What is a clearinghouse?

The discussion of clearinghouses appears to be missing some crucial elements.  From the latest Squam Lake Working Paper:

[There are] two important advantages of clearinghouses. First, by allowing an institution with offsetting position values to net their exposures, clearinghouses reduce levels of risk and the demand for collateral, a precious resource, especially during a financial crisis. Second, by standing between counterparties and requiring each of them to post appropriate collateral, a well capitalized clearinghouse prevents counterparty defaults from propagating into the financial system. Because of these advantages, the U.S. Treasury Department has announced that in the future all credit default swaps that are sufficiently standard must be cleared.

Clearinghouses, however, are not panaceas. In the fight for market share, they may compete by lowering their operating standards, demanding less collateral from their customers, and requiring less capital From their members. To ensure that clearinghouses reduce rather than magnify systemic risk, regulatory approval requires strong operational controls, appropriate collateral requirements, and sufficient capital. Clearinghouses should be subject to ongoing regulatory oversight that is appropriate for highly systemic institutions.

It strikes me as utopian to think that regulatory oversight could possibly ensure the solvency of a clearinghouse — especially of a clearinghouse for financial contracts that are subject to sudden changes in value like credit default swaps.  The reason that clearinghouses, like the New York Clearing House founded in 1853, were financially stable is because the clearinghouse liabilities were guaranteed jointly by the full faith and credit of every member of the clearinghouse.  In other words, if a firm wants to use a clearinghouse, it has to be willing to stand behind the liabilities of the clearinghouse.

Pushing derivatives onto clearinghouses without insisting on member liability for clearinghouse debt seems foolhardy.  When firms like Goldman Sachs and JP Morgan Chase are willing to put their shareholders on the line, regulators can be confident that clearinghouse policies are well designed.  Without such a seal of approval from the major derivatives dealers, how could regulators ever be sure that sufficient safeguards are in place for the clearinghouse?

And if the response is that the banks are unwilling to support a clearinghouse with member liability, that would imply that there is no way to design a sound clearinghouse for the derivatives under consideration.  This in turn has implications for the inherent stability of the derivatives market — and would immediately raise the possibility that the appropriate action for regulators is simply to shut the market down.

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CDS and systemic risk

As GoldmanSachs’ outstanding earnings and bonus plans ricochet through the news, one refrain is heard repeatedly:  Even though Goldman received more than $10 billion via the government’s bailout of AIG, Goldman did not need the money because it was “fully hedged”.

This is really a perfect illustration of how credit default swaps create systemic risk.  Goldman Sachs has effectively taken the position that it doesn’t matter whether or not AIG (or any other counterparty) is creditworthy — as long as it can find another counterparty who is willing to sell Goldman CDS protection against the event that AIG defaults.

In a world where financial institutions have perfect judgment, this system could not create systemic risk.  In a world, however, with management failures and inattentive or inexperienced traders it is highly likely that someone will be willing to sell too much default insurance on the AIGs of this world.

When a firm like Goldman Sachs — which is generally reputed to have the best risk management on Wall Street — is willing to extend tens of billions of dollars of credit to firms that are not creditworthy on the principle that it is protected by insurance, then the financial system has lost its strongest bulwark against systemic risk.  We need the Goldman Sachs of this world to use their judgment to reject large-scale trades with firms that are likely to default.

I think that most people would agree that there’s not much hope that the financial world can eradicate incompetent and short-sighted traders.  It is precisely for this reason that systemic risk is created when the few financial firms that are well managed act on the theory that it is possible for them to buy insurance against credit risk.

Does Goldman Sachs really believe that, if AIG had gone through bankruptcy court, its counterparties would have been in a position to compensate Goldman for its losses?

On high frequency trading and liquidity

The volume of trading on a market has often been used as proxy for the liquidity of the market.  Of course, the only reason that volume can function as a proxy for liquidity is because it is an indicator of the degree to which a financial asset trading on the market can be sold without changing prices.

It should be clear that the definition of liquidity that is important to the typical investor who trades on markets is precisely the latter:  Can I trade without affecting prices?

For this reason, claiming that high frequency traders provide liquidity to markets is simply foolish.  The goal of high frequency traders is to profit off of the infinitesimal (microseconds are the current unit of measure) timing differences between when small scale buy and sell orders arrive in the market.  In some sense, their goal is to ensure that every 1000 share sale on the stock market reduces the price of the stock and that every 1000 share purchase on the market increases the price.  By ensuring that every 1000 share order moves prices, they have two effects on the market:  first, they reduce liquidity and second, they increase the volume of trades on the market.

The fact that this “innovation” that reduces market liquidity has been permitted by all of the major stock markets in the US has driven the growth of off market trading in the form of “dark pools” (link: h/t zero hedge).

Another important factor to keep in mind when analyzing the value of high frequency traders is that the economic models that support the idea that self-interested behavior is socially valuable assume perfectly liquid markets.  Every change in market structure that reduces liquidity – in the sense of increasing the effect of small trades on prices – is a change that increases opportunities for rent-seeking and thus reduces the value of the market to society as a whole.

Our financial markets are by and large self-regulatory organizations.  If they cannot be managed in this form with the goal of minimizing the effect of small trades on prices, then perhaps they need to be changed into regulated organizations.

On backstopping the financial system

To those who believe that the solution to the crisis is for the government to backstop the financial system:  Surely one of the first lessons we should draw from the crisis is that as soon as the presumption is established that an institution can not fail, it ends up being so loaded with liabilities that failure is inevitable.

It’s better to live …
Horace Odes II.10
translated by Peter Saint Andre

It’s better to live, Licinius, neither
always pressing out on the deep nor, trembling
and cautious, hugging overly close to the
dangerous shoreline.

Whosoever cherishes the golden mean
safely avoids the squalor of a hovel
and discreetly keeps away from a palace
that excites envy.

Most often it’s the huge pine that is shaken
by the wind, and the highest towers that fall
the greatest fall, and the tops of mountains that
attract the lightning.

Hopeful in adversity, apprehensive
in prosperity is the heart that prepares
well for either fate. Zeus brings the winter, but
also takes it back.

For even if right now times are bad, they won’t
always be that way: for Apollo doesn’t
always tense his bow, but sometimes he inspires
the silent Muses.

When the straits you sail have narrowed, show yourself
to be undaunted and bold — yet also be
wise and tuck your sails when they’re swelled by too strong
a following wind.

This is not a Minsky Moment

This is not a Minsky moment.  A Minsky moment would have taken place if the housing market had collapsed in early 2005 after the Fed had started raising rates.

This is much, much worse than Minsky moment.  On top of the natural tendency toward speculation we have a new class of speculative derivatives that had been illegal for more than a century before Congress chose to legalize them.  This is not a natural Minsky bubble, this a souped-up bubble in hyperdrive.  On top of this souped up bubble, we have a financial sector that has been encouraged to increase its “efficiency” by maintaining minimal equity capital and relying on the government for a bailout whenever things go a little bit wrong.  These are not Minsky’s natural speculators, these are speculators who fully expect to be permitted to charge their losses to a government credit card.

What we are going through is much more frightening than a Minsky moment.  I think we’re going through a Minsky moment cubed.

For a little reduction in healthcare costs

A simple means of reducing unnecessary healthcare price inflation and administrative costs: Pass a law requiring every healthcare provider to sell services at the lowest contracted price to all comers.

This will throw a huge wrench in the current system and therefore will require at least a two year phase-in horizon.  It will also throw a whole bunch of specialists in healthcare contracting out of work — reducing administrative costs.  On the other hand, the current billing system is such a mess that doctor’s offices are always making billing errors, because they have a different contract with every insurer.  (I know because I take the time to fix these errors on principle.)

Note:  This post was inspired by Denninger.  When you cut through the profane histrionics he usually has a point.

Will bank regulation fail?

Note:  The post below presents a very bleak view of our current situation.  I hope it’s wrong.

One consequence of the Savings and Loan crisis in the United States was the decision by Congress to impose strict regulatory capital requirements on banks and other depository institutions.  Through the 1980s regulators had jerryrigged the rules so that insolvent Savings and Loans would not have to be shut down and could try to earn their way to solvency.  This had the effect of encouraging S&Ls to “gamble for resurrection” with the result that the S&L losses grew from about $10 billion in 1982 to more than $150 billion in 1989.  A financial reform act was passed in 1989 with the express purpose of “never again” allowing banks to gamble with a taxpayer guarantee.

The FDIC Improvement Act followed in 1991, set strict regulatory capital requirements and assigned regulators the task of forcing banks to rebuild their capital positions.  Unfortunately requiring banks to improve their capital position is a form of deleveraging and deleveraging is a surefire way of pushing the economy into recession.  Thus, the statement that banks are undercapitalized is also a statement that the economy needs a recession.  And neither Congress nor the regulators were prepared to do what was necessary to put the financial system on a sound footing.

Even as regulators were assigned the task of imposing stricter capital requirements on banks, they were expected to make sure that credit continued to flow to the economy.  These two contradictory goals were met by stripping capital requirements of their meaning and making it much harder to see where the leverage in the financial system was hiding.

There’s a strong argument that the parallel banking system grew out of the desire on the part of both banks and regulators to circumvent the capital requirements of the FDIC Improvement Act.  The parallel banking system is just a bunch of trusts – that is, legally independent entities – that have investors and own assets, but don’t do anything except pass the payments received on the assets to the investors according to the terms laid out in the initial documents forming each trust.  The creation of this parallel banking system allowed a bank to make loans and then sell them to a trust.  Because the bank did not keep the loan, it wasn’t required to maintain capital to cover the possibility that the loan would fail.

From the start there was a huge problem with the system:  when a loan owned by a trust went into default, investors in the trust faced losses.  Regulators repeatedly accepted the argument that, if the bank that sold the loan didn’t cover the trust’s losses, the bank’s ability to sell more loans to trusts would be impaired.  Thus the parallel banking system was built on a fiction: loans appeared to be sold to trusts, but in fact were insured by implicit and explicit bank guarantees.

The most important consequence of the development of the parallel banking system was that on the surface the financial system appeared to be healthy.  Banks met their regulatory capital requirements.  Loans were abundantly available to keep the real economy humming.  Everybody was happy.

Regulators found other ways to circumvent capital requirements.  In 1996 the Federal Reserve approved the use of trust preferred securities (TruPS) as Tier 1 capital.  Tier 1 is supposed to designate the highest quality capital and includes common stock and perpetual preferred stock.  Trust preferred securities are a form of debt with a dual maturity structure:  TruPS mature after 30 years or not at all, but are designed to be called much earlier, because the interest payment on the debt increases if they are not called.  They also include the option to defer interest payments for five years.  According to the Federal Reserve, five year deferral approaches “economically indefinite deferral” and 30 year maturity approaches “economic perpetuity”.  For these reasons securities that were marketed to investors as medium-term debt are comparable as far as regulators are concerned to common equity.  To compound this insanity smaller banks were encouraged to invest in diversified pools of bank-issued TruPS.  (Update 7–7-09:  Did regulators encourage small banks to invest in TruPS?  I’m not sure that they did.  They definitely, however, did not discourage the practice.)

In the 1980s the US concluded that permitting undercapitalized banks to operate only served to make the Savings and Loan crisis worse.  In the 1990s a superficial effort was made to address the problem of an undercapitalized financial system, but in practice this effort just fostered a crisis of unprecedented dimensions.  The concern that this quarter century of history raises is:  Will we just repeat the same mistakes again?

Our problem is that there are no good solutions to the current situation:  costly choices must be weighed against more costly choices.  Unless policy-makers acknowledge that governing requires making hard choices – and that putting the financial system on a sound footing will require a major reduction in the credit available to firms and consumers – any official increase in capital requirements will be circumvented, because the policymakers want the requirements to be circumvented.