Data on the market makers’ CDS books

Thanks to the FASB’s September 2008 amendment of FAS 133, it turns out that all the market makers report the notional values of their credit derivatives positions bought and sold in their 10-Ks and 10-Qs.  So I was able to look up the positions of the five biggest market makers in the US.  These holding companies account for 95% of all credit derivatives bought and sold by holding companies in the US (per the OCCs data).

Here’s what I found.  (Blue is credit derivatives bought, red credit derivatives sold and green is the difference between the blue and the red columns):

Observe that because we only have aggregate data, the net credit derivative position in the chart above represents a lower bound on the unmatched portion of the bank’s derivative books.  It possible that when individuals companies and indices are taken into account, an accurate count of each bank’s net position would be much larger than the green column above.

To emphasize the fact that it appears that market makers are buying credit protection on their own account, here is a chart of the net credit derivatives as a fraction of the total credit derivatives bought.


We see that about 9% of the credit derivatives bought by Citigroup and 5% of the credit derivatives bought by Goldman Sachs are not matched.  Most likely these firms are using credit derivatives to protect themselves against losses.

Finally we can look at the net credit protection bought relative to the firm’s assets:

This chart just emphasizes the fact that the commercial banks have much larger balance sheets than the investment banks, and thus that even though a bank like JP Morgan has a net credit derivative position that is similar to that of the investment banks, it is relying less on the protection of credit derivatives once one takes the size of the bank into account.

Because only Bank of America/Merrill Lynch is now (this is a change from previous quarters) a net seller of credit protection, we find that in aggregate the market makers are buying at least $400 billion notional in credit protection from other participants in the market.  An interesting question is who is selling this protection:  foreigners, insurers, end users?

On the maturity distribution of the public debt

In 2009 we reached the point where almost 50% of the debt outstanding was due in one year or less.   (Table B88 of the 2009 Economic Report of the President indicates that from November 2007 to November 2008 the fraction of the debt due in one year or less increased from 34% to 48%.)  In 2009 Treasury has worked at restoring balance to the maturity distribution of the debt, which since the late 80s has been approximately one-third less than one year maturity, one-third one to five year maturity and one-third long-term debt.

Given that this transition has been taking place throughout 2009 and that it does not appear to have adversely affected the prospects of recovery (such as they are), returning the maturity distribution of the debt to its historic norm seems to be a reasonable goal.

Do the market makers keep matched books?

I’ve been spending some time with the Office of the Comptroller of the Currency’s data on derivatives.  This is what I’ve found about credit derivatives:

(i) Commercial banks tend to buy and sell credit derivatives under the name of the bank, not under the name of the holding company.  The credit derivatives of the investment banks are at the holding company level although about one-sixth of Goldman Sachs’ credit derivatives are bought and sold by the Goldman Sachs Bank.  (In the chart below blue is the credit derivatives bought/sold by the holding company and red is the credit derivatives bought/sold by the bank.  Note that I did not actually download the data on Morgan Stanley’s Bank because its credit derivative positions were trivial.)

(ii)  Because the OCC collects detailed data about the derivatives bought and sold by banks we have extensive information on the positions of Citigroup and JPMorgan.  However, detailed information on the derivatives bought and sold by Goldman Sachs Group, Morgan Stanley and Bank of America (now that it includes Merrill Lynch) is not available.

On the other hand what we know about the derivatives held by banks is interesting in its own right.

(iii) Neither Citibank, nor Goldman Sachs Bank is running a very closely matched credit derivatives book.  (Note that for its size JPMorgan is reasonably closely matched, but the data simply doesn’t fit on the same chart as the other banks.  Also, in the chart below blue represents credit derivatives bought by the bank and red credit derivatives sold by the bank.)

(iv)  What’s more interest the difference between credit derivatives bought and sold doesn’t show up as much in the data on credit default swaps.  (In the chart below blue is now CDS bought by the bank and red CDS sold by the bank.)

(v)  The banks that are buying more credit protection than they sell  are not using CDS to do this.  (Blue:  credit options bought; Red: credit options sold; Green: other credit derivatives bought; Purple (not visible): other credit derivatives sold; Light blue:  TRS bought;  Orange:  TRS sold.)

While some of the market makers may be running matched books, it certainly looks as though others are using the credit derivatives markets to buy protection for themselves.  Given the pricing power currently in the hands of the market makers, it may be worth paying close attention to the trades of market makers who are trading on their own account in a big way, because there is no question that the market makers are well-placed to extract rents from end users if that is what they wish to do.

Of course, it would be far more interesting to have this data for the holding companies, because that would give us all a better idea of how the dealer banks are using derivative markets.  As things stand the claim that all the market makers keep matched books does not appear to be supported by the data that we have.

Reality Sucks

Just read Jeffrey Sachs’ takedown of Obama’s failure to secure anything substantial from the Copenhagen summit on climate change.  And I can just imagine what Rahm Emanuel has to say about it.

In the meanwhile I’m midway through Lords of Finance — and I can’t help thinking that the fundamental problem that led to the Depression and World War II wasn’t the gold standard, it was the squabbling European states (not that the US did much to help).  Don’t want to think what that implies for climate change.

Politics may be the art of the possible — but sometimes the possible just isn’t good enough.

On the value of models

Paul Krugman discusses the value of models.

But he misses an important point:  the value of models is also their greatest flaw.  Models simplify things so everybody can follow the train of thought, but that simplification means they’re always wrong.  In other words, they are excellent tools for communicating ideas and highly flawed when it comes to understanding complexity.

So the problem with models is that they served to hide the fact that this assessment of the Depression is also entirely true.  “Faced with the Depression, institutional economics turned out to have very little to offer, except to say that it was a complex phenomenon with deep historical roots, and surely there was no easy answer.”

As far as I’m concerned the only solution to this problem is to develop competing models and demand that each individual researcher decide for him or herself what weight should be put on each model in explaining a given circumstance.  That is, to acknowledge that there is no easy answer and enjoy the consequent debate.

Thus the task of economics is to encourage and facilitate the development of competing models.  This will require that far more respect be paid to verbal models, as qualitative models are needed to lay the foundations for the development of new formal models.

A thought on global warming

I just read this piece over at Economist’s View and here’s my solution to the global coordination problem.

Set up an international carbon tax and direct the revenue to an overseeing organization.  (If cap and trade can generate revenue for government that could work too.)  The funds should then be dedicated to carbon mitigation and climate change adaptation — with the rules deliberately set so there is a generous annual transfer from developed to developing countries.  Finally, any country that turns out to be faking things like carbon offsets will have the funds that flow to government decreased so that international monitoring of offsets and similar policies can be funded

The basic idea that I think would be very useful is to take the revenue from a carbon tax — or cap and trade — and use that revenue to deal with the issue of aiding the transition for developing countries.

On Lords of Finance

I’ve just started reading Lords of Finance (about 1/3 through) and unfortunately I’m really put off by character descriptions that seem to belong more to the world of fiction than to non-fiction.  I just don’t understand how it is possible in a work of non-fiction to have an omniscient narrator make statements like:  “He displayed an astounding self-confidence.  This was not a facade.”

I have rarely met anybody who was outwardly confident without being inwardly insecure.  In fact, I would say that it is precisely those who present themselves as uncertain who have the deepest confidence — that is, they are confident enough to display openly that there’s a lot they don’t know and don’t worry about how the world judges them.  In short, I would argue that the character of someone who died some sixty years ago is in some sense unknowable.

That’s why biographers use lengthy quotes.  What a man’s wife has to say about him always says something about the man — even if it’s only about the kind of wife he chose.   But surely this issue:  whether a character description says more about the speaker or the object of the description is for the reader to decide.   Thus, the introduction of an omniscient narrator into a work of non-fiction is problematic — the reader has difficulty judging whether the character descriptions say more about Liaquat Ahamed or about the character he’s describing.

Given my discomfort with Ahamed’s approach to the subjects of his book, I can’t help but wonder what evidence the author has for his diagnosis of Montagu Norman as suffering from “severe manic depression“.  This reads to me as an outrageous case of pop psychology, which may be supported by nothing more than Carl Jung’s diagnosis in 1913 of GPI and death within months  (Norman lived until 1950) and episodes of moodiness.  There seems to be strong evidence that Norman suffered from more than one “nervous breakdown”, but conflating a reaction to excessive stress with mental illness strikes me as one of those decisions that says far more about Ahamed than about Norman.

On an alternate note in Ahamed’s takedown of the competence of the governors of the Bank of England (whom he notes in the same pages made the best decisions) he derides the real bills doctrine as “clearly fallacious” — and goes on to explain why it held true:  because it was espoused in an environment with a gold standard.  The author shows no awareness whatsoever that the purpose of the real bills doctrine was to protect the economy from inflation caused by speculative bubbles and frauds.

Despite the preceding criticism, I am learning a lot about finances throughout Europe during World War I and the interwar period.  And it appears to me that when Ahamed focuses on factual information he is generally careful to be accurate.

Economics and complacency

There is a faith amongst some economists that growth will save us — but economists don’t have a good grasp of why economic growth does or does not take place — a fact that most of them will admit.  The current fad is to attribute growth to “institutions” — with the understanding that the specification of what institutions matter to growth, what institutions don’t matter and what institutions hinder growth has hardly been started (with the exception of the importance of property rights).

The foundation of the belief that growth will come seems to be the view that financial crises are just extreme versions of recessions and recessions are followed by recoveries.  This is an extremely ahistoric approach to economics since there are many examples of failed recoveries:  Holland in the late 18th c, Britain in the 1920s, Japan in the 90s.

This is probably related to the fact that most of the research on the Depression of the 30s takes the view that our ancestors made mistakes that we would never make.  Therefore, the outcome of our crisis has to be better than the outcome of their crisis.  However, as someone who has studied the 19th c approach to central banking, I suspect that we have made mistakes that our ancestors would never have made.

For example, about six years ago I corresponded with a researcher at a Federal Reserve Bank.  My question was this:  When tracking monetary data, why does the Fed report the “Non-financial commercial paper” series, but not the “Financial commercial paper” series?

The answer:  Financial commercial paper is used to make loans, so the assets and liabilities of the financial companies will zero out and have no effect on the money supply.

Think about that answer for moment.  The Fed’s policy was literally to ignore the increase in the liabilities of financial institutions because they did not affect measures of the money supply.  The Fed had a policy of ignoring credit growth on the part of financial institutions.  This is an error that 19th century bankers would never have made.  I suspect it grows out of the lazy habit of using Arrow Debreu based models where financial institutions don’t matter.

At the time I pointed out to the Fed researcher that the Fed should be keeping an eye on measures like financial commercial paper, because they were likely to be correlated with the risk of financial instability (and that I drew this conclusion from my knowledge of 19th c central banking).

On credit growth and central banking.

It looks like Schularick and Taylor — along with most of the rest of the economics profession — need to brush up on their Ralph Hawtrey and Benjamin Strong reading.  (Note that there’s a short version of the paper at the Economists’ Forum.)  They state:  “Our ancestors lived in an Age of Money, where aggregate credit was closely tied to aggregate money, and formal analysis could use the latter as a reliable proxy for the former.”  While it is possible that early central bankers could have relied on money as a proxy for credit, the fact is that they did not.  In fact, I can’t help but wonder Schularick and Taylor have their causality backwards:  Perhaps it was because early central bankers focused equally on credit growth and on price levels, that they maintained a relatively stable relationship between credit and money.

The evidence that early central bankers focused much of their attention on the state of credit is overwhelming.  Early central bankers didn’t even view themselves as implementing monetary policy, they implemented credit policy.  In Hawtrey’s The Art of Central Banking published in 1932, credit and money are given equal emphasis.  Similarly in Interpretations of federal reserve policy in the speeches and writings of Benjamin Strong, we find that Strong wrote in 1923:

Some people think that prices should be the guide …
Just as credit is one of the influences upon the price level, so the price level should be one of the influences in guiding a credit policy. There are other influences which affect prices, and so there must be other influences which affect a credit policy. Here are a few briefly suggested:
Is labor fully employed?
Are stocks of goods increasing or decreasing?
Is production up to the country’s capacity?
Are transportation facilities fully taxed?
Is speculation creeping into the productive and distributive processes?
Are orders and repeat orders being booked much ahead?
Are bills being promptly paid?
Are people spending wastefully?
Is credit expanding?
Are market rates above or below … Bank rates?
What this country and the world needs is stability. … The banking system’s … best policy is to supply enough credit and not too much — enough for legitimate enterprise, but not enough to satisfy those who want simply cheap and limitless supplies of credit regardless of the consequences they are too blind to perceive.

So when Schularick and Taylor find that:

Our results also strengthen the idea that credit matters, above and beyond its role as propagator of shocks hitting the economy. The credit system is not merely an amplifier of economic shocks as in the financial accelerator model of BGG. The importance of past credit growth as a predictor for financial crises and the robustness of the results to the inclusion of other key macro variables, raises the strong possibility that the financial sector is quite capable of creating its very own shocks.

we learn that careful empirical research in the 21st century can confirm traditional principles that central bankers recognized in the early years of the 20th century.