Arnold Kling  

Financial Flows and Regulation

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James Hamilton writes,

Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren't traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.

And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I'm afraid the answer is, they figured Bear was too big for the Fed to allow it to fail. And on this, I'm afraid they proved to be exactly correct.

I would feel better if Bernanke were less focused on how to "provide liquidity" and more focused on how to get the system deleveraged and more transparent.

I am a big fan of organized futures markets, so I agree with a lot of this. But I doubt that Bear's counterparties were confident that it was too big to fail. Instead, they thought that in almost any reasonable state of the world Bear would be both solvent and liquid.

I don't think you can regulate your way out of liquidity booms and busts. Let me formulate Kling's Law of financial markets; During a boom, as risks premiums are falling, financial activity tends to flow out of the regulated sector. Instead, risks accumulate either in mis-regulated firms (think of the S&L's around 1978-1981) or in unregulated firms.

I think that Ben Bernanke is making a reasonable contrarian speculative play, betting that the assets that he is buying are illiquid rather than insolvent. It turns out that his balance sheet is not all that large relative to the market, and now he seems to be looking for ways to expand it. I am not sure I trust any one institution that much.

I know this financial "crisis" is the sexiest thing in economics these days. But I would like to see something worse than a 5 percent unemployment rate before I expand the Fed or demand new forms of regulation.

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COMMENTS (4 to date)
scott clark writes:

I wish more people would listen to you. Your take on housing markets in earlier months was spot on, and these ideas here sound about right.
Panic leads to error.

spencer writes:

the S&L crises was after they were deregulated.

essentially the S&L crises occurred because private individuals though that the unregulated market would behave just like the unregulated market. Under regulation Q the S&L were not allowed the mismatch between the costs and prices that created the crises after deregulation.

eric falkenstein writes:

I think you're forgetting that most of Bear's fall was from the securities held long on their balance sheets, not derivatives. But perhaps the size of this was indirectly caused by derivatives, in that Credit Default Swaps on ABS referencing the ABX (an index on res mortgage backed securities) and single-name exposures induced Bear to load up on these in part to sell of pieces that could be used in such deals.

Yet it takes a long time to create a new exchange traded instrument, and once you do, the specs are pretty constant. So forcing financial companies to use exchange traded derivatives would greatly inhibit their growth in the US, and it would be naive to think this activity would be curtailed worldwide, it would just move offshore.

I'm new here, but you're implicitly accepting that the numbers pouring from the BLS are accurate. I think it's an open secret that they are totally bogus due to changes in methodology...So why would you tack your narrative to this black hole?

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