Streetwise Professor

Oh, yeah.

The WSJ seized on Ben Bernanke’s “Puddin’head Wilson” speech about the need to be especially vigilant about the risks inherent in huge CCPs, including those engendered or expanded by Frank-n-Dodd mandates (h/t Carl E and Mark B):

One by one, financial regulators who supported the Dodd-Frank law in 2010 are beginning to deny paternity, especially for the bouncing bundle of new derivatives rules. Perhaps they now realize the law created more systemic risk than it eliminated. Witness Federal Reserve Chairman Ben Bernanke speaking in Atlanta recently and warning about the consequences of forcing much of the derivatives market into central clearinghouses.

Mr. Bernanke specifically warned of this “concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.” He went on to say that “strong risk management at these organizations as well as effective prudential oversight is essential.”

It sure is, and the federal regulators who failed to oversee the big banks will now have to oversee both the banks and the new entities housing their derivatives trades. As we’ve noted before, clearinghouses have succeeded in managing risk and enabling efficient markets in many areas of trading over many years. They are especially useful when they develop organically to meet a market need. [Emphasis added.]

Uhm, where have I heard the phrase about CCPs “develop[ing] organically to meet a market need”?  Sounds verrryyy familiar.

Perhaps the WSJ is too aggressive in stating affirmatively that Frank-n-Dood “created more systemic risk than it eliminated.”  But it would not be aggressive at all to state that (a) that is a very real risk, (b) that risk depends in large part on the decisions that regulators make going forward, and (c) that risk received virtually zero attention from legislators and policymakers at Treasury (a very guilty party), the CFTC (similarly guilty), the Fed, or Congress.

The WSJ is on very firm ground in excoriating those who have now found their voices on CCP risks, but who remained conspicuously silent when weighing in on the issue could have slowed down the stampede to clearing:

Add it all up and you have a disturbing number of financial eminences suddenly rushing to get clearinghouse warnings into the public record. Do they know something that the taxpayer doesn’t? It’s hard to tell, because even as the Beltway crowd scrambles to draft clearinghouse warning memos for posterity—and for their posteriors—regulators are also promoting “independent director” rules that will discourage people with knowledge and experience from overseeing these institutions. This is the last thing regulators should be doing if they now understand the risks.

When we started warning against forcing this market into clearinghouses in 2008, the regulators who agreed could have held meetings inside a phone booth, if we still had phone booths. Last May, our story about Senator Chris Dodd’s effort to give clearinghouses access to the Fed’s discount window—and therefore to a taxpayer rescue—attracted scarcely more support. Dodd-Frank was the law of the land by July, with taxpayers officially backing Wall Street derivatives trading for the first time.

Now taxpayers get to watch regulators who did nothing to stop this policy, when their opposition might have made a difference, suddenly offering insightful critiques when it doesn’t.

I share the WSJ’s anger and dismay at the Johnny-come-latelies who now sound alarms.  NOW they tell us.  I wonder if it’s not just CYA, as the Journal would have it, but also another way to assert power and authority, and to expand bureaucratic turf.

The Economics of Contempt is, er, contemptuous of the WSJ stand:

The WSJ says that it’s “not aware of any governments that have ever asked clearinghouses to manage risks as complicated as those mandated by Dodd-Frank.”

That’s funny, because we still don’t know what financial instruments will be subject to Dodd-Frank’s clearing requirement yet! So how does the WSJ know how complicated the risks that clearinghouses will be asked to manage are? They don’t. The CFTC and the SEC don’t even know yet. The WSJ is just making things up.

This is like the people who make the fairly simple and widely-understood point that clearinghouses don’t work well for illiquid or bespoke instruments, and then claim that because of this, Dodd-Frank’s clearing requirement was a bad idea. They apparently don’t have the patience to wait to see which instruments the CFTC and the SEC decide have to be cleared — they want to demagogue the clearing requirement, and they want to demagogue it now, dammit!

FWIW, EOC is a pretty strong Dodd-Frank booster.

IMO, EOC is far too contemptuous of the Journal piece.  Yes, many of the implementation details of Frank-n-Dodd remain to be determined, notable among them just what products will be cleared, and more importantly the process by which that decision will be made.  Yet it is abundantly clear that the intent of the authors of Frank-n-Dodd, the Treasury, and Gensler in particular at the CFTC is to push as many derivatives as possible onto CCPs.  This can be done directly through mandating that particular products be cleared, or indirectly, by imposing punitive margin and capital requirements on non-cleared trades.  We don’t know exactly what they will do, but we know what they want to do–they’ve told us over and over again.  The WSJ editorial is quite fair in speaking to the risks that CCPs could pose if these people get their way.

But even if EOC is right, then we have two alternatives: either clearing mandates and much of Frank-n-Dodd was sound and fury, signifying nothing, or it runs the kinds of risks that the WSJ and, uhm, others identify.  And the sound and fury is not without its costs.  It has created huge uncertainty, and led to the commitment of innumerable resources to trying to understand, shape, plan for, etc., the regulatory changes.

Regardless, the WSJ is spot on in calling out those currently speaking out on their failure to do so when it mattered.

But that’s water over the dam now.  What’s needed is for these newly vocal regulators to put their supposedly new revelations into practice.  Two very practical issues on which they can do so are taking a duly humble approach to the process of determining what gets cleared and what doesn’t (the issue that EOC focuses on), and on CCP membership and governance standards.

Not that I’m holding my breath.

I haven’t written much about clearing lately, and I just know some people are going through withdrawal as a result, so a quick post to feed your jones.

The ISDA Annual General Meeting was in Prague last week.  Clearing was on everybody’s mind.  There were numerous discussions that echoed things I’ve said on SWP and in my academic writing over the past 2.5 years or so.

One example: the head of UniCredit Group’s commercial and investment banking expressed concerns that CCPs will be  undercapitalized.  He compared them to, yes, monoline insurers:

Mustier said the “thin capitalisation” of CCPs – which will end up clearing hundreds of trillions of dollars notional in standardised derivatives – could be compared with monoline insurance companies that underwrite securitisations. Before the crisis, individuals who questioned the ability of monoline insurance companies to underwrite large amounts of securitisations using little capital were told small levels of capital were appropriate because the underlying deals had high credit ratings and the risks had been modelled, said Mustier – although he emphasised CCPs have other lines of defence, which makes the monoline comparison an unfair one.

“I don’t want to make a comparison between clearing houses and other very leveraged financial institutions of the past such as monoline insurance, for instance, where we had roughly the same ratios, because in clearing houses we have something that is fundamentally different, which is the initial deposits that financial participants provide when they open up a trade, and the margin calls, which should mitigate the risks of clearing the position,” said Mustier. “But, nevertheless, clearing houses are very thinly capitalised even if their structure should protect them.”

On the one hand I agree with Mr. Mustier–there is a danger CCPs will be undercapitalized. On the other hand, I think the comparison with monolines is a very fair one. Indeed, this is the gravamen of my post on wrong way risk in CCPs. As Jon Gregory has pointed out, monoline insurers were subject to wrong way risk because they were insuring very senior claims. They insured AAA tranches, and the junior tranches provided a cushion that made it very unlikely that the monolines would have to pay off. Armageddon had to happen for the monolines to pay off on what they insured. But Armageddon did happen, they had to pay off, and they had far too little capital to deal with it.

The initial margins that Mustier refers too, along with the default fund contribution of a defaulting CCP member, are exactly like the junior tranches of the securities that monolines insured.  Those funds will get blown through only in Armageddon, and it is quite possible that in such a situation, CCP capital will prove inadequate.  And even if it is sufficient, under those circumstances the member firms–primarily banks–are going to absorb huge hits.  Which kind of defeats the whole purpose of CCPs–to insulate big financial institutions from risk during crises.  Actually, there’s no “kind of” about it.

The dangers of fragmentation of CCPs resulting from the desire of each major jurisdiction to have its own clearinghouses was another theme of the AGM:

“We must not fragment the clearing house and exchange environment. A fragmented approach will lead to weaker institutions, and greater risk.”

But while Rohner urged closer co-ordination of regulatory reform, he warned it is not a sure thing: “Governments may be unable or unwilling to achieve the necessary level of co-operation, which could lead policymakers to resort to ring-fencing or other limitations on structures or geographic reach to protect the home market or taxpayer. This could fragment the OTC derivatives market.”

And yet another SWP theme is that low entry requirements for CCP membership are extremely problematic.  Cue Athanassios Diplas of Deutsche Bank and Tom Benison of JPM:

Regulators are pushing for CCPs to lower their barriers to entry, letting weaker firms into clearing’s inner circle – but these firms could be overwhelmed in a crisis, the larger banks argued.

“Let’s say you’re a clearing member with $75 million in capital, and your cost of entry to a CCP is $25 million for the guarantee fund – and you join two CCPs. But those CCPs also have the right to call on you for an additional $25 million if they run out of money,” said Athanassios Diplas, global head of counterparty portfolio management at Deutsche Bank, at a press briefing. “They can’t both get it, they don’t know about each other – and the assessment will come at the worst point in time – the day after the Lehman Brothers collapse, for example.”

Tom Benison, managing director for credit trading at JP Morgan, echoed the point. “If one CCP has to make a call for more funds, it’s likely to mean we’re really far out in the tail when it happens – which means every CCP is really far out in the tail. So how many CCPs are calling for funds?”

Benison’s point is a variation on the wrong-way risk point I’ve made before: CCPs are going to call on member capital during extreme circumstances–the Armageddon scenarios.  That’s precisely when those entities may themselves be facing dire circumstances, meaning that the capital might well not be there  when you need it.

Now, you may just write me off as a running dog of the big banks.  All I can say is that I’ve been making these arguments in my spare time for a long time–in some cases, before the crisis and before clearing mandates were even thought of and before anybody was really thinking about clearing period. And regardless, if the argument is faulty–have at it.

In my view, the concerns expressed at the ISDA AGM are real ones.  Ones that didn’t even enter the heads of  the Sorcerer’s Apprentices who conjured clearing mandates to life.  But they are ones that market participants and regulators are going to have to deal with going forward.  And the very scary thing is that we’ll only find out in the next financial Armageddon time whether they’ve got it right.  Which, given the very unsettled situation around the world, could happen sooner than we’d like.

For some reason, the Clash come to mind:

PS. Hopefully quite soon a more authoritative and complete discussion of these issues that I’ve just completed (the draft, anyways) will be released. As they say: Watch this space!

I’ve been a China skeptic for a while now.  Post-crisis, I referred to it as “the Michael Jackson economy,” kept going by massive doses of stimulants.  Huge sums have been directed to investment in real estate and infrastructure, and financed by a massive expansion of credit.  I am deeply skeptical that such a top down, throw money at everything, approach is a viable way to create self-sustaining growth.  Instead, it appears to be a politically-driven way to protect elite interests and avoid social unrest–for now.  The fact that people like Thomas Friedman swoon at Chinese economic policy only confirms my suspicions.

I’m not alone in those suspicions.  Some noted shorts like Jim Chanos have been sounding the alarm about China for some time.  And just the other day, Dr. Doom himself, Nouriel Roubini, added his voice to the skeptic’s chorus:

China’s economy is overheating now, but, over time, its current overinvestment will prove deflationary both domestically and globally. Once increasing fixed investment becomes impossible – most likely after 2013 – China is poised for a sharp slowdown. Instead of focusing on securing a soft landing today, Chinese policymakers should be worrying about the brick wall that economic growth may hit in the second half of the quinquennium.

Despite the rhetoric of the new Five-Year Plan – which, like the previous one, aims to increase the share of consumption in GDP – the path of least resistance is the status quo. The new plan’s details reveal continued reliance on investment, including public housing, to support growth, rather than faster currency appreciation, substantial fiscal transfers to households, taxation and/or privatization of state-owned enterprises (SOEs), liberalization of the household registration (hukou) system, or an easing of financial repression.

. . . .

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

. . . .

Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate, and infrastructure, and thus will intensify the coming economic slowdown once further fixed-investment growth becomes impossible. Until the change of political leadership in 2012-2013, China’s policymakers may be able to maintain high growth rates, but at a very high foreseeable cost.

Roubini, then, is all in with the Michael Jackson economy hypothesis.

The main question is how long the Chinese leadership can keep playing Dr. Feelgood.  Roubini suggests 2013.  That sounds about right, but it’s impossible to be very confident in any timing prediction.  I would say that the longer they try and succeed in this strategy, the more brutal the fall will be.  But once you start with this regimen, it’s virtually impossible to stop.

Relatedly, I’ve been reading a book on the Chinese financial system, Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl Walter and Fraser Howie.  I can’t recommend the book all that highly because it’s poorly written, and particularly poorly organized.  But if you slog through it, you can pick up some valuable insights.  One main theme is that the Chinese financial system is oriented towards supporting the enterprises of the politically powerful, and that as a result, there have been periodic episodes of malinvestment followed by bad loan problems followed by shunting these bad loans from the banks to . . . somewhere.  The shady/opaque means used to make banks appear healthy would make Andrew Fastow blush–or turn green with envy.  Just who is on the hook for these bad loans is virtually impossible to figure out.  I have little doubt that the need to resort to such chicanery will soon recur–but given the very real possibility that the looming problem dwarfs the previous ones, I do have doubts whether the same tricks will work again.

When all is said and done, one’s view on whether Chinese economic management can avoid the kind of catastrophe that Roubini and I consider to be likely depends on your view of the efficacy of centralized economic management of the type that China practices.  The Thomas Friedmans of the world, and arguably Obama, believe that such dirigisme is superior to the messy, decentralized, unplanned and non-centrally coordinated actions of greedy individuals in markets.  People like me, conversely, believe that the visible hands of greedy, largely ignorant, and short-sighted politicians and bureaucrats is likely to lead to inferior outcomes.

I know that Coase (at age 100!) has a book coming out about China’s transformation to capitalism, which argues that Chinese policy in recent years has been pragmatic and empiricist rather than ideological (“seeking truth from fact”).  But  I strongly sense they’ve gotten themselves into a major mess from which there is no pragmatic exit.

The controversy over the culpability of US government real estate policy in the ’90s and ’00s, and Fannie and Freddie in particular, continue to rage.  To me, those who deny the central role of government policy and the GSEs have to answer a crucial question: if they were not absorbing a substantial amount of the credit risk in subprime mortgages, how did they lose so much money?

There are two new editorials that press the argument for a substantial F&F role.  The first is by Mark Brickell, formerly of J.P. Morgan and a past chairman of ISDA.  Writing in the FT, Brickell writes:

This suggests two important things. First, the housing finance crisis was not an unregulated market failure; no financial sector had more government involvement before the outbreak of the crisis than housing. It was failure driven by a public policy that was accepted by voters willing to spread the benefit of home ownership to fellow citizens. Yet, extra loans prompted by that housing policy nudged upward the indices that regulators and businessmen relied on to make their decisions.

Second, we need to remember that in any market, government subsidies have an important, indirect, cost when they affect the information that market participants – and regulators – use to make decisions. This time the distortion was pervasive, difficult to quantify, and hard to correct. That should guide regulators as they look for sources of widespread risk in the financial system.

It should inform Congress as it considers the fate of Fannie Mae and Freddie Mac. It should be of concern to participants in subsidised markets, such as education and healthcare, and to electorates that will be asked to approve “investments” in other sectors, such as green tech in the months ahead. The housing finance crisis has shown us how painfully high that cost can be.

The point in the last paragraph is particularly important for thinking about the future, as opposed to forensically examining the past.  All of the “investments” that Obama and the Dems are asserting are essential to “winning the future” (aka “WTF”) involve huge subsidies and government steering of capital to politically preferred sectors and firms.  Those tend to distort the allocation of resources, and the bigger the subsidy, the bigger the distortion.  Sooner or later, reality intrudes.  When that happens, the crash is brutal.  We’re still experiencing the dead cat bounces in the housing market, going on 4 years after that crash began.

AEI’s Peter Wallison also examines Fannie and Freddie, and particularly the ongoing failure to investigate thoroughly their role in the crisis:

For many years, Fannie Mae defined subprime mortgages as loans that it bought from subprime lenders, not by credit score. This had the effect of making its investment holdings seem less risky. In its 2007 10-K annual report, for example, the company estimated its subprime exposure at about 0.3 percent of its single-family mortgages. Tables deeper inside the report showed loans with FICO credit scores of less than 660 were 18 percent of the company’s single-family holdings.

The significance of this for the financial crisis is that Fannie and Freddie’s reports might have lulled analysts and risk managers into believing that if the housing bubble collapsed, the damage would be limited because the number of risky loans was small.

We now know the damage was severe. Had those 12 million Fannie Mae and Freddie Mac loans been prime instead of subprime, delinquencies and defaults probably would have been around 2 percent, not almost nine times higher.

No Inquiry

In writing my dissent from the commission’s majority report, I searched widely for examples of anyone — academic researcher, credit rating analyst or housing market expert — who knew before 2008 that half of all mortgages in the financial system were subprime or otherwise risky, or that Fannie and Freddie had contributed almost half of that total.

The commission had a chance to investigate the risks that Fannie and Freddie were taking and why the information available in the market was so deficient. But this would have required the commission to examine the losses caused by government housing policy. Angelides refused to do so. Instead, Fannie and Freddie’s contribution to the housing crisis was called “marginal” in the commission’s report.

As a result, the American people and Congress received a distorted picture of the causes of the financial crisis, not the thorough investigation they deserved.

Monocausal explanations of anything as complex as the housing collapse are unpersuasive.  But so are explanations that overlook the role of the GSEs.  There are hundreds of billions of reasons to suspect that they played a central role.  The Brickell and Wallison pieces help keep those reasons in mind.  That’s important not just so that we can understand the past better, but so that we have some chance of avoiding similar mistakes in the future.  Mistakes that we can no longer can afford.

CFTC Commissioner Bart Chilton has been touting research that he claims supports his view that speculation has distorted prices, thereby necessitating position limits.   I’ve read each one.  My conclusion: if this is the best he can come up with, the case for position limits is weaker than I thought.  And that’s saying something.

The citations fall into a couple of categories: superficial quasi-academic studies, and quotations from various figures, including some well-known economists, who have done absolutely no serious research on the subject.

Here are my quick takes on each one.

Since Chilton has had three years to trawl the earth to find work that would support his idee fixe, it is rather amazing that this is the best he can come up with. It’s rather sad, actually, that he believes that he is looking at the problem in a “more sophisticated way.” Although Chilton says that based on his literature review, “[i]t’s simply not the case that ‘there is no evidence that financial investors affect commodity prices,'” that’s not true. What I wrote in Regulation last summer, and what I’ve repeated numerous times on this blog remains true. As yet there is no serious theory, and certainly no serious evidence that speculators have distorted commodity prices.

On Monday, Fed Chairman Ben Bernanke gave a speech on clearinghouses to the Atlanta Fed’s annual conference.  Ironically, Bernanke echoed the theme of my talk at that conference in May, 2009: central counterparties (CCPs, i.e., clearinghouses) could fail, and are a potential source of systemic risk:

Overall, the historical record shows that clearinghouse arrangements have generally withstood even severe crises. This solid performance reflects good planning and sound institutional structures but also some degree of good luck, as crises have also revealed important vulnerabilities, vulnerabilities which prompted subsequent reforms by both the private and public sectors. Clearly, if we do not want to put all our trust in continued good fortune, we will have to continue to be proactive in identifying and remedying weaknesses in these critical infrastructures.

. . . .

Clearinghouses around the world generally performed well in the highly stressed financial environment of the recent crisis. However, we should not take for granted that we will be as lucky in the future. Past crises, including the financial panic of 1907 and the 1987 stock market crash, led to significant reforms and improvements in clearing and settlement that paid off in subsequent periods of financial stress. Given the growing interdependencies among clearinghouses, along with the new mandates for central clearing, now is a good time to reflect on the lessons of the recent crisis and consider whether further improvements are possible. For more than a century, financial stability has depended on the resilience under stress of clearinghouses and other parts of the financial infrastructure.

As we rely even more heavily on these institutions in the United States and around the world, we must do all that we can to ensure their resilience, even as our financial system continues to evolve rapidly and in ways that we cannot fully predict. In short, I think Pudd’nhead Wilson would agree that that is one important basket.

Bernanke discusses some historical episodes in which CCPs teetered on the brink, notably the Panic of 1907 and the Crash of 1987.  He notes, quite rightly, that the expanded role of clearing under Dodd-Frank (and likely in Europe under EMIR) means that CCPs are even more systemically important, and that it is therefore essential to ensure their safety and soundness.

Although Bernanke has taken up a theme that I’ve been flogging for going on 2.5 years now, please don’t get the impression that he got the idea from me.  Bernanke wrote an important paper on clearing and the Crash (RFS, 1990) that was instrumental in helping me understand the “plumbing” of the market and where it can go wrong.  I lived through the Crash, and witnessed first-hand of the near implosion of the clearing system in Chicago, but Bernanke’s article helped me understand some of the issues on a deeper level.   Indeed, I think that one salutary effect of my speaking and writing on the subject has been to make more people in industry and government aware of what Bernanke wrote 20+ years ago.  Credit where credit is due.

I agree with what Bernanke says in this speech, but I think it’s essential to go further.  Bernanke focuses on the potential for CCP failure, and how that can be prevented.  That’s no doubt important, but that’s not the only systemic risk arising from clearing mandates.

Most importantly, the imposition of these mandates will alter the entire financial system.  They will alter the way firms contract, how they borrow, their capital structures, etc.  These changes will have systemic effects and affect the way the system operates in a crisis.

Moreover, I am concerned that a focus on protecting CCPs can lead to the adoption of policies that are destabilizing.  For instance, conventional means of strengthening CCPs can increase their vulnerability to wrong way risk.

As another example, CCP margining can have destabilizing effects.  Although the regulatory tendency to protect CCPs may lead them to agitate for more collateral, and tighter collateralization mechanisms, this can have destabilizing effects during a crisis.  Similarly, having immense amounts of liquid assets tied up in collateral at CCPs can make the system more vulnerable to liquidity shocks.  Put differently, it increases the burden on central banks to respond to liquidity shocks.

Consider the following scenario.  There is a spike in the demand for liquidity.  Vast amounts of liquid assets are tied up in derivatives collateral at CCPs.  One likely response to the liquidity shock is to liquidate derivatives positions to free up the liquid assets–“dead liquidity”–held at CCPs.  This can lead to big price movements that can be destabilizing.  Central banks may need to be especially aggressive in supplying liquidity to avoid these problems.  Perhaps this would require extending credit to CCPs, or to their members, in a way that would effectively permit rehypothecation of margin monies to the Fed.

Again, clearing mandates are a major change to the financial system.  There will be far reaching effects on all aspects of financial contracting.  Most of these are unpredictable and will be dynamic.  But regulators have to be aware of those ripple effects, and understand that those effects will depend on how CCPs operate and how they are regulated.  A microprudential focus on CCPs (which is the default tendency of financial regulators) could have perverse macroprudential effects.

I’m sure Bernanke is aware of that, but a conventional reading of this “watch that basket” speech could lead regulators to focus on the microprudential, and overlook the potentially perverse unintended macro implications of that focus.

I liked Bernanke’s historical discussion.  The Panic of 1907 case is particularly interesting, and I will discuss it in some detail in my forthcoming book.  One thing that is of particular interest, that Bernanke does not discuss, has implications for one current regulatory debate.

Specifically, as shown by Elmer Wicker in his book Banking Panics in the Gilded Age, the New York Clearing Association often failed to deal effectively with panics by mutualizing risk because of heterogeneities among its membership.  Although mutualizing risk would have mitigated adverse selection problems (because there was less uncertainty about the condition of the banking system as a whole than individual banks), it also would have transferred wealth from the healthy banks to the unhealthy ones.  The disagreements among heterogeneous banks undermined coordinated action during several crises–including especially the Panic of 1907.

That is worth keeping in mind today when evaluating proposed rules regarding CCP membership policies.  Encouraging open access through low capital requirements, or aggregate ownership restrictions, as proposed by the CFTC, will lead to more heterogeneous memberships at CCPs.  This will have many perverse consequences, including the real potential for the same kind of problems that undermined the effectiveness of the NYCH in the Gilded Age.

I’m pleased that Bernanke brought this episode into the public eye.  I’m also pleased that he has brought the potential vulnerabilities of the clearing system into the public debate.  His speech is a welcome antidote to the superficial happy talk of Geithner and Gensler and the cheerleaders for Frank-n-Dodd.  Without a sober recognition of the vulnerabilities that a greater reliance on clearing can create, the cure may actually kill us in the next crisis.

In Walther Bagehot’s famous formulation, central banks should lend during crisis situations “against good collateral at penalty rates.” Apparently, during the maelstrom of the crisis in September, 2008, the Fed considered pretty much anything “good collateral,” except perhaps Lloyd Blankfein’s baseball card collection and a ’72 Buick up on blocks in front of an old doublewide somewhere in Alabama. As revealed in documents pried out of the Fed as result of a FOIA request, the US central bank lent massive amounts against very dodgy collateral:

At the height of the financial crisis, the Federal Reserve allowed the world’s largest banks to turn more than $118 billion in junk bonds, defaulted debt, securities of unknown ratings and stocks into cash.

Collateral of those asset types made up 72 percent of the total $164.3 billion in market-rate securities pledged to the Fed on Sept. 29, 2008, two weeks after the bankruptcy of Lehman Brothers Holdings Inc., according to documents released yesterday. The collateral backed $155.7 billion in loans on the largest day of borrowing from the Primary Dealer Credit Facility, which was created in March 2008 to provide loans to brokers as Bear Stearns Cos. collapsed.

. . . .

The Fed loans on Sept. 29, 2008, represented a 5.49 percent “collateral cushion,” the amount by which the pledged assets exceeded the loan value, according to the Fed data. Equities comprised $71.7 billion, or 43.6 percent of the total. High- yield debt, including the defaulted issues, accounted for $18.4 billion, or 11.2 percent. Collateral of unknown rating was $28 billion, or 17 percent.

High-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.

The haircut–the percentage by which the collateral value exceeded the amount of money lent–was amazingly small, given the quality (or lack thereof) of the collateral, and prevailing market conditions.  The 5.5 percent haircut was far smaller than the 40 percent number that was prevalent during these days (as estimated by Gary Gorton).  Moreover, it was a pitifully small number for the equity that made up the largest single component of the collateral accepted by the Fed.  On the 29th, the VIX equity volatility index closed at a record of 46.72.  Thus, there was a very high likelihood of an adverse price move that would have put the equity collateral under water.

It’s also an open question of whether the marks on the collateral reflected true market values.  I pretty much doubt it.  It’s not outside of the realm of possibility that the real haircut was negative.

Note too that very few Treasuries were posted as collateral: presumably all this was out on repo, and the desperate need for liquidity forced banks to pawn everything else in the safe at Uncle Ben’s Cash America.

These eye opening data reveal just how extreme the situation was post-Lehman.  Or at least how extreme the Fed considered the situation to be.  Given those extraordinary circumstances, it is understandable why the Fed acted in a truly extraordinary way, and honored Bagehot more in the breach than the observance.

The real issue that still remains unresolved is how this in extremis situation came to be.  Did the Fed’s and Treasury’s handling of Lehman, and before that Bear, create the panic?  The Fed’s version of Pawn Stars on steroids is but a symptom of what had transpired in the days, months, and years leading up to 29 September.  That’s what we need to understand better–far better–than we do now.

It is ironic that this story about UBS came out on the day I arrived in Switzerland.

UBS has received subpoenas from the SEC, the US Commodity Futures Trading Commission and the US Department of Justice in connection with investigations regarding submissions to the British Bankers’ Association, which sets LIBOR rates. UBS understands that the investigations focus on whether there were improper attempts by UBS, either acting on its own or together with others, to manipulate LIBOR rates at certain times. In addition, UBS has received an order to provide information to the Japan Financial Supervisory Agency concerning similar matters. UBS is conducting an internal review and is cooperating with the investigations.

I wrote several of posts about Lie-bor back before the financial crisis climaxed.  The story seemed to fade from view very quickly, despite the fact that the effects of a distortion in the LIBOR index due to misreporting could lead to the transfer of  Carl Sagan-esque billions and  billions of dollars between swap counterparties and floating rate borrowers and lenders.  Moreover, since unlike in the natural gas misreporting episode where some firms had an incentive to report prices that were too high (and did) and other firms had an incentive to report prices that were too low (and did), here all the potential misreporters had the same incentive: to underreport the rates at which they borrowed.  This would tend to cause the effects of misreporting to be greater, as misreports would have no tendency to cancel out.

I surmised at the time that despite the fact that there was some pretty convincing stories to support the claims, government regulators did not seem to pursue the allegations aggressively because (a) that was the least of the problems in the banking sector and regulators had other fish to fry, and (b) because of those other problems, regulators were beyond loath to compound them and pour additional burdens on banks that were already reeling and threatened to bring down the financial system.  Regulators were looking to put out fires, not start them.  LIBOR was something that regulators, like Scarlet O’Hara, could worry about . . . tomorrow.

Those days of forebearance, it appears, are gone.  If you are a there’s-got-to-be-a-pony-in-there-somewhere kind of person, you might view this investigation as a strong signal that regulators believe that banks are healthy enough to stand the strain–and the potential fines (and perhaps damages in private litigation).  If you’re not, you’re probably saying “when will it all end?”  Be careful what you ask for.

A gratuitous image of a UBS branch, a block from my hotel:

In what will hopefully be the continuation of a spirited and thoughtful exchange of views on OTC derivatives markets, John Parsons and Antonio Mello at Betting the Business respond to my response to their response to my post on Gensler’s beliefs about the efficacy of central counterparties.  Or something like that.

We agree on some key issues, namely, (a) the amount of margin is not the measure of the total amount of credit firms use up when moving from bilateral to cleared trades, and (b) systemic risk is the crucial issue when evaluating the effects of clearing mandates.

I think we also disagree on some issues.

Netting, for one.  MP state:

The reliance on bilateral arrangements meant that exposures that offset one another at the system level were not offset. Individual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures. A major objective of the reform is to encourage the canceling of offsetting exposures and reducing systemic risk by substituting standardized instruments and clearing, among other things, where possible.

As I’ve written repeatedly before, multilateral netting primarily effects priority; netting effectively places derivatives counterparties in front of other creditors in the event that a firm goes bankrupt.  The systemic consequences of this are ambiguous: yes, derivatives counterparties may be systemically important, but other creditors may be too, meaning that it is not obvious whether this reordering of priorities improves stability.

Insofar as the other claims are concerned, I am somewhat puzzled by the statement that “[i]ndividual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures.”  With respect to bilateral offsetting exposures, presumably market makers relied on set-offs in bankruptcy.  With respect to multilateral exposures, market participants internalized any improvements in capital efficiency from netting (or compression).  They also internalized any benefits that resulted from lower risk of replacing defaulted positions with counterparty A that were offset by non-defaulted trades with B, C, D, etc.  Crucially, they recognized that capturing some netting efficiencies multilaterally could undermine some bilateral netting for deals that could not be compressed or cleared because of the nature of these contracts or their liquidity; they internalized these various netting efficiencies.  They internalized the benefits of customization.  They would have internalized the transfer of wealth arising from the shift in priorities inherent in multilateral netting.  Thus, they could trade-off these various effects and internalize the resulting costs and benefits.  Maybe some costs and benefits were not internalized, so it is literally true that the incentives were not sufficient to lead to a completely efficient outcome, but I don’t consider insufficient netting to be the first order problem.  Indeed, to the extent that netting transfers wealth, there can be too much netting.

I’d also note, as was recognized when the CBT was considering whether to adopt clearing in the early-20th century, that by improving the efficiency of capital utilization (by freeing up credit committed to offsetting positions with different counterparties), netting can also lead to increases in the size of net positions and net risk exposures. (This was also an objection to clearing that was raised vociferously in the aftermath of Black Friday in 1869.)  This can increase systemic risks.

MP also criticize the opacity of OTC markets, and suggest that clearing would make things more transparent:

It lacked transparency. Neither the end-users nor the public authorities had adequate information about the market. This lack of information has handicapped end-users in getting good prices. The lack of transparency has hampered competition. The lack of transparency promoted unsound accounting. Opacity perverted incentives. It distorted compensations. We could go on… It also handicapped the authorities in supervising the marketplace. A major objective of the reform is creating transparency, which will then make it possible to improve the functioning of the market.

Transparency is used in different ways here.  It is used to refer to price transparency and position transparency.  There is another type of transparency–counterparty transparency–that MP don’t discuss but which is relevant to the issues they raise.

With respect to position transparency, this is a bad argument in favor of clearing.  It is possible to achieve such transparency via reporting to repositories without the problematic risk sharing and risk pricing aspects of central clearing.  Indeed, a single trade repository is required because (a) there will be multiple clearinghouses, and (b) some products will not be cleared.  If it’s position visibility that you want (especially to regulators), that should be achieved via reporting to a single repository, not by having multiple CCPs.

With respect to price transparency, I think that MP overstate the lack of competition and price information, especially for the more liquid products that are likely to be traded most actively on SEFs.  Most end users I’ve heard discuss the subject state that they have been able to get good price quotes from multiple dealers.  ISDA recently ran an experiment which found that spreads for liquid products are extremely tight–in the .5bp-1bp range.  Moreover, with respect to many standardized OTC products, end users can compare the bids and offers they get to the prices of exchange traded instruments (e.g., Eurodollar futures, crude oil futures) to determine the quality of a dealer’s quotes.  End users also have the ability to utilize those products–to the extent they don’t, that means that the bundle of services provided by the dealer is more valuable to end users than the different bundle available on exchanges.

Moreover, as I’ve written before, trading in a non-anonymous way by soliciting quotes from dealers can actually be cheaper for end users than trading in an anonymous exchange or exchange-like (i.e., SEF) environment with pre-trade transparency.  The verifiably uninformed are typically going to get better prices in non-anonymous settings than in anonymous ones, where spreads are widened and depths reduced in order to protect quoters against being picked off by the informed.

All of this is not to say that OTC bilateral markets were perfect.  Too big to fail provided perverse incentives.  Uncoordinated replacement and hedging of defaulted positions exacerbates price moves.  But clearing presents its own difficulties, so just inventorying the defects of bilateral markets is not sufficient to prove the superiority of clearing.  You have the Churchill democracy issue: something can be the worst thing ever, except for all alternatives that have been tried from time to time.  Moreover, I don’t consider the defects that MP identify to be nearly as problematic as they do.

Thus, it still comes down to a comparative analysis which must make comparisons along numerous dimensions; some of these comparisons may cut one way (e.g., favoring centralized clearing), others may cut the opposite way (favoring bilateral mechanisms).  Moreover, when discussing policy it is important to recognize that clearing bundles many services–risk pricing, risk sharing, netting/compression, default risk management, position reporting–that may be better provided separately.

I still think that a crucial issue that relates to one of my areas of agreement with MP–that firms subject to a clearing mandate will substitute one form of credit for another–deserves further analysis.  I hope that they respond more fully to my analysis of the implications of the degree of substitutibility of different forms of credit.  In my view, that will have very important implications for the effects of clearing mandates.

John Parsons and Antonio Mello have a series of posts taking aim at the notion that requiring end users to post collateral on derivatives trades will impose a large burden on them that will cause them to reduce real investment.  Their basic point is that OTC derivatives trades often embed an unsecured credit line, and that firms that are forced to post collateral can fund it with an explicit borrowing transaction and/or credit line. This ability to substitute one form of credit for another should dampen the impact of clearing and collateral mandates on corporate end users.

I agree with the essential point.  It was one of the reasons why I long ago opined that requiring AIG to post collateral (initial margin/independent amount) likely would not have materially caused them to reduce their positions in CDS because they would have been able to borrow–and would have wanted to borrow–to fund that collateral.  Less debt in one portion of the balance sheet would have made it possible to borrow more in other ways.  I discussed that point more generally in my Cato Policy Analysis piece.

I further agree with Parsons’ and Mello’s conclusion that this means that looking at the total collateral that end users will be required to post is a misleading measure of the financial burden that collateral, clearing, and capital requirements will impose on end users.

That analysis is as fine as it goes, but it’s worthwhile to push it further–much further.  In particular, to push it to examine the effects on systemic risk, which Parsons-Mello also (rightly) identify as the key driver of the ultimate impact for good or ill of clearing mandates.

There are a couple of cases.  In the first case, firms have access to perfect substitutes for the unsecured credit embedded in many OTC derivatives trades.  In the second, there are not perfect substitutes.  (It seems to me that M-P believe there are pretty close substitutes–feel free to correct me if I’m wrong, guys).

In the first case, clearing mandates and required collateralization will have no appreciable effects.  Firms will just substitute an economically identical form of financing/credit for the proscribed bundled credit.  New labels will be slapped on old bottles.

But that means that the systemic effects of the mandates will be minimal–and perhaps non-existent.  That’s because the mandates will not affect the quantity, character, and crucially, fragility of the capital structures of either end users or financial intermediaries.  The same banks will end up extending the same amount of credit of the same risk characteristics to the same counterparties. It will just go by a different name.

In the second case, where there are not perfect substitutes, things are much more complicated.  Firms will adjust on many margins.  They will substitute different kinds of financial claims (debt and equity) for the proscribed financing embedded in derivatives: the systemic effects of this are very difficult to know.  Firms will engage in less risk management, most likely: again, the systemic effects, and efficiency effects more broadly considered, are hard to predict.  And yes, firms will likely reduce the scale of investment as limited pledgeable capital will be diverted from supporting real investments into liquid assets to support derivatives positions.

It is interesting to note that corporate end users–manufacturers, airlines, energy companies, and the like–have been the most outspoken critics of clearing mandates and margin requirements, while financial firms have been relatively mute on the subject.  This is particularly interesting given that to address end user concerns, CFTC Chairman Gensler has emphasized that financial firms are the main targets of the mandates and margins.

To me, this makes sense in light of the foregoing analysis.  Banks and other financial institutions likely can substitute other forms of unsecured credit for credit bundled in derivatives trades more readily than can end users.  Banks engage in massive amounts of unsecured credit transactions (e.g., interbank funding) with other banks with which they trade derivatives and extend and receive embedded credit.  (Many interbank trades are not collateralized.)  A mandate that says “thou shall not extend unsecured credit via derivatives trades” is unlikely to be hugely burdensome on the banks, because they will just increase other unsecured  financing to substitute for the decreased credit embedded in derivatives trades.  It is plausible that end users have fewer such options.

Why might end users have poorer substitutes?  Here are some conjectures.

For one, the mandates may reduce the set of firms from which end users may obtain credit.  Consider a firm that is looking to hedge natural gas prices.  It can do a swap with Goldman, sure, but it it can also do a trade–and get credit from–BP, or Cargill, or myriad other firms.  With the mandate, the firm won’t be able to get credit from those counterparties.  It may still trade with them, but it would have to finance the necessary collateral either out of its own resources or by borrowing from a bank.

This creates many potential difficulties.  For instance, due to concentration limits and other factors, any given creditor may incur increasing marginal costs to extend financing to a given borrower.  This means that it is often more efficient to get a given total amount of credit from multiple sources, rather than just one.  Reducing the number of potential suppliers of credit can therefore raise the costs of credit.

Moreover, narrowing the sources of potential credit may expose end users to greater opportunism.  It is well understood that banks obtain information about the firms that they finance which gives them an advantage over other potential sources of credit.  They can exploit this information advantage opportunistically.  Firms seeking credit can limit their vulnerability to such holdups by dealing with multiple creditors.  Margin and clearing mandates that force end users to get credit to support derivatives positions through banks may therefore increase their vulnerability to holdup–thereby inflating the cost of trading derivatives.

I also wonder whether the credit embedded in derivatives trades is likely to represent a more robust commitment to extend finance in the future than other forms of unsecured lending.  This is more conjectural, but I find it a plausible conjecture.  If the suppliers of other forms of credit can more readily renege on commitments to supply liquidity to support a derivatives position, the liquidity and funding risks are greater in a clearing/margin mandate world.

These are just thoughts off the top as to how bundled and unbundled credit can differ.  I suspect that there must be some difference, at least for end users, based on revealed preference grounds.  This essentially turns the Parsons-Mello point on its head.  If the form of credit associated with a derivatives position is a matter of indifference, why do we see a decided preference among many users for non-collateralized trades that bundle credit from the counterparty?  Why are end users so vociferous in their opposition (granting that some of their vociferous arguments don’t really hold water)?

But these are the kinds of questions that have to be addressed to understand fully how clearing and collateral mandates are going to work.  And these are the kinds of questions that the advocates of the mandates haven’t even acknowledged, let alone answered.

There’s another issue here that deserves special attention.  Clearing and margin mandates must be met by the posting of high quality, liquid collateral such as cash and Treasury securities.  Where is the increased supply of these instruments going to come from?  (Manmohan Singh at IMF has written about this issue.)

Here I think that the Holmstrom-Tirole distinction between “inside” and “outside” liquidity is important.  They distinguish between liquidity supplied within the corporate sector (“inside liquidity”) and liquidity supplied by households, or through the government (via taxing the household sector) (“outside liquidity”).  My thoughts here are very preliminary–this is really thinking out loud–but I sense that the effects of clearing mandates on inside and outside liquidity is actually the crucial issue, and one that deserves probing analysis by knowledgeable people.

One plausible conjecture is that much of the liquidity that currently supports derivatives trading is inside liquidity, and that mandates, by requiring posting of collateral in the form of cash and high quality securities, will increase the demand for outside liquidity.  Some of this may be supplied by the corporate sector as they adjust investment policies to favor more liquid assets.  But a good portion will have to come from the household sector or the government sector.

This is unsettling.  It is unsettling in part because it means that the efficiency of derivatives markets will be intertwined even more closely with fiscal and monetary policies that affect the supply and demand for outside liquidity.  It is also unsettling because as Gary Gorton, Bengt Holmstrom, and Jean Tirole (and others) have argued, one impetus for securitization–including subprime securitization–was the need for high quality collateral, i.e., it was a response to demand for liquidity from the corporate/financial sectors. To the extent that clearing and margin mandates make the corporate and financial sectors more dependent on outside liquidity, it would tend to drive a similar dynamic.

Moreover, when systemic risk is considered, correlated/aggregate/macro shocks are the most difficult to address through the design of liquidity supply mechanisms.  If we are worried about the financial system’s vulnerability to aggregate shocks–more generally, shocks that can’t be diversified away within the corporate sector–we have to think seriously about legislative and regulatory changes that may affect the reliance of the corporate/financial sector on outside liquidity.

In sum, I think it is worthwhile to think long and hard about some of the indirect effects of clearing mandates–especially their effects on capital structure and the demand for liquidity, particularly specific forms of liquidity.

To try to close the circle here, Mello and Parsons analyze a crucial issue: the effects of clearing mandates on capital structure.  In a Modigliani-Miller world, this wouldn’t matter, and that might be their point.  But if capital structure is relevant, legislatively mandated changes in the way companies finance themselves and the way credit is extended and used will have real effects.  What’s more, some of these effects may be systemic.  After all, research on systemic risk focuses on the ways that imperfections in financial markets can lead maximizing firms to choose capital structures that lead to inefficient, and often destabilizing, responses to economy-wide shocks.   Therefore, to understand the systemic effects of major policy changes like mandatory clearing and collateralization of derivatives trades, we need to understand how these policies will affect financial contracting generally.  I don’t think we understand even remotely what those effects will be.  I am far from convinced that those effects will be salutary, or even benign.  But that’s the kind of thing academics and policy makers should be focusing on.