Arnold Kling  

Misleading Story

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Today's Washington Post gives us the inside story of how some regulators sought to put derivatives under and exchange. They met with resistance from other regulators.

It is all very entertaining, but at the end of the day, an organized derivatives exchange would not have prevented the crisis. If anything, it would have facilitated the use of derivatives to securitize more mortgages, and securitization was the main cause of the crisis. Counterparty risk in derivatives was simply not the main issue here.

The main appeal of the Post's story will be to people who want the narrative to be "regulators good, markets bad." The problem is that the dots don't connect. Organizing a derivatives exchange would not have curtailed securitization, low-down-payment lending, or hedging default swaps by short-selling financial institutions on their way down. If anything, it might have exacerbated those problems.


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COMMENTS (13 to date)
Colin Fraizer writes:

Dr. Kling,

[Pardon my ignorance. I'm not an economist.]

The "make an exchange" people seem to be arguing that an exchange would (a) reduce or eliminate counter-party risk; and (b) provide a central place for systemic risk to be observed.

IIRC, you've argued that we shouldn't be so worried about counter-party risk, compared to our worry about systemic risk, but I don't quite see how all the dots connect in your argument.

- Isn't counter-party risk a big part of the problem we've experienced so far? Didn't the collapse of Lehman trigger the collapse of the largest money market fund? Didn't that lead more-or-less directly to the "seizing" of the commercial paper market?
- Doesn't having an exchange allow for more transparency in the system as a whole? If the systemic problem is that everyone has a strategy that works singularly, but cannot be executed "all at once", wouldn't an exchange allow participants (or regulators) to observe that situation and pick alternate strategies?

Thanks for all the great blog posts.

Best regards,
--Colin

Erik writes:

For some reason, Arnold persists in ignoring the fact the exchanges can set the margin requirements for the derivatives that are traded (and guaranteed) on the exchange.

Obviously, if the margin for selling a CDS were 100%, then the systemic risk would be eliminated. Not that it would be desirable to set the margin so high, but it would be a solution. An exchange would also allow "experiments", for example, if the margin for selling a CDS were 50%, how does this effect the volume of CDS trade, and how much volatility (linked with systemic risk) results?

Steve Roth writes:

>people who want the narrative to be
>"regulators good, markets bad."

How about those whose narrative is "good regulations, good market"?

Knee-jerk antiregulators like Arnold should be thinking really hard about what smart regulations can be put in place that obviate the need/justification for stupid or failed regulations.

i.e.: requiring companies to conform to GAAP. Intrusive, onerous, and expensive, yes. An effective regulation to create efficient markets? Double yes.

Come on Arnold, give us smart ideas for effective, sensible regulation that makes markets more efficient, and stable, with minimum intrusiveness/distortion.

You just know there are some win/wins lying around on the ground out there.

(You know my pet reg in this class: ratings agencies.)

mjh writes:

So is this an instance where more information ends up being less efficient?

eccdogg writes:

I have to agree with others here.

A central exchange, would have allowed banks to know where thier exposure was so there would not be a fear of cascading failures.

True it would not have solved the underlying economic problem (bursting bubble in housing and lending markets) but it would have allowed institutions that were imprudent to go down without dragging others with them.

R. Richard Schweitzer writes:

What would be the function(s) of what kind(s) of "regulation?"

Would there be just regulation of the the terms of trade in a "regulated" exchange?

Would there be specific "filing" requirements for the instruments traded on a regulated exchange?

It is all so amorphous, like molten sulfur, that the issues don't seem to match the thinking.


Bill Stepp writes:

Securitization has been charged by several commentators as having been a cause of the crisis, but it stands innocent of the charge.
The crisis was caused by the Fed's easy monetary policy; when it reduced the Fed-funds rate well below the natural rate, that caused the boom in homebuilding, its allied businesses, mortgages, and mortgage securitization. It also magnified the ill effects of loose mortgage underwriting standards, which were encouraged and even mandated in a couple of cases by federal laws.
The Fed's policy distorted economic calculations, especially up and down the structure of the building and ancillary industries. This also happened in the financial industry, especially in mortgage-backed paper and derivatives. When the process was reversed, the homebuilding industry declined, as did industries that supplied it, as well as the secondary market for homes, and the commercial real estate industry (the latter shoe hasn't dropped as far yet). The banking industry (including investment banks, commercial banks, and some insurers such as AIG) was found to be short of capital, and the malinvestments were liquidated, at least when the Mussolini State didn't step in and prevent this. This process is consistent with the Austrian theory of the business cycle.

Sam Wilson writes:

Here's my question:

To what extent is the problem here that banks are undercapitalized as a result of the fact that they reduced the impairment of their mortgage assets by entering into CDS arrangements with counter-parties like AIG and Lehman that were not sufficiently capitalized to cover that "insurance"?

To me, this arrangement was one in which banks were able to artificially inflate their asset base (and thus the amount that they were able to lend) by moving risk off of their "regulated" balance sheets onto the "unregulated" balance sheets of AIG and Lehman. This effectively "hid" the risk from the Fed... though I'm sure the Fed was fully aware of what was going they didn't have access to information about AIGs capitalization except that they had a reasonable credit rating from the various agencies.

As a result, our normal regulatory requirements on bank capitalization were entirely circumvented allowing for a large number of banks to become undercapitalized in fact when they were sufficiently capitalized on paper.

The real "crisis" at the moment seems to be that a number of banks are undercapitalized. In part, this is because they transitioned a good amount of their assets from highly-illiquid assets (like regular mortgages) to assets that are (or at least, were) relatively liquid (like mortgage-backed securities). It's a lot harder for the price of a house to go from $500,000 to 0 than it is for a CMO to become worthless. This means that banks had much higher risk sensitivity than was being accounted for (that higher risk sensitivity should have been accompanied by either higher capitalization requirements or greater impairment of those assets).

The other contributing factor is that banks engaged in funny business with their accounting by attempting to reduce risk on their assets so as to maintain a higher "on paper" asset base so that they could keep on lending long after they should have stopped. But what's even worse than that was that the counterparties to many of these arrangements were unregulated and the banks clearly showed a lack of due-diligence in requiring that those counter-parties be sufficiently capitalized.

So if all that is reasonable valid (1) It's obvious we need new bank/accounting rules to more adequately address the use of mortgage backed securities (and derivatives in general). (2) We can either choose between giving the Fed oversight of all non-bank entities that engage in derivative contracts with important bank assets so as to ensure proper capitalization of the system or we can create exchanges for the trade of these assets which would (a) increase transparency by standardizing the contracts and making the trade information public, (b) allow for the market to regulate itself by instituting margin requirements, (c) provide a forum for transparent government participation (the Fed could get involved much as it does with T-bills by acting as a regular market participant), (d) create a process for the unwinding of these contracts in a regular manner by establishing a common set of market participant contracts.

Personally, I would rather go with the exchange approach rather than the Fed-only approach.

Sam Wilson writes:

Does anyone have any real numbers on the number and total value of homes purchased through things like the Community Redevelopment Act?

I have to say, I cannot fathom that the current crisis is the result of inner-city and rust-belt home buying. Those people are generally purchasing homes valued between $80K and $150K (at least, based on what I see in Eastern PA).

I don't understand the argument that anyone was twisting bankers arms, forcing them to lend. Which bank put "We are taking on a bunch of loans that we don't think are profitable because we are required to do so by the government" in their annual report? I highly doubt it... most of them probably wrote something more along the lines of "we have continued to outperform the market through the efficient, but prudent, use of mortgage asset derivative securities".

The gym I used to go to was full of mortgage brokers. I never heard those guys complaining about *having* to sell someone a mortgage. They were more than happy to cold call and pressure people into reverse mortgages, second mortgages, lines of credit and the like.

I'm not saying the consumer is not without some fault here. But the argument that the banks were forced into this arrangement is laughable.

Rick writes:

Arnold,

It seems that the market for CDS was virtually non-existent just a few years ago. Can you shed some light on why this market came to be and grew so rapidly? I would guess that it was, at least in part, an unintended consequence of some other regulations.

Also, I would appreciate your thoughts on why the market mispriced risk so badly. Thank you.

Rick

Sam Wilson writes:

Here is an interesting paper that talks about the pros and cons of implementing a CDS Index exchange traded options market at the CBOE.

http://www.kellogg.northwestern.edu/research/fimrc/papers/jakola.pdf

@Rick

It provides one argument to answer your question:

"This rapid growth was spurred by the ISDA [International Swaps and Derivatives Association] creating a set of standardized documentation. This standardized industry standards and benchmarks which greatly lowered the transactions costs to trading CDS."

That's partly the author's opinion, so take it for what it is. It is probably a valid statement, though I think your question goes more towards "what made banks so interested in CDS?" Your supposition is that it was some government action that compelled them. I would probably argue that it was the bank's belief that engaging in CDS arrangements allowed them to continue making loans even after they should have stopped doing so because they "offloaded" some of the risk from their portfolio. As long as the spread between the CDS cost and the return on any lending was worthwhile, it meant they could basically go on lending indefinitely.

To whit (from the paper):

"CDS allow hedgers or speculators to take an unfunded position solely on credit risk." (emphasis added)

Lastly, on this issue of the need for an exchange for these sorts of contracts:

"Given the state of CDS trade settlement, there is a significant risk that the price of the ultimate underlying asset of the CDX options, the CDS and the CDX index, would not reflect accurate market prices during a shock to the credit markets. Pricing the CDX indexes depends on a LIBOR-like survey of the member banks and requires that these banks can produce accurate prices for the individual CDS. The risk of poor price transparency in the CDS market and the risk that it would cause liquidity in the CDX option market to dry up are both significant risks for market makers and potential deterrents for CDX option users." (emphasis added)

The key concern here was the completely lack of transparency in this market, as well as the inefficient trading regime being used. Establishing an exchange for CDS securities would have provided not only much needed transparency, it would also have created an opportunity for there to be market makers in the event of a credit crunch.

The key sentence in the summary, as I see it, is this: "The primary barrier to introducing the options is the risk of price failure in the underlying CDS market."

And that is where we are today. A $17 TRILLION market based on what Allen Greenspan called "19th century" trading technology that allowed banks to lend well beyond what their capitalization would allow.

This isn't a failure of markets OR regulations alone. It clearly demonstrates that inefficient markets will do inefficient things (like wipe out the international banking system). Efficient markets are founded on efficient, transparent regulation that is derived from both public (government) and private (industry) sources.

Rick writes:

Thanks, Sam. That was an interesting article and it led me to others.

But my question persists. The market for CDS suddenly exploded. Why? I understand that institutions are motivated to maximize the efficient use of available capital, but why so recklessly?

Why did banks lend beyond what their capital would allow (if Greenspan's assertion is correct)? Regulators aren't the only check on reckless behavior. Where was the ownership? They had a huge interest in controlling risk.

I have trouble with the notion that they all suddenly became stupid with greed.

Sam Wilson writes:

I agree with you that its hard to believe everyone suddenly became stupid with greed.

I do, however, think that key players were ignoring the size of growing risks that were developing. Greenspan and many others were raising flags, but no one listened.

Clearly, the current situation is the reflection of a SYSTEM that failed and not any one particular thing or group of things.

We have Fannie and Freddie. We have uninformed and unrepentant retail/consumer speculators. We have poor government regulation and oversight. We have inefficient markets.

And the "crisis" has many fronts... falling housing prices, illiquid credit markets, under capitalized banks, a weak manufacturing sector and insurmountable public deficits and debt.

But when we focus in on banks I think what we are seeing is an inefficient market that was allowed to grow beyond its infrastructure coupled with a few bad players and an overzealous effort to keep out regulators.

I think it really only took one or two bad players in the form of AIG and, perhaps, Lehman. Companies that do something like Enron and basically engage in bad business. Why AIG is being allowed to go on operating is beyond me. If they really do represent the systemic threat that the Fed and Treasury say they do then I don't understand why they aren't being dismantled and restructured.

It seems to me that these two, and possibly one or two more, entered as counter parties to a lot of contracts for which they didn't really have sufficient money to cover. Since they don't have a regulator like the FDIC or the FED watching over them they just let the thing run... with no one to answer to and as long as the market was booming who cared?

I don't know if an outright fraud was perpetrated here, but it sure smells like there may have been.

Unlike Enron, though, the major market players in this case were banks and their assets which have a multiplicative, money generating effect on the economy. So the shenanigans of these firms were multiplied throughout the economy rather than confined to a particular commodity like California Electricity.

Also, without an efficient, regulated and transparent market for these securities to be traded on, it may very well be that no one really knew the true extent of the problem or that even a problem existed.

So perhaps it's not that anyone was stupid, perhaps its that they were ignorant. And willfully so, because everyone so strongly feared any effort to shed light on this market for fear that it would hurt "innovation". As that paper noted, it could take months if not YEARS for the SEC to draft the appropriate regulations to properly structure a market in CDS.

Ignorance isn't stupidity, but willful ignorance is surely something more than simple ignorance.

Then again, maybe the models were just wrong?

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