Streetwise Professor

The clearing debate is getting more complicated, with major brokerages/FCMs clamoring to be admitted to OTC derivatives clearinghouses:

MF Global Holdings Ltd., Hexagon Securities LLC and at least 19 other financial firms are pressing regulators to force swaps clearinghouses to lower entry barriers in order to improve competition in a $605 trillion derivatives market dominated by the world’s biggest banks.

Brokers formed an association last month that hired a Washington-based law firm to pursue the issue with lawmakers and regulators, said Mike Hisler, a partner at New York-based Hexagon. They also seek tougher conflict-of-interest laws to ensure that a bank’s derivatives desk doesn’t influence clearinghouse decisions that could shut out new competitors.

There are numerous issues here that cut in different ways, and make policymaking treacherous.  Indeed, these are issues that I have raised in some of my academic work.

One issue is market power.  I’ve shown that in the presence of substantial scale and scope economies (which definitely exist in clearing), a coalition of intermediaries can form a cooperative firm to provide these services that is (a) smaller than optimal, and (b) immune to competitive entry.  The basic idea is that by adding just enough members to ensure that any other competing effort does not have the scale or scope to compete, this decisive coalition (which consists of the most efficient suppliers, e.g., the big dealers) can reap market power rents even if the cooperative itself charges marginal cost prices.  So, it is potentially problematic to permit a clearing cooperative firm to limit membership.

But there is another issue.  The whole idea behind a clearinghouse is to mutualize risk and, hopefully, to reduce systemic risk.  Admitting anybody willy-nilly is contrary to these goals.  Permitting less financially solid, not to say dodgy, entities imposes costs on the more solid ones, unless those risks can be priced effectively.  But, as I’ve argued extensively, clearinghouses typically do not have the information or the incentive to price the balance sheet risks of members properly.  Moreover, since the price setting process will inevitably be political in such an organization, it is likely (for reasons similar to what Peltzman described in his famous JLE ’75 article on regulation) that the prices will transfer wealth from the efficient to the inefficient (i.e., from the low risk to the high risk).  (A median voter-style analysis leads to a similar result.) Thus, open entry is a recipe for moral hazard–and systemic risk.  And hence, more financially solid firms have an incentive to bridle at the prospect of being required to share risk with other entities.

Allowing anybody in also increases the heterogeneity of the membership, which makes governance more costly and cumbersome.

This is just another example of the dilemmas posed by the network-nature of financial markets generally, and clearing in particular.  Scale and scope economies make competition difficult, if not impossible; efficiently scaled-entities are very large relative to the total market, and arguably natural monopolies.  These scale and scope economies can be exploited to exercise market power by limiting entry.  But permitting open entry creates its own difficulties, especially in clearing, because member heterogeneity that is inevitable with open entry, and member heterogeneity can be expected to lead to cross subsidies.  In this context, that means that some risks are underpriced, and riskier firms can expand and the expense of less risky ones.  That hardly comports with the putative objective of forcing more things onto clearinghouses.

In their rush to find a “solution” and the resulting embrace of clearing, regulators and legislators have largely ignored these very real challenges.  Mandating an expansion of clearing, and micromanaging the organization and governance of clearinghouses (as Gensler has advocated, and as the Lynch Amendment does), will involve unintended consequences.  These consequences will almost certainly undermine the ostensible objectives of these initiatives.

Again: Fools rush in.

The Valukas report on Lehman makes for interesting reading.  One of the most interesting things in the report is what isn’t in it: specifically, OTC derivatives.  Given the hyperventilating over the role of OTC derivatives in the financial crisis, this is quite important news.

Yes, OTC derivatives are mentioned, but in only the most perfunctory way.  Valukus concludes that Lehman’s methods for valuing its OTC derivatives was sound, and that alternative valuation methods gave very similar estimates of the value of Lehman’s positions.  Moreover, he notes that Lehman’s OTC derivatives positions were in the money to the tune of $21 billion, which represented only about 3.3 percent of the firm’s assets.  And that’s about it.

It is clear that the OTC derivatives were not the problem with Lehman.  Indeed, they were arguably the only thing that WASN’T a problem with the firm.  The huge losses were in residential real estate-related positions, commercial real estate, private equity, and leveraged loans.

Even the collateral and contagion issues were associated with other activities, notably repo funding.  In this regard, its interesting to note that, unsurprisingly, the mechanism that is often held out as the way of protecting the safety of the system—collateral—is actually what fed the death spiral.

The report also should open some eyes about the other supposed magic bullet—clearing.  Valukas concludes that there is a colorable case against the CME to claw back losses that resulted from the sale at a deep discount of Lehman’s house positions with the CME clearinghouse.  Valukas states, however, that preemption under the Commodity Exchange Act, the immunity of self-regulatory organizations, and the safe harbor provisions of federal bankruptcy law may shield the exchange from these claims.  I don’t know much about the first two things, but based on my knowledge/experience it is very plausible that the safe harbor provisions would apply here.

But that’s not the main thing of interest here.  It is evident that the Lehman bankruptcy posed risks to the CME clearinghouse, and hence its members.  After finding out about the impending bankruptcy, the CME ordered Lehman to trade for liquidation only, but the firm added to its positions over the next couple of days.  Moreover, the exchange failed in its initial attempt to get members to buy Lehman’s positions in bulk; it decided on this approach after concluding that liquidating the positions on the open market would have been extremely disruptive, given their size and the chaotic conditions in the market.  Several days later the positions were auctioned in bulk, but only at a steep discount.  Resolution of the problem clearly stressed the CME.  (There’s nothing in the report about what happened with SwapClear.  It would be interesting to know more about that.)

Note that the CME clearinghouse was at risk while these positions were still held at Lehman.  The risk posed by these positions didn’t magically disappear.  Moreover, note that what sparked the crisis was Lehman’s balance sheet risk, not the risk of its cleared positions.  This is the kind of risk that clearinghouses have little ability to measure, manage, or price.

In the end, the CME worked through the problems, though there were doubtless some sleepless nights.   Yes, the clearing process worked, but so did the OTC market.  The point is that the failure of a big member posed a big risk to the clearinghouse—and hence its members.  Clearing doesn’t make risk go away, or eliminate systemic risk.

In brief, the Valukas report on Lehman does not comport with the received narrative of the crisis, in which OTC derivatives play a central, and malign, role, and in which clearing is the panacea.  The narrative is so entrenched, however, I doubt that the facts will make any difference.  It will be interesting to see whether the Usual Suspects acknowledge this reality.  I am not holding my breath.

Igor Sechin says that any decision to take TNK-BP’s license for Kovytka would be “fair.” “‘There’s no talk of any blatant expropriation. I think we will find a solution to this issue,'” Deputy Prime Minister Igor Sechin told reporters.”

Yes, I am sure there will be a fig leaf.  I am sure that TNK-BP will be browbeaten behind the scenes to convince them to smile and play nice and do a deal and say “thank you sir may I have another?” in public.  But at the end of the day, any deal will take place under the threat of expropriation, and will not be a truly voluntary transaction.  Just another day in the life of the natural state.

Meanwhile, Sechin and Kudrin are taking it to the mattresses over the issue of tax breaks for Siberian oil:

A feud between Russian Prime Minister Vladimir Putin’s deputies over how to plug the budget gap may end up curbing growth in oil output, the biggest source of state revenue, and limiting flows to Asia, analysts said.

Finance Minister Alexei Kudrin wants to claw back some of the Siberian tax breaks granted to oil companies led by OAO Rosneft and increase taxes on gas producers such as OAO Gazprom. Rosneft Chairman Igor Sechin, Kudrin’s fellow deputy prime minister, wants to prolong oil export tax exemptions to fund output increases. Gazprom and Rosneft are both state-run.

“The Pandora’s box has been reopened,” Yaroslav Lissovolik, chief strategist of Deutsche Bank AG in Moscow, said in an interview. “The tug of war between the ministries is starting.”

. . . .

Kudrin wants to boost gas taxes either at the extraction or export stage, a government official said last week. Gazprom, the world’s largest gas producer, defeated a similar proposal last year. Russia hasn’t increased extraction taxes for gas suppliers since 2006.

Kudrin is under pressure.  Sechin/Rosneft and Gazprom want to keep the rents flowing.  To add to his travails, Putin is trying his old gambit of pacifying discontent at the first signs of its appearance by playing Santa Claus.  Most recently, he ordered a 6.3 percent increase in pensions against Kudrin’s protest:

The government will increase pensions by 6.3 percent next month despite warnings from Finance MinisterAlexei Kudrin on Thursday that the budget cannot afford it.

“We have the means, and I think the decision to increase pensions will not affect the macroeconomic conditions,” Prime Minister Vladimir Putin said at a Cabinet meeting. The increase signifies “carrying out our responsibilities before our citizens,” Putin added.

The pension fund may see a deficit of up to 170 billion rubles ($5.71 billion) if any increases not indicated in the legislation are made, Kudrin said. By law, pensions can be increased if the Pension Fund makes a profit or if inflation is especially high. The fund’s profits did not increase, nor will they increase in the current year, and inflation is expected at clock in at 5.6 percent to 7.5 percent in 2010. Therefore, the law does not allow for a pension increase, Kudrin said, RIA-Novosti reported.

“We have the money,” Putin replied. “Our ability to lower inflation last year … indicates that we can maintain macroeconomic conditions as planned,” he said.

Putin says it, so it must be true!

Russia’s economy has bottomed out, but its rebound has been less robust than elsewhere in the world.  The service sector is barely growing.  Foreign direct investment is still in the dumper. Manufacturing eked out a extremely small gain: the most recent PMI came in at 50.2, with anything above 50 indicating growth.  In contrast, the Eurozone PMI was 54.2 and the US  was 56.5.  So Russia is a definite laggard.

The recent rise in oil prices to over $80/bbl is a mixed blessing.  It bolsters Russia’s budget, but also causes the ruble to strengthen, which hurts manufacturing in particular.  So while the rest of the world is recovering with some vigor, Russia is languishing.

So Kudrin is caught between the rent seekers and Putin doing his populist turn.  (What about Medvedev you ask?  Don’t make me laugh.)  He has done a remarkable job over the years at steering a very respectable macroeconomic course for Russia: the country’s problems lie with its institutions and microfoundations.  But it is a thankless job, and there is no guarantee that he will be able to hold off indefinitely those baying after state funds.

Which makes me think: maybe we should offer Kudrin a job over here, as, say, Treasury secretary.  He has just the skills we need.  The ability to craft and implement sensible macro and budget policies in the face of intense political pressure.

So how’s this for reset: we trade Timmy! for Kudrin, straight up.  Now that would be the steal of the century, sort of like Brock for Broglio.

Greece desperately needs people to buy its bonds.  So what does it do?  It excludes potential buyers, specifically hedge funds:

Greece ordered its bankers to exclude hedge funds from a bond offering this week in an effort to punish the speculators it blames for destabilising its debt markets.

The decision came amid growing anger among European leaders over what they see as the role speculators played in undermining the Greek debt market and driving the country towards a possible default.

. . . .

According to people familiar with this week’s €5bn (£4.5bn) Greek bond issue authorities in Athens told banks handling the sale to make sure they did not allocate any bonds to hedge funds or any bodies that might be a proxy, or front, for them.

Uhm, those hedge funds that want to buy are going to result in lower interest rates for Greece.  Excluding them from the primary market can only make things costlier for Greece.  (Although since these folks can buy in the secondary market, the effect of excluding them from an auction might not be that large.)   You don’t punish bearish hedge funds (not that they deserve punishment in any event–see below) by taking a smack at bullish ones.  How assinine.

The Queen of this Greek drama, Prime minister Papandreou is absolutely over the top with his anti-speculative rants:

Greek Prime Minister George Papandreou, drawing parallels with the 1947 fight to contain communism in Europe, called for trans-Atlantic cooperation to combat “unprincipled speculators” who threaten to bring a new global financial crisis.

“Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system,” he said in a speech today in Washington. “An ongoing euro crisis could cause a domino effect, driving up borrowing costs for other countries with large deficits and causing volatility in bond and currency rates across the world.”

Papandreou and other leaders such as German Chancellor Angela Merkel have blamed much of the surge in Greek financing costs on market speculation, rather than its inability to tame the region’s biggest budget deficit. Germany and France are pushing for curbs on “speculators” using derivatives to bet against Greek debt, which will be ready in June, officials in Berlin and Brussels said today.

Papandreou called the market for credit-default swaps a “scourge” that “haunts Greece and all of us.” U.S. and European regulators need to bolster regulations to curtain such activities, he said, or “a small problem could be the tipping point in an already volatile system.”

Puh-lease.  I mean seriously.  What should haunt you, Mr. Prime Minister, is years of profligacy only partially concealed by financial chicanery (enabled, true enough, by some of the very banks against whom you rail today).  If you are facing some sort of financial  Armageddon, it’s the fault of your government and its predecessors, dating back years.  I would say that it was the governments of Greece–and other countries, the US included–that acted with “utter disregard for the consequences on the larger economic system.”

And which are acting with such utter disregard today.  Only more so.

But the shoot-the-messenger histrionics don’t end with Papandreou.  All of Europe’s government leaders are closing ranks to blame everybody but those who actually spent the money they didn’t have and couldn’t pay back.  Here’s Sarkozy:

“If Greece needs them (the measures), we’ll be there,” he said. “Speculators … must know that ‘solidarity’ means something.”

France, Germany and Greece will take a common initiative to fight speculation, and the euro zone’s two biggest economic powers “have decided to do what’s necessary so that Greece is not isolated,” Sarkozy said.

And Merkel:

German Chancellor Angela Merkel said that Greece doesn’t need financial aid, as she turned her focus to restricting the use of derivatives to halt “speculators” from exploiting countries’ budget deficits.

“Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb,” Merkel said at a joint press conference in Berlin yesterday with Greek Prime Minister George Papandreou.

. . . .

“We must succeed at putting a stop to the speculators’ game with sovereign states,” Merkel said. “We can’t allow speculators to be the profiteers of Greece’s difficult situation.”

So the Merkel story is, effectively, that the Greek financial house was all in order, nice white stucco and all, until one day, out of a clear blue Aegean sky, some malicious speculators decided to burn that house down.

What a crock.

It would be more accurate to say that the Greek financial house was used to store gasoline, while the family was busy puffing away on cigarettes (the Greeks being among the greatest smokers in Europe, BTW) and throwing their butts and matches around with abandon.  Some people noticed this, figured out something bad was almost inevitable, and put their money where their eyes were.  Yes, they probably made a few bucks for themselves, but also did the service of accelerating the inevitable fiscal reckoning, not just in Greece, but in Europe as a whole.

Oh, and even Merkel’s own German financial regulator, BaFin, denies that speculation caused the Greek crisis:

German market regulator BaFin said Monday that so far, it doesn’t see any sign of massive speculation in credit default swaps against Greek government bonds, despite some recent press reports suggesting this.

A significant reason behind widening CDS spreads is the increasing demand for insurance against Greek risk, BaFin said in a statement, adding that it closely watches the government bond and credit derivatives markets for selected euro-zone countries.

. . . .

BaFin said data published by the U.S. Depository Trust & Clearing Corporation don’t signal an increase in new open positions and don’t indicate massive speculation. It is true, however, that the gross volume of outstanding CDS contracts for Greek government bonds amount to around $83 billion as of Feb. 12, according to DTCC, more than twice the $41.1 billion a year earlier.

In other words, Papandreou, Sarkozy, Merkel et al are saying: “Don’t bother me with the facts.”  They don’t want to face up to fiscal realities, so they are trying to direct blame elsewhere.

Politics as usual, in other words.  And it is politics as usual that put Europe in this positions in the first place, and politics as usual that will prevent any fundamental change.

I’m just back in Houston from speaking at a conference at the Columbia Law School, titled “The Financial Crisis: Can We Prevent a Recurrence?”  It was probably the best conference I have ever attended.  It was a gathering of a truly talented group of academics (mainly legal scholars, but some economists), practicing lawyers, finance practitioners, central bankers (US and non-US), and government folks, all of whom offered excellent insights on various aspects of the crisis, and policy responses to it.  The organizers, Jeff Gordon of Columbia and Howell Jackson of Harvard Law School, are to be congratulated for putting on a phenomenal event.  It was a privilege to participate.

I spoke on clearing.  (Go figure.)  My remarks were well received, I think.  Robert Pozen of MFS Financial Management said in his remarks that he didn’t agree with a lot of what I had to say, but that any supporter of mandated clearing (which he is) had to take my critique seriously, and address the concerns I’d raised.  Which is quite fair.  I don’t claim to have all the answers, but I think I have good questions, and hope that posing them will contribute to the formulation of better policy.  (I started my talk with Hayek’s quote “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”  I think that some in policymaking circles think they know far more than they do about the systemic implications of clearing, and all I aim to do is what Hayek says economists should do.)

The conference finished up with a session on “Radical Solutions.”  Charlie Calomiris and Luigi Zingales gave very interesting talks that echoed two major SWP themes, namely that too big to fail is the result of governments’ inability to commit credibly not to bail out, and that the ultimate source of moral hazard and the excessive growth of financial institutions is that their creditors are convinced that they will be bailed out, and hence are willing to lend on terms that do not reflect risk.  They offered interesting proposals to address these problems.

One thing that struck me throughout the event is the widespread belief that financial reform efforts are dead in the water.  Some considered that unfortunate.  Others, including yours truly, were not so negative; not that I/we don’t believe that some sort of reform is needed, just that the alternatives on offer are likely to be counterproductive.

Today’s luncheon speaker was Henry Hu, a University of Texas law prof now heading up the SEC’s new Division of Risk, Strategy, and Financial Innovation.  I don’t always agree with Henry–I have criticized his analysis of the “empty creditor” problem, for instance–but he is obviously a thoughtful man who is bringing tremendous energy and enthusiasm to his DC job.  In his talk, he asked the audience to let him know whether they observed any new product or trading strategy that threatened to destabilize the financial system.  That’s fine, but I would also hope that he would be equally alert to regulations or legislation that could have deleterious effects; and be particularly alert to the creation of policies that could encourage the development of problematic strategies and products in direct response to such policies.

Friday’s dinner speaker was Simon Johnson.  I have an extremely mixed reaction.  I share his concern about too big to fail, and the potential for legislative and regulatory capture by the finance industry.  But given that I consider much of the proposed legislation to be counterproductive, unlike Johnson I don’t believe that it is axiomatic that bank opposition to this legislation is an outrage.  His is a very Manichean world view, with big finance as the epicenter of evil, and those who fight big finance as the avatars of goodness.  Not quite that simple, IMHO.

It was weird, to say the least, to hear someone channeling Andrew Jackson in a Brit accent.  He started out talking about TR taking on the trusts, and FDR taking on the banks, but I was thinking that his real hero should be Andy Jack.  Sure enough, a few minutes later he said that the true first opponent of financial oligarchy was Jackson.

Again, I have some sympathies; much of Jackson’s critique was correct, as is some of Johnson’s.  But much of Jackson’s criticism was misguided, and what’s more, the system that he advocated to replace the corrupt Second Bank of the US was plagued by chronic instability and crisis.  Johnson was less than candid about Jackson’s banking legacy: he would only admit that the post-Jackson banking system was “complex.”  But to admit that a previous populist response to concentrated financial power was hardly ideal would undermine Johnson’s populist jeremiad against today’s concentrated financial power.  That failure to confront the possibility that a populist reaction can be destructive undercuts Johnson’s credibility in my eyes.

Johnson’s tone was also extremely off-putting.  It was snide and arrogant.  He came off as a populist provocateur poseur.  Not particularly appealing.  But worth hearing nonetheless.

At the conference, there was a lot of agreement about the underlying causes of the crisis.  There was, however, less agreement about policy responses going forward.  That’s not surprising, but given the caliber of the people at the conference, it does suggest that we are in for a long debate over policy going forward.

And while I was at the Columbia conference, SWP daughter Renee was at a conference at Texas A&M, sitting 10 feet from George H. W. Bush and Barbara Bush.  And someone really important: Chuck Norris.  And she lived!  (He gave the death glare to one of her friends who was laughing too hard at something.)  Nobody quite that famous at Columbia, but it was worth the trip nonetheless.

The Greek crisis (or, more generally, the EuroSov crisis) is leading to increasingly shrill calls to line up short sellers–and especially “naked” CDS buyers–against the wall for summary execution.  Among the shrillest is this piece by Wolfgang Munchau (sorry about the missing umlauts):

I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer.

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece”. Using CDSs to destabilise a government was “counter-productive”, he said. Unfortunately, it is legal.

I only have time for a few comments.

• Like Wretched Gretchen Morgenson (whom I adamantly will not link to, not wanting to corrupt impressionable minds), Munchau lumps together CDS and other kinds of derivatives, namely currency and interest rate swaps that oh-so-pure European governments used to conceal their debts.  Is he ignorant?  Is he duplicitous?  Does it matter? It is incorrect, and it is misleading.
• He trots out the tired “CDS are insurance-insurance law prohibits buying insurance without insurable interest-so we should ban naked CDS purchases” argument.  Beware misleading analogies.  Try to understand the particular reasons why, in general, an insurable interest is required to by life insurance on, say, Wolfgang Munchau or fire insurance on his dwelling.  Moral hazard, for instance: Wolfgang’s life and home could be in some jeopardy if this were allowed.  Of course, resources could be devoted to investigate anything untoward that happened to Mr. Munchau, thereby deterring such abuse, but this is costly, and it is difficult to see any social benefit at all from permitting others to bet on Mr. Munchau’s longevity or the reliability of the wiring in his home.
• Which brings us to Mr. Munchau’s most important point: that there is NO social benefit associated with naked CDS.   He says:
  

  It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

• Not a single social benefit?  All speculators agree on this?  That’s a pretty strong assertion, which is just that: an assertion, offered with little argument and less evidence.  I agree that it is unlikely that the social benefits and social costs of speculation do not align with the private benefits and private costs.  For instance, a good deal of speculation is rent seeking activity, where individuals expend resources to collect information which they trade on in order to receive a transfer from some less-informed sucker.  But that’s different from saying that speculation has no benefit whatsoever.
• In particular, the information that is embedded in prices by informed speculators can lead market participants to make better decisions, or more timely ones.  This was no part of the speculators’ intentions, but it is a benefit of speculation nonetheless. To the extent that speculation leads to a speedier, and more credible, revelation of the wasteful profligacy of spendthrift governments (or banks, or corporates), the sooner and more effectively this waste can be curbed.  For instance, if you think corporate fraud is wasteful (think Enron), you should also think that short sellers that detect it and profit from it and lead to its ultimate revelation are providing a valuable social benefit.
• Again, there’s no clean alignment between the individual incentives of speculators and the benefits of their activities, but that’s quite a different thing from saying that there is no benefit at all.  And as Mr. Munchau’s article demonstrates, there’s a real choice involved since it’s impossible to quantify the costs and benefits of any particular speculative trade: you either ban it or let it go (with, perhaps, rules against purely opportunistic activity, such as spreading false information to enhance the value of a speculative position).
• Mr. Munchau has absolutely no data on how much CDS purchasing is naked.

Muchau’s outrage is shared by virtually every government in Europe.  Spare me.  This is clearly shooting the messenger.  As James Carville noted long ago, the bond market (and now, the CDS market), disciplines governments, and they don’t like it one bit.

This article from Bloomberg hits the nail squarely:

Blaming derivatives for governments’ financial problems is like faulting the “mirror for your ugly face,” according to analysts at Citigroup Inc.

. . . .

“We would do better to spend our time addressing the defects the mirror shows than blaming the mirror,” Citigroup analysts led by Michael Hampden-Turner in London wrote in a note to investors. “After all, banning mirrors does nothing at all to make the world a prettier place.”

Damn right.  Nobody likes market discipline, especially governments.  But they’re the ones who usually need it the most.  Hence we should resist cynical, self-interested calls to terminate CDS speculators, and instead pay more attention to the message they are sending about the unsustainability of fiscal policies in Europe, and around the world.

AEI’s Peter Wallison’s opinions on matters related to the financial crisis and financial regulation are highly and positively correlated with mine.  He has an excellent oped in today’s WSJ which echoes my views on the real source of moral hazard and too-big-to-fail: namely, bailouts don’t directly distort the incentives of bank executives and equity holders, but they do seriously distort the incentives of those who lend to banks:

The same failure to understand the power of moral hazard is what makes the administration’s call for a resolution authority most inapt and troubling. Although the administration has argued, and some in Congress believe, that moral hazard and too-big-to-fail would be curbed by a resolution authority, the opposite is true. Both would be enhanced.

This is because the principal danger of moral hazard—the key to its adverse effects on private decision-making—is its impact on creditors and counterparties. The fact that shareholders and managements will lose everything in a government resolution is largely irrelevant. What really matters are the lessons creditors draw about how they will be treated. And it is clear creditors will be treated far more favorably in a government resolution process than in a bankruptcy.

To understand why this is true, consider the administration’s reasons for preferring a government resolution process. The claim is that large, interconnected firms will drag down others when they fail. The remedy for this is to make sure their creditors and counterparties are fully paid when the takeover occurs. That’s why the Fed made Goldman Sachs and others whole when it rescued the insurance giant AIG. It’s also what distinguishes a government resolution process from a bankruptcy, where a stay is imposed on most payments to creditors when the bankruptcy petition is filed.

Creditors will realize that by lending to large companies that might be taken over and resolved by the government, their chances of being fully paid are better than if they lend to others that might not. Thus a resolution authority will enhance moral hazard not reduce it—and as creditors increasingly assume that large firms will be rescued, the too-big-to-fail phenomenon will grow, not decline. In the end, a resolution authority becomes, in effect, a permanent Troubled Asset Relief Program.

Exactly so.  The effects of this can be far-reaching.  For instance, it can make it rational for banks to take on excessive leverage.  Moreover, it can distort the types of leverage banks use; it tends to favor short-term debt and fragile capital structures, because it is that kind of debt that provides the greatest systemic risk, and hence is most likely to induce the government to ride to the “rescue.”

On these lines, note that the widespread belief that the government stood behind Fannie and Freddie debt allowed these entities to grow immense and highly leveraged.  Funny, isn’t it, that even though F&F are gulping down government money in quantities that make AIG look like a piker (another $15+ billion last quarter for Fannie, with NO end in sight), that this goes largely unnoticed, and draws nothing of the outrage that the AIG bailout does?

Wallison also expresses skepticism about the importance of contagion and interconnection in driving the financial crisis:

Then there is the proposal to give a government agency the authority to take over and “resolve” failing financial firms. Here, the administration has pointed to the chaos that followed the bankruptcy of Lehman Brothers in September 2008. To prevent that kind of breakdown, the administration says all large and “interconnected” financial firms in crisis should be dealt with by a government agency, rather than by a judge in bankruptcy proceedings.

The term “interconnected” is important here. It implies that when one large firm fails it will carry others down with it, causing a systemic crisis. But that is clearly not the lesson of Lehman. Although the company went suddenly and shockingly into bankruptcy, none of its large financial counterparties failed. The systemic significance of “interconnectedness” proved to be a myth.

There seems to  be a tendency to attribute any simultaneous implosions among financial firms to a contagion effect.  I think it is more plausible, however, that the observed correlation in distress reflected correlations in investment strategies across financial institutions, making them simultaneously vulnerable to a common shock.  In the event, it was exposure to real estate prices.

Look at the week or so beginning September 7, when the Feds took over Fannie and Freddie, followed by the Lehman collapse and the AIG bailout.  All of these were heavily exposed to real estate prices.  The most heavily damaged survivors, Citi, Merrill, and BofA most notably, also had big exposures.  Before them, it was Bear.  It wasn’t a single bad firm dragging healthy ones to which it was interconnected down with it; it was an epidemic of financial sickness caused by exposure to a single, common pathogen that simultaneously brought many firms low.

It is important to understand the relative importance of contagion and correlated solvency shocks in contributing to the crisis.  Most of the proposed “solutions” seem motivated by a belief that the crisis was a chain reaction made possible by excessive interconnectedness.  If this diagnosis is wrong, the prescriptions are likely to be either useless, or positively harmful.  The same is true with the diagnosis of the true source of moral hazard underlying TBTF.  Unfortunately, as Wallison suggests, we seem to be misguided here as well.  This doesn’t bode well for avoiding the next crisis.

My dad told me that he’d seen a CNBC interview with some Congressmen advocating a law to prohibit the government from bailing out financial firms.  It is hard to get excited about this watching what’s going on in Europe.  The Maastricht Treaty expressly proscribes bailouts of member countries, but there are all sorts of plans under consideration to do just that for Greece, while avoiding a direct government-to-government bailout.  These schemes would utilize various cutouts, such as having German banks buy Greek government debt, and the German government providing guarantees to the banks.

As I’ve written before, the difficulty with too big to fail is the inability of governments to commit credibly not to bail out.  The Europeans recognized this problem, and attempted to write language in the EU founding treaty that would commit the members not to bail out others who are failing.  But where there’s a will–or, more accurately, a lack of will to adhere to commitments–there is a way.  This is why TBTF is so intractable, and why we should be wary of any claims that this legislative measure or that here in the US will make the problem go away.

I say only somewhat facetiously that what is needed to prevent TBTF is a financial doomsday machine, a la Herman Kahn/Dr. Strangelove, that would automatically impose a prohibitive cost on any government that attempts to bailout.  Short of that, with mere humans in charge, credible commitments are nearly impossible.

I knew that the Commodity Futures Modernization Act (CFMA) was a powerful piece of legislation, but I was unaware just how powerful.  It apparently has the ability to alter the space-time continuum, and affect events even prior to its passage.  How did I learn this?  From a letter signed by senators Feinstein, Cantwell, Snowe and Dorgan to Chris Dodd.  (I haven’t been able to find a copy online.)  The senators state:

As you know, in 2000 Congress made the mistake of exempting energy from commodities regulation in the Commodity Futures Modernization Act.  This exemption, known as the “Enron loophole” led directly to the Western Energy Crisis.

Uhm, compromise language that was ultimately incorporated into CFMA passed the House on 14 December, 2000, and was introduced into the Senate on 15 December.  A conference committee hashed out differences, and the bill was ultimately signed into law (by Bill Clinton) on 21 December, 2000.

Meanwhile, the California/Western energy crisis had been building throughout 2000.  Power prices first spiked in May, 2000.  The first blackouts were in June, 2000.  San Diego Gas & Electric made allegations of market manipulation in August, 2000.  FERC rejected California’s request for a price cap on–wait for it–15 December, 2000.  The peak prices observed during the entire crisis occurred in December, 2000.

In other words, the energy crisis was well underway long before the passage of the CFMA, and reached its crescendo at the very time that the bill was being passed, and well before it could have, let alone did, affect one transaction in energy or anything else.  Since cause must precede effect, for these senators to say, in the very opening paragraph of their letter, that the Act “led directly” to the crisis is complete and utter bilge.

What’s more the underlying causes of the crisis are well known, and had nothing to do with the matters addressed in the CFMA, and everything to do with the wretched market design put in place by the California legislature.  Indeed, to the extent that derivatives were involved at all, it was the legislature’s ban on the ability of CA utilities to enter into long term purchase deals or hedging contracts that exacerbated the crisis.

Insofar as Enron is concerned, its actions (e.g., Death Star, Fat Boy, Ricochet) were designed to exploit flaws in the market design (particularly the design of the Power Exchange–PX–and differing price caps across markets).  They had nothing to do with the kinds of things addressed in the CFMA.

(I would also add that the exemptions in the CFMA were not quite so broad as the senators suggest in their letter.)

So, the senators got off to a very bad start.  What about other matters raised in the letter?  Well, better, but not much.

The basic thrust of the letter is to argue against providing end user exemptions from clearing requirements, or treating end users more liberally generally.  The essence of their argument is that systemic risk is unpriced, and that clearing internalizes this externality.

This represents just another example of clearing as deus ex machina that magically addresses systemic risk concerns.  The authors of the letter, like many others who have discussed the subject, assume that (a) counterparty risks are not priced properly in OTC markets, and (b) central counterparties will do a better job at pricing counterparty risks.  As I’ve written extensively, neither claim is necessarily true, nor even plausible.

The letter commits another factual gaffe when it claims that there was a “systemic failure caused by the Enron bankruptcy.”  Certainly counterparties lost money as a result of the Enron bankruptcy, but there was no systemic failure, particularly if one defines “systemic failure” to mean a contagion effect.

The Enron failure did not cause a major upset in the energy markets.  The implosion of the merchant energy sector occurred some months later.  The key event was the SEC’s announcement that it was investigating Dynegy’s accounting on 25 April, 2002.  Subsequent to that time, merchant energy stocks declined by about 90 percent in value, and other companies went bankrupt (e.g., Mirant).

But this wasn’t a systemic contagion event.  Instead, it was the result of a widespread recognition that the energy trading boom was overdone, that profitability estimates were probably inflated, and profit projections would not be realized due to overbuilding of capacity and other reasons.  That is, every firm in the sector was overvalued, and when the market reached that conclusion, they all fell  in value.  There was a common shock, and the affected firms fell in common.  That implosion would have occurred, clearing or no.

This point about confusing contagion effects (in which the demise of one big firm induces financial distress in otherwise healthy firms to which it is connected) and simultaneous collapses of multiple firms caused by a common shock is quite important, and gets too little attention.  The common shock in the recent financial crisis was real estate price declines, communicated to large financial institutions through their holding highly correlated positions in real estate price sensitive investments.  That’s different than a contagion resulting from the bad decisions or bad luck of one firm bringing down others just through contractual connections.

We can barely expect such more discriminating analysis, alas, from senators who are either completely ignorant of the legislation that they write about, or who don’t understand the basic fact that cause must proceed effect.

Update (3/1/10): SWP daughter #1 wonders if a silver DeLorean and a wild haired professor were seen in the vicinity of either Congress or California when the CFMA passed.

Matt Leising and Shannon Harrington have been on a roll lately.  Today, they report that big buy side firms are resisting Fed calls to clear a targeted percentage of their deals:

The biggest credit-default swaps investors oppose targets for clearing trades as regulators attempt to curb risk in the $25 trillion market.

Pacific Investment Management Co., BlueMountain Capital Management LLC and AllianceBernstein LP are among asset managers and hedge funds that won’t agree to specific goals before the Federal Reserve Bank of New York’s March 1 deadline requiring them to outline the industry’s next steps to move swaps through clearinghouses, according to people familiar with the matter who declined to be identified because the talks are private.

. . . .

The asset managers, while backing efforts to broaden the use of clearinghouses, want assurances that cleared trades would be protected under bankruptcy laws, the people said. They’re also concerned they may be saddled with collateral costs that are double or triple what they’re paying now because they could lose benefits now granted by prime brokers that give credit for offsetting trades, the people said.

For example, hedge funds and other asset managers often will perform trades that seek to profit from price dislocations between index contracts and swaps on companies included in the index. Prime brokers typically will demand collateral on the net amount at risk from offsetting trades.

Tying Up Cash

If one leg of the trade were required to be cleared, while the other contracts aren’t eligible, fund managers may be forced to increase the amount they have to post, tying up cash, the people said.

This is ironic because the best economic case for clearing is that reduces counterparty risk for end-users.  For instance, the classical futures clearinghouse reduces customer default losses (but doesn’t necessarily eliminate them) that could result from the failure of a brokerage firm by shifting the liability to the clearinghouse, and thus, to the other brokerage firms that are members of the clearinghouse.  Note that the Chicago Board of Trade has always argued that no CUSTOMER has lost money as the result of a default; the CME now makes a similar claim.  Thus, if anybody should be clamoring for clearing, it is customers.

But, as the article notes, this doesn’t come for free.  In particular, the article notes that clearing, especially through single-instrument clearinghouses, can eliminate scope economies (achieved, for instance, through netting and cross margining), thereby inflating costs.

So it can be reasonable for customer firms to resist clearing even though if it benefits anybody, it is most likely to benefit them.

Dealer firms have agreed to clear a large fraction of some inter-dealer trades (e.g., CDS trades).  In other markets (e.g., interest rate swaps) banks have elected to clear a decent proportion (around 50 percent) of inter-dealer trades.  But in many respects, inter-dealer clearing offers fewer potential risk sharing advantages than customer clearing (that shifts risks from customers to the dealer-members collectively).

In bilateral markets, there is extensive inter-dealer trading; this creates performance risk between dealers.  Clearing basically does the same thing.  It can reduce some exposure, through multi-lateral netting, but as Duffie and Zhao have shown, and as I have shown, this gain is reduced, and at times non-existent, because clearing can reduce bilateral netting opportunities across a portfolio of instruments.  Thus, the exposure reductions may be limited, especially if the clearinghouse handles only a narrow range of the instruments that dealers trade.  But even if there is some exposure reduction, a lot of what inter-dealer clearing does is to share the same risk among the same players.

The way this risk is allocated can differ somewhat; in particular, it is possible that risk exposures through clearing are less concentrated than the bilateral inter-dealer exposures in non-cleared markets.  But dealers have incentives to limit concentration on their own, and do so through exposure limits and credit limits with each counterparty.  Moreover, dealers have the ability to use their own information to choose these limits in bilateral dealings, whereas the clearinghouse cannot rely on this information.  Thus, clearinghouse members may have exposures that are less concentrated than their bilateral exposures, but they still may be worse off because they take more exposure with some counterparties via the clearinghouse than they would voluntarily take in a bilateral market.  That is, concentrations in bilateral markets are endogenous, and high concentrations can be sensible, based on counterparty risk evaluations.

The resistance of some sophisticated buy side firms to clearing should be another hint to regulators and legislators that mandated clearing is not necessarily a good thing.  If those who, if anyone, would be the biggest beneficiaries of clearing, decide it’s not worth the candle, that strongly suggests that the total benefits are illusory.