Category: Economics

Be wary when you hear talk of "derivatives" without further qualification.  They fall into three quite distinct categories: exchange-traded, over the counter (OTC), and swaps.  Here is the best overall paper I know on that division.  Wikipedia is useful as well.

I’ll cover swaps in a separate post soon, so for now let’s set those aside.

Exchange-traded derivatives include the instruments traded at the Chicago Mercantile Exchange and The New York Stock Exchange.  Their regulation has overall gone well and no one serious has alleged that they are responsible for our current financial problems.  That said, a single regulator is preferable to our current dual SEC-CFTC structure.

Most but not all OTC derivatives are interest rate derivatives.  Equity derivatives fit this category as well and so do credit default swaps (even though they are called "swaps" they do not here fit into the swaps category). 

These instruments are OTC because no clearinghouse in the middle guarantees the deal.  That means more credit risk and that no single middleman is tracking net positions on a more or less real time basis.  Ideally we would like to make OTC derivatives more like exchange-traded derivatives and we should consider regulation toward that end.  (Do note that private swaps regulators have already done quite a bit to
clear up the issue of hanging and unconfirmed transactions.)  At the margin the social benefits of such homogenization are higher than what the private swaps regulators will bring on their own accord.  In essence homogenization and trading through a clearinghouse limits the leverage issue to a single, easily-regulated institution and therefore it limits the problem of counterparty risk.

The cost of such additional regulation will be higher transactions costs for the trades themselves and also greater contract homogeneity, which is a requirement for exchange trading, netting, and clearing.  We need to make this move wisely and carefully, otherwise OTC derivatives could move to even wilder and less well regulated markets.  Simply trying to shut down the OTC markets, even if that were the economically ideal vision (unlikely), would in terms of risk prove counterproductive.  But the strong market positions of New York and London do make some effective regulatory action possible for OTC derivatives, especially if done in concert.

The lack of sufficient offset and netting and the inefficient spread of counterparty risk across a large number of institutions is an important issue behind current crises and it does not receive enough attention in most blogosphere discussions.

How about Europe?  The 2006 Markets in Financial Instruments Directive extends traditional European financial regulation to OTC derivatives.  Here is one source: "MiFID expands the definitions of financial instruments to include other frequently-traded instruments, including contracts for difference (CFDs) and other types of derivatives such as credit, commodity, weather and freight derivatives."  Here is one overview of MiFID. 

Implementation and enforcement is on a country-by-country basis and of course the UK is the big player.  Read pp.27-29 in the very first link above and you’ll see that overall the UK has a looser regulatory approach than does the United States, though not on every single matter.  For instance the UK is stricter on regulating hedge funds in OTC derivatives markets.

The more important point is that no country uses regulation of the derivatives market as its major line of defense against financial crises.  Rather countries regulate their financial institutions, their risk, their leverage, and their accounting directly, of course with more or less success.  Regulating the derivatives market, as opposed to regulating the institutions, and their possible participation in those markets, simply isn’t a very effective instrument.

To sum up: a) we should regulate OTC derivatives more, b) those regulations should aim toward establishing netting and well-capitalized clearinghouses, not micro-management of those markets, which would prove both impossible and counterproductive, and c) regulating OTC derivatives is only a weak substitute for regulating the institutions which trade in them.

The U.S. passed the Commodity Futures Modernization Act of 2000, which, among other things, limited the ability of the federal government to regulate OTC derivatives.  I’ll cover that Act in a separate post and yes I do think it should be amended.  But I’ll start by saying that most blogosphere critics of the act simply do not know or understand much of the above.

It’s always worth hearing from both sides, in this case Nadav Manham:

This [the purchases of the Paulson plan] has the effect of modestly increasing the stated book value of
these financial institutions.  More importantly, with the toxic waste
off the books, it improves the likelihood that an outside
investor–Treasury itself, a sovereign wealth fund, even our man in
Omaha–now feels able to value the enterprise.  Hold your nose and
admit it:  the relatively few franchises that manage the capital
raising and M&A activities of Corporate America are worth a lot.

3)
Said outside investors collectively have enough capital to recapitalize
the major Wall Street insitutions via injections of new equity.  Here
comes the tricky part: In exchange for their largesse, both the outside
investors and Treasury (e.g. via warrants struck at the same price as
the outside investor) must be allowed to invest on very favorable
terms.  In a perfect world existing equity holders and stock options
would be essentially wiped out, a la AIG.  In an even more perfect
world, existing debt holders (i.e. unsecured lenders to Morgan Stanley,
Merrill, etc.) would also take a big haircut, just as they usually do
when corporations declare bankruptcy. 

4)  Both liquidity and
solvency are restored, credit starts to flow again, and the downward
spiral of asset sales is prevented, allowing whatever pain will occur
to occur over time, and to be spread widely.

…as far as I can tell, the plan does not specify when Treasury
is obligated to buy toxic assets, nor does it prevent Treasury from
doing another AIG.  Conceivably it could wait until the maximum moment
of pain to get the best price possible for its assets.  Or it could
continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself.

There is more at the link.  A key assumption here is that jump-starting liquidity for bank assets is a big part of the cure; having the government dilute bank equity, as the Elmendorf plan suggests, does not on its own achieve this end.  I do find this a reasonable view, though as Paul Krugman points out it is unlikely that it is only a liquidity issue.  The implicit belief here is that resolving the liquidity issue is needed to make progress on the solvency issue.  Maybe.  But still I do not like the Paulson plan.  It reminds me of everything I dread about unchecked power and the administration’s score on this question is very, very bad.

I’d like to reproduce chunks of his old yet prescient post (or go here and scroll down to 22 January):

Pundits continue to link the Enron debacle to a need for increased regulation,
especially of derivatives. What most of these people…don’t appreciate is that regulation and/or accounting rules are the
most fertile breeding ground for derivatives and synthetic or packaged
securities. Regulations and accounting rule-inspired transactions
describe the bulk of the well known derivative-related blow-ups of the
last two decades. Proscriptive regulation and the derivative trade have
a symbiotic relationship.

Investors and operating companies buy derivatives for two basic
purposes: speculation and risk transfer. A derivative, (a financial
contract based on the price of another commodity, security, contract or
index) either eliminates an exposure, creates an exposure, or
substitutes exposures. That last one, substituting exposures, is
important to heavily regulated investors.

For example, insurance companies were a goldmine for derivatives
salespeople in the last two decades, only slowing down in the late
1990s. The fundamental reason for this is not because insurance
executives were stupid, but because they manage their investments in a
thicket of proscriptive regulation. Insurance companies have to respond
to their national regulatory organization (the NAIC), their home state
insurance department and the insurance departments of states in which
they sell or write business. They file enormous statutory reports every
quarter using special regulatory pricing, and calculate complex
risk-based capital reports and "IRIS" ratios regularly.

Even though the insurance industry has been heavily regulated
throughout the entire post-war era, the incidents of fraud and
financial mismanagement have been numerous and spectacular.  Remember Marty Frankel?
Mutual Benefit Life? For each of these cases that are in the news,
there are many smaller ones you don’t hear about. Some of that may be
the nature of the industry, but it doesn’t make a prima facie case for more regulation…

Insurance companies often need the yield of less creditworthy
obligations. So derivative salesmen see an opportunity to engineer
around the regulations. They package securities that substitute price
volatility for the proscribed credit risk. Then the investor can be
compensated for taking some additional risk, and the banker can be
compensated for creating the opportunity. A simple example of this is
the Collateralized Bond Obligation (CBO). A CBO is created by buying a
bunch of bonds, usually of lower credit quality, putting them in a
"special purpose vehicle" (SPV) and then issuing two or more debt
instruments from the SPV. The more senior instruments can obtain an
investment grade rating based on the "cushion" created by the junior
debt tranche. The junior bond absorbs, for example, the first 10% of
losses in the entire portfolio and only when losses exceed that amount
will the senior obligations be impaired. The junior instruments, known
as "Z-Tranches" become "toxic waste", suitable only for speculators and
trading desks with strange risks to lay off (or, in a famous 1995 case,
the Orange County California Treasurer).

A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing – they decrease frequency of loss but increase the severity.
So they blow up infrequently, but when they do it’s often a big mess.
Ratings-packaged instruments are less risky than the pool of securities
they represent but often riskier and less liquid than the investment
grade securities for which they are being substituted. As a result,
they pay a yield or return premium (even net of high investment banking
fees). That premium may or may not be enough to pay for their risk. But
they pass the all-important credit rating process and are therefore
sometimes the only choice for ratings-restricted portfolios reaching
for yield.

…[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests
that regulation is often the derivative salesman’s best friend.
Complicated rules encourage complex transactions that seek to conceal
or re-shape their true nature. Regulated entities create demand for
complex derivatives that substitute proscribed risks for admitted
risks. If a new risk is identified and prohibited, the market starts
inventing instruments that get around it. There is no end to this
process. Regulators have always had this perversely symbiotic
relationship with Wall Street. And the same can be said for the
ridiculously complicated federal taxation rules and increasingly
byzantine Financial Accounting Standards, both of which have inspired
massive derivative activity as the engineers find their way around the
code maze.

Dreck, in case you don’t know, used to blog with Megan McArdle over at Asymmetric Information.  Here is what happens when you enter "Star Dreck" into YouTube.

He doesn’t like it.  And he has another idea:

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture.  But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain.  Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.

And now come the real zingers:

It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

Addendum: Here is further comment.

1. Very good David Brooks column

2. What would the new RTC look like?

3. When will bank loans fall more?

4. Beating LeBron James at "HORSE"

5. Treasury will guarantee money market funds

Well, short-term T-Bill rates were very close to zero yesterday.  But I’ve long felt that the liquidity trap argument is overrated in its import.  Here is my previous post on the topic.  (As you may know, I don’t like "re-runs" but I’ve received many requests for this.)  Here’s one bit from the post:

Open market operations, when tried, seem to have worked in 1932.
Was Japan in a liquidity trap in the 1990s?  They could have printed
more money and given it to me.  With an interpreter at my side, I would
have spent it right away.  Who knows, maybe you could have helped me.
Here is a good critique of Krugman on Japan.

…What is the evidence for a liquidity trap?  Low nominal rates and the
absence of a recovery?  That’s not much evidence.  I suspect real
coordination problems are at fault in most of these settings, and
hoarding is at most a secondary issue.  Few serious economic problems
are purely monetary in nature, yet the liquidity trap encourages us to
embrace that dangerous idea.

By the way, some sources (now verified) claim that Treasuries "traded negative" for a brief while yesterday.  T-Bills are standard collateral for many kinds of transactions, so for very brief periods of time they can have a shadow value higher than that cash, even apart from the possibility of earning a nominal interest rate.

The liquidity trap is most likely a problem when the Fed is restricted to open market operations, namely trying to trade cash for T-Bills.  A less orthodox Fed (and yes, that is what we have) has many ways around the trap, if indeed it was ever a trap in the first place.

So says Felix Salmon:

AIG’s $2.5 billion of 5.85 percent notes due in 2018
plunged 19.5 cents to 33 cents on the dollar as of 9:55 a.m. in New
York, according to Trace, the bond-price reporting system of the
Financial Industry Regulatory Authority.

(quote from here).  33 cents on the dollar? The message is loud and clear: AIG
is toast. This is the massive counterparty failure everybody’s been
scared of, and frankly I’m astonished that the broader stock market
isn’t plunging as a result. No one is prepared for the
repercussions here: the failure of AIG is likely to be an order of
magnitude more harmful than the failure of LTCM would have been. And
it’s not even happening on a Friday, where we could have yet another
Emergency Weekend to try to work things out.

Obama wins, 59-31 percent, here is the story.  The individuals responding to the poll had this distribution of opinion:

48 percent — Democrats

17 percent — Republicans

27 percent — Independents

3 percent — Libertarian

5 percent — Other or not registered

In other words, Obama didn’t do as well as I would have expected, relative to the survey group.  There is much more information in the article, such as this:

On the issue of international trade, only 42 percent of our Democratic economists support Obama’s plans, with 34 percent favoring McCain. Independents favored McCain on this question by 63 percent to 16 percent, while favoring Obama overall.

Another indicator of objectivity is that the income levels of the economists have little impact on their opinions. The economists with lower incomes are no more likely to favor taxing the rich than the rich economists favor taxing themselves.

Likewise, economists in the academic world were largely on the same page as the nonacademic types in predicting which candidate would be best for the long term.

I thanks Alice Miller for the pointer.  And if you do leave a comment, note that the marginal return to being partisan in this setting is very low or even negative.

Table of Contents with links to articles (pdf)

• Crossfire Over Shall-Issue: Writing in the Stanford Law Review
  in 2003, Ian Ayres and John J. Donohue found the balance pointing
  toward "more guns, more crime." Making a number of upgrades, Carlisle
  Moody and Thomas Marvell redo it and find the balance pointing the
  other way.
  (Professors Ian Ayres and John J. Donohue have been
  invited to reply to this article, and their analysis will appear in the
  January 2009 issue of the journal.)
• Economists on Sports Subsidies: Dennis Coates and Brad Humphreys call the rout.
• Colleagues, Where Is the Market Failure?: Daniel Klein dissects the judgment and rhetoric of economists on the FDA.
• The Curtailment of Critical Commentary: A report from Down Under.
• The State of Economics Science—82 Years Ago: A reprint from Social Forces, 1926.
• Endeavor in “We”: Daniel Klein invites a discussion about building an identity for [Placeholder] economics.
• Salute to Stiglitz on Iraq: Fred Foldvary reviews The Three Trillion Dollar War by Joseph Stiglitz and Linda Bilmes.
• Where There’s Smoke: All funding is agenda-laden, says a correspondent.

Thanks goodness we bailed out Bear Stearns back in March if we hadn’t we might have lost Fannie Mae and Freddie Mac, Lehman Brothers, Merrill Lynch and who knows what else.  Oh wait…

Here is my NYT column from today.  Excerpt:

In short, there was plenty of regulation – yet much of it made the
problem worse. These laws and institutions should have reined in bank
risk while encouraging financial transparency, but did not. This
deficiency – not a conscientious laissez-faire policy – is where the
Bush administration went wrong.

…the Bush administration’s many critiques of regulation are
belied by the numbers, which demonstrate a strong interest in continued
and, indeed, expanded regulation. This is the lesson of a recent study,
“Regulatory Agency Spending Reaches New Height,” by Veronique de Rugy,
senior research fellow at the Mercatus Center at George Mason
University, and Melinda Warren, director of the Weidenbaum Center Forum
at Washington University.
(Disclosure: Ms. de Rugy’s participation in this study was under my
supervision.) For the proposed 2009 fiscal budget, spending by
regulatory agencies is to grow by 6.4 percent, similar to the growth
rate for last year, and continuing a long-term expansionary trend.

For the regulatory category of finance and banking, inflation-adjusted
expenditures have risen 43.5 percent from 1990 to 2008. It is not
unusual for the Federal Register to publish 70,000 or more pages of new
regulations each year.

…The biggest financial deregulation in recent times has been an implicit
one – namely, that hedge funds and many new exotic financial
instruments have grown in importance but have remained largely
unregulated. To be sure, these institutions contributed to the severity
of the Bear Stearns
crisis and to the related global credit crisis. But it’s not obvious
that the less regulated financial sector performed any worse than the
highly regulated housing and bank mortgage lending sectors, including,
of course, the government-sponsored mortgage agencies.

There is much more at the link.  Mark Thoma adds comment.  So does Arnold Kling.

No:

The overall picture of economic development that emerges from this analysis is in some ways very similar to the traditional pre†growth†theory development economics, although it is related to the modern reformulations of economic growth through the lens of development economics (Banerjee and Dulfo 2005). The recipe for productivity growth is the formation of official firms, the larger and the more productive, the better. Such formation must perhaps be promoted through tax, human capital, infrastructure, and capital markets policies, very much along the lines of traditional dual economy theories. From the perspective of economic growth, we should not expect much from the unofficial economy, and its millions of entrepreneurs, except to hope that it disappears over time. This “Walmart” theory of economic development receives quite a bit of support from firm level data.

That’s from a recent La Porta and Shleifer paper, just presented at Brookings.  I find this very convincing.  The pointer comes from Greg Mankiw.