Streetwise Professor

Barney Frank has admitted it.  He was wrong about Fannie and Freddie:

“I hope by next year we’ll have abolished Fannie and Freddie,” he said. Remarkable. And he went on to say that “it was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.” He then added, “I had been too sanguine about Fannie and Freddie.”

When I asked Frank about a long-term phase-out plan that would shrink Fannie and Freddie portfolios and mortgage-purchase limits, and merge the agencies into the Federal Housing Administration (FHA) for a separate low-income program that would get government out of middle-income housing subsidies, he replied: “Larry, that, I think, is exactly what we should be doing.”

Well, I guess several hundred billion dollars of losses is enough to convince even Barney.  (No similar mea culpa from Chris Dodd.  Putz.)

That’s fine as far as it goes, but one would have hoped that this recognition that his judgment in matters financial was fundamentally flawed would have led Frank to  show a little more humility in his recent legislative doings.  But one would have hoped in vain, for Frank and his partner in slime Dodd were the creators of the monster that is Frank-n-Dodd.  So what I wrote in September, 2008 holds:

And that’s where the real moral hazard lies. At root, moral hazard exists when a decision maker is not accountable for his actions, when he is able to reap the benefits but somebody else pays the costs. Due to the arcane nature of the GSEs, the ability of Congress to deflect attention, the advantages of incumbency, and myriad other factors, Barney Frank and Chris Dodd and the others in Congress who have protected Fannie and Freddie at every turn will never, ever, pay a political cost for their actions. They have reaped the political benefits, in the form of campaign contributions and the channeling of Fannie and Freddie funds to their pet political causes in housing, but you and me and every other taxpayer will have to pay to clean up the mess. Few people who matter–the constituents of Frank and Dodd et al–will understand the connection between their actions and the F & F blowup, and what’s more, the costs are spread broadly among all taxpayers, the vast majority of whom would be unable to exact a punishment on the perps even if they had the information and incentive to do so.

So Frank paid no price for the havoc he created.  “Whoops. Sorry!”  Doesn’t quite cut it now, and in light of what he now realizes, it is doubly reckless to be a primary architect of a wholesale reengineering of the financial markets.  So this holds true too:

WTF are the people who bear tremendous personal responsibility for one of the most costly aspects of the crisis–and what is arguably a key underlying cause of the crisis–doing in charge of “fixing” the system instead of donning sackcloth and squatting on a pile of ashes, begging abjectly for forgiveness?

If Frank really means what he says about abolishing F&F, why didn’t he even make a start along that path in his most recent legislative “achievement”?

And the recent summit on housing finance policy makes it plain that the government is almost certain to continue to wreak havoc in the housing market, even if it doesn’t do it through F&F.  And the scope of the intervention looks ready to balloon:

The Federal Housing Administration (FHA) will offer financial institutions holding mortgages worth more than the value of the houses, so-called “underwater” mortgages, a guarantee on 90 percent of the mortgage value if the institution will write-off 10 percent of the mortgage. These risky mortgages have been bought up by Wall Street investment banks at may be 30, 40 or 50 cents on the dollar. The government now says that if the holder takes 10 percent off the mortgage, the government will guarantee 90 percent of the mortgage. So they may have bought a $400,000 mortgage for $200,000. If the mortgage holder agrees to write-off $40,000, the government will guarantee the mortgage for $360,000.

I presume that this is intended to be a political initiative intended to buy popular support prior to November’s elections.  If so, I think it is a grave political miscalculation, as well as an economic one.

Remember that the whole Tea Party movement grew out of a rant by Rick Santelli.  And what was Santelli ranting about?  He was ranting about “how many people want to pay for your neighbor’s mortgage?”  What does this FHA initiative do?  Have the government guarantee your neighbor’s mortgage, meaning that if s/he doesn’t pay–you will.  And given that many mortgages are far more than 10 percent underwater, pay you will.

Santelli Rant

There is already bailout fatigue in the country, and this will make it all the worse.  Especially given the fact that a disproportionate share of the dough will flow to people in a few counties in a few states.  If this happens, it will only stoke the anger.

When it comes to housing, the government just can’t leave well enough alone.  Barney Frank has that figured out.  Sort of.  Will he commit himself with ever fiber of his being to help others have a similar come to Jesus moment?  Given the havoc he caused, he owes nothing less.  Because sorry just ain’t enough.

I’ve been writing for some time that Frank-N-Dodd will open a battle over derivatives market structure.  This battle will be waged in the markets, and in the political and regulatory arenas.  In particular, clearing mandates will lead to a protracted conflict.  The nature of the clearing business, with its strong scale and scope economies and the myriad competitive implications of alternative configurations of the clearing business will make this battle particularly intense.  And the stakes will be particularly high given the importance of clearing in the new financial architecture.

In an article forthcoming in the Journal of Applied Corporate Finance, I put it this way (link to follow when it’s available):

It is well known that the effects of central clearing on the costs of bearing counterparty risk and on systemic risk depend crucially on the equilibrium configuration of the clearing industry.  For instance, netting benefits are maximized when clearing is concentrated into a small number of multi-product clearinghouses—and arguably into a single CCP.  But the failure of an immense CCP would have disastrous consequences for the stability of the financial system, and could set off a daisy chain of failures of other CCPs, with further damaging effects.  Moreover, the scale and scope of CCPs are almost certain to affect incentives, governance costs, and the effectiveness and accuracy of risk pricing.  So it is by no means obvious what is the structure of the clearing market that optimally trades off these competing considerations.

It is equally unknown what clearing market structure will evolve, and how close this structure will come to approximating the ideal structure.  In this regard, it is essential to keep in mind two facts.

First, the extensive scale and scope economies associated with clearing make it likely that the clearing industry will be highly oligopolistic, and that strategic considerations will influence decisively the way that the industry develops.   Moreover, scope economies across trade execution and clearing (Pirrong, 2010b) will also affect the strategic and efficiency forces that will shape industry structure.  Strategic considerations will almost certainly drive a wedge between what is optimal for the individual decision makers, and what is optimal for the economy.  This is particularly true inasmuch as there is no market mechanism evident that would induce CCPs to internalize the systemic externalities associated with their failure.

Relatedly, governance and organizational form will matter.  For instance, for profit and not-for-profit mutual CCPs are likely to act differently.  Which choice is preferable?  What will determine CCP choices of organizational form?  CCPs are effectively cooperatives: how will collective action problems affect their incentives  and actions?  What regulations are required to address the governance problems that might arise under each form?  These are not easy questions to answer, but those answers will have an important effect on how clearing works in practice.

Second, industry evolution will inevitably be a highly politicized process.  Dodd-Frank gives regulators enormous discretionary authority over the operation of CCPs.  Interested parties will influence the regulatory process for their private benefit.  Political tradeoffs, rather than efficiency considerations, also threaten to cause serious divergences between the structure that evolves in practice, and the one that would optimize the relevant economic tradeoffs.  The effects of politics are particularly pronounced in this context because finance is a truly international industry, and hence jurisdictional issues and competition between jurisdictions will play a decisive role in determining the industry’s ultimate configuration.  For instance, governments in major financial centers (e.g., the US, London, the EU, and individual countries in the EU, Japan, Singapore, and Hong Kong) have all expressed a strong interest in domiciling CCPs, for both economic and political reasons.  But accommodating these interests would fragment clearing, reducing netting benefits and raising serious concerns about coordination during a crisis.  Moreover, regulatory competition between jurisdictions to favor their local CCPs could compromise financial market stability.

I’ve written elsewhere–long before the crisis, in fact–that there is a fundamental tension in clearing organization.  Risk control and moral hazard considerations provide a strong rationale to limit participation in CCPs, and/or to impose substantial capital requirements on participants.  But limiting membership to CCPs can also be a way of cartelizing the industry: given the strong scale and scope economies, a CCP that has fewer than optimal members can still be large enough to make it impossible for any other competing CCP to achieve the scale economies to compete with it.

What’s the right trade off?  Barney?  Chris?  Gary?

The politicized process is underway.  Bloomberg’s Matt Leising (article not online, it appears) and the WSJ describe how the battle lines began to form at a recent CFTC-SEC public workshop.  The competition-risk trade-off is a main axis of conflict.  First Matt Leising, describing the arguments of those who favor opening up CCPs to encourage competition:

Financial firms should be allowed to become members of over-the-counter derivatives clearinghouses even if they don’t meet current minimum capital requirements, according to an industry group. The Commodity Futures Trading Commission and Securities and Exchange Commission should allow smaller firms that don’t meet clearinghouse guidelines to become members, said Jason Kastner, vice chairman of the Swaps and Derivatives Markets Association.

Kastner spoke at a roundtable discussion today on OTC derivatives clearing at CFTC headquarters in Washington. Clearinghouse operators Intercontinental Exchange Inc., CM Group Inc. and LCH.Clearnet Ltd. in the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of their organizations to withstand losses. Those requirements prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, the SDMA told the Federal Reserve in June.

“It’s not just about capital,” Kastner said today, referring to rules such as Intercontinental’s that members of its credit-default swaps clearinghouse have a minimum net worth of $5 billion. Regulators should create and enforce rules so that smaller firms can become members so “that it’s somehow proportional.”

But then Matt notes that some argue that Dodd-Frank is about reducing systemic risk, and has nothing to do with competition:

The main purpose of the financial-reform law, named after its principal authors, Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, was to make the financial system stronger by increasing risk-management standards, said Jonathan Short, a senior vice president at Intercontinental.

“It all sounds great on paper to say ‘let a thousand flowers bloom,’” he said. “I’ve never heard the Dodd-Frank Act
described as something that was done to promote competition among firms.”

[It should be noted that Dodd-Frank does include provisions encouraging competition and enjoining CCPs not to violate anti-trust rules.  How to reconcile that with the injunctions to reduce systemic risk?  Who knows?  Not Dodd and Frank’s problem.  They just wave their wands and presume the broomsticks will take care of it.]

This all makes some people nervous:

Ananda Radhakrishnan, director of the CFTC’s Division of Clearing & Intermediary Oversight, said he would hesitate before telling clearinghouses to lower their capital standards for members.

“As someone in charge of clearing, I’m reluctant to tell someone ‘you should lower the level of capital,’” he said. [In charge of clearing?  Think much of yourself, Al Haig Radhakrishnan?]

The WSJ article notes that people have picked up on the tension inherent in the issue:

James Hill, a global credit-derivatives officer at Morgan Stanley, warned that if companies without proper risk management expertise were allowed into the clearinghouses, “they will become the next “too big to fail,” and we don’t want to do that.”

After J.P. Morgan Chase & Co. managing director Jeremy Barnum said regulators would have to weigh “very complicated tensions” in determining how to write the rules, Mr. Kastner shot back that “it’s not credible to say it’s complicated.”

Not credible, indeed.

So, barely weeks after the passage of Dodd-Frank, we are seeing the sausage making process begin.  Efficiency and rent seeking and competitive considerations are all going into the hopper.  Who the hell knows what will come out the other end?  The potential for a colossal mistake–or mistakes–is great.  And these mistakes will be systemic in the effect.  For as I also say in the JACF piece:

This change is fraught with potential unintended consequences.  It is predicated on a belief that market participants systematically chose the wrong ways to trade derivatives and allocate the default risks inherent in them, but there strong reasons to believe that in fact many of the institutions adopted prior to the crisis had a strong economic rationale.  This means that forcing the implementation of a particular market infrastructure via legislative fiat runs the serious risk of reducing the efficiency of the financial markets.  In particular, although it is intended to reduce systemic risk, the mandating of expanded clearing carries its own systemic risks.  Moreover, the future evolution of market structure is highly uncertain, especially given the cost characteristics of clearing and the fact that this evolution will occur in a highly regulated environment in which political—and rent seeking—influences will play an important role.  Very bad evolutionary paths are certainly possible.  In brief, the effects of Dodd-Frank on the efficiency and stability of the financial markets are highly uncertain at best, and highly unfavorable outcomes wholly unintended by the authors are quite possible, and indeed, likely.

One final thought about systemic risk.  It is worth remembering that the imposition of a single, one-size-fits-all infrastructure is inherently systemic in its effects.  Any flaw or failure in that standard structure will have systemic consequences.  A mandate that is ill-adapted to the fundamental economic conditions in the derivatives markets creates a systemic risk because (a) ill-adaption makes failure more likely, and (b) the sweeping breadth of the mandate means that the effects of such a failure will be system wide in scope.

But have no worries, Gary Gensler tells us: “U.S. regulators won’t succumb to Wall Street efforts to weaken financial-market oversight as they implement the biggest rules overhaul since the Great Depression.”

Just how is this supposed to happen?  Yes, interested parties–and not just the big banks–have an incentive to shape the rules to benefit them.  But interested parties also have the best information and the greatest knowledge.  Are Genlser and the other regulators to shut their eyes and ears to what industry participants tell them?  That would mean ignoring the good advice, as well as the bad, self-interested kind.  If not, how are they to distinguish between the good and the bad?  Mistakes are inevitable.

This information problem is inherent in regulation, especially when involving something as incredibly complex, dynamic, reflexive/responsive, and interconnected as the financial markets.  Painting this as a morality play between the good government types (the “Goo goos” in Boston Mayor James Curley’s trenchant phrase) and the malign self-interested banks is insultingly simplistic.

Congress and Obama have given regulatory agencies the authority to lead the industry, but no map to show them where to go.  The blunder potential is huge.  The cacaphony  of voices, reflecting differences in information, interest, and motivation, will make it difficult to avoid such blunders.  Last week’s meeting gives just an inkling of the conflicts to come.

But I’m sure it will all turn out well.  It always does, doesn’t it?

You don’t have to answer that.

In today’s WSJ Jerry O’Driscoll summarizes quite well something I was saying at the depths of the crisis in late-’08 and early-’09, and during the debate on the stimulus:

The financial panic and ensuing great recession was a classic balance-sheet recession. As balance sheets shrank in value, demand collapsed. There was a liquidity crisis as well, centered around Lehman’s collapse, but the driving force was collapsing balance sheets, impaired capital values and, for many, insolvencies.

The declines in home values, investor portfolios and 401(k) plans, and the uncertainties surrounding retirement plans, have all had a big impact. The solution lies in restoring balance sheets. For financial firms, that means raising capital. For consumers and businesses alike, that means saving more of their reduced incomes.  [Note the symbiosis between raising capital and household saving.]

Yet public policy has focused almost exclusively on stimulating spending without much regard to why spending, especially consumption, has flagged. Until balance sheets (corporate and household) are restored, increased spending cannot be sustained.  [This failure to ask “why” is endemic in current policymaking.  It’s been my pet peeve in the whole debate over changing financial regulation.]

Temporary spending and tax breaks are always dubious, and especially so now when the rational motivation is to save more and consume less.

Amen to that.

The way I put it during the stimulus debate is that while people clearly wanted to rebuild their balance sheets and delever in the aftermath of a huge wealth shock that occurred at a time they were highly leveraged, the government decided that it had to re-lever on their behalf.   For their own good, dontcha know.

Under this interpretation, it is not at all surprising that the stimulus, and government spending in the US generally, has been anything but stimulating, and has indeed been highly counterproductive.  People, seeing the splurge of spending and associated debt, add that to their consolidated mental balance sheet–what they see in their bank account and loan statements plus the future liabilities they are being forced to assume.  The greater the liabilities forced onto them, the more they have to save to get their balance sheets in some semblance of order.  (That’s doubly true when what the assumed liabilities are spent on doesn’t provide that much–if anything–of value to households.)  (The argument is analogous to the one in classical finance whereby investors can undo firm capital structure choices.)

Uncle Sam stomps on the gas, we stomp on the brakes.  All that is produced is a lot of burning rubber and the car doing donuts.

What should raise questions is that Europe, especially in Germany and the UK, are making appreciable progress despite their having banking systems that are in as bad or worse shape than ours.  But, crucially, they have sworn off the stimulants and are making efforts to restore some fiscal sanity.  This isn’t dispositive, but it is suggestive.

Merkel and the Germans are openly contemptuous of US policy.  With good reason.  But Team Obama seems committed on personifying the definition of insanity as doing the same thing repeatedly in the expectation of getting a different result.

Don’t hold your breath.

A good deal of my summer reading has been focused on books about the financial crisis.  The more that I read, the more that I am convinced that capital rules were a major contributor to it.  Not a sufficient condition, but a condition of first order importance.  A good chunk of the problematic securitization, subprime, SIVs, the lot, was a direct response to capital rules and the efforts of banks to minimize the amount of capital that they had to hold.  “Optimizing” structures with respect to the ratings and the capital rules allowed leveraging of subprime securities to 50:1 or better.   Moreover, since all major institutions faced the same incentives, the capital rules encouraged them to crowd the same trades, greatly exacerbating the systemic effects of the real estate meltdown.

The capital rules are also heavily implicated in other problems in the news recently, e.g., the sovereign debt problems at many European banks.

Which is why I shudder whenever I hear capital requirements ritually invoked as a crucial component of policies intended to prevent the next crisis.  Talk about your triumphs of hope over experience.

My trepidation was heightened even further when I read the excellent Deus ex Macchiato this morning:

Basel III, as one might expect for something written in an awful hurry and without the luxury of much impact analysis, will make this situation worse. It adopts the same approach to regulatory capital as I apply to wrapping parcels: keep on adding things piecemeal until it looks bulky enough to survive. I can go through half a roll of tape for a big parcel, and the result is always ugly. Sadly the consequences of adding extra lumps of capital here and there are equally ugly but less likely to result in safety: they could well result in risk leaving the banking system, and/or banks optimising the channels of their risk taking. The fact that these consequences are not obvious to the Basel Committee is deeply dispiriting. It isn’t quite too late to fix these problems, but with the full Accord due in October, the clock is ticking…

Dispiriting indeed.  I have seen this movie before.  I don’t want to watch it again, but feel that I am–we are–fated to.

Great.

PS.  Feel better, David.  I had a virus that kicked my backside a couple of weeks ago, so I can relate.

In one of the few feelgood stories of this dreary summer, Paul Krugman was last seen shouting “runaway, runaway” from a nasty netstorm in his comment section.   Change your armor, PK!

It’s about time somebody consistently called Krugman out.  (Steve Landsberg tries regularly, but dammit Jim, he’s just one man.)  In his repeated shrieks for more, More, MORE STIMULUS!,  Krugman resembles nothing more than an 18th century physician who, gazing upon his ghostly pale, weak, and failing patient, concludes he hasn’t been bled enough.

Another such “cure” would kill us.  Krugman’s commentors have figured that out, and a good swathe of the country has as well.  The administration hasn’t, but since most of the Democrat delegation is also screaming “runaway” while scattering in terror at the mere thought of even being seen with Obama, perhaps we’re safe for a little while, anyways.

There is a viral rumor that Fannie and Freddie will unilaterally reduce the principal amounts owed on underwater mortgages.

This is generating a lot of criticism, and talk of “bailout.”  Yes, there is probably a bailout element to it, and the political timing would be highly suspect.  But to the extent these mortgages are underwater, F&F are eventually going to eat losses.  Any such program, if rumor is fact, will not be entirely a bailout.  The program would be a mixture of political payoff and recognition of reality.

But even the rumor and the credence many people give it emphasizes a point I’ve tried to make repeatedly about F&F.  Namely, that those who strive mightily to absolve F&F of any responsibility for the housing boom and bust refuse to come to grips with the GSE’s massive losses.  The losses already recognized are huge.  The rumor is essentially an acknowledgement that the losses to come are, er, huger.

Those who defend F&F tiresomely point to statistics about the measured characteristics of F&F’s portfolio, e.g., the percentage of subprime and Alt-A.  They argue that F&F’s participation in such lending was small, compared to non-GSEs.

But the ultimate measure of risk and credit quality is realized performance on the portfolio.  F&F’s huge losses demonstrate that the credit quality of the portfolio was actually quite low, that the value of the portfolio was quite sensitive to housing prices and/or concentrated in overpriced regions, or both.  Most likely, both.   In other words, the huge losses say far more about the credit quality and housing price risk of the portfolio than analyses based on characteristics measured ex ante.  Especially inasmuch as there is reason to believe that F&F fudged these measurements (and isn’t fudging one of Fannie Mae’s main activities?) in order to  increase the amount of credit extended to riskier borrowers in the most bubbly and overpriced markets, while maintaining the pretense that it was continuing to maintain underwriting standards.

The proof of the pudding is in the eating.  We are now eating F&F’s losses.  They demonstrate, quite forcefully, that their brand of pudding was rotten.  Going on and on about statistics allegedly demonstrating the quality of the ingredients doesn’t mean squat if the first bite makes you puke.

The rumor relates to the consequences of past actions.  Sunk costs are sunk.  What is a mistake is to ignore the causes of these past actions, and to repeat the mistakes going forward.  Fannie Mae, however, is falling back into bad habits:

The Washington Independent has an excellent story today about an ongoing housing programme in the US that is almost breathtaking in its stupidity.

Known as “Affordable Advantage”, it involves a kind of partnership between Fannie Mae, the government-sponsored enterprise, and the housing finance agencies of individual states. Here’s the explanation from the Washington Independent:

Before the recession hit, these housing finance agencies, known as HFAs, issued tax-free bonds and used the funds on programs to encourage developers to build in underserved areas and to support single-family mortgages. When the financial crisis hit, private companies — leery of the collapsing housing bubble and freezing mortgage market — no longer wanted to buy the HFAs’ bonds.

Then Fannie Mae entered the scene, agreeing to buy these bonds under the assumption that the homeowners had strong credit histories. In exchange, the HFAs said they would buy back loans that went delinquent.  And this is how the programme now works (also from the Washington Independent, emphasis ours):

Now, qualified homebuyers in the three states pioneering Affordable Advantage do not need to put down the 3.5 percent minimum down payment required by the Federal Housing Administration, or much of a down payment at all. They can get 100 percent financing — a loan as big as the purchase price of the house — for a 30-year, fixed-rate mortgage — a vanilla mortgage. The deal includes a program to help homebuyers if they become unemployed, lowered fees and there is no requirement that the homebuyer purchase mortgage insurance.

The only requirement is a $1,000 downpayment.  Perhaps you can already see where this is going.

Yeah, we can see where it’s going because we’ve already been there.  “Groundhog Day” is not a business plan.

But what’s the one thing that the “financial reform bill” didn’t do?  That’s right: it didn’t do a damn thing about F&F.

So if the rumor about F&F’s treatment of existing mortgages turns out to be true, that will be less worrisome than the things that they continue to do and are likely continue to do going forward.  The only way to prevent that going forward is to put these monstrosities down, with extreme prejudice.

Jeremy Grant is going to town with stories and video interviews on the implications of clearing mandate on his FT TradingRoom site.  One that particularly caught my attention was this interview with Guy Sears.  They discussed the implications of clearing mandates on pension funds.  Sears says (about the 5:55 mark):

It’s about the governance and who carries the risk in this model.  Clearinghouses work by seeing an instrument and worrying about the risks of failure in an instrument.  How far away has it got from its original price?  What’s the market risk in the instrument?  At the end of the day, of course, what really matters is whether the guy holding the instrument is good for his money.  We would say that the pension schemes and savings pools are good for their money.  Making them provide margin to pay for everyone else’s risk is asking them to take part in socializing risks they really should have to pay for because they aren’t risky.

Sears makes a point that I’ve emphasized from early on that has largely been overlooked.  Specifically, two factors interact to determine the risk of default: instrument risk and balance sheet risk.  CCPs price instrument and generally don’t price balance sheet risk, except in the crudest and most problematic of ways.*

As Sears says, balance sheet risk–the risk that “the guy holding the instrument is good for his money”–is crucial.  Not pricing it leads to distortions in the allocation of trading activity across market participants.  It also means that those who use clearing do not pay a price for adding balance sheet risk, which distorts their risk taking decisions.

Sears effectively objects to charging pension funds the same price for risk as a hedge fund pays.  This is a fair objection.  It harms pension funds directly, but it can also distort trading activity, causing hedge funds to trade derivatives relatively more than they should, and pension funds relatively less.  Does this reduce systemic risk?  That seems difficult to argue.

Moreover, different entities have different ways of effectively undoing the effects of clearing.  High and frequently adjusted margins on cleared products mean, essentially, that market users are not in a credit relationship with the CCP, in the same way that they can be in a bilateral dealing.  But this means that mandating clearing frees up credit capacity that can be used to undo, in whole or in part, the debt-reducing effects of clearing.  Some entities, notably pension funds, have less ability to leverage up (and indeed, given their high creditworthiness, are not really in that much of a credit position relative to their counterparties in any event).  This means that a clearing requirement would hit pension funds particularly hard, and unjustifiably.

Pension funds will respond by (a) reducing their usage of derivatives, and (b) reducing their investments in higher return assets in order to accumulate the cash needed to post margins on the derivatives they do trade.  Response (a) means that these funds will incur higher transactions costs to achieve their investment and liability management objectives, and will bear more risks.  Response (b) means that pensions will be less remunerative.

The Frank-n-Dodd bill exempts retirement funds from the clearing mandate to the extent that they utilize derivatives for risk management/hedging purposes.  It is ambiguous whether this exemption would, for instance, cover a fund’s use of an equity derivative or commodity derivative contract to achieve an investment objective.  But the recognition that retirement funds might deserve different treatment is one good thing I can say about Dodd-Frank.  (Although it’s not evident whether this exemption was the result of a fluke moment of lucidity, or the lobbying power of pension funds–including public and union funds.  The latter would be rich indeed.)

But Sears’s main point holds.  Balance sheet risks are an important determinant of counterparty risks.  CCPs don’t price this risk.  This lack of risk pricing is costly.

* CCPs often impose capital requirements, but these are generally multiples of margins.  Since margins don’t vary with balance sheet risk, these capital requirements don’t either.  Moreover, CCPs sometimes condition margins on credit ratings.  Given the crudity of these ratings, and the perverse feedback that results from ratings change-induced increases in margin, this is a coarse and potentially destabilizing way of pricing balance sheet risk.

In a harbinger of an avalanche of unintended consequences from Frank-n-Dodd (not to mention the health care fiasco), Ford Motor Company yanked the sale of securitized auto loans because the members of the credit ratings cartel refused to allow the company to utilize their ratings out of fear of liability provisions in the new law (h/t ASI/Tim Worstall):

Market participants said the auto maker pulled a recent deal, backed by packages of auto loans, because it was unable to use credit ratings in its offering documents, a legal requirement for such sales. The company declined to comment.

The nation’s dominant ratings firms have in recent days refused to allow their ratings to be used in bond registration statements. The firms, including Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, fear they will be exposed to new liability created by the Dodd-Frank law.

The law says that the ratings firms can be held legally liable for the quality of their ratings. In response, the firms yanked their consent to use the ratings, hoping for a reprieve from the Securities and Exchange Commission or Congress. The trouble is that asset-backed bonds are required by law to include ratings in official documents.

The result has been a shutdown of the market for asset-backed securities, a $1.4 trillion market that only recently clawed its way back to health after being nearly shuttered by the financial crisis.

“Issuers have stopped issuing bonds,” said Paul Jablansky, senior ABS strategist at the Royal Bank of Scotland in Stamford, Conn.  [Emphasis added.]

So we have the regulatory analog to a bad drug interaction.   One government policy, imposing liability on ratings issuers, is toxic when mixed with another, a requirement that public debt offerings be rated.

Brain teaser: now that the federal government is writing a blizzard of new policy prescriptions, do you think the likelihood of such toxic interactions will rise or fall?  Now that’s a real toughie, huh?

The legal privileging–no, fetishization–of credit ratings and the ratings cartel was a material contributor to the financial crisis.  But in layering on a new regulation in an effort to “fix” the ratings system while retaining that privileging, Congress just created new problems.

It is this kind of policy boomerangs that will continue to weigh on investment and innovation in the coming years.  Putting a boot in the ABS markets as they struggle to their feet is hardly the way to encourage  a recovery in credit an investment.

The faint recovery is clearly a major concern to the administration.  But rather than grapple with the possibility that their Dr. Feelgood (or Dr. Morell) prescription practices constitute a serious drag on the economy, administration officials are spinning an alternative narrative that casts blame elsewhere.  Taking the lead in this effort is Timmy!, who after being under a rock for the last several months, is now making the rounds telling the tale of how the economy is suffering from some form of PTSD; that business reluctance to invest and hire, and consumer reluctance to spend, has NOTHING, NOTHING to do with government hypertrophy and hyperactivity, but is instead attributable to flashbacks about the crisis.

Today Timmy! was weaving the narrative on Meet the Press.*  Get used to hearing it again and again if the economy continues to stumble.  And get used to the economy continuing to stumble as the number of bad policy interactions, and the fear of bad policy interactions, grows.

* What is it about Timmy! always looking at every interviewer sideways out of the corner of his eye, with his head half-turned?  It is very weird.  Any body language experts have an interpretation?  For his part, MTP host David Gregory played Charlie McCarthy to Krugman’s Edgar Bergen, asking several times whether it wouldn’t be better to spend more, more, more! to stimulate the economy.

Dripping with condescension, Timmy! blew off the concerns of, oh, I don’t know, just about everyone in every kind of business about the effects of the regulatory avalanche that the administration and Congress have unleashed.  No sign here of that deep empathy that is supposedly he hallmark of Obama appointees (h/t R):

“Businesses always want their taxes lower and always want to live with low regulation,” Geithner said. “There is nothing remarkable, or particularly interesting frankly, that we’re in the midst of another debate, which you hear in almost any administration, with people looking for ways to help affect the outcome on the basic path of regulation and taxes.”

. . . .

But when asked a third time by The [Daily Caller] to address the [Business Roundtable] memo, Geithner said it was “a long, diffuse list of familiar concerns, again reflecting nothing remarkable … in the fact that business would like to operate with fewer restrictions.”

Translation: “The concerns expressed from coast-to-coast by businesses large and small, in virtually every industry, are not legitimate.  They are just petty, grubby attempts to achieve favorable regulatory treatment and reduced taxes.  Those who advance these concerns are self-interested and mercenary, and beneath the contempt of a high minded Olympian such as I.  Let them eat regulation.”

Astoundingly, Geithner dismisses any idea that the financial deform and health care bills are creating spending-suppressing uncertainty:

Geithner contested the idea that the health and financial regulation bills have made it more difficult for businesses to plan for the future.

“The basic framework is set. And that should help again give people a lot of clarity about what the basic rules they’re going to operate under is [sic],” he said. “But of course there’s a lot of rule-writing design, and there should be. A lot of the existing set of rules, muck of rules, were not any good. And so you want people to go back and revise and reform.”

Anyone who could say this is either a mendacious liar or a clueless clown.  (And yes “both” is making a strong run for the money.)  In the financial bill alone, there are at least 243 rules touching on every aspect of banking, securities, and derivatives markets that remain to be written: the true total is probably higher.  Nobody knows what those rules will be.  Nobody knows how those rules will interact.  Nobody knows how businesses and households are going to respond to this blizzard of new ukases.

A lot of clarity my [insert body part of choice here]. “Revise and reform” suggests an incremental process to fix known problems.  In contrast, what we face in the coming years is anything but incremental, but is instead a wholesale re-engineering of the entire financial sector.  And the same is true of the health care legislation.

Let’s just take one slice of one piece of legislation: the derivatives title of Frank-n-Dodd.  What has to be cleared?  No idea.  What will margin requirements be?  Who knows?  What capital requirements will regulators impose?  Oh, probably somewhere between zero and 100 percent.  Who will be exempted from the clearing requirements?  I’ll get back to you on that.  How will derivatives be traded (e.g., WTF is a “swaps execution facility”)?  I haven’t the foggiest idea.  What will energy position limits be?  Ditto.  And on and on and on.

Then, once you’ve finally learned what the rules will actually be, now try to figure out how market participants will respond to them.  What will happen to credit?  Prices?  Entry and exit?  Liquidity?

I talk to quite a few people in finance and energy on a regular basis.  A big part of the reason that I talk to them is that they’re trying to figure out what the hell is in the bills, how regulators are going to respond, and what the implications are for their businesses, and they figure that maybe I have some insights onto that.  And my answer is: I only wish I knew.

“A lot of clarity.”  All that people are clear about is that NOTHING is clear.  As a result, the pucker factor is quite high.

In typical administration fashion, Geithner admits that there is uncertainty out there, but this has nothing to do with anything the administration or Congress has done.  It’s just a psychological phenomenon, a sort of financial post traumatic stress syndrome dating to 2008–conveniently before Obama and Geithner arrived to save us peons:

“The big uncertainty that the world is still in … is that people, again, scarred by the trauma induced by the crisis are still looking to see how strong is growth going to be,” he said.

No, Timmy!  The big uncertainty is that, letting “no crisis go to waste,” the administration and Congress have played the Sorcerer’s Apprentice, and cast spells touching on every aspect of the economy, the effects of which by their own admission they have not the slightest understanding.  (Cf. Nancy Pelosi: “And we will find out what is in the Bill, as soon as it passes,” and Chris Dodd: “We don’t know ultimately how well the ideas we’ve incorporated here will achieve the results we desire” and “No one will know until this is actually in place how it works.”  Yeah, just screams “clarity,” doesn’t it?)  If the people who wrote this stuff have no idea, how are the rest of us poor slobs supposed to figure it out?

In fact, if it sticks with the attitude Geithner expressed, the administration is signing its own death warrant.  Call it a capital strike, going Galt, what have you.  With this barrage of regulations; pea soup fog of uncertainty; and higher spending and taxes as far as the eye can see, investment and consumer spending and employment growth will remain moribund, at best, with devastating political consequences.  And in 2010 or 2012, if things do indeed play out this way, the incantation “Bush did it” won’t work any electoral magic.  Sadly, by then the damage that the nation will have suffered will be immense.

I have a  couple of recent publications that may be of interest to some of you.

A couple of folks have expressed interest in my recent Energy Law Journal paper on manipulation.  Here it is: my policy recommendations are at the end.

Cato just released a Policy Analysis I did on clearing mandates. The link is here: you can download the paper from that page.