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May 20, 2010

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Latest Posts from Economist's View


Should We Ban Naked CDSs?

Posted: 20 May 2010 01:59 AM PDT

Brad DeLong:

Should We Ban Naked CDSs?, by Brad DeLong: I say, narrowly, no--that if we can get proper clearing, transparency, and capital adequacy requirements in place banning naked CDOs would not do any good and would do a little bit of harm. But it is a close call. And if we can't get proper clearing, transparency, and capital adequacy requirements in place then we should ban them.

Let's go back to first principles. The direct benefits of having more developed, liquid, and sophisticated financial markets are threefold:

  • They allow people to buy insurance: people facing or holding too much of one particular risk can trade piece of it away to others, and so make a win-win deal: the buyer of insurance makes a negative expected value bet but one that, given the magnitude of the distress that would be caused if the risk became reality, they are happy to make; the sellers of insurance make a positive expected value bet.

  • Saving and investment: people with wealth who went to spend later can make win-win deals with people with ideas who need financing to turn those ideas into productive and profitable enterprises.

  • People who have done research and learned information about the structure and likely evolution of the market can bet on their knowledge: they win because they make their positive expected-value bets, and everyone else wins because after they have bet financial market asset prices better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.

The disadvantages of having more developed, liquid, and sophisticated financial markets are fourfold:

  • People who are excessively and irrationally averse to risks can trade those risks away at a price, and so lose wealth because they are shrinking at shadows.

  • People are are excessively and irrationally unconcerned about risks can trade to accept those risks, and so lose wealth because they are excited by the thrill of tossing the dice.

  • A more developed financial market is one in which it is easier to make money by unfairly appropriating somebody else's information through insider trading.

  • A more developed financial market is a more fragile market: when prices move suddenly and bankruptcies and failures to deliver emerge, it destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.

In general, you want to set up your financial markets so that they do as good a job as possible at (i) rewarding those who work hard doing research into fundamental values, (ii) matching individuals with wealth to save with entrepreneurs with ideas to try out, and (iii) enabling those who want to shed diversifiable risk to do so. And you want to set up your financial markets to minimize (i) the irrationally risk-averse's ability to throw away their money, (ii) the irrationally risk-loving's ability to throw away their money, (iii) the unfair appropriation of other people's information through insider trading, and (iv) the chance that a chain of bankruptcies and failures-to-deliver will disrupt the web of trust, cause a flight to liquidity and quality, and create a depression in the real economy.

There is an eighth consideration, however, and which way it cuts---whether it is a benefit or a disadvantage--is unclear:

  • A more developed financial market increases the chance that somebody who thinks market prices are too low and wants to buy will find a counterparty who thinks that market prices are too high and wants to sell.

This eighth consideration is definitely not win-win. One of the two parties is definitely wrong--prices right now are, if they are not exactly right, either too high or too low. Both think that they are getting a good deal, but both cannot be correct. As far as the two parties are concerned, these trades are at best zero-sum and probably less than zero sum: risk is, after all, increased.

However, when all the people making too-high and too-low bets meet in the marketplace prices move until the number who think prices are too high (and are willing to put their money behind that belief) equals the number who think prices are too low (and are willing to put their money behind that belief). This reveals the balance of opinion, and so moves financial market asset prices to a place where they better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.

On the other side of the argument, somebody is holding a portfolio that is based on false beliefs about the way the world works. Such people are especially likely to fail when reality comes calling--and so encouraging these directional-bet transactions increases the chance that, when reality comes calling and when prices move suddenly, they go bankrupt or fail to deliver--and that destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.

George Soros believes that this last consideration should lead us to limit the extent to which our financial markets are friendly to directional bets. Thus he calls for the banning of "naked" credit default swaps:

George Soros Says Credit Default Swaps Need Much Stricter Regulation: AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps....

CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them toxic is that such speculation can be self-validating. Up until the crash of 2008, the prevailing view -- called the efficient market hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matter of anticipation, not knowledge....

[B]eing long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling. The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry... exerts a downward pressure on the underlying bonds.... The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect... bear raids on financial institutions can be self-validating.... AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule.... The unlimited shorting of bonds was facilitated by the CDS market.... Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies...

Tim Geithner disagrees:

Seeking Alpha: My own sense is that banning naked (CDS) volumes is not necessary and wouldn't help fundamentally in this case. It's too hard to hard to distinguish what's a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.... [T]he absolutely essential thing is that there is more capital held against these positions so we never again face the situation where those types of judgments could imperil the system...

I call this one, narrowly, for Geithner: The key elements are clearing, transparency, and capital adequacy requirements that maximize the flow of information into market prices from the fact that people with money are willing to put it on the line to back their predictions and that minimize the chances of disruption of the web of trust.

"James Tobin's Hirsch Lecture"

Posted: 20 May 2010 12:49 AM PDT

Rajiv Sethi discusses James Tobin's "four distinct conceptions of financial market efficiency," particularly his notion of functional efficiency"

James Tobin's Hirsch Lecture, by Rajiv Sethi: James Tobin's Fred Hirsch Memorial Lecture "On the Efficiency of the Financial System" was originally published in a 1984 issue of the Lloyds Bank Review, and republished three years later in a collection of his writings. Willem Buiter discussed the essay at some length about a year ago in a provocative post dealing with the regulation of derivatives. Both the original essay and Buiter's discussion of it remain well worth reading today as guides to the broad principles that ought to underlie financial market reform.

In his essay, Tobin considers four distinct conceptions of financial market efficiency:

Efficiency has several different meanings: first, a market is 'efficient' if it is on average impossible to gain from trading on the basis of generally available public information... Efficiency in this meaning I call information arbitrage efficiency.

A second and deeper meaning is the following: a market in a financial asset is efficient if if its valuations reflect accurately the future payments to which the asset gives title... I call this concept fundamental valuation efficiency.

Third, a system of financial markets is efficient if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies... I call efficiency in this Arrow-Debreu sense full insurance efficiency.

The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to to their more socially productive uses. I call efficiency in these respects functional efficiency.

The first two criteria correspond, respectively, to weak and strong versions of the efficient markets hypothesis. Tobin argues that the weak form is generally satisfied on the grounds that "actively managed portfolios, allowance made for transactions costs, do not beat the market." He notes, however that efficiency in the second (strong form) sense is "by no means implied" by this, and that "market speculation multiplies several fold the underlying fundamental variability of dividends and earnings."

My own view of the matter (expressed in an earlier post) is that such a neat separation of these two concepts of efficiency is too limiting: endogenous variations in the composition of trading strategies result in alternating periods of high and low volatility. Nevertheless, as an approximate view of market efficiency over long horizons, I feel that Tobin's characterization is about right. 

Full insurance efficiency requires complete markets in state contingent claims. This is a theoretical ideal that is impossible to attain in practice for a variety of reasons: the real resource costs of contracting, the thinness of potential markets for exotic contingent claims, and the difficulty of dispute resolution. Nevertheless, Tobin argues for the introduction of new assets that insure against major contingencies such as inflation, and securities of this kind have indeed been introduced since his essay was published.

Finally, Tobin turns to functional efficiency, and this is where he expresses greatest concern:

What is clear that very little of the work done by the securities industry, as gauged by the volume of market activity, has to do with the financing of real investment in any very direct way. Likewise, those markets have very little to do, in aggregate, with the translation of the saving of households into corporate business investment. That process occurs mainly outside the market, as retention of earnings gradually and irregularly augments the value of equity shares...

I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this 'paper economy', not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitation nth-degree speculation which is short sighted and inefficient...
Arrow and Debreu did not have continuous sequential trading in mind; when that occurs, as Keynes noted, it attracts short-horizon speculators and middlemen, and distorts or dilutes the influence of fundamentals on prices. I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.

Recall that these passages were published in 1984; the financial sector has since been transformed beyond recognition. Buiter argues that Tobin's concerns about functional efficiency are more valid today than they have ever been, and is particularly concerned with derivatives contacts involving directional bets by both parties to the transaction:

[Since] derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution.  Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults.  Defaults, insolvency and bankruptcy are key components of a market economy based on property rights.  There involve more than a redistribution of property rights (both income and control rights).  They also destroy real resources.  The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved.  There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners.  But there is such a thing as insolvency for losers, if the losses are large enough.
The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple.  The party purchasing the insurance should be able to demonstrate an insurable interest.  [Credit Default Swaps] could only be bought and sold in combination with a matching amount of the underlying security. 

The debate over naked credit default swaps is contentious and continues to rage. While market liquidity and stability have been central themes in this debate to date, it might be useful also to view the issue through the lens of functional efficiency. More generally, we ought to be asking whether Tobin was right to be concerned about the size of the financial sector in his day, and whether its dramatic growth over the couple of decades since then has been functional or dysfunctional on balance.

"Stunning Overbuilding"

Posted: 20 May 2010 12:09 AM PDT

Richard Green:

Stunning Overbuilding Fact of the Day, by Richard Green: I am listening to a presentation at the Homer Hoyt meetings on the condo meltdown in South Florida. Developers planned on building 95,000 units in the city of Miami between 2002 and 2007. In the 2000 census, the whole city had 163,000 units.

Unless the old people who move to Florida and buy these condos are partying so hard they destroy them in a few years -- maybe golf and bingo really bring out the wild side -- then that is, as noted, some "stunning overbuilding." Makes you wonder about the claim there is no way to tell if a bubble is developing until it pops.

links for 2010-05-19

Posted: 19 May 2010 11:05 PM PDT

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