care should be exercised.

I have explored both questions in my academic work, and will draw upon that work in drafting these posts. I have recently done more work on the collective action issue, and will report the results of that analysis for the first time in the blog; I will write up the results of the analysis more formally in the coming weeks.

This post focuses on the collective action issue. If clearing is welfare enhancing, but it has not been adopted due to transactions costs/collective action problems, then arguably a case can be made for regulatory or legislative initiatives to encourage–or even force–its creation. Indeed, one can argue that the NY Fed’s frantic efforts in recent weeks to push market participants towards creation of a CCP reflects such a belief.

I first mooted the possibility that CCPs were not adopted due to some sort of collective action problem in a working paper in 1997. I also mentioned this idea in a more recent paper. The basic idea was that clearing could have distributive effects, most particularly, redistributing wealth from well capitalized firms to less well capitalized ones. This could occur if clearing leveled the competitive playing field by eroding the competitive advantage held by well-capitalized OTC dealers.

In my earlier work, this argument was made verbally. It is not an easy thing to formalize it, but I have made some progress in that direction. The model is a relatively simple one. There is a representative agent hedger, with CARA utility. The hedger has an endowment of a risky asset. There are two risk neutral dealer firms. These dealers are risk neutral, and have no endowment of the risky asset, but they have limited capital. Their capital is also risky. Therefore, if they enter into derivatives contracts, they may default as their losses on their derivatives positions may exceed their capital.

The two dealers have different starting capitals. There is a large dealer and a small one. The volatilities of the firms’ capitals can also differ. The dealer capitals are imperfectly correlated.

The dealers incur operational costs to execute derivatives transactions. For simplicity, these costs are quadratic in the quantity of contracts executed. Although the dealers have different capitals, I assume that they are equally operationally efficient. That is, their costs of execution are the same for a given number of transactions.

It is well known that a defaultable derivatives contract, such as a forward or swap, is effectively an option. In this model, the hedger that buys a forward contract from a dealer actually enters into contract with a payoff equal to the minimum of the payoff on a non-defaultable contract, and the counterparty-dealer’s capital.

Due to this optionality, the problem is inherently non-linear, and even assuming CARA utility, must be solved numerically. Therefore, since that nettle has already been grasped, there is no need to make the drunk-looking-for-his-wallet-under-the-lamppost assumption of normality in the distribution of the price of the risky asset, or the values of the dealers’ capitals. Normality facilitates the determination of closed form solutions in linear problems, but since this problem is non-linear that is of no help. I therefore utilize more realistic assumptions. I allow for heavy-tailed and skewed price distributions, by assuming that returns on the risky asset are characterized by a negatively skewed normal inverse Gaussian distribution. (This means that crashes are more likely that upward spikes in prices, as is the case for equity indices.) I assume that dealer capitals are characterized by fat-tailed Student-t distributions. Skewness and kurtosis are realistic features of real markets, and may provide an important reason to hedge and affect the likelihood of default. The world is not normal, and non-normality is especially important in this context.

I first solve for equilibrium in a bilateral OTC market. I assume that all parties are price takers. The resulting equilibrium is quite sensible. The hedger trades more with the firm with the greater capital, and sells at a higher price to the less-well capitalized firm. That is, since the deals are negotiated individually, and since the counterparties are heterogeneous, the terms of trade and quantities of trade differ. The hedger sells more at a lower price to the advantaged well-capitalized firm.

I next solve for equilibrium in a cleared market. In the cleared market, the two dealers form a CCP and share default risk. If one firm defaults, the other party covers the loss, up to the amount of its capital. The hedger suffers from a default only if the dealers’ collective losses on their trades is larger than the sum of their capitals.

The details of possible sharing arrangements under a CCP are complex, and potentially varied, so I simplify matters by assuming that the CCP allocates trades among the two so as to maximize joint profits. This would require some sort of pricing mechanism, or some other means of allocation, which is not modeled specifically. I do turn attention to the possible pricing issues later.

Due to the equal operational efficiency of the two firms, the efficient outcome is for the output of the two dealers to be equal. In the clearing equilibrium, (a) the hedger trades more, (b) the output of the small capital dealer goes up, and (c) the output of the large capital dealer goes down. Moreover, the price at which the large dealer buys goes up slightly, and the price at which the small dealer sells goes down. The hedger’s expected utility rises, and joint profits of the dealers are higher because (a) total output is higher, and (b) total costs go down due to a more efficient allocation of output across the dealers. There is also a more efficient allocation of risk, and the incidence of default falls, even though the scale of trading rises, because of the diversification of the dealers’ capital risks.

In brief, the formal model, solved numerically, generates results along the lines of what I laid out informally in the earlier working papers.

The implications are quite striking, and important. Implementation of a first-best risk sharing mechanism improves welfare (obviously) but redistributes wealth from the large dealer to the small dealer. The small dealer’s smaller capital makes him a less desirable trading party for the hedger, even though from a social perspective diversification and operational costs make it efficient for the hedger to split his trades between the two dealers. That is, from a welfare perspective, pooling of the dealers’ capitals is efficient as it facilitates efficient allocation of output across dealers. (This raises the question of why don’t the dealers just merge? Well, merger of all the dealers into one would effectively create a clearinghouse. Moreover, there may be sources of diseconomies of scale and scope not captured in the simple, formal model that mean that sharing of risk via a clearinghouse is a more effective way of pooling capital for default mitigation purposes than a formal merger.)

Since the joint profits of the dealers are higher under clearing, the small dealer’s profits rise more than the large dealer’s profits fall. In the absence of transactions costs, the dealers would execute a Coasean bargain that would make both better off, and one would expect the CCP to form.

However, it is well known (see particularly Libecap’s work–some done with Steve Wiggins–on the creation of property rights in natural resources), that distributive effects can interfere with the creation of efficient property rights. The common pool problem in oil (which I discussed in earlier SWP posts) is a classic example of this. Even though unitization of oil fields–the efficient allocation of output across potential producers–maximizes joint profits, it has proved devilishly complicated in practice for competing drillers to consummate this wealth-enhancing bargain, due to the tussle over rents.

Moreover, due to the complexities in bargaining, and the potential costs of enforcing any arrangement among the firms, the dealers may arrive at a pricing or trade allocation structure that limits the distributive impact of the formation of a CCP. In the stark model, however, any such deals reduce welfare. Thus, even if a CCP is formed, it may not achieve the efficient outcome. Alternatively, the feasible bargaining outcomes may not include the efficient outcome. If there are fixed costs to implementing the CCP, it may not form.

In particular, as I have shown in my work on exchanges (JSTOR access privileges required), coalitions of heterogeneous firms create the potential for redistributive rent seeking. As a result, organizational form and governance structures for coalitions of heterogeneous firms are usually crafted to mitigate the potential for such redistribution. The resulting structures and pricing mechanisms may not be first best.

It should also be noted that even though CCPs are typically formed as coalitions of dealers, some of the benefits flow to (in the model) hedgers. That is, CCPs are usually coalitions of sell-side firms, but the benefits of CCPs spillover to buy side firms. Again, since the CCP is first best (in the model), there is a potential grand bargain that makes the buy side and the sell side firms better off. This only expands the bargaining complications, however.

Thus, one explanation for the failure to adopt a CCP in OTC derivatives is that even though it is efficient, collective action and bargaining problems have impeded, and in some cases precluded, its creation. Distributive effects can preclude the adoption of efficient organizations and institutions. The model shows that the adoption of clearing can have pronounced distributive effects. Therefore, the failure to adopt clearing may reflect the effects of distributive effects and rent seeking behavior that impede collective action.

In this situation, government action (and essentially, government can serve as a mechanism to reduce the costs of collective action) can improve welfare to the extent that it reduces transactions/coordination costs.

In essence, government is just another mechanism through which parties can act and bargain to achieve a given outcome. Government possesses coercive powers. Moreover, especially in democratic/republican polities, a broad array of interests can influence/bargain through the government. This can be important, and sometimes result in enhanced efficiency–though it can reduce efficiency at other times. In the present instance, for example, buy side firms that would benefit from the formation of a CCP can exert influence on various government entities (the Fed, Treasury, the legislature), and beseech the government to employ its coercive powers to advance the interests of these firms. It may be cheaper for these firms to bargain through the government, than directly with the sell side firms.

This analysis reflects the strongest case for government intervention to, ahem, encourage the formation of a CCP for credit derivatives, and other products traded OTC. But one must be careful. Clearing is a risk sharing arrangement, and it is well known that risk sharing arrangements are often plagued by adverse selection and moral hazard costs. These costs can vary depending on the type of risk being insured. These costs reduce the amount of risk sharing, and in some cases, can make it better not to share risks at all. Thus, the failure to form a CCP that shares default risks for some products may also be due to the fact that moral hazard and adverse selection costs are so large as to make risk sharing inefficient. I will consider that possibility in the next post, and argue that this possibility is particularly pertinent for products like credit derivatives. Thus, the benefits of the formation of a CCP for these types of products may be substantially smaller, and the case for government intervention weaker, than the collective action problem-focused analysis of this post suggests.

There are at last count five major initiatives to create a credit derivatives clearinghouse. The two leading contenders are a CME-Citadel (CIG) initiative, and a collaboration between the Clearing Corporation (and hence the major banks that own it) and ICE (further proof that ICE is firmly aligned with the major banks, as its CBT foray also indicated). This Reuters article gives the CME-CIG venture the inside track. I don’t handicap things quite the same way.

I see two big obstacles to the CME, both essentially political in nature. First, the big banks and CME have been in a cage match for the last couple of years, and the banks will resist transfer of additional power to the CME. The CME will have to depend on buy side support, b/c the buy side hates the banks worse than the CME.

Citadel’s alliance with CME very interesting in this regard. CIG is with the banks in the ELX initiative to compete with the CME in futures trading , but with the CME and against the banks in this effort to compete with the latter. It seems that CIG is trying to play balance-of-power games here, leaning against the dominant party in the exchange and OTC spaces.

Second, the DOJ concerns about CME market power (expressed in the infamous February letter) will become more acute. Their precedent in the CBT merger tied their hands in NYMEX, but it would not do so in contesting CME market dominance in OTC clearing.

The big bank opposition to the CME is probably the biggest hurdle. All of CME’s OTC clearing initiatives have focused on the buy side, and probably for good reason. But support from the big OTC dealers–as long as any of the latter exist–is probably vital for any venture to succeed. But at the same time, the CME has a lot more credibility than the major dealers and the (until recently moribund) Clearing Corp. I would therefore expect some sort of uneasy alliance involving both CME and the dealers and important buy side participants, perhaps resulting from a shotgun wedding arranged by the NY Fed and the Treasury.

It is also interesting to note that both the CME/CIG and CC/ICE ventures plan an execution platform piece to go along with the clearing piece. The execution platform is probably more essential for the CME venture because it has to pry away transactions from the dealers to succeed.

A more transparent pricing and execution system is also an important element of a successful clearing venture. As I have laid out in my academic work, and will discuss further in soon-to-follow SWP posts, clearinghouses don’t create price transparency, they depend on price transparency. Clearinghouses can improve position transparency by collecting and aggregating position information. But clearinghouses use prices determined in the execution market. They do not create these prices. Price information is vital for marking positions and managing collateral, and also for calibrating risk models used to establish collateral levels and monitor clearing member risk. Therefore, initiatives to improve price information are essential to making clearing work. One way to do that is to move trading onto centralized platforms. Another is to centralize the collection and dissemination of price information through the creation of a data hub, a subject I’ve discussed on SWP before.

It will be interesting to see how this will all play out. There will be a political component here, as the sums at stake are immense–as the Reuter’s article discusses. Moreover, the economic issues are quite fascinating. Over the next couple of days I will focus on those issues in more detail in upcoming SWP posts.

Today’s musical selection is Queen’s I Go Crazy. (Some may dispute the verb, or the tense thereof.) What is making me go crazy? The continuing stream of conclusory assertions that someway, somehow, OTC derivatives are at the root of the current financial crisis, and that some past opportunity to regulate these monsters was missed, thereby paving the way for our current difficulties.

This WaPo article is a classic in the genre. Inasmuch as I am quoted in it, perhaps I seem an ingrate to criticize, but criticize I must–although it is better than most. In this narrative, ardent free marketers and patriarchial figures Alan Greenspan, Arthur Levitt, Robert Rubin, and Larry Summers crush the Quixotic crusade of valiant CFTC chair Brooksley Borne to regulate OTC derivatives. If fair Brooksley’s advice had been taken, the article suggests, what went wrong wouldn’t have gone wrong.

That is, to say the least, a very debatable proposition. One thing worth noting is that the focus at the time was interest rate swaps, instruments that have played no role in the collapse of any financial institution. Credit derivatives were in their infancy at the time discussed in the article. Indeed, they were barely a gleam in their inventors’ eyes.

More importantly, although Born warned of the systemic risk posed by OTC derivatives, discussion of how any specific regulation she proposed would have affected current events is completely absent. Nor was Born herself particularly specific at the time.

The article discusses clearing, but importantly misses a key point. The Commodity Exchange Act (CEA) requires contracts for future delivery to be traded on a designated contract market, i.e., and exchange regulated by the government. The concern at the time was that the legal status of OTC swaps ambiguous given this language. Were swaps futures? If they were, any swap not traded on an exchange would potentially be legally unenforceable. This was a major, major concern. In response to this, during this time period the CFTC proposed a set of criteria to distinguish futures–that had to be traded on exchanges–from non-futures, that were exempt from the contract market provision of the CEA. One of the criteria that would have made something a future was centralized clearing. That is, a centrally cleared product was more likely to be considered a future than one that was not centrally cleared.

Thus, if anything, CFTC policy ideas at the time militated AGAINST moving to central clearing of OTC instruments. In essence, the Born-era CFTC approach tied the means of execution (on an exchange) to the means of sharing credit risk (central clearing.) The Commodity Futures Modernization Act (CFMA) essentially avoided this pernicious bundling constraint, and thereby made it more likely that OTC clearing would develop.

There is no reason to force all trading into a particular model, e.g., to force all transactions to occur on exchanges. Many important markets are dealer markets–the Treasury market being a prime example. A CEA-type link between trading mechanism (on exchange) and performance risk sharing mechanism (clearing) creates an unnecessary constraint that raises costs. It requires a one size fits all approach despite the fact that a diversity of trading and risk sharing mechanisms satisfying heterogeneous and diverse needs is likely to be efficient.

The article also denigrates the elimination from the CFMA of a provision calling for federal oversight of a clearinghouse. But, as the article notes, the OTC clearing idea “sat dormant.” If it wasn’t adopted with less onerous regulations, is it reasonable to conclude the industry would have started one if more strict regulations were in place?

The reasons for the dormancy of OTC clearing are important to understand, and not completely understood. I have a slew of clearing-related posts coming, so I will defer fuller discussion until then. For now, suffice it to say that Brooksley Born’s defeat at the hands of the patriarchy had nothing to do with it. As I already noted, the Born ultimatum approach would have actually impeded the development of clearing. It should also be noted that the article’s narrative is contradictory; the article specifically states that Treasury pushed for the idea of an OTC clearinghouse even though Treasury Secretary Rubin is portrayed as one of Born’s antagonists.

Moreover, the article states that the failure of AIG was attributable to its large losses in credit derivatives, and implies that if credit derivatives had been better regulated then (a) AIG’s failure might have been avoided, and (b) the financial crisis would have not been as bad as it is. The latter proposition is the important one, and the basis for it is completely lacking in the article, and in most discussions of the issue.

Ultimately, AIG’s failure is attributable to the fact that it insured against losses on mortgage securities, and these mortgage securities plummeted in value. It is exactly analogous to an insurance company that insured against earthquakes, only to be bankrupted when a trembler of unprecedented power occurred.

That is, in the first instance AIG’s losses on credit derivatives were a symptom of, rather than a cause of, the financial tremors. And as I have written before, it is plausible that (a) AIG was the efficient bearer of this risk, and (b) as a result, the same tremor would have wreaked even greater havoc on less-well capitalized institutions had they not purchased insurance from AIG. No insurance company should be so well capitalized that the probability of default is zero. Thus, the fact that an insurance company failed does NOT imply that constraints on its issuance of insurance would have been welfare improving. In fact, the opposite conclusion is far more likely to be true; constraining or eliminating even incomplete insurance would have almost certainly been inefficient.

To make OTC credit derivatives the villain of the piece requires a more complex argument. One would have to argue that the existence of insurance for mortgage derivatives contributed to the proliferation of subprime debt, and tranched securities created atop it, and to the housing bubble. For these mortgage/real estate factors are at the root of the current difficulties. This causal link is inherently indirect, and very hard (and perhaps impossible) to prove. Moreover, any contribution of credit derivatives is almost certainly of second or third order as compared to the direct causes–loose monetary policy, political encouragement and subsidization (via Freddie and Fannie) of subprime lending, agency problems, rating agency failures, etc.–that fed the housing bubble and the proliferation of subprime debt.

I again reiterate that one needs to be specific as to the content of regulations before passing judgment on their likely effects. In particular, it is very difficult to demonstrate how most regulatory proposals, which frequently focus on various fraud, disclosure, trading mechanism, and manipulation-related issues, mitigate systemic risks.

Furthermore, I would suggest that any attempts to regulate instruments per se are almost inevitably doomed to failure. Regulate one instrument, and in a trice financial engineers will figure out a workaround. This is almost certainly a wealth-reducing arms race. (Were I speaking completely self-interestedly, I would advocate such regulatory efforts, for it would increase the derived demand for my services.) A functional regulatory approach is preferable under these circumstances, but the basic distinction between functional regulation and regulation of particular instruments has been completely overlooked in most of the public debate.

In sum, I go crazy because the public treatment of regulatory issues surrounding derivatives is largely built on myths, incomplete history, and a failure to understand the basic vulnerabilities of any regulatory system. A Reuter’s article aptly states that credit derivatives are “vilified as a major contributor to the current financial crisis.” This is true, but the argument behind the vilification is largely–and arguably completely–nothing but an assertion, repeated over and over again, with little supporting argument and less supporting evidence. This is the perfect hothouse environment in which to grow bad policies and bad regulations that will have serious, adverse unintended consequences down the line.

What is needed is a sober appraisal of the costs and benefits of specific financial innovations, and proposals to regulate their use and development. What we have instead is knee-jerk reactions based on bad analysis. Virtually everyone is calling for more regulation, details to follow. Having seen how regulation often works, I reply: Be damned careful what you ask for.

Treasury Secretary Paulson called an assembly of all the major banking families, and offered them billions in equity in exchange for preferred shares. The money sentence: “The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.”

The first offer not to be refused. I doubt it will be the last.

I continue to believe that the Humpty Dumpty Option is worthy of consideration, and perhaps of another Don Corleone soliloquy. Although stabilization and recapitalization of the supermajor banks is certainly an important element to addressing the credit crisis, it will not be sufficient. It focuses on the biggest banks, and only on those in the US, but the problems exist at banks of all sizes throughout the US and the world. This intervention does not address the issue of the vast amounts of dodgy mortgage debt lurking in bank portfolios, and it is this dodgy debt that is at the root of the problem.

Interestingly, the Treasury seems to be moving away from the TARP scheme (praise the Lord). This may reflect (a) that it will take a long time to get the auction process going, (b) the Treasury’s dawning recognition that the auction program is likely to be impractical, and (c) that more urgent action was needed to stabilize things. This last consideration is somewhat worrisome, and I think that helps explain why other initiatives announced by the Treasury and other governments over the past couple of weeks have seemed to send the markets into a tizzy. The markets infer from every new move that the Treasury and other governments are signaling that things are even worse than originally feared.

Humpty Dumpty has numerous merits, some of which I pointed out in the original post. One advantage is that although it would require the exercise of Federal power to implement, it would not entail government ownership or direct investment, and could reduce the amount of government investment required to stabilize the banking system going forward. Under this alternative, the original investors in mortgages and mortgage derivatives would continue to own claims against these assets. This would limit the potential for wealth transfers between taxpayers and (current) asset owners. It would also limit the massive potential for mischief that accompanies the government’s holding large stakes in the financial system.

Such transfers would be inevitable under TARP, and it’s a heads we lose tails we don’t win proposition. If the transfer is from asset owners to the taxpayers (as would be the case when the government underpays), the program would do little to address the capitalization of banks, and could actually make them worse off, thereby prolonging the crisis and requiring additional injections of public funds later. If the transfer is from the taxpayers to the asset owners, well, that might effectively inject capital into some banks, but some of the windfall is almost certain to flow to asset owners who do not need assistance to avoid posing a systemic risk.

Furthermore, since it is almost certainly easier to value mortgage-based claims relative to one another, than in cash, valuation errors (and the related wealth transfers) should be smaller under Humpty. This would reduce the magnitude of the wealth windfalls–which again, under this plan, would be among asset owners who exchange their claims on the mortgage-based assets for shares in The Firm, and would leave the taxpayers out. In essence, The Firm would essentially pool and share valuation risk within the financial community (banks, hedge funds, and other investors.) This seems preferable than sharing that valuation risk with taxpayers. It should also be noted that if all asset owners participate, since many of them have diverse portfolios of mortgage-based claims, the variability of valuation errors on these portfolios will be smaller than the variability of valuation errors on individual components of them.

The Humpty Option also addresses the problem at the root, by undoing the complexity (and associated informational problems) created by financial engineering. Rather than razing that thicket, the TARP/auction alternative runs right into it. It would be infinitely easier to create a liquid market in shares of a portfolio of all the mortgage-based assets in question than in many of–let alone all of–the mortgage-based assets individually. If the liquidity discount on the individual assets is as large as Paulson and Bernanke suggested in touting TARP, the shares in The Firm would likely be much more valuable than the sum of the values of the individual assets even were the TARP program to improve liquidity in the market for the individual assets.

In other words, the Humpty Dumpty Option almost certainly would accomplish more than TARP, and without putting taxpayer funds at risk.

When thinking about Humpty over the weekend, a quote from Eisenhower came to mind (I quote from memory, but I’m sure it’s close to the original): “If a problem appears intractable, enlarge it.” That’s Humpty Dumpty in, well, if not a nutshell, an eggshell. Go large. Tackle the problem at the root.

It is not The Solution, but neither is making multi-billion dollar “investments” in the big banks. In conjunction with other efforts, however, it can make a big difference. Indeed, by mitigating the bad asset problem at no direct expense to taxpayers, it would reduce the cost of other measures necessary to restore the financial system to health.

By using the Don Corleone approach–and Paulson just crossed that bridge today–it would also be possible to avoid the adverse selection problems that will almost certainly bedevil TARP (and which would ultimately be the source of wealth transfers from taxpayers to asset owners.)

The Economist has two articles that cleave very closely to various SWP posts that predate their publication.

This one discusses the “collateral damage” of the SEC short-sale ban on the convertible bond market, and particularly its effect on banks. The 9 October article says that the effect on convertibles was “a typical example of the unintended consequences of meddling with the markets in response to populist pressures.” Gee, but that seems very, very similar to what I wrote on 27 September in “Unintended–But Totally Predictable–Consequences.” Specific use of the term “Collateral damage”? Check. Specific use of the term “Unintended consequences”? Check. Analysis of the damaging effect on convertibles market and on banks? Check. Criticism of stupid pandering policy? Check. Very pronounced similarities here, undoubtedly.

This one makes several arguments regarding commodity speculation that I have flogged repeatedly on SWP and in my Congressional testimony and WSJ piece. Here, the similarities aren’t quite as close, but the focus on looking for distortions in stocks and the lack of a direct channel by which fund money can affect physical commodity prices reprises two themes that I have emphasized repeatedly.

But, then again, maybe both things are so obvious that it’s no surprise that the Economist advanced the same arguments. But, especially with the short sale ban post, the similarities in argument and language make me lean towards rejecting the null hypothesis of “coincidence.”

Any thoughts, readers?

In an earlier post I mused–in an abbreviated, bloggish sort of way–that reassembling subprime and Alt-A mortgage backed securities by bundling CDO tranches would improve liquidity in this market. My confidence in this intuition was strengthened by reading Gary Gorton’s much more thorough and penetrating analysis of the informational effects of the complexity of CDO structures, and the implications of these effects for the liquidity of the CDO market. (H/T to Marginal Revolution for the Gorton link.)

That has encouraged me to think bigger. What follows is basically a thought experiment, with a critique of the difficulties of making it a reality.

How big? What if . . . ALL assets backed by subprime mortgages were contributed to a single firm? (Still noodling over how synthetic CDOs would fit into this scheme.) The owners of these assets would receive shares in this corporation, which I will refer to as The Firm.

This would offer several advantages.

Most importantly, The Firm would effectively hold basic subprime mortgages. Bundling all the contingent claims on all the subprime mortgages would eliminate all the offsetting embedded options positions, leaving only the underlying mortgages.

Now these would not be easy to value, but they would be a lot easier to value than CDOs and CDOs squared, etc., because these products (as Gorton points out) embed complex option structures. The underlying mortgages have optionality (pre-payment, and especially default). Every slicing and dicing creates additional optionality–CDOs are compound options, CDOs squared are compound options on compound options, and so on. And every additional option increases complexity, destroys information, and makes valuation inherently more difficult.

The reduction in complexity–and the reduction of what Gorton refers to as the “informational losses” that result from the creation of complex chains of contingent claims on the underlying mortgages–would make the shares in The Firm substantially more liquid than the CDOs. Moreover, it is well known that lemons problems are less severe for portfolios than for individual assets that make up those portfolios. As a result, claims on portfolios (e.g., S&P 500 futures) are usually far more liquid than claims on the individual components of the portfolios. Thus, shares of The Firm would be a lot–a lot–more liquid than the CDOs contributed to it, and even more liquid than the underlying mortgages.

If, as is almost certainly the case, illiquidity depresses prices, the shares of The Firm will have a greater market value than the current market values of the CDOs, etc., that are contributed to the firm. This increase in market value would reduce the insolvency issues and questions currently dogging banks and other intermediaries.

This effect is essentially what the Paulson plan is trying to achieve through the creation of a market for the individual CDOs. Given the heterogeneity of the individual CDOs, however, in my view it will be much harder to create a liquid market in these individual components than it will be to create a liquid market for less complex bundles of them. (A sort of alchemy is at work here–putting together multiple complex things in the right way results creates a less complex thing. This is the KISS–keep it simple, stupid–approach to financial engineering.)

Financial institutions that contribute assets to The Firm will replace these assets on their balance sheet with shares in The Firm. This has two important effects. First, since due to their greater liquidity the shares are likely to have a higher market value than the “fair value” of the assets the banks give up, this innovation will increase the capitalization of the banks. Moreover, it will homogenize the balance sheets of financial institutions because the shares are identical and fungible. This will make it easier for banks to evaluate one another. This, in turn, may help rejuvenate the interbank lending and repo markets, ,which are malfunctioning primarily because banks do not know with any precision who is solvent and who isn’t due to the opacity of balance sheets that contain subprime exposures. (The shares can also potentially serve as repo collateral in both private transactions and transactions with central banks.)

Another potential benefit is that The Firm would internalize the benefits of restructuring the underlying mortgages and optimizing foreclosures. This could redound to the benefit of both (a) the shareholders (because the values of the CDOs are reduced because securitization means that those best able to negotiate restructuring of the underlying mortgage debts do not reap the benefits), and (b) the mortgage borrowers who enter into mutually advantageous restructurings with The Firm.

In a nutshell, putting the mortgage Humpty Dumpty back together to create a less complex, more homogeneous financial claim–equity in The Firm–would improve market liquidity and facilitate more efficient restructuring of mortgage debts, thereby easing the solvency and lemons problems that bedevil banks and the money markets.

Sounds wonderful, but the Humpty Dumpty solution as outlined above is akin to Steve Martin’s plan to make a million dollars without paying taxes: First, make a million dollars. I’ve cut straight to the end by assuming the magical creation of The Firm, just as Steve Martin assumed away the hard part of making $1 million without paying taxes.

The problem, of course, is getting there. There are myriad obstacles practical and political.

Most importantly, there is a major scale economy here. The benefits (per dollar of principal or asset value) are increasing in the fraction of subprime mortgage contingent claims that The Firm owns. If it owns all these contingent claims, it will end up with the least complex possible portfolio (simplest, not smallest)–the underlying mortgages, without all of the compound optionality, compound compound optionality, etc., embedded in the CDO structures.

Even though as a result of this scale economy it would be best to put everything in The Firm, it is hard to imagine that this outcome would occur voluntarily, without considerable coercion. Even though this approach makes the size of the pie bigger, and arguably much bigger, it will inevitably have distributive impacts which will induce collective action problems. Moreover, a voluntary approach would likely create adverse selection problems. I’ll consider each point in turn.

Contributors of assets would receive shares in the corporation. Given that the assets contributed are inherently heterogeneous, this raises the issue of how to determine how many shares would be distributed for each asset.

Now, mispricing (which is almost a metaphysical concept in this context) would lead to redistributions of wealth among the contributors of assets. (This is an important difference with the Paulson Plan, in which mispricing leads to redistributions of wealth between current asset owners and taxpayers. This is a potential political selling point for this alternative.) If The Firm gets all assets, this is merely shifting wealth around among asset owners, and from behind the veil of ignorance (which is almost completely opaque here), ex ante any individual asset owner is as likely to incur a distributive windfall as incur a distributive loss.

However, just as everybody thinks–or will assert–that their child is better looking than average, even if some have faces that could stop a clock, asset owners will think–or assert–that their assets are more valuable than average. They will fight tooth and nail to get the highest relative valuation of what they have. This will generate massive transactions costs.

The amount of money that could be redistributed could be immense. Voluntary negotiations among asset owners to form The Firm, and determine the pricing (in shares) of each asset to be contributed, would generate tremendous inefficiencies as the asset owners would negotiate to receive windfalls and impose the distributive losses on others. As Gary Libecap and Steve Wiggins showed in their analysis of unitization of oil fields, even when an agreement leads to substantial increases in aggregate wealth, rent seeking to receive redistributive windfalls can preclude the consummation of the wealth enhancing Coasean bargain. And the magnitude and complexity of unitization negotiations pale in comparison to those involved with the creation of The Firm.

Moreover, if contribution of assets to The Firm is voluntary, adverse selection problems are likely to be acute, resulting in incomplete participation. If The Firm sets a schedule of prices, X shares for AAA (at issuance) CDOs, Y<X shares for AA (at issuance) CDOs, etc., based on a the best available information about the average value of these various securities, asset owners with private information will tend to withhold the assets with higher than average values, and contribute the lemons. Thus, (a) The Firm is unlikely to acquire all of the assets voluntarily, and (b) will be stuck with the lowest quality ones.

There is likely be a critical mass effect here. Due to the scale economy discussed above, the value of the greater liquidity of The Firm’s shares will encourage the owners of assets that are undervalued relative to other assets by the share distribution formula to participate anyways because the alternative is to hold onto the assets or sell them individually in an illiquid market. (I.E., even if I know my asset is receiving a smaller share of The Firm than another asset of the same quality, I may still contribute it in exchange for shares since those shares are worth more than I could get by selling the asset as a standalone.) Since the liquidity benefit should be increasing in the fraction of troubled assets The Firm acquires, once The Firm gets big enough the adverse selection problem should disappear. The challenge, then, is to make The Firm big enough to start this virtuous cycle. This is not a self-starting phenomenon. There is something of a Catch-22; everyone will want to participate if The Firm is big, but how can it get big to start with? Asset owners may re-enact the old Alphonse and Gaston vaudeville routine: After you, Alphonse. No! After you, Gaston. No, I INSIST, Alphonse. . .

It should be noted that the valuation challenges in setting the prices in shares of The Firm for different assets should be less daunting than attempting to determine the prices of these assets in dollars (or equivalently, other goods and services). The values of subprime contingent claims are affected by a set of common factors, most importantly, real estate prices and interest rates. Errors in estimating one of these factors will tend to affect the values of different contingent claims in similar ways. For instance, if in determining values, real estate prices are assume to be lower than they are in actuality, the prices of all mortgage contingent claims will be underestimated. As a result, the errors in estimation of the values of the various contingent claims relative to one another (which is what is relevant in determining the allocation of shares) will be smaller in magnitude to errors in the estimation of the values of these claims to other goods and services.

Of course, due to the optionality of the CDOs, a Z percent error in the real estate prices assumed to determine the number of shares to be given for each asset will not lead to a Z percent error in each of the assets. So there will be errors in determining the relative prices. But due to the fact that all the assets at issue are affected by a set of common factors, it should be possible to set relative prices (i.e., the number of shares to be distributed for each asset) more accurately than it would be to set the prices of each asset in dollars–which is what the Paulson Plan attempts to do.

As a result of the collective action/rent seeking and adverse selection problems, it is highly likely that considerable coercion would be required to create The Firm. That is, the government would almost have to employ the Don Corleone option. (This could involve punitive taxation on the owners that do not contribute their assets, or abrogation of the CDO contracts that are not contributed.) It would truly take all the King’s Horsemen and All the King’s Men, exercising vast powers, to put Humpty Dumpty together again.

Given that the asset owners are numerous and include citizens of myriad nations (not just the US), the political and diplomatic outcry that would result from such measures would be deafening. More importantly, the exercise of such overwhelming coercive power is truly frightening, and would set troubling precedents. As someone who values free contract, and the sanctity of private contracts, and abhors the exercise of government power, I could not in good conscience countenance such a solution. But . . . given that other alternative actions that will be advanced if the Paulson Plan fails will also inevitably involve massive coercion, at the end of the day we may be confronted with choosing between the least coercive of two evils. Or put differently, we may have to determine which alternative offers the greatest value, once the costs of coercion are taken into account. If we come to that sticking point, The Firm, with CEO Corleone, may look good by comparison.

I should also note that one of the potential theoretical benefits of The Firm discussed above may prove problematic. Specifically, although in theory The Firm should be able to negotiate more effectively and efficiently to restructure underwater mortgages (because of its better incentives and information), in practice it would face tremendous political pressures that would impede its ability to achieve this outcome. The owners of The Firm–those contributing assets, or those to whom the asset contributors sell their shares–want to maximize the value of the underlying mortgages. But, the borrowers want to minimize the value of those mortgages, and they will be a powerful political constituency. Indeed, one can imagine that a company that could only be created by a massive exercise of Federal power would be the creature of that power, and would be used as an instrument to redistribute wealth from the owners of mortgages to the mortgage buyers. This would, of course, offset in whole or in part the salutary effects of the creation of The Firm on the balance sheets of financial institutions, and the follow on benefits to the money and credit markets, and the real economy. At the very least, given the trillions of dollars at stake, The Firm would be at the center of the biggest stakes political game in history. Public choice theory tells us that efficiency is not the most likely outcome of such a contest.

So, if we start at the end–the creation of The Firm, the proverbial Bad Bank on massive doses of steroids–this approach of attempting to reverse the effects of years of Frankensteinian financial engineering has some real attractions. It would not be a complete fix–the underlying mortgages are experiencing huge defaults, and as a result the value of The Firm’s shares will still be less than the principal amounts of the underlying mortgages, meaning that banks and others will still have holes in their balance sheets, albeit smaller ones. Even those smaller holes may be big enough to make some institutions insolvent. But we’ll have a better idea of which institutions are insolvent (which will help direct government funds to where they are most needed, and which should help mitigate the uncertainty that is effectively shutting down the corporate paper and interbank lending markets), and we’ll have smaller holes to cover either through recapitalizations or government performance of deposit insurance obligations. This approach avoids many of the problems with the Paulson Plan, which relies on buying the individual assets.

The problem is getting there. It will require coercion–maybe not mobs with pitchforks and torches besieging Dr. Frankenstein The Financial Engineer’s castle, but the government employing its powers of taxation and the ability to abrogate private contracts. Lots of coercion. That is a cost, indeed. But as Ronald Coase never tires of pointing out, in the real world we have to compare real alternatives to real alternatives, rather than to Nirvana. Maybe, as Churchill said of democracy, the creation of The Firm is the worst possible alternative, except for all others that have been considered or tried from time to time.

This concept is still a protean one. I think it has some merits that deserve consideration, but I am sure that there are difficulties that I have not yet discerned. Although it is speculative and theoretical, it is no less speculative and theoretical than the bailout bill just enacted into law. Moreover, I think it has some advantages over that bill. If, as I expect, the bailout plan does not work as hoped (and it is a triumph of hope over experience), the Humpty Dumpty Option deserves a look.

At the very least, I think that this thought exercise helps focus attention on a fact that has not received anything near the attention it deserves: Namely, that any attempt to deal with the subprime morass (or, as my former Naval Academy roommate, now a workout specialist for small banks, puts it, la cosa subprimo) should go to the root of the problem. As Gorton persuasively shows, that root is complexity induced by financial engineering that created dense layers of options on top of options. Reversing that complexity–putting Humpty back together, or, to mix metaphors, putting the toothpaste back in the tube–would go a long way to mitigating the problem. Such a reversal would inevitably involve coercion, so the question will be: is the cost of coercion worth it? As bad as things are, I can’t answer affirmatively today. Tomorrow. . . who knows?

So, for now, consider this a straw man that lays out a particular approach to attempt to strike at the root of the problem. I therefore encourage commentors to (a) point out difficulties, or new complexities that this alternative would create, and (b) propose other ways to attempt to reduce complexity through reverse financial engineering. For if the specifics of what I have outlined here are faulty, I have a strong sense that the fundamental intuition that such reverse engineering is the way out of this mess. If anybody can think of incentive compatible schemes, schemes that are voluntary and will not be scuppered by collective action problems, transactions costs, and adverse selection. . . please share them with the class!

Could be raining.

That (apologies to Marty Feldman) is my take on the current iteration of the bailout process.

Actually, it could be a lot worse. The egregious “affordable housing” (AKA let’s dump huge amounts of money in the same ratholes that helped get us into this mess) component of the Democrat proposal is gone. (This is the part that was pushed most aggressively by the usual suspects, Frank & Dodd. What’s next? Willie Sutton to negotiate federal sentencing guidelines for bank robbery? Al Capone to bargain over liquor distribution laws?)

But that is damning with faint praise. As for what’s actually in the proposal? Color me less than enthusiastic.

Everybody involved made a big hullabaloo over the inclusion of warrants in the deal. Hello, finance 101 calling. Those selling troubled assets to the government will take into account the value of the warrants when calculating the price in dollars they will accept for the assets they want to sell. Every dollar increase in their estimate of the value of the warrants they must give up will reduce the reservation price for the cash component of the sale.

But it’s actually worse than that. The warrant component increases the government’s exposure to adverse selection/winner’s curse/lemons problems. The warrant is a claim on the assets (and liabilities) of the pieces of the firm that aren’t sold to the government outright through the auction or whatever process the government uses to buy assets. Indeed, equity, and especially a levered claim on equity like a warrant, is the most information sensitive component of a firm’s capital structure. The seller of the troubled asset has much better information than the government about the value of the unsold portion of the business (which includes not only the value of the assets and liabilities on the balance sheet, but the values of other pieces of the business, such as the franchise value of a retail banking operation.) Thus, if the winner’s curse is bad for the troubled assets, it will be much worse for the warrants.

The CEO of Bankrupt Bank (Motto: “Insolvent? Who? Us?”) will be glad to give Uncle Sucker all the warrants he wants. You want warrants? We got ’em!

Moreover, the inclusion of warrants will greatly complicate the purchase process. In an auction for a particular MBS or CDO, the government will receive cash bids, and will demand warrants. The cash components of the bids are readily compared, but the warrant components will be extremely difficult to value. (Maybe the government will have to hire investment bankers to do this. Maybe that’s the real point.) This will add an element of arbitrariness and uncertainty to the determination of the winner.

It also strikes at the root of the theory underlying the buy-the-bad-assets-plan. The bids submitted to, and therefore the prices determined in, the auctions will not reflect only the value of the assets qua assets, but they will reflect the value of the warrants. This last component adds noise to the auction prices (and bids) as measures of the true value of the assets. Since the main defensible rationale of the buy the assets approach is that it will increase liquidity in the market for troubled mortgages by generating information about their value and thereby mitigating informational asymmetries, this additional noise impedes the ability of the asset purchases to achieve the stated objective.

UPDATE: My analysis of the warrant feature of the proposal was based on (a) the statement from Pelosi’s office that it “[g]ives taxpayers an ownership stake and profit-making opportunities with participating companies.” My interpretation of this, based on earlier descriptions of this feature, was that any company that sold assets to the Treasury would have to provide warrants. Tapscott’s summary of the “final bill” gives a very different impression: “Mandatory equity interests in total takeover scenario. Proportional equity interest based on percentage of assets sold if deemed appropriate Secretary.”

This is quite different. It means that, absent discretionary intervention by the Treasury secretary, the government will obtain equity only when it takes over an institution. Thus, the auctions for the assets will be clean, and not present the problem of multiple and potentially difficult to value sources of consideration paid for each asset purchase. This isn’t quite so problematic.

Also, the Tapscott summary states that the final bill has no bankruptcy “cramdown” provision as originally proposed. More good news.

END UPDATE.

UPDATED UPDATE.   Seems Tapscott got it wrong.   The actual draft bill requires the Treasury to obtain warrants on non-voting common stock (from companies with listed equity) or senior debt (from those without) from any financial institution selling a troubled asset to the Treasury.   There is no language limiting the provision to institutions the government takes over.   It is unclear from reading the language whether the warrant is required for each transaction in which an institution participates, or whether the warrant is a one-time pay to play provision.   Although the act sets out the purpose the warrant provision is intended to achieve, it establishes no specific guidelines.     All in all, the warrant provision is impossibly vague, and will no doubt need the Treasury to specify detailed guidelines before it is operative.   These specifics could either neuter the provision, or create the problems suggested in my original post.   I’ve only scanned the rest of the bill, and “vague” seems the operative word.   There are numerous gaps that will have to be filled going forward.

END UPDATED UPDATE.

Another problematic feature of the proposal is the inclusion of pension funds and politically favored financial institutions (e.g., community banks) to sell assets to the government. As I have argued before, one problem with the purchase the assets plan is that it doesn’t necessarily direct liquidity (cash in exchange for illiquid assets) to the institutions that most need it. The expansion of the set of participants only exacerbates this problem, as many of the new participants (a) likely don’t need the liquidity, or (b) don’t pose a systemic risk even if they do.

The only argument I can see for their inclusion is to increase the competitiveness of the auction process. Any such competitive benefit is conjectural at best. I wonder whether these firms would really want to participate in the auctions, knowing that they are likely relatively uninformed. If they don’t participate, though, they won’t get any money, which would alleviate my first concern.

All in all, my verdict on this iteration, as on all the others, is that it seems to put great faith in an untested theoretical conjecture; that the government purchases of some troubled assets will improve liquidity in the market for all troubled assets, thereby increasing their value and facilitating the recapitalization of the institutions that hold them. $700 billion–or whatever–is a helluva lot to pay for an experiment.

As a result, I fear that the epitaph for the bailout may be the same as the one Jefferson Davis penned for the Confederacy: “Died of a Theory.”

A couple of quick, semi-random thoughts.

First. Many of the difficult to value assets in bank portfolios are tranched claims on payments from mortgages. The securitizers took pools of mortgages, and created securities that had different priority claims on the cash flows. The more senior tranches have first priority on cash flows, and lowest exposure to a default by the borrowers; the less senior tranches have lower priority, and the highest exposure to borrower default.

These complicated structures have option-like characteristics, and complicated relations between default rates and timing on the one hand and security cash flows on the other. This makes each piece more difficult to value than the underlying pool of the loans. Put differently, even if you have a good idea on the default risk of the underlying pool of loans, it is more difficult to determine how this default behavior will affect the cash flows on the different tranches. Therefore, it is harder to value the individual tranches than the pool of loans underlying them.

One way to facilitate the valuation of these securities, and hence the liquidity of the market, would be to reverse the tranching process and create vanilla MBSs. Equivalently, if the bailout plan proceeds, and the government starts bidding for assets, it could solicit offers only for bundles of the tranches collateralized by a given pool of loans, where each bundle would be equivalent to a vanilla MBS on the underlying pool.

Operationally this might be a challenge because, by design different tranches were typically marketed to different clienteles. But it is worth considering as part of the strategy, as pools of whole loans should be easier to value than the sliced and diced CDO tranches created from them.

Second, the WaMu bailout seems to be preferable to the buy assets approach of the Paulson plan. It is targeted at an institution that needs help, and utilizes the existing powers of the government. Indeed, other than the monoline insurers and the investment banks (notably Goldman and Morgan Stanley), most of the financial institutions that warrant concern are banks subject to FDIC regulation, and therefore standard FDIC approaches can be relied upon rather than taking a wholly new approach that doesn’t necessarily address the problems of the institutions posing systemic risk.

Third (I guess this is a bonus, as I set out promising only “a couple” of comments). The essential intellectual underpinning of the Paulson plan to buy assets is that the auction process–or whatever process that the government will use to buy assets–will improve market transparency. That is, the prices “discovered” in the auctions/market purchases will reflect private information about the value of the assets, and other market participants can use this information to mitigate asymmetric information problems that seriously impair market liquidity for problem assets. Even though sellers will receive an information rent (i.e., the government will overpay due to its information disadvantage), the creation of information is a public good that improves efficiency that is an offsetting benefit.

Perhaps. I am skeptical that the auction prices will be all that informative, given the heterogeneity of the underlying assets and the (related) lack of competition that is likely to characterize the auctions. Discovery of a noisy price in a not-very-competitive auction for a particular CDO is unlikely to improve the precision in the valuation of another CDO that is not bought in the auction.

The SEC’s short sale witch hunt has burned some innocent victims–convertible bonds and options. Short selling of stocks is an essential hedging tool for these instruments, and the short sale restrictions have therefore undermined widely used hedging strategies, thereby driving the investors that rely on them from the market.

Brilliant move. The effect on convertible bonds is particularly unfortunate. Just when financial institutions are looking to recapitalize, throw a monkey wrench in a part of the capital market many banks have tapped to strengthen their balance sheets.

This is a perfect illustration of the dangers of regulators taking a cartoon view of the world, where evil villains are responsible for all the chaos in fair Gotham. In their monomaniacal focus on the manipulative potential of short selling, Cox and his his minions have completely overlooked its benefits, and implemented policies that have inflicted substantial collateral damage on other portions of the financial market, including parts of the market that could facilitate fixing problems at the institutions allegedly protected by the regulations–banks. This is particularly tragic given that the rationale for the policy is based on anecdote–to put it as charitably as possible. Remember what George Stigler said: The plural of “anecdote” is not “data.”

The collateral damage inflicted by a policy with a threadbare rationale (or should I say it is nakedly short of a rationale?) provides a chilling reminder of how regulation can make things far worse, rather than better. Apparently Chris Cox wants to regulate the financial markets in the worst way, and has succeeded.