Streetwise Professor

Vladimir Putin weighed in on the ouster of S&P’s CEO:

Russian Prime Minister Vladimir Putin on Wednesday appeared to link the resignation of Standard & Poor’s chief executive to the agency’s downgrade of the U.S.’s sovereign rating earlier this month.“We all know what goes on in the financial world. Here you have the S&P ratings agency lowering the U.S. sovereign debt rating. And now they fired the agency’s head, and started an investigation regarding the agency itself,” Mr. Putin told a meeting of Russian academics, Interfax news agency reported.

“There is much that’s unclear about the situation, many things which are, let’s say, superficial,” Mr. Putin said.

To quote Joe Biden (always dangerous, I know), Putin’s suspicions are completely understandable.  That would be the obvious inference regarding a similar situation in Russia.

The more interesting question is whether Putin is merely projecting/mirror-imaging, or is instead correct in his conclusions.

Developments in recent years, most notably from 2008 on, and especially post-January, 2009, increase the odds that Putin has in fact nailed it.  There has always been an element of gangsterism in American government (as in any government), but those tendencies have become more overt and numerous in recent years.  So, as a Bayesian, I would say that my estimate of the likelihood that Putin is right is far higher now, than it would have been several years ago.

There is an ironic sort of convergence in this story.  One of the reasons my interest in Russia was rekindled several years ago after decades of slumber is that it struck me as a classical liberal (libertarian, if you must) dystopian novel come to life.  It illustrated all of the dysfunctions that arise in the absence of a rule of law and particularly property rights, the atomization of civil society, the dominance of a government operating with few real institutional checks, and the intersection between private economic interests and said unchecked government.

A crucial function of a dystopian novel, of course, is to point out through extension and exaggeration what will happen if existing repressive tendencies and features in society grow.  If the leading figure in a real world dystopia has, in fact, correctly diagnosed the reason why Deven Sharma was ousted from S&P, it would indicate that the US is itself slouching towards dystopia.

I have little respect for the rating agencies, and recognize that they are in many respects government creations and benefit from various government protections and mandates.  That said, N wrongs don’t make a right.  Better to eliminate privileges as a matter of principle, than to strongarm a company for having the temerity to question Leviathan’s solvency.

So I hope Putin is merely projecting, but I would also lay non-trivial odds on his prescience, at least in this matter.

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There are rumors flying around–all adamantly denied–that JP Morgan Chase will acquire tottering Bank of America.  In my opinion, that’s crazy talk.  It’s crazy because JPM has to be smarter than to buy a toxic loan dumping ground and lawsuit magnet.  (There’s a joke going around: “Will the last person to sue Bank of America turn out the lights?”)

The only way it would not be crazy in the sense of it might actually happen is that another shotgun marriage is being arranged, with Uncle Sam at the trigger.  I can see that.  This is a tried and true regulatory game.  It happened in 2008: Bear (with JPM), Merrill (BAC), Lehman (with Barclays, ultimately aborted).  It happened during the S&L Crisis.  Regulators like this because offering financial support to dodgy banks through the front door is politically radioactive, and that’s especially true now.   Mashing together a (relatively) healthy bank and a very unhealthy one kicks the problem into the future, and miracles–including resurrection–can happen in the future, dontcha know.  Moreover, regulators can reduce the risk of leaving fingerprints if they do it this way.  If it turns out bad, it looks like the dealmakers made the mistake (witness BAC’s Ken Lewis).

But it would still be crazy in the sense of economic irrationality.  The first order problem that needs to be addressed right now is rightsizing banks, not creating fewer, bigger ones.   Moreover, the analogy that I made with respect to Europe–amputation vs. gangrene–works here too.  Grafting the definitely gangrenous Bank of America on top of the still healthy (in comparison to its peers around the world) JP Morgan would extend the rot far more directly than would be possible along the normal inter-bank connections.  It would be better to ringfence, isolate, quarantine Bank of America and deal with the problem straight up (like the Swedes did in the early-90s, or the Resolution Trust Corporation did with S&Ls in the same time frame).  But that would be politically parlous, which means that the sensible thing might not happen.

I believe–and hope–that this rumor is only that, the product of heated imaginations dealing with possible resolutions of BAC.  If it isn’t, if there is there there, be afraid.  Be very afraid.  Because it will mean that things are very bad indeed, and that the political and regulatory will does not exist to deal with the problem in a rational, hardheaded way.

I was quoted in this WSJ/Dow Jones article about why sovereign CDS are not being cleared.  I think that legal risk has something to do with it.  But upon further consideration, I think the problem with sovereign CDS is far deeper than that.

The problem is not exclusively with clearing vs. bank intermediated-bilateral.  The problem is with wrong way risk which makes it very dangerous to have a bank as the counterparty selling protection in a sovereign CDS.  Clearing sovereign CDS through a bank-dominated CCP means that banks are the ultimate counterparty, and if the protection seller defaults there is a possibility that banks will be on the hook to pay out on the defaulted contracts precisely when they are in financial distress.

The recent crisis in Europe demonstrates that with current monetary arrangements, the default of any sovereign name of any size can trigger a financial crisis that threatens banks.  Note that bank CDS spreads tend to blow out whenever one of the PIIGS looks shaky. I don’t have the data at hand, but I would wager there is a very high correlation between Greek, or Portugese, or Spanish, or Italian CDS spreads and bank CDS spreads.  Which means that there is a substantially elevated risk that a bank or bank-backstopped counterparty (i.e., a CCP) won’t be there if a sovereign defaults.

There are structural reasons for correlation.  Banks tend to hold large amounts of sov debt in their portfolios.  A surge in sovereign default risk tends to lead to funding problems for banks–especially those with large sovereign exposures.  Thus, sovereign debt crises are associated with substantially elevated risk of bank failure.

This is actually a firmer basis for governments and regulators to be skeptical about–and perhaps even hostile to– sovereign CDS than their usual kill-the-messenger bleats about evil speculators.  Sovereign CDS are potentially beset with wrong way risk, and they pose a real systemic threat to banks if the banks sell protection: in contrast, banks buying protection makes good sense as a hedge if the counterparty is likely to be able to perform in a sovereign debt crisis.  The risk is right-way when banks are protection buyers.

The issue with clearing sovereign CDS is that clearing makes banks contingent protection sellers, and the contingency kicks in right when banks are least able to afford it.  But even a bank running a balanced book would still pose problems because if a counterparty from whom it bought protection defaults, it would be obligated to dip into its capital to pay off the parties to whom it had sold protection, and again precisely when it is least able to afford it.

This suggests that there are acute systematic risks inherent in sovereign CDS under both bilateral and cleared approaches.  Since we have seen that the potential default of any European sovereign name, even those of middling size, can precipitate financial panic, sovereign CDS are arguably the most problematic derivatives out there from a counterparty risk/systemic risk perspective.  They are likely beneficial as long as banks are not major protection sellers under any contingency.  That’s impossible to achieve with clearing, and likely very difficult to achieve in a bilateral market.

What this suggests to me is that (a) it is unwise in the extreme to clear sovereign CDS, and (b) banks should be subject to a hefty capital charge on their gross sales of sovereign protection.  Gross, not net, because the gross drives their contingent exposure.  Low capital charges on a positive net position in protection purchases would be defensible as that risk is right way and net protection purchases gives banks an incentive to lay off sovereign debt risk on those who can bear it at a lower cost than they can.

Looking at the issue of sovereign debt risk more broadly, this analysis again raises serious alarms about the wisdom of mandating or incentivizing banks to hold large sovereign debt positions, where the incentivizing comes in the form of liquidity requirements that must be met by sovereign debt holdings and favorable capital charges, and the mandating comes in the form of margin and clearing requirements.  But the financial repression pressures driven by the pressing need of governments to get somebody to hold their bonds is driving us in that direction.

Which suggests to me that the systemic risk of the future–and the systemic risk from hell–is the prospect for chronic fiscal crises around the world.

And on that cheery note . . . back to work.

High frequency trading firms came under heavy fire in the aftermath of the May 2010 Flash Crash because they largely withdrew from the market shortly before the Crash.  Indeed, the lack of liquidity (which is nowadays largely provided by HFT firms) was likely a necessary condition for the Crash to occur.

In light of that, and of last week’s market craziness, it is therefore quite interesting to read this:

The stock market’s fastest electronic firms boosted trading threefold during the rout that erased $2.2 trillion from U.S. equity values, stepping up strategies that profit from volatility, according to one of their biggest brokers.

The increase from Aug. 1 to Aug. 10 over their 2011 average surpassed the 80 percent rise in U.S. equity volume, showing that high-frequency traders made up more of the market during the plunge, Gary Wedbush, executive vice president and head of capital markets at Wedbush Securities, said in a telephone interview. Wedbush is the largest broker supplying bids and offers on the Nasdaq Stock Market, according to exchange data.

“We’re seeing a tremendous amount of high-frequency trading,” said Wedbush, whose company is one of the biggest execution and clearing brokers catering to high-speed firms. “Their business is a trading business, and volatility creates far more opportunities. Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment.”

It is therefore incorrect to say that HFT firms are Sunshine Liquidity Suppliers who head for the hills when things get volatile.  Sometimes HFT reduce the amount of liquidity they supply.  Sometimes they increase it.  And volatility alone is not enough to spook HFT firms.  Indeed–and this shouldn’t be surprising, really–volatility can be a huge profit opportunity for them.  Note, moreover, that their profit-spurred entry almost certainly reduces volatility below what it would be otherwise and improves efficiency.

One should hope, therefore, that regulators and others who blame HFT for every market outcome they don’t like will take this more recent experience into account in order to develop a more mature understanding of HFT, and use that understanding to develop sensible policies that encourage beneficial HFT.  Policies that don’t throw the baby out with the bath.

A study of what caused the differences between the first two weeks of August and the Flash Crash could be quite illuminating.  Market making, whether old school on the floor of an exchange or new school on computer at high speed, is vulnerable to toxic order flow–that is, order flow driven by private information.  Any market maker who wants to survive has to have the ability to determine when order flow is toxic and when it is not.  Old school traders could intuit the likelihood that the guy who wanted to buy from or sell to them was trying to pick them off because he had better information.  HFT uses algorithms to try to sniff out such opportunistic order flow.

It is pretty clear that on May 6, 2010 HFT algos were flashing warning signs that the order flow had turned toxic,  and they cut back as a result.  It is also clear that despite all the volatility in these days of Downgrade and Debt Crises, the algos are not picking up evidence of an increased intensity of privately-informed trading.  As a result, the HFT firms are sufficiently confident that the risk of being picked off is low that they can profitably supply liquidity.

One interpretation of this is that HFT firms are primarily responding to market conditions, rather than creating them.  One implication of this is that regulators should try to develop tools that would allow them to pick up the same warning signals that HFT algos do in order to anticipate potential market disruptions a la 6 May 2010.  This would permit the implementation of precautionary policies that could reduce the likelihood and intensity of Flash Crashes.  This would be a far better policy than micromanaging HFT trading through things like order time limits or commitments to make markets even when that is unprofitable.  Micromanagement is likely to be counterproductive as it raises the costs of supplying liquidity, and inducing exit of market making capital–which would make prices more volatile during conditions like those that have prevailed this month.

Exchanges are in the business of facilitating the discovery of prices.  The whole rationale for exchanges is that discovering more accurate prices encourages the efficient allocation of scarce resources.  That’s the value that they produce for society.

Which is why it peculiar, to say the least, that exchanges consistently don’t use prices to allocate a scarce resource at the heart of their businesses: communications capacity.  The recent volume surge caused by the intense volatility over the past week has taxed this capacity heavily, as this FT article shows.  Four major exchanges faced technical problems due to an avalanche of message traffic, most notably Borsa Milano.

To the extent that exchanges react to message traffic surges, they do so through non-price allocation methods, such as “throttling.”

As I have been discussing since the very first SWP post, exchange bandwidth is a scarce resource.  There can be intense spikes in bandwidth usage.  Some market participants exploit the fact that this capacity is not priced to engage in trading strategies that may be parasitical, predatory, and destablizing.  Even non-opportunistic use of exchange bandwidth can cause serious technical problems, including problems so severe that exchanges must shut down.   There is every indication that there are periodic tragedies of the commons on exchanges.

Pricing capacity, including peak-load pricing, is the obvious way to eliminate tragedies of the commons and abusive uses of system capacity.  You’d think that idea would come naturally to those in the business of pricing everything from stocks to bonds to soybeans.  But despite recurrent, and arguably increasingly serious, problems, exchanges uniformly shrink from this solution.

It was a puzzle to me five plus years ago.  It puzzles me still.

I don’t have much to say about today’s kamikaze market.  The truly fascinating thing is how bonds rallied big time–the 10 year Treasury yield fell 25 basis points, the 30 year 21.  German Bund yields were down too, but not nearly as much.  There is a very wild dynamic going on here.  The downgrade is part of it, but the European debt crisis is the bigger driver right now.  It is difficult, however, to deny the interaction between the dual debt crises, which feed off one another.  Everything is relative, in the near term Treasuries look a damn sight better than banks.   In the longer term. . .

And whose brilliant idea was it to send Obama out there, while the market was open, to get up and say . . . well, say the exact same bilge he’s been spewing for the past month?  That went well, didn’t it?  He came.  He spoke.  It sank.

Apparently someone hadn’t remembered their Mark Twain: “It is better to keep your mouth closed and let people think you are a fool than to open it and remove all doubt.”  Even with a teleprompter.  Or should that be, especially with a teleprompter?