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.

Knightian uncertainty and the financial crisis

Over at Rortybomb Mike writes:  “In economics there is something called Knightian Uncertainty. In quant circles, it can be called ‘model risk.’ …”

Because Mike is reproducing an analytical mistake that is common in the financial industry, I want to discuss this.  Knightian uncertainty is unmeasurable risk.  That is a completely different entity from unmeasured risk.  If somebody puts together a bad model, they are choosing not to measure risk that can be measured by a more careful model.  Then, the problem isn’t Knightian uncertainty, it’s just poor quality risk estimation.

Mike continues:  “Now that we’ve just lived through an empirical experiment in how well the best modeling can predict tail risk, I tend to look closely at [tail risk in climate change models]. And the uncertainty there has me worried.”

I think that it is very hard to defend the view that what happened to our financial system had anything to do with “how well the best modeling can predict tail risk”.  The problem had a lot more to do with the expunging of negative data from the inputs.  Linda Lowell over at HousingWire covered this in a piece titled “Those who bury history are doomed to repeat it”.

As far as I can see there’s very little evidence of some grand human struggle with Knightian uncertainty when it comes the financial debacle.

Update 07-01-09:  Maybe Paul Wilmott agrees with me.

Moody’s finally realizes Tier 1 capital is equity

Is anybody else taken aback by how bluntly Moody’s is acknowledging that it’s credit ratings for financial institutions depend on a government backstop of bank debt?  From Bloomberg:

Before the credit crunch, Moody’s assumed government support for troubled banks would extend to investors in subordinated and preferred securities, not just senior creditors, according to the report. Moody’s plans to link the ratings on subordinated securities to banks’ stand-alone creditworthiness, rather than their senior unsecured grades, which take account of a degree of government support. … “With recent government interventions, investors in subordinated capital have been left to absorb losses,” the New York-based ratings company said today in a report. “Consistently, regulators have confirmed that many of these instruments are more equity-like than debt-like.”

Does anybody else think it would be interesting to learn how long ago Moody’s started assuming that the governments would always step in to absorb bank creditors’ losses, so there was no need to assess “banks’ stand-alone creditworthiness”?

A final thought on wheat prices

I got into an extended discussion of the use of data in the social sciences over at Felix Salmon’s blog.  The underlying issue was the recent Senate report attributing price dislocations in the wheat market to long only index investors (aka excessive speculation).

dWj chimed in with a good summary:

The existence of the delivery oligopoly [in the wheat market] is necessary and nearly sufficient. That should be considered the primary cause of the failure here, even if it needed a trigger before the spreads got particularly wide in the last couple years. Making the futures cash-settled requires a way to determine the authoritative final settlement price; if it’s not too messy (in terms of performance risk) to dramatically expand the number of permitted deliverers, that would seem to me to be the sensible solution.

I think, however, that there are two important issues brought up by the Wheat Report:  first, what caused the huge divergence between cash and futures prices at expiration in 2008 and, second, is it possible for speculators to affect the spot price of a commodity.   dWj’s comment addresses the first issue — which may well require the existence of a delivery oligopoly.  On the other hand, I don’t see any reason that a delivery oligopoly is necessary for speculators to affect spot prices.

(I’m posting this comment here, because from an aesthetic point of view I think dWj’s comment is a fine conclusion to that thread.)

Ann Rutledge channels Confucius

“If language is not correct, then what is said is not what is meant; if what is said is not what is meant, then what must be done remains undone; if this remains undone, morals and art will deteriorate; if justice goes astray, the people will stand about in helpless confusion. Hence there must be no arbitrariness in what is said. This matters above everything.”

From The Analects of Confucius, Book 13, Verse 3 (James R. Ware, translated in 1980.)

According to Ann Rutledge, who has been in the securitization business for decades and is a scathing critic of current practices, the solution to the current problems with securitization is:  creating formal definitions for the terms used in the industry.