On the costs and benefits of speculation

Darrell Duffie writes “In defense of financial speculation” in the WSJ (via Alea):

George Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.

It is interesting that he opens his defense by eliding from a discussion of speculative trades to a discussion of speculators:

Speculators earn a profit by absorbing risk that others don’t want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.

The problem with this elision is that when “speculators” are taking on economic risk that investors do not want, their trades don’t meet the definition of a speculative trade and thus are rarely covered by laws proposed to restrict speculative trades.  For example, when a law requires purchasers of CDS protection to own the underlying bonds, nothing prevents bond investors from hedging with or selling their positions to “speculators”.

A speculative trade take place when (i) the transaction (like a standard derivative contract) is zero-sum — whatever one party gains the other necessarily loses and (ii) neither party to the transaction has an existing economic exposure that would be hedged by the transaction.   In other words, a speculative trade occurs when both parties to the trade are speculators.  Typically regulations to control speculation focus on speculative trades and are careful to exclude hedging transactions.

The only defense of these transactions is:

Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment’s value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country’s default.

The argument rests on an assumption that more accurate prices mean that information is more “useful” and that this has some social value.  It’s possible that this is true, but it certainly hasn’t been demonstrated.  What were the costs of inaccurate pricing in the bond market before CDS contracts allowed speculators to express themselves?  We know that bond markets functioned well enough to develop dramatically from the 18th through the 20th centuries.  But somehow the incremental information created by CDS contracts is supposed to have some great added value.  How do we measure this?  To whom does the added value accrue?  Does the public actually benefit or do the speculators themselves capture all the gain?  These questions need to be answered before one can conclude that any increase in the accuracy of prices created by speculation outweighs the costs of such speculation.

Duffie fails to take into account the largest cost created by speculation.  He focuses only on market manipulation, but the real cost of speculation is the cost to the judicial system of enforcing speculative trades.  Remember that these are trades between two speculators — these trades do not interact directly with the real economy or contribute to economy’s productive capacity.  On the other hand under current law these trades are enforceable contracts.  Judges on the public payroll must spend weeks if not years adjudicating issues related to these contracts.

A successful defense of financial speculation will require a careful demonstration that the social benefits that derive from the incremental pricing accuracy due to speculative trades outweighs the social costs of expending public resources on the enforcement of speculative contracts.

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What are the elements of a healthy financial system?

Gary Gorton argues that the repo and securitization markets that developed over the last quarter of the 20th century are healthy phenomena and that we really don’t have much choice, but to preserve them.  While there are many aspects of his analysis with which I agree, I draw very different conclusions from the evidence he cites.  The bullet points below are the conclusions of this paper (h/t Felix Salmon actually that should be h/t Richard Smith — my apologies for sloppy link-tracking — was too overcome by the debating spirit once I took a look at the paper in question).

•As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.

I have no argument with this narrative of financial evolution, but I think that Gorton is missing an important point.  Money market mutual funds (MMMFs) are banks that are exempt from capital requirements, because they are (in theory, if not in practice) not protected by deposit insurance.  Any regulation that puts traditional banks in competition with money market mutual funds is sure to result in an undercapitalized banking system — either because uncapitalized MMMFs take over the role of intermediation or because the banks find ways around traditional capital requirements.

In fact, I agree with many aspects of Gorton’s analysis:

Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed. If an industry is not profitable, the owners exit the industry by not investing; they invest elsewhere. … One form of exit is for banks to not hold loans but to sell the loans; securitization is the selling of portfolios of loans. Selling loans – while news to some people—has been going on now for about 30 years without problems.

My difference with Gorton lies in the approach to MMMFs and securitization.  I think that MMMFs are uncapitalized banks and that securitization was the process by which traditional banks also became undercapitalized.  Thus both are a major source of financial instability.  Gorton, by contrast, believes that MMMFs and securitization have stood the test of time.

In my view, the fact that this predictable evolution occurred does not mean that it was a healthy development for the financial system.  The fact that it took 30 years for all the contradictions built into this brave new financial system to result in a crisis large enough to threaten the whole financial system does not mean that crisis was not inevitable from the beginning.

•The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short‐term, safe, interest‐earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.

Once again, I don’t see that the fact that securitized assets were used as an important source of collateral in repo as evidence that this phenomenon is either good or healthy.  In all likelihood, the bankruptcy reform act of 2005 (which expanded the priority status in bankruptcy proceedings of Treasury/Agency repo to virtually all repo contracts) precipitated the growth of low-quality repo and may (given the absence of repo data this is all but impossible to demonstrate) have been a proximate cause of the catastrophic failures of Bear Stearns and Lehman Bros.

It’s my impression — once again on the basis of very limited data — that the repo market currently has shrunk to depend mostly on the traditional high-quality collateral that underlay its growth over the last quarter of the 20th century.  And that the broker dealers have shrunk their balance sheets and changed their liability structure to adapt to this new environment.  This change is healthy, because high-quality assets are by their very nature protected from the 20% and higher haircuts that precipitated the repo crises of 2008.  In my view the growth of the repo market is not unhealthy, as long as the market is restricted to only the highest quality assets.

•Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.

Absolutely, “repo is money”.  And sound backing for the money supply is found (i) in a Central Bank that holds mostly government debt as backing for the money supply and (ii) in a banking system that is well capitalized.  If banks want to use repos for funding (which are collateralized, rather than protected by capital reserves like traditional loans) then they need to rely on collateral that is appropriate backing for the money supply — like Treasuries.  Allowing senior tranches of synthetic CDOs — in other words credit default swaps — to be used as backing for the money supply was madness.  And I sincerely hope that our regulators do not experiment again with the degradation of the money supply that took place in the late naughties.

•In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.

“Firm failures should not be caused by fire sales.”  This statement is just far to general.  If hedge funds fail because of fire sales, the appropriate regulatory response is:  “Sorry, folks.  Shit happens.”  Our regulators do not have a responsibility for ensuring that all markets are liquid all the time.  If they ever try to take on this responsibility, they will probably be as successful as the Soviet Union was in planning production.

Banks that play an important role in the monetary system are different matter, but even here the goal of regulators is not to prevent firm failures — the goal is only to protect the stability of the money supply.  Traditionally (see Bagehot’s reaction to the failure of Overend Gurney) the first bank is allowed to collapse and the central bank provides abundant liquidity to support the remaining banks through the fire sales.  Any bank whose capital is wiped out by the failure of the first bank to honor its liabilities is also allowed to fail (since it faces a solvency not a liquidity crisis).

When one remembers that the goal of regulators is not to protect firms from failure, but to protect the stability of the money supply, one realizes why it is so important for regulators to demand that repos be backed only by the highest quality assets.  Any other policy will force the central bank to take low quality assets onto its balance sheet in a crisis and undermine the stability of the money supply.

One also realizes that there is a strong theoretic foundation for the argument that banks should be small.  The failure of any large bank that holds more than 5% of the economy’s deposits can undermine the stability of the money supply — and may put regulators in a position where they are forced to conflate protection of the money supply with protection of an individual firm from failure.  I don’t think that the dangers created by government officials who believe that their job is to protect firms in a free market economy from failure need to be explained.

• The crisis was not a one‐time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.

Bank liabilities have a vulnerability — and banks protect themselves from that vulnerability by being well-capitalized.  The fact that securitization undermines a bank’s capital position is precisely the reason that it has come in for so much criticism.  When and if securitizations are structured as true sales with no implicit or explicit recourse to bank balance sheets, they will be a positive addition to our financial arsenal.  However, as long as securitizations just represent bank assets against which banks are not required to hold capital reserves, they weaken the financial system rather than strengthening it.

In my view the elements of a healthy financial system are:

(i) a central bank that stands ready to provide abundant liquidity in a crisis, but will not step in to protect individual firms from failure.
(ii) a well-capitalized banking system.
(iii) absence of pseudo-banks that face preferential regulation like money market funds.
(iv) regulators who understand the many ways in which banks underwrite “market-based” lending and who require banks to hold reserves to honor their commitments to such “market-based” lending programs.

Elvin, money and technological change

Saw this title “More empires have fallen because of reckless finances than invasion” just after reading DeLong’s links to Mark Elvin on the bewildering end to China’s 12th century technological advance.  And assumed they were related.  Not.

It’s always been my opinion that technological advance is closely tied to paper monetary systems.  And that when a paper monetary system collapses, so does the capacity of the economy to support the kind of growth that makes technological advance possible.  So I’m guessing it was the collapse of China’s monetary system (in the 14th century) that put an end to technological advance.

Is there a lesson in here somewhere?

On synthetics in Maiden Lane III

Calculating the exposure of a CDO to synthetic assets is complicated for two reasons:  (i) first because, not only can the CDO itself use swaps to generate synthetic exposure, but also the CDO and RMBS tranches in which the CDO invests may include synthetics; and (ii) secondly, because the tranche structure of CDOs complicates things.

Because it is easier to create synthetic exposure to an asset than to originate an actual loan (remember creating a synthetic asset involves selling protection on an asset, not buying it — thus you just need to find counterparties willing to pay small premia for protection), I will generally assume that the synthetic exposure of a CDO or RMBS is close to the limits permitted in the deal documents.  This is an assumption and therefore subject to correction if the actual data is ever made public.

The collateral underlying the Broderick I CDO is 20% CDO, 80% RMBS.  20% of this collateral may be in the form of synthetic assets.  Since the industry (and undoubtedly Merill Lynch in particular as a major CDO issuer) had a great need to place junior CDO tranches most likely it was the RMBS that was referenced synthetically, not the CDOs.  So as a working assumption lets consider that the Broderick I CDO is 20% CDO, 20% synthetic referencing RMBS and 60% RMBS.

The thing to remember is that the 20% CDO collateral is likely to also be 20% synthetic.  I’m not going to make any assumptions about the synthetic exposure in the RMBS, because I haven’t found reliable information on the issue, but there is no question that some synthetic RMBS were issued.  Thus Broderick I could easily be backed by 24% synthetic assets — and possibly more.

But it’s important to understand that 24% would be a low estimate of Broderick’s exposure to synthetic assets.  This is because the structure of a CDO is designed to concentrate risk by increasing the exposure of the junior investors to losses..

To explain, consider a simple tranched securitization of five $1 million mortgages with one junior $1 million investor and one senior $4 million investor.  It should be obvious that the junior investor — because he absorbs losses first — has 100% exposure to each of the five mortgages.  If one of those mortgages is synthetic, then the junior investor has 100% exposure to the synthetic mortgage.  In short, in a CDO you must always remember that only the first priority investor is guaranteed to benefit from diversification of assets.

For this reason when calculating the exposure of subordinate CDO tranches to synthetic assets, what is important is whether the detachment point of the tranche (that is the point at which it stops absorbing losses because it is worth nothing) is lower than the fraction of synthetic assets in the CDO.  If the CDO has 20% synthetic assets and the tranche in question detaches at 10%, then the tranche can be wiped out twice over by losses on synthetic assets alone.  Thus it doesn’t really make sense to claim that the tranche has less than 100% exposure to synthetic assets.

Since the subordinate tranches in Broderick (as a group) detach at 16%, every one of them probably has 100% exposure to synthetic assets.  If the CDOs included in Broderick are similarly structured (and if I am right that these CDOs made maximal use of synthetic assets), then it is fair to say that Maiden Lane’s exposure to synthetic assets via Broderick I is $400 million or 40% of the CDO.

Why does this matter?  Because as I asked in my first post on Maiden Lane III as taxpayers we need to consider these issues:

Are we okay with the fact that financiers who saw how dysfunctional our debt markets were didn’t go off and raise hell at the Fed and SEC, but instead expressed their views via the market?  Are we okay with the fact that when one of their counterparties to the expression of these views couldn’t honor it’s obligations, the taxpayer stepped to validate the existence of this market?  Is there a difference between bailing out banks that were financing real economic activity and grossly underestimated the risks of that activity and bailing out traders who used derivative markets to express their views on the dysfunctionality of the debt markets?

I think we need public disclosure on each of the Maiden Lane vehicle’s exposure to synthetic assets.  So we can have a robust public discussion about the role of government in underwriting synthetic assets.

On Maiden Lane III – 2

This post will continue my effort to understand Goldman Sach’s huge first-priority exposure to a few of the CDOs in Maiden Lane III.

Yves Smith has some nice clues to what was going on, pointing out that the November Blackrock memo at the time of Maiden Lane III’s formation states:  “Access to assets:  Goldman has said that it does not hold the cash CDOs, but has back-to-back swaps on most of the positions”.  (I’ll address the remarkable fact that a 20% synthetic CDO could be considered a “cash CDO” in another post.)  This indicates that Goldman probably sold the first priority exposure in Broderick I on to customers, offering a Goldman guarantee on the returns in the form of a swap.  Goldman then transferred this risk to AIG using another swap.  In other words, this was Goldman’s clients’ CDO exposure that was protected first by a Goldman and then by an AIG swap.  That this is a likely explanation is confirmed by the fact that $7.4 billion of the CDOs in Maiden Lane settled almost a month after the first CDOs were transferred because they were “contingent upon the ability of the related counterparty to obtain the related multi-sector CDOs”.  In short, Goldman probably had to buy Broderick I from its clients before it could make use of the Maiden Lane facility.

However, if we are interpreting the available facts correctly and, if Goldman took almost all of the first priority Broderick I exposure in order to sell it on to clients, then we still need an explanation for why Merrill Lynch rather than Goldman was the firm originating the CDOs.  The answer is probably that Merrill had the collateral and Goldman had the clients.  Although Merrill wasn’t a big player in the mortgage market (and purchased First Franklin in order to change that situation), Merrill was one of the lead issuers of CDOs (2004 thru 2006).  It is likely that Merrill had established an RMBS pipeline while GS had clients to whom senior CDO tranches could be sold.

It occurs to me that because the senior CDOs that Goldman was selling to clients were like covered bonds (that is investors were protected by the guarantee of the bank in case the mortgages themselves went into default) and the legal structure for the covered bond market does not exist in the US, there may have legal reasons for the issuer of the CDO and its guarantor to be distinct parties.

This innocuous explanation of Goldman’s large first priority exposure to Maiden Lane’s CDOs does not, however, obviate the main concern of my previous post:  There is still plenty of reason to be concerned that Maiden Lane III has far too much synthetic exposure for taxpayers’ comfort — in part because the CDOs in question were issued right at the time that synthetic RMBS started to become more common.  More in the next post.

First rule of investing

The first rule of investing:  Once a trading strategy has become public knowledge, it will no longer be profitable.

This is in fact an immediate consequence of one of the weaker forms of the efficient markets hypothesis.  It is also enough of an empirical regularity that trading strategies constitute privileged information in the financial industry.

For this reason, I do not find this result surprising.