Arnold Kling  

Morning Commentary

My Talk on Financial Regulatio... Taylor Rules...

All pointers courtesy of the indispensable Mark Thoma.
First, Hernando de Soto writes,

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property.

I don't think this generalization works. Credit default swaps may be poorly documented. However, mortgage-backed securities (which de Soto includes as derivatives) are as well documented as bonds and other securities. The international currency markets are filled with derivative transactions, and those markets are not malfunctioning. Readers of this blog know that I am a fan of de Soto and I am not a fan of credit default swaps, but this article did not persuade me.

Second, we have Michael J. Roberts.

Expected returns of the underlying asset go down with risk. Expected returns for the taxpayer would be somewhat less than that of the underlying asset since the investor gets 10% in expectation. A seriously raw deal for the taxpayer kicks in around an SD of 15% of the purchase price.

I don't know how much uncertainty there is. But my guess is it's less than an SD of 15%.

I have not checked Roberts' analytics. However, if he is correct that the standard deviation on the "toxic assets" has to be 15 percent or more to shaft taxpayers, then my guess is that taxpayers are shafted. I think of the typical toxic asset as being not a bond, which might have a reasonably low standard deviation. I think of it as a put option that is just barely out of the money, so that it has a huge standard deviation.

Finally, David Leonhardt writes,

The car rental industry's original sin isn't so different from the economy's. It took on too much debt.

The point of the article (I think) is that if a company's fundamentals are not good, tight credit is not really the issue.

I would go beyond that and restate my point that instead of worrying about making our banking system hard to break we should try to make our economy easy to fix. Our economy would be easier to fix if we did not encourage so much debt finance. Having corporate tax laws that punish equity and reward debt is an issue. Encouraging home ownership by subsidizing mortgage indebtedness is another issue.

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COMMENTS (8 to date)
Maniel writes:

Arnold writes: "... we should try to make our economy easy to fix. Our economy would be easier to fix if we did not encourage so much debt finance. Having corporate tax laws that punish equity and reward debt is an issue. Encouraging home ownership by subsidizing mortgage indebtedness is another issue."

Yes, yes, and yes. I strongly believe that moving to an "equity-based economy" (as opposed to a debt-based economy) is the answer to the major underlying problem. The rubble of debt is everywhere: in the public sector at local, state, and federal levels; and in the private sector in mortgages and credit-card balances. If we are to reverse the current tide of a declining economy and standard of living, the value of savings and equity accumulation will be relearned.

tjames writes:

"Having corporate tax laws that punish equity and reward debt is an issue.

Having a government that bails out the profligate at the expense of the prudent isn't helping either.

If I think the government will bail me out (because I am too big to fail, or because I employ politically powerful unionized employees, or because I invested in a GSE), then why wouldn't I mortgage to the hilt and roll the dice. Privatized gains, socialized losses.

MrDan242 writes:

Does the de Soto article imply another point for the conspiracy theorists? If the CDS are so hard to track, nobody knows how many there are (even the exec’s as some other articles imply), could Goldman et al be generating some after the fact to further the looting of the US taxpayer (presumably with kickbacks along the road to facilitate the trade)?

ed writes:

Having corporate tax laws that punish equity and reward debt is an issue.

I also agree, and I'm surprised that I haven't seen others make this point.

Dave writes:

Dr. Kling,

You have probably covered this in a prior post, but would you please explain how our corporate tax laws punish equity and reward debt? I'm not sure I understand what this statement means.

Mark T writes:

You are absolutely right that the tax system has distorted economic decisions in favor of debt finance for homes and business. It would be good to undo that. However, I think one has to do so slowly over time because the debt is long term in most cases and on the home ownership side, there are issues of intergenerational equity to think about if you break with the past too abruptly on what is for most people the largest financial decision they will ever make.

diz writes:

With respect to the Desoto quote:

I have some problem analyzing what problems might be traced back to CDS at least in part because most of my finance education seems to suggest they should not exist.

What useful purpose do they serve in an efficient financial market?

Why would anyone hedge the default risk of a specific debt issue?

If I don't want default risk of a specific BBB bond, I can buy a diversified portfolio of BBB bonds. Why would I buy a BBB bond and pay a derivative counterparty (whose credit I now must worry about as well) to lower my risk?

It seems like bond + hegde is almost certain to give me a worse overall yield than the occasional default within a diversified portfolio would produce. The swap maker has to cover his cost and profit. At best, I break even. He has to charge me at least a fair prioe for the expected defaults he would experience (which are the same expected defaults I would experience.)

And, if I don't want to take the overall default risk of a diversified portfolio of BBB bonds, I can buy a portfolio of AAA bonds or even treasuries.

I just don't see how the bond + CDS ever makes it too the efficient frontier of investment options.

So, in practice, I don't think hedging holds up as a valid reason for their existing. In practice, I suspect they exist because of regulatory arbitrage (supposedly under Basel II they gave banks beneficial effects) and because they were a convenient vehicle for speculators (like Goldman) to take advantage of mispriced risk (by AIG.)

Benjamin Wright writes:

Part of the issue with the recordation of derivatives is that technology (e-mail, text message and so on) has made the formation of legally-binding contracts very cheap and easy. Efforts to promote better documenation on derivatives (as advocated by both de Soto and Geithner) will provoke massive campaigns to capture, archive and comprehend electronic financial records. See Details --Ben

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