Category: Commentary

Conventional Wisdom About Credit Default Swaps

I originally published this post over at The Hearing on Monday, but it feels more like a Baseline Scenario kind of post.

One part of the Obama Administration’s financial reform plan is tighter regulation of credit default swaps – those previously unregulated derivatives that brought down AIG and nearly the entire financial sector with it. One of the problems with AIG was that its regulators were apparently unaware that it had amassed a huge, one-sided portfolio of credit default swaps that amounted to a massive bet the economy would do just fine; another problem was that, because credit default swaps were “over the counter,” custom transactions between individual private parties, they created a large amount of counterparty risk – the risk that the party you were trading with might not be there to honor the trade.

In response, the administration proposes to “require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).” In addition, “regulated financial institutions should be encouraged to make greater use of regulated exchange-traded derivatives.” Major players in the market will also be subject to conservative capital requirements (making sure they have enough money in case their trades go badly) and reporting requirements. These provisions aim to increase regulatory oversight and minimize the chances that a derivatives dealer will fail and take its counterparties down with it, and as far as they go they are a good thing.

However, there is one potential loophole that, according to UCLA law professor Lynn Stout (on Friday’s Morning Edition), is “potentially big enough to put the state of Texas into.” The loophole is that “customized bilateral OTC derivatives transactions” would remain out of the reach of both exchanges and CCPs.

Continue reading “Conventional Wisdom About Credit Default Swaps” →

It Takes A Citi

Washington-based policy tinkerers seem increasingly drawn to the idea that greater reliance on market information can forestall future problems – e.g., providing input into an early warning system that can be acted upon by a “macroprudential system regulator”. And while leading critics of the administration’s proposed approach to rating agencies make some good points, they also seem to think that the market tells us when big trouble is brewing.

The history of Citigroup’s credit default swap (CDS) spread is not so encouraging. Continue reading “It Takes A Citi” →

Goldman’s Best Year Ever?

A reader pointed me to this story in The Guardian citing Goldman insiders saying this could be the investment bank’s most profitable year ever.

Staff in London were briefed last week on the banking and securities company’s prospects and told they could look forward to bumper bonuses if, as predicted, it completed its most profitable year ever. Figures next month detailing the firm’s second-quarter earnings are expected to show a further jump in profits.

A couple months back I said that it would be unlikely for the banks to repeat their spectacular first-quarter results in the second quarter, because it depended on fixed-income revenues being even higher than during the peak of the boom. It looks like I was wrong.

Like most things, there are two ways to interpret this. For the optimists, if some of the big banks are making big profits, that gets us back to a normally functioning financial sector sooner and reduces the chance that they will face a panic in the short term. As many people have pointed out, including us, this is basically the Obama Administration’s strategy.

For the pessimists, the phoenix-rising-from-the-ashes profitability of the big banks is a direct result of massive government aid in the form of cheap money, liquidity programs, and let’s not forget the bailout of AIG; it’s also the result of reduced competition resulting from the consolidation of Bear Stearns into JPMorgan, the failure of Lehman, and the weakened state of Citigroup and Bank of America/Merrill. So the government bought a partially healthy banking sector (the big question is what Citi and B of A will report) with public funds, the few winners (Goldman, JPMorgan) are more powerful than ever, and the government is hoping to get an anemic regulatory reform package through Congress in exchange.

By James Kwak

What Next For The Global Crisis?

Slides for speech to World Bank conference (Lessons from East Asia and the Global Financial Crisis), Tuesday in Seoul (1pm local time), are attached. This post summarizes my main points.

There are two views of the global financial crisis and – more importantly – of what comes next. The first is shared by almost all officials and underpins government thinking in the United States, the remainder of the G7, Western Europe, and beyond. The second is quite unofficial – no government official has yet been found anywhere near this position. Yet versions of this unofficial view have a great deal of support and may even be gaining traction over time as events unfold. Continue reading “What Next For The Global Crisis?” →

Efficient Markets and Innovation

Our little Internet debate about reverse convertibles (my contribution here) prompted this post by Mike at Rortybomb. To simplify a little, some commentators defended reverse convertibles by saying, “it’s basically the same as writing a put option” – or, looking at it from the other side of the trade, “there are valid reasons to want insurance against a stock price falling.” To which Mike says, “just sell (or buy) the put option.”

But this is just a specific case of an important point that Mike has made before, but that is more clear when seen in the context of a specific security. Mike’s basic point is that efficient markets imply that financial innovation does not create value. The efficient markets hypothesis says that the prices of financial assets already reflect all available information; in other words, there is no such thing as a free lunch.

Continue reading “Efficient Markets and Innovation” →

The McAllen Problem

What is the lesson of McAllen, Texas, the focus of Atul Gawande’s celebrated article (discussed here and here)? This is my attempt at an answer:

Currently, our health care system has high-cost and low-cost areas; the high-cost areas have no better outcomes than the low-cost areas. So theoretically we can solve our health care cost problem by making the high-cost areas behave like the low-cost areas.

However, the market incentives go in the other direction; the economically rational thing for providers (doctors, hospitals, etc.) to do is to run up procedures and thereby costs. It would be better if providers focused more on patient outcomes or organized themselves into accountable care organizations, as Gawande prefers; but there is no economic reason for them to do so. People are not magically going to become more altruistic overnight. Even shame has only a temporary effect on behavior. Here’s Gail Wilensky from a Health Affairs roundtable:

It’s only by being able to offer compelling evidence that it’s the physician that is the outlier relative to his or her peers, that the patients really aren’t different, and in fact they are not having better outcomes, that you are able to pull back physician behavior — although there seems to be a high recidivism rate.

(Emphasis added.)

In some ways McAllen isn’t the aberration; according to the old Chicago economics department, everywhere should be like McAllen.

Remember all the people who said that you can’t blame mortgage brokers and investment bankers for being greedy, because that’s how a capitalist economy works? Well, you could make the same defense for the McAllen doctors. We long ago stopped expecting lawyers and accountants to behave contrary to their economic interests; now we simply expect them to conform to the law and to certain professional codes of conduct, and otherwise make as much money as possible. Why should we expect anything different from doctors?

In a capitalist economy, the thing that is supposed to keep prices in check is the buyers. If someone offers me a product that costs more than it is worth to me, then I won’t buy it. But we can’t count on patients to play this role in health care, because there is no way to make patients internalize all of the costs of their care; they simply don’t have the money. Furthermore, most people don’t understand the health production function (the relationship between treatments and outcomes), so they don’t have the ability to select treatments that provide benefits that are worth their costs. (And, in many cases, it’s not obvious even to professionals that a treatment isn’t worth the cost; it’s only obvious when you look at the data in aggregate.)

What about payers (health insurers?) A “market” solution would be to change the reimbursement rates for different procedures – increase payment for things that doctors should do more of and reduce payment for things that doctors should do less of. Theoretically, payers should be doing this already. However, in the current situation, a private payer who tried to reduce the rates for popular, expensive procedures would find itself unable to attract providers. The only payer with any real negotiating power is Medicare. The private payers have little ability to control costs. Or, if they have the ability, they aren’t exercising it.

In short, prices will only go up. As a result, the cost of health insurance goes up, and the market finally kicks in in the crudest possible form: people who can’t afford it become uninsured. At some point, if we have enough uninsured people, the health care industry will hit a point where it cannot increase revenues anymore, because it has fewer and fewer paying customers.

The proposed public health insurance plan would have the power to negotiate lower rates with providers. That’s why some providers don’t like it. That’s also why private payers don’t like it; they would be at a cost disadvantage to the public plan. (They can live with Medicare because Medicare leaves them the entire under-65 market.) Maybe that’s unfair. But the current situation isn’t working.

By James Kwak

Shadow Banking for Beginners

Last Friday, Mark Thoma wrote a guest post for The Hearing arguing that the “shadow banking system” was a significant contributor to the financial crisis and needed to be regulated. This prompted a series of posts either attacking or defending his position; for a rundown, see today’s Hearing post.

For now, I just want to highlight the analysis by Mike at Rortybomb (hat tip Mark Thoma). (Those who have read Gary Gorton’s new paper can probably skip this post.) Mike points out that people mean at least three different things by “shadow banking system:”

1) Subprime lenders, who were not subject to the same regulatory burden as depository institutions.

2) A market that trades “informationally insensitive” debt as the result of the repo market and securitized debt as collateral. Where depositors are corporations and money market funds and where lenders are financial firms.

3) Traditional firms who took big bets in the investment markets while their regulators were not present or asleep at the wheel.

For Mike, #2 is the the one that matters. Here’s his explanation:

A bank is, in abstract, an institution that borrowers short and lends long.

Your local bank borrows short deposits and lends long investments. If it needs liquidity it can always go to the central bank’s discount window. The central bank’s discount window is the market maker of last resort for this banking system. [Regulated banks can always borrow money from the Fed at a pre-set interest rate, so they always have access to cash.] This prevents bank runs. In exchange it is regulated by the government.

Your local shadow bank took in money in the repo market as deposits, and used senior tranches of debt as the collateral. Now what happens when it needs liquidity? There is no market maker of last resort who the system as a whole could turn to. Repeat that again. It exists in the shadows, there is nowhere to turn to for emergency liquidity. There is no regulation/liquidity tradeoff here. This is what is meant by being unregulated – not that there weren’t any government agents in sight.

I’ll take that last paragraph a little slower. A repo, or repurchase agreement, is a transaction where one party (the “shadow bank”) sells some securities to another party (the “depositor”) in exchange for cash and simultaneously agrees to buy those securities back at a predetermined (higher) price at some date in the (near) future (like tomorrow). In effect, the depositor is lending cash to the shadow bank, and holding the securities as collateral; the difference in the two prices is the interest. It wants the collateral because nothing else is guaranteeing its loan to the shadow bank (as opposed to ordinary FDIC-insured deposits). The collateral is generally worth at least as much as the amount of the loan, to minimize the risk to the depositor; but the remaining risk is that the shadow bank won’t make good on the repo and the collateral will fall in value.

Why would this happen? The depositors do it because they get higher interest rates than they can get in an ordinary deposit account at a commercial bank. Why would the shadow bank offer higher interest rates? It wants to attract the cash so it can lend it out at a yet higher interest rate (“lend” here could mean buying up subprime mortgages to package into securities that are then used as the collateral for more repurchase agreements to start the cycle again); it doesn’t want to become a commercial bank because commercial banks were traditionally more highly regulated. For example, the major commercial banks were significantly less leveraged than the investment banks during the boom.

The problem that Mike highlights is that there was no liquidity backstop for the shadow banking system. So when the “depositors” got nervous about investment banks like Bear Stearns, they refused to roll over their repo agreements (that is, when the shadow bank closed a repo by buying back the securities, the depositor refused to lend new cash via a new repo), or they imposed a larger “haircut” – they lent less cash for the same amount of collateral. The result is a bank run – only this time the run is on the shadow bank. (Gorton focuses on a slightly different problem, which is that when the same collateral doesn’t bring in as much cash, you have to shrink your balance sheet by dumping assets.)

Mike’s analysis draws heavily on Gorton’s paper, which is helpfully summarized by Ezra Klein. The basic conclusion of both Mike and Gorton is that banking systems need to be reliable, the shadow banking system is a banking system, and hence the shadow banking system must be regulated to some degree. Robert Lucas, quoted in Mike’s post, puts it well:

The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or “bank runs.” The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.

By James Kwak

TARP for Rating Agencies

I would have thought that the credit rating agencies would be at least one group that everyone could agree to throw under the bus. We know that the powerful chieftains of Wall Street are trying to pin the credit crisis on rating agencies – see page 3 of JPMorgan’s blame-shifting attempt, for example. Yet the new Financial Regulatory Reform plan has almost nothing on the subject. Apparently the rating agencies, too, are Too Big to Fail.

Reuters catalogs the provisions relating to the rating agencies. Here’s the summary:

The plan urges Moody’s Corp’s Moody’s Investors Service, McGraw-Hill Cos Inc’ Standard & Poor’s and Fimalac SA’s Fitch Ratings and others to bolster the integrity of their ratings, especially in structured finance.

It also calls for reduced conflicts of interest and for regulators worldwide to tighten oversight.

But the blueprint does nothing to address what critics call the industry’s key shortcoming: That the biggest agencies are paid by issuers whose securities they rate, creating an incentive to win more business by assigning high ratings. . . .

“The overall impact of existing and proposed regulatory changes on rating agencies is extraordinarily easy to summarize: They reward abject failure,” said Jonathan Macey, deputy dean of Yale Law School.

Also see the Huffington Post, which has this understated but damning criticism: “Today, the agencies welcome the government proposals, saying that they favored improved ratings quality and transparency.”

Perhaps this is one area where Congress can improve on the administration’s plan.

Update: Krugman:

The plan says very little of substance about reforming the rating agencies, whose willingness to give a seal of approval to dubious securities played an important role in creating the mess we’re in.

By James Kwak

TARP for Regulators!

We’ve had TARP for banks, TARP for auto companies, and now, with the Obama Administration’s plan for financial regulatory reform, we have TARP for regulators. After AIG, Citigroup, Bank of America, and General Motors, the administration has decided that all the existing regulators are Too Big to Fail – except for the Office of Thrift Supervision, which must play the role of poor Lehman Brothers in this saga. (Actually, they are more like Merrill Lynch, since they are getting merged into the new National Bank Supervisor, so most of them will probably keep their jobs.)

There is actually a serious issue here, and one with no obvious solution. One question that has gotten a lot of ink, both before and after the unveiling of the plan yesterday, has been the identity of the systemic risk regulator: new agency? council of agencies? the Fed? What this really shows is that it’s easier for the media, the administration, and Congress to focus on the how the agency acronyms will be reshuffled, which is a bit like covering a sporting event, than on the underlying issues, like how to make those agencies more effective.

Continue reading “TARP for Regulators!” →

Too Big To Fail, Politically

What is the essence of the problem with our financial system – what brought us into deep crisis, what scared us most in September/October of last year, and what was the toughest problem in the early days of the Obama administration?

The issue was definitely not that banks and nonbanks could fail in general. We’re good at handling some kinds of financial failure. The problem was: a relatively small number of troubled banks were so large that their failure could imperil both our financial system and the world economy. And – at least in the view of Treasury – these banks were so large that they couldn’t be taken over in a normal FDIC-type receivership. (The notion that the government lacked legal authority to act is smokescreen; please tell me which statute authorized the removal of Rick Waggoner from GM.)

But instead of defining this core problem, explaining its origins, emphasizing the dangers, and addressing it directly, what do we get in yesterday’s 101 pages of regulatory reform proposals? Continue reading “Too Big To Fail, Politically” →

More Financial Innovation

Felix Salmon discusses reverse convertibles, inspired by a Larry Light article in the Wall Street Journal.

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead. (The terms can depend on whether the stock ever went below the threshold and where it is at the end of the period, which makes the deal worse for the investor, but that’s the basic idea.)

The simplest thing to compare this to is just buying the stock. Compared to buying the stock, there are three outcomes:

The stock ends up below $80: In this case, the reverse convertible is slightly better, because you got the$10 in interest, which is probably more than the dividends you gave up.
The stock ends up between $80 and $110: Again, the reverse convertible is better, because you got $110 (your principal plus interest); it’s a little better if the stock ends up close to $110, a lot better if the stock ends up at $81.*
The stock ends up above $110: Here, you do anywhere from a little worse (if the stock ends at $111) to much, much, much worse (if the stock goes over $200).

The expected value for $100 of stock after one year is about $108 (6% real return on equities plus 2% inflation), so the chances of a gain and a loss (relative to buying the stock) are roughly equal; however, the distribution of returns is asymmetric, because if the stock does poorly your gains are capped, while if the stock does well your losses are not capped. Whether a given reverse convertible is a good deal or not depends on the specific terms – the interest, the term, the threshold, the volatility of the stock, and the transaction fee. But the question I want to ask is . . .

What the hell is the point of this product?

Continue reading “More Financial Innovation” →

Regulatory Reform For Finance: Three Views

There are three views on who exactly is behind financial regulatory reform package that will be officially presented Wednesday lunchtime (update: NYT.com has the draft). Each view has distinct implications for political dynamics going forward.

The first view is that Tim Geithner and Larry Summers have genuinely become radical reformers. They see the error of the ways they pursued during the 1990s – both in terms of financial deregulation for the United States and in their advice to other countries, particularly through the capital market liberalization policies urged upon the IMF. They now seek to put globalized finance back in its box and will pursue any sensible means possible to this end.

This view is not widely held. Continue reading “Regulatory Reform For Finance: Three Views” →

President Obama’s Regulatory Reforms Announcement: A Viewer’s Guide

At 12:30pm on Wednesday at the White House (someone: please update the Treasury’s schedule of events), President Obama is due to “unveil” his proposals for reforming the functioning of our financial system. The content has already been foreshadowed in some detail, most notably by the Geithner-Summers op ed in the Washington Post on Monday, but what the President himself stresses is still important – everyone who matters for the reform of financial regulation will be in attendance and his remarks (and perhaps those of Secretary Geithner) can absolutely set the tone of the debate.

In particular, the implicit story the President tells will frame our collective discussions going forward and – on some points – could even help tip the balance against established lobbies.

There are at least 10 important questions the President may address or shy away from tomorrow. Add your own suggestions below. Continue reading “President Obama’s Regulatory Reforms Announcement: A Viewer’s Guide” →

Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals

Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.

The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.

Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time. Continue reading “Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals” →

How to Sell Toxic Waste

One point I’ve made a couple of times is that complex structured financial products are sold, not bought. If you want to see how they are sold, check out Zero Hedge’s post on the lawsuit brought by those same Wisconsin school districts that were the subject of the Planet Money/New York Times feature back in November. The second attachment is the Stifel Nicolaus PowerPoint presentation used to sell those school districts a levered bet on a AA- tranche of a synthetic CDO.

It really takes you back to 2006, doesn’t it?

By James Kwak