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The Wrong Crisis

Robert Waldmann

What isn’t going on in financial markets ?

There are various theories of the financial crisis which suggest simple solutions and have the only defect that they are fantasies.

1) The only problem is mark to market accounting.

Market prices for mortgage backed securities (MBS) are very low because of a panic. Banks are required to list assets on their balance sheet at market prices. Banks appear to have negative equity (debt greater than assets) because of this silly rule. This caused the crisis.

This seems to be the theory of a weird left right alliance including Rep Darrel Issa (R Calif.). It is based on the idea that ideologue Congress persons can price assets better than professionals. The assets include MBS but also debt and shares of banks. This is fairly clearly a wish fulfillment fantasy. The idea is that if we resolutely say everything is fine, everything will be fine.

2) The problem is adverse selection in the MBS market and mark to market accounting.

Here there is a theory better than “I know best” for why MBS market prices are below the average hold to maturity value of MBSs. MBSs are worth less than was thought a year ago, but some of them are worse than others. For one thing, the value depends on the standards of the initiator of the underlying mortgage e.g. are they liars’ loans or normal loans. Owners of such MBSs know more about them than potential buyers. Therefore, the stuff that is for sale is the most toxic of the toxic securities. Therefore the market price is the price for the worst of the worst of MBSs. Therefore it would be irrational to sell anything which is only semi toxic. There is a separating equilibrium with low volume of trade and very low prices. Applying such prices to all MBSs understates their value.

Now without irrationality this shouldn’t matter. People who know that the stuff for sale is the worst of the worst should also know that the other stuff is better no ? Here market participants are required to be sophisticated when they buy and sell MBSs and unsophisticated when they read balance sheets.

3) The problem is mark to market, adverse selection and capital controls.

Ah now a regulation which is definitely unsophisticated. The rule is that Assets minus debt divided by debt must be over some number. If this rule is applied along with the principle that assets are marked to market it can cause two equilibria one with high asset prices and non binding capital controls and one with low asset prices and binding capital controls.

Here the problem is that all entities must be equally exposed to MBS risk and initially equally close to the capital requirement. In the real world different entities have different capital requirements. In particular capital requirements for investment banks (set by the SEC and relaxed in 2004) are much looser than capital requirements for commercial banks. Also hedge funds’ capital requirements are set by their counter-parties and are (if this is still true) about 2%. Plus Warren Buffet had $5 billion to spare. Note that the firms with the most flexible capital requirements are the ones that no longer exist. A problem for the theory.

More importantly,
binding capital requirements should cause a flow of assets from the firms with binding requirements to the ones with some slack. This flow would, among other things, make markets thick, volume high, markets unfrozen and adverse selection drowned in the flood of liquidation by firms with binding capital requirements (note the argument works fine and the metaphor isn’t even mixed). It is very hard to have a market frozen by adverse selection with market prices below the value of the average asset causing, via mark to market and regulations some firms to have to liquidate large amounts of assets. Firms that have to liquidate eliminate the separating only the worst of the worst is for sale equilibrium.

If agents are forced to sell assets at fire sale prices any agent who isn’t in the same bind should be buying at fire sale prices. It’s just not true that all entities in the world have binding capital controls. The explanation is nice in theory, but doesn’t fit the facts.

Now all these theories would imply that the original Paulson plan could work without a huge transfer from the public to banks. However, they don’t make sense.ù

Furthermore they are totally false for two more simple reasons which I put after the jump for no particular reason.

The theories assume that banks actually mark assets to market. They are supposed to, but they don’t. Page 81 of the September 20-26th Economist notes that at the end of 2007 Bank of America, Citigroup, HSBC, JP Morgan, Lehman Brothers, Morgan Stanley and Merrill Lynch marked less than half of their assets to market (which UBS Credit Suisse, Duetsche Bank and Goldman Sachs market more than half of their assets to market with Goldman Sachs over 75%). Sorry no link. I am working from uhm ink on deceased trees. Note first that uhm not quite all assets are marked to market. Note also which investment banks are still independent firms.

Finally, if markets are frozen and the market price makes a huge difference to balance sheets, it is easy and almost legal to manipulate the market price. Bank A can tell bank B “we will buy 1% of your toxic sludge for twice the current price if you buy an equal amount of our toxic sludge.” Then both can mark to that agreed price and make their balance sheets look fine (this is the favorite technique of Italian soccer teams who don’t trade players. Each buys the contract of a player for the other and they state an absurdly high price. They sometimes run out of cash with fine looking balance sheets). Now transactions which count as the market to mark too are supposed to be arms length, but no one is going to be picky in the middle of a crisis.

In fact, such a transaction would work without fraud if adverse selection were really a problem. Bank A could say “I will buy some of your MBSs but I pick which ones (at random)” that way, the expected value would be the average value of MBSs not the value of the worst of the worst. Still not quite arms length, but not obviously fiddling the price, since it would be a sensible transaction even if balance sheets didn’t matter.

Now some might think that the idea that fraudulent prices can be created when markets freeze is a fantasy. I think it has happened. The assets were long term calls options on European stock indices. Long Term Capital Management was short these assets. When it seemed fairly likely that LTCM would fail and be liquidated and when they had to liquidate to keep the balances of their REPO accounts above zero (they were excused from the 2% rule by counterparties) these assets suddenly became very risky and the market froze up. The market price became the list price chosen by brokers who knew that no one was buying or selling. The same brokers were LTCM counterparties. The list price of the options became absurdly huge. The counterparties were about to gain the right to seize the extremely valuable LTCM short positions (can seize when the mark to market value of LTCMs account at a bank is negative even if the hold for a month value is huge). It is alleged, without proof, that investment bank brokerages listed the absurd price then secretly traded at a reasonable price. Fact is that the market price was absurd and it was absurd in a direction helpful to the investment banks.

The crisis ended when the President of the New York Federal Reserve Bank, William McDonough told the investment banks to cut the crap and, in effect, divide up LTCM equally among them. It is very bad for an investment bank to anger the New York Fed. Bear Stearns was the only investment bank which refused to co-operate.

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more on Mallaby

Robert Waldmann

Looks like I should have put the post to which the post below links here. Thanks for clicking the link. I will try to add up by adding a point here.

Sebastian Mallaby argues that deregulation did not cause the crisis, because hedge funds are regulated even less than investment banks. Based on something I read somewhere on the web, I noted that it is hard for hedge funds to get in trouble during a quarter as their investors can’t pull out money (it can be done LTCM managed but it is hard).

Now I will make another argument. The anti Sebastian (let’s call him archer) argues that regulations were fine on January 20 1993 and that the changes from then till now made the crisis possible (or at least worse than it would otherwise be). The changes would be de-regulation and a failure to create new regulations to deal with new financial instruments. Roughly the Commodities Futures modernization act of 2000 and the 2004 decision to allow investment banks to increase leverage.

Now this has nothing to do with hedge funds. They existed and were regulated in 1993 and they exist under roughly ?) the same regulations now.

The point is that regulations do not fall out of the sky. They are created because of a perceived need for regulation. A type of firm might be lightly regulated because of neglect. If so, relatively good performance by that type of firm is a sign that regulation is bad. Rather more likely a type of firm might be lightly regulated because legislators and regulators think that it is not dangerous. Mom and pop book stores have played a minor role in the crisis. They are lightly regulated. Does this prove Mallaby’s point ? I think the answer is obviously no.

So, if hedge funds played a minor role in the crisis, would that prove Mallaby’s point ? I would say it is just as obviously no.

Banks are highly regulated, because, by their nature, they are at risk of bank runs. They borrow short term and invest long term. Their creditors make small investments and, rationally, do not invest large amounts of money in looking out for their investment.

Hedge funds borrow medium term and in huge chunks of at least $100 million. Therefore the logic of banking regulation implies (and has implied since the first hedge fund was founded) that there is little need to regulate hedge funds.

The change in regulation concerns banks and insurance companies. If the crisis were confined to sectors where regulation changed, that would tend to be evidence that the change in regulation contributed to the problem.

If the crisis also affected firms which no one had ever argued should be regulated (as we will probably learn it did) that would tend to be evidence against the hypothesis of the advocates of keeping regulation the way it was in 1992.

The idea that support for the logic of the old regulatory strategy is proof that it was no good is so silly that only a top pundit could think of it.

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General Equilibrium theory and Finance

Robert Waldmann

I wrote a post below on how economic theory as presented to the public and economic theory are very different. In particular, even given the standard super strong assumptions, economic theory does *not* imply that Laissez faire is the best policy, does not imply that market outcomes are even Pareto efficient (a very weak statement anyway) does not imply that financial innovation can’t hurt everyone and certainly does not imply that financial markets can’t freeze up.

In this post I will write about general equilibrium theory [more on that after the jump] and assume symmetric information.

Furthermore I will talk about Pareto efficiency. [more after the jump].

I will assume that markets are incomplete. This is obvious. For markets to be complete, there must be a security (or portfolio) which pays positive value in any conceivable contingency and otherwise pays zero. It must be possible to buy in effect “an umbrella if it is raining” separately from “an umbrella if it is not raining”. No one has ever suggested that markets are approximately complete. To have any connection with reality, general equilibrium theory must concern economies with incomplete markets.

All that aside the conclusions of the literature is that

1) Generically (definition of generically after the jump) the market outcome is not constrained Pareto efficient. This means that the government can make everyone better off by restricting free market exchange on financial markets forbidding people to make mutually beneficial trades at a market clearing price.

2) If markets were complete the outcome would be Pareto efficient. However the introduction of a new security does not necessarily cause a Pareto improvement. In fact, for an open set of economies (definition after the jump) banning trading in a security causes a Pareto improvement. Generically, if markets are incomplete, there is a security whose introduction will make everyone worse off.

3) with incomplete markets sunspots (variables which have no effects on tastes or technology) can cause prices to change. Outcomes can occur with a sunspot that couldn’t possible occur without a sunspot. I don’t remember if this is generically true of just true for an open set of economies.

4) it is easy to write down a model in which the volume of trade is zero. In standard models agents who do not maximize welfare are introduced to cause trading volume to be greater than zero. It is possible to write a model in which there is some trading even if everyone is rational (for example due to life cycle saving and dis-saving or people hedging against risk in their labor income). No one writes such models as they give trading volume vastly lower than, say, current volume with markets that are “frozen” and have “seized up.”

Roughly none of the claims about general equilibrium with complete markets apply to general equilibrium with incomplete markets. The exceptions are not strange cases, rather the claims are true only if there are extraordinary coincidences.

General Equilibrium theory is extreme even as economic theory goes

I will therefore assume that agents have rational expectations — that is they know the probability of any conceivable event — and that they are price takers, that is there is perfect competition. I will assume that there are no non-pecuniary externalities like pollution (the only externality is that my demand affects the price that you have to pay too). I will also assume symmetric information although there is a large literature (founded by Robert Lucas) on general equilibrium with asymmetric information). Thus the assumptions are the very strong ones typically criticized by people who say that the support for laissez faire (libertarianism in English) from economic theory is irrelevant the real world.

Is it Pareto efficient is not an interesting question (as stressed I might add by Kenneth Arrow who proved the first welfare theorem and said it was no big deal).

This has little to do with efficiency in the normal sense of the word. An outcome is Pareto efficient unless it is possible to make someone better off without hurting anyone. Slavery was Pareto efficient if it helped the slave owners. The statement that an outcome is Pareto efficient tells us essentially nothing. In particular if we have two outcomes and one is Pareto efficient and the other isn’t that tells us nothing of interest. It certainly doesn’t at all mean that the Pareto efficient outcome is a Pareto improvement over the other outcome.

uh oh. I have to define what general equilibrium theorists mean when they say “an economy”

1) an economy includes a set of agents each of which has a utility function. The agents rationally maximize their expected utility.
2) Each agent has an initial endowment of goods and maybe abilities
3) There is a production possibilities set describing how goods and abilities can be used to produce goods.

In particular all the results mentioned above are for “fruit tree” economies in which no one works. Instead the production is of the form of fruit trees which produce goods by themselves. Typically the models have 2 periods (I think this assumption isn’t really restrictive). In period zero people start with endowments of fruit trees. They trade them. One can short sell a fruit tree.
In period 1 the trees produce the fruit. People exchange fruit. Then they eat it.

Clearly this is a very special case of general equilibrium and the fact that the standard results for a 1 period model (no fruit trees) don’t hold is especially striking.

Open: Actually this is an abstract concept. Given a set we can define a “topology” which is the set of open subsets of the set. The only rules are
1. the whole set is open
2. the empty set is open
3. The intersection of a finite number of open sets is open
4. The union of any set of open sets is open.

in general equilibrium theory “open” has a standard relatively narrow defintion. It always (almost always ?) means that if we take an economy in the set, there is an epsilon so low that if we change the endowments of goods initially owned by agents so that the largest over i and j change in the endowment of good j owned by agent i is less than epsilon the new economy with new endowments is in the set of economies.

So something is true of an open set of economies means I can take a little from this guy and give to that gal and it will still be true.

dense: a subset of a set is dense if for any point in the set, for any open set containing that point, there is an element of the subset in that set. For example rational numbers are a dense subset of real numbers.

Generically: Roughly something is true generically if it is true except in knife edge cases of extraordinary coincidences. Consider the set of pairs of real numbers. Generically the two numbers are not equal, only by an amazing coincidence would they happen to be equal.

Formally a statement is true generically if it is true for an open and dense subset of economies. In practice what is shown is if we have an economy for which it is true we can make little transfers of endowements so small that it is still true after the transfers. For any case in which it is not true for any epsilon, there are transfers where the biggest amount of any good given to or taken from anyone is less than epsilon such that after the transfers the statement becomes true.

Another way of saying it is that if we have a set and an open and dense subset, the complement of the subset (the points in the set which aren’t in the subset) has measure zero for any measure based on the topology of the set.

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What’s Wrong with Economic Theory as Presented to the Public ?

Robert Waldmann

I have a very low opinion of economic theory. I think that its survival is the result of a bait and switch where the core principles (roughtly Nash equilibrium) can’t be proven false, because they have no implications, and, given the fact that they have not been proven false, economists attempt to convince people of the joint implications of the core principles and further assumptions which are known to be false. Fortunately, very few people pay much attention to economic theory.

To continue the diatribe, the implications of economic theory as presented by right wing economists are the implications of models which are about 50 years old now. They depend on assumptions which no one claims are approximately valid. In particular, the traditional application to finance of economic theory, that is general equilibrium theory, (generically) gives the standard results only if markets are complete — that is there is a contingent claim for every conceivable contingency (including say this pays 1 unit of numeraire good if it is snowing on Mars or if Robert Waldmann stubs his toe between 6:55 EST of October 3 2008 and 7 EST).

With incomplete markets, the market outcome is generically (that is except for a set of economies with measure zero) constrained Pareto inefficient (that means that there are legal restrictions on peoples positions in financial markets which make everyone better off).

Also, there is no claim based on economic theory that financial market prices reflect fundamentals. A large set of general equilibrium economies *with complete markets* have multiple equilibria. Which equilibrium occurs is not determined by fundamentals (tastes and technology). With incomplete markets payoff irrelevant signals (sunspots) can affect prices in general (I think generically).

The conclusions of economic theory as presented by many or perhaps most economists do not follow from current economic theory, but rather from the 50 year old efforts at mathematical economic theory.

Thus the New York Times Op-ed page is not to be blamed for publishing an op-ed full of false claims about economic theory written by Mark Buchanan a physicist. I won’t excerpt, read it if you want. My objections after the jump.

Bachman has no idea what he is talking about.

First he has no idea of what economists mean when we say “equilibrium”. He just assumes that we mean stable steady state (which is what we used to mean 50 years ago). Now we mean Nash equilibrium or Walrasian General equilibrium which is nothing of the kind. He should check on recent developments in general equilbrium theory in the past 30 years. He will find the word “sunspot”. He will find that general equilbrium theorists argue that there are “equilibria” in which market prices jump around with no relevant news (based on irrelevant news that has nothing to do with tastes or technology). That is, the view of general equilibrium theorists is the exact opposite of the view Buchanan attributes to them.

He will also note that general equilibrium theorists conclude that market equilbria are generically not constrained Pareto efficient — the theorists who showed that are Herakles Polimarchakas and John Geanokoplos (hey where did I just read that name ?).

Finally the bit about how economists don’t use computer simulations is, if possible, even more wrong than the rest of the op-ed. It is like saying economists refuse to use mathematics or have no use for the theory of statistics.

I’d say that Buchanan demonstrates complete ignorance about what economic theorists have been doing in the, depending on the paragraph of the op-ed, past 30 to 50 years.

By now I’m tempted to just post my explanation of why I won’t post. I think I will.

On the other hand, while Buchanan doesn’t know anything about current economic theory, I think he does have a sense about how economic theory affects the political debate. There is a general view that, according to economic theorists, laissez faire is the best policy. Pro-market politicians are a bit reassured by this and pro-regulation and egalitarian politicians probably think they are fighting against the false prevailing economic theory. In fact, many economists argue that economic theory shows (if they are delusional about the scientific standing of economic theory) or suggests that the market is socially efficient. This is just not true at all. In particular someone who confuses “Pareto efficient” and “efficient” can claim this about markets with rational agents, perfect competition and *complete markets*. It is hard to explain what complete markets would look like, because an economy with complete markets is so totally unlike the real world. No one has ever argued that markets are approximately complete and no general equilibrium theorist has ever argued that this is a matter of less than critical importance.

The problem is, I think, that when they talk to non economists, many economists pretend that traditional economic theory is a good approximation to reality. By “traditional” I mean 50 year old. The fact that the conclusions are the result of strong assumptions made for tractability and are known to not hold without these assumptions is irrelevant. In the case of financial market equilibrium, the assumptions are not just the core assumptions of rationality and old assumptions of perfect competition but the totally crazy assumption of complete markets.

Once a model has been put in textbooks, it becomes immortal invulnerable not only to the data (which can prove it is not a true statement about the world but no one ever thought it was) but also to further theoretical analysis.

Buchanan should have talked more to Geanakoplos before shooting his keyboard off. The Times should have checked claims about current economic theory with an economist before printing them, but I think the worse problem is that economists who are also libertarian ideologues are lying about the current state of economic theory, not only its very weak scientific standing, but the fact that, even if it were all absolutely true, their policy recommendations do not at all follow from current economic theory.

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WaMu tries to lend $9,000 to Cliff105 at subprime

Robert Waldmann

notes a bit of financial news that must be read to be believed.

Cliff105 who is between jobs and reading about the financial crisis receives an interesting bit of junk mail.

a credit card offer from my recently failed bank, Washington Mutual.

Normally, I throw these credit card offers into the recycle bin un-opened. &As every school kid knows, the credit market is so tight in America right now millions of people are on the verge of losing their jobs because businesses can’t get any money from the “seized up” financial sector.

America faces a “once in a lifetime” major crisis of enormous dimensions, or so I’ve been led to believe.

For laughs and giggles I checked out what The Bank Formerly Known As Wamu had to offer: more than 9 grand at 1.99% APR until next August, with an upfront finance charge of $150 (about 1.6%).

Read the whole post. It is beyond belief.

Ah so that’s how bankrupt banks act during a credit crunch.

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Mark to Market Accounting

Robert Waldmann

is about to share his ignorance on banking, banking regulation, accounting, And accounting standards all in one post.

You know the end is near when ordinary people get interested in accounting standards.

A wide variety of politicians have decided that the problem with the US financial system is Mark to Market Accounting. It is tempting to argue that this is equivalent to arguing that closing our eyes will make the problem go away. However, there is one way in which accounting standards can create a crisis. It is through the interaction of accounting standards and capital requirements. Capital requirements are a way in which the numbers written on a balance sheet have real effects even if everyone knows they are made up.

So one could argue that the problem might be mark to market accounting if one were ready to argue that the problem is due to capital requirements. I’d say that is crazy. For one thing US investment banks didn’t long survive the relaxation of capital standards for US investment banks (held out about 4 years IIRC). For another its crazy.

However, there is a particular way in which mark to market times capital requirements can create a crisis. Paul Krugman called it a systemic margin call.
When the value of assets held by banks falls, the difference assets minus debt declines. Capital requirements imply that banks must reduce their total debt by selling assets and paying it off. Thus when the price of assets owned by banks declines banks sell those assets. This creates a downward sloping supply curve for the assets which can make multiple equilibria possible with one in which the capital controls are binding and prices are low and one in which they are not binding and the asset prices are high. The first equilibrium is Pareto inferior to the second and we seem to be in it.

So what is to be done ? I don’t think that eliminating capital controls or making them depend on made up prices is a solution. They were introduced because the same thing can happen at assets minus debt equals zero and then bankruptcy. A purpose of capital controls is to allow regulators to seize banks when the cost of liquidating them is still small. Notably investment banks have capital requirements on the REPO accounts of their clients (typically 2% I think but the investment bank knows what’s happening even before the client does). You’d have to be an idiot not to.

I think the problem is that banks decided to go close to the limit ignoring the risk in new instruments. Basically, I see a problem with allowing a bank to get as close to a line that it must not cross or it might be seized and liquidated while the CEO is in an airplane (al la WaMu even though that was triggered by liquidity requirements not capital requirements).

So I think there should be multiple levels of punishment for bad capital ratios. At a ratio of notionally 8% the bank can be seized. But if the ratio falls below 10% during a year no dividends or bonuses can be paid that year. This is painful enough that banks will try to stay well above 10% but they won’t go into a liquidation vicious cycle if they hit 10%.

The idea of no bonuses is that the dollar value of all payment for services under contingent contracts must be equal to the lowest possible value which means for example, if people are paid in shares or options they get $0 worth of shares or options.

The idea is a punishment so bad that bankers will act so as to make the subjective probability negligible (which we now know corresponds to an objective probability way higher than we should accept) but not so horrible that they will drive the bank bankrupt if they touch the line.

Maybe no bonuses is enough that the bankers will just blow up the bank in rage. If this is a concern a 70% tax on bonuses would probably work fine.

update: Hilzoy has an excellent discussion of the issues and (minds think a like) concludes that, if there is to be reform, there should be reform of capital requirements not accounting standards. She is a bit casual about relaxing capital requirements given what happened the last time that was done (2004 for institutions called “investment banks” which now don’t exist).

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What Is to be done ?

Robert Waldmann

OK what now ? Unless someone has just submitted a post, AngryBear doesn’t have a post on what to do now that the House Republicans (and some Democrats) have voted down the Paulson-Dodd-Frank bailout bill.

The contingent consensus of the Left Blogosphere seems to have been to go for the Swedish solution if the Paulson solution is rejected — that is nationalize banks with inadequate capital. I think this is still politically impossible. Even if the Democrats go alone and Bush is afraid to veto, the blue dogs will be blue dogs.

I think 2 complementary and more moderate proposals might pass over Republican objections and save the financial system. They are, of course, exactly what I have already proposed here and here.

First preferred shares. Economists of all ideologies agree that what the banks need to do now is increase their equity by selling shares. No one much wants to buy so if they sold a lot the shares would be very cheap. I think a bill which allows banks to sell a lot of preferred shares to the Treasury and makes sure that the Treasury will lose money only if the bank goes bankrupt might make enough sense to people who aren’t even me, that it would be a political winner. See the old post for details.

I add one clause — a contingent surtax on the rich. Withold an extra 10% of income over $1,000,000 and, each year, return the part that wasn’t needed to cover losses in the Buffet X 100 plan (plus the chained 3 month t-bill interest rate). This is very much in the interests of the rich as they will get their money back and the financial system will be saved. The under a million crowd will be protected.

Also squabbling over exactly what to do with the profits that the Treasury will make might convince people that there will be profits (I think there will be if the purchase is at share prices as of today September 30).

The other is Toxic Sludge Inc. This is a mandatory program in which the Treasury contributes 0 dollars (sky divers holding hands and thinking they are pulling each other up in Drum’s words but it might help). The proposal would be to require all owners of mortgage based assets to contribute those assets to the new entity in exchange for shares proportional to the current market value of the assets.

The point is that it is easier to price the whole pool of toxic waste than each droplet so the shares of toxic waste Inc will be traded and, I hope, for a reasonable price. Also Toxic Sludge Inc will be able to reassemble whole mortgages and authorize mortgage initiators to re-negotiate if it is more profitable than foreclosure.

I think these ideas might be popular enough (both have guarantees that they cost most people nothing and don’t add to the deficit long term) that the Democrats can afford politically to pass them over Republican objections.

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How did Lehman manage that ?

Robert Waldmann

A commenter over at naked capitalism notes that

$110b of senior LEH debt went from trading .95 to .12 in a matter of days …. If you include the less senior debt that is trading at essentially zero, LEH had $110b hole in its balance sheet. And just days before this, the market was being told and was believing that the $10b disposition of Neuberger was going to solve their funding problems.

Now is there a precedent in this history of bankruptcy–excluding cases of accounting fraud–where bonds collapsed like this once a bankruptcy court opened up the books? I’m thinking the answer is ‘no.’ Which then makes you re-evaluate the premise that there wasn’t fraud at LEH in marking the value of their assets.

Now I may be crazy, but I think that the idea that accounting fraud is required to achieve this is old fashioned and out of date. I think it can be achieved without breaking the laws, such as they are.

Lehman could have made their senior debt worth 12 cents on a dollar in case of default by selling CD insurance on their own debt — lots of it. This would not require any false accounting as they are not required to report this fact.

Now I would be reluctant to believe that a bank could insure its own debt if it hadn’t already happened .

The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.

Who would buy a CDS on Lehman from Lehman ? Only a fool ? Well I have another candidate — someone who had bought lots of cash settlement CDSs on Lehman debt from a third party. The payout on a CDS depends on par value minus settlement value. A huge amount of Lehman insurance of Lehman is not very useful to someone who wants to hedge, but it is very useful for someone who wants Lehmen to settle for as few cents on the dollar as possible because, he or she has bought Lehman CDSs from a third party.

Now to Lehman, insuring their own debt is a very very attractive proposition. It is money for nothing unless they go bankrupt and if they are bankrupt well they are bankrupt. The whole source of moral hazard and adverse selection in credit markets is that it doesn’t matter to the debtor how much he goes below zero.

A positive price for Lehman insurance of Lehman makes sense (algebra will be after the jump when I type it up). There was money to be made at the expense of holders of Lehman debt who didn’t think of the possibility of over-insurance.

Is this what happened ? I have no idea, but I guess we will find out fairly soon.

update: My claim about reporting requirements has been contested. I should stress *again* that I am not an expert and add that I know jack about accounting standards.
I have learned a lot from comments here and at crooked timber. I reply at tiresome length in comments at crooked timber and at my home blog.

As far as I can tell firms must report the total fair market value of CDS written as liabilities, but this is not what matters to bond holders. To them liabilities matter only to the extent that they cause bankruptcy and/or affect the value of liabilities or assets in case of bankruptcy. Knowing the expected value of a liability which is worth zero the 99.9 % of the time in which bond holders just get interest and principal and a whole lot the 0.1% of the time in which Lehman brothers is liquidated is of little use to bondholders. Also, as John Quiggin notes, accounts are not published continuously and our latest information on Lehman Brothers appears to date from May 31 2008 which was a while ago.

First a CDS on LEH issued by LEH is definitely not worthless. It can’t possible pay out as described in the terms of the contract, because it only pays when Lehman defaults, but it can pay its stated value times the cents on a dollar payout ratio found by a bankruptcy court. Even in the case of LEH,this will be positive.

Now algebra. I will assume all debt is equally senior. The par value of LEH debt is 1 (for simplicity). They go under with assets equal to y (which must be less than 1 for them to be bankrupt). the payout ratio phi is equal to assets over total liabilities. However the liabilities are not just debt. They include self CD insurance for x units of par which, in theory shold pay x(1-phi). Actual payment on the CDSs is .

phi is given by
1) phi = y/(1+x(1-phi))

Note that phi is not zero, so the CDS has positive value — you don’t have to be crazy to buy it.

This gives a quadratic equation with one solution to phi between 0 and 1

2) phi = (1+x – ((1+x)^2-4yx)^0.5)/(2x)

phi is definitely real and positive. 2 can be rearranged to

3) phi = (1+x – ((1-x)^2+4(1-y)x)^0.5)/(2x)

And y
taking a first order approximation alpha is approximately equal to

4) phi is roughly equal to y/(1+x)

Which is positive.

So total payouts on CDSs are

5) x(1-phi)phi= xy(1+x-y)/(1+x)^2

And the ratio of the payout to the face value is

6) payout/x = y(1+x-y)/(1+x)^2

oh this is odd. take the derivative of the payout/x with respect to x

7 d(payout/x)/dx = y[(1+x)^2-2(1+x)(1+x-y)]/(1+x)^4 = y(2y-1-x)/(1+x)^3

So the payout per unit of self CDS increases in units of self CDS outstanding until the number of units, x is equal to 2y-1. For LEH senior debt, imagine the accounts were accurate (as far as they were supposed to go) and y = 0.95, the value of LEH self insurance would increase in LEH self insurance outstanding until the amount was equal to 90% of total LEH senior debt. That seems to me to be an unstable market.

Now how high would it have to go before it stops making sense to buy CDS from LEH ?

Well that depends on the price doesn’t it. If normal investors like Janet Tavakoli won’t touch it, the price could be very low, say one tenth as much as third party insurance. That would make it optimal to a price taker so long as alpha is greater than 0.1. Obviously I chose 0.1 out of my hat, because it is close to current market estimated phi of 0.12.

Could this have happened ? I don’t see why not. As far as I know it was all legal and profitable to both parties in the contract.

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Financial Arsonists ?

Robert Waldmann

Many people are using the term “arsonists” as a loose metaphor for people who share the blame for the current financial crisis. They aren’t suggesting that anyone actually wanted a financial crisis. Cocking my tinfoil hat I will note that it is entirely possible that someone has been making out like a bandit — and might even be one (as far as I know almost legally). I stress as I have in these posts that I am ignorant and might be totally confused.

I remember when arson was a big profit center in New York. Many buildings in crime ridden neighborhoods were grossly over-insured, so, in case of fire, the owners received much more than the value of the building. Oddly there were many many fires.
The burning of New York was brought under control when the over-insurance was eliminated.

Currently, credit is a bit over insured. The amount to be paid if all insured debtors default is over $ 50,000,000,000,000 which is much greater than the total face value of insured credit.

Now the most likely explanation for this is that credit default swaps are an unregulated form of gambling which appeals to arrogant people who are convinced that they can beat the market — that they are side bets by people with different optinions on the probability of default or, more likely, future assessments of the probability of default.

However, over-insuring against risk can be very profitable.

Consider the partners of a partnership Bandit, Arsonist and Thief. What if they buy 2 dollars of credit default insurance on their bonds for every dollar of equity (note no regulation no disclosure requirements) then enter chapter 11 ? They make out like bandits. Now entering chapter 11 for no good reason creates suspicion, but, if you want to go bankrupt there are always people eager to help.

Or how about an evil banker who buys credit default insurance on a client firm having some difficulties then calls its loans and shuts off lines of credit ? I’d say there are a fair number of bankers who can force a fair number of firms to default.

Finally best of all, how about Bandit, Arsonist and Theif’s banker ? Working together they can create a cash flow problem, a chapter 11 filing, a big payout and a workout so Bandit Arsonist and Thief keep their firm and make out like bandits.

Unregulated insurance is a license to steal.

Does this explain the odd behavior of Bernanke Paulson and the Big Bad bankers ? Bernanke and Paulson have been arguing that they have to entice banks into agreeing to a bailout. Huh ? Could it be that the banks in question have bought so much credit default over-insurance that if one of them fails the total capital of all of them increases, because the disruption would be less than the value of over-insurance ? Or how about officers of the banks whose wealth is in blind trusts ?

Now a lot of these credit default policies will never be paid up, because the insurer will be bankrupt, but a lot will be and there is no limit (of which I know) on how much banks and their officers can legally buy and they can afford a huge amount.

Recall Ben and Hank have opened an $85,000,000,000 credit facility for AIG. Is it possible that, in the absence of the bailout, all of that money will go to owners of AIG credit default swaps ? Can the US Federal Government really put a subsidiary into chapter 11 ? If that is inconceivable the logic would be “better to pay 700 billion for stuff worth 650 billion than $85 billion for nothing.”

update: I am trying to follow the White House meeting bailout circus. It is obvious that McCain and the House Republicans kicked over the negotiating table proposing a magic free lunch plan at the last minute so they can vote no on an unpopular bailout and claim they could have saved the financial system a not cost. It is clear that McCain is an unpatriotic totally selfish reckless egomaniac. In fact, I doubt that Paulson is used to dealing with such a totally selfish reckless egomaniac given his background as an investment banker (and I never expected to write that).

However, it took me a while to figure out just how flaky the House Republican pony plan is. Of course they want to cut the capital gains tax and deregulated more (I think they didn’t put in drilling in ANWR or threatening to bomb Iran). However their main idea is that what the US financial system needs is *more* credit default insurance, since $ 50 trillion isn’t enough !!!

On Thursday, a small group of conservative House Republicans — including Texas’ Jeb Hensarling and Virginia’s Eric Cantor — offered their own alternative to the Bush proposal. Focused on mortgage insurance, the one-page alternative plan was presented to reporters at a briefing.

The plan calls for the U.S. government to offer insurance coverage for the roughly half of all mortgage-backed securities that it does not already insure. The Treasury Department would charge premiums to holders of the securities, under the plan.

OK now explain to me how that would have saved AIG ?ù

I don’t know if financial arsonists are a significant factor in the crisis, I don’t even *know* that any exist. However, there is no doubt that political arsonists are a huge problem.

update II: Look I’m ignorant. I don’t know anything about new financial instruments. However, I can’t manage to find any reason to doubt that the House Republicans’ plan would destroy the US financial system. If all mortgage backed securities are insured by the US government, which will not go bankrupt any time soon, many many agents will be over-insured so that they would benefit from defaults and some will be in a position to cause defaults. They will have to cause huge transfers among private agents and huge financial distress costs in order to get their public money and that won’t stop all of them.

Also, as with buying assets, the problem is the price, in this case the premium. If it is vastly less than the probability of default, the House Republicans have found a way to throw money at bankers and financial arsonists instead of just bankers. If it is actuarily fair, it will force liquidity constrained firms to unload the securities — they could wait and hope for no default, but they can’t pay actuarily fair premiums. When you are insolvent, risk, variance, double or nothing is your only hope of survival. Thus aside from the contribution to financial arson (which I guess will be huge) the plan would also force distressed banks etc to unload mortgage backed securities at fire-sale prices. Now I don’t think the current problem is mainly due to systemic margin calls due to mark to market and capital requirements, but making that problem vastly worse would hasten the collapse of the US financial system even without financial arson.

Vladimir Lenin is kicking himself in his grave for not thinking of such a simple way to destroy capitalism.

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If Warren Buffett can do that why can’t we X 100 ?

Robert Waldmann’s Pony Plan.

This plan is modeled on Buffett’s deal with Goldman Sachs. It is also based on arguments by Doug Elmendorf and Luigi Zingales. I may show how good ideas from smart people can be sliced and diced to make toxic foolishness.

One reason the deal had an impact is that it was a signal that Buffett thinks that Goldman Sachs was, at most, $ 5 billion in new capital short of sound. The remaining banks in trouble are less sound (I assume Buffett knows what he is doing) and those who participate in my plan will be the least sound banks.

That said, I think that a lot can be accomplished by issuing new preferred shares to the Treasury.

I’d say the deal is
1) banks can issue preferred shares to the Treasury worth up to 1% of their total assets.
2) These shares pay a 10% annual dividend.
3) the Treasury gets an equal number of warrants to buy common stock at its price as of when the bill passes.
3) At any time t, the bank can buy back any or all of the preferred shares for the original price plus interest equal to 2% per year plus the linearly interpolated average of the treasury bills issued when this bill passes and maturing just before and just after t
4) While any of the preferred shares are outstanding, for each employee, consultant or person who provides any service for pay, the bank must transfer to the treasury the greater of $0 and half of the difference between that person’s total compensation and $ 400,000.

Why would this work? The new equity would improve banks’ capital ratios. Given the law as it is and should be, capital is assets minus debts and equity doesn’t enter.
The risks to the Treasury are 1) that the bank will fail and 2) that it will never pay dividends so the preferred shares are worthless.

Probably, few banks would pay the huge dividend, therefore they would not be allowed to pay dividends on common stock. The 10% dividend is a price the bank has to pay to the treasury for the privilege of paying dividends on common stock. Even the most impatient shareholder must understand that it would be better to buy back the preferred stock first. Thus, while wholly voluntary and using a standard instrument (preferred stock) the plan would discourage banks from paying dividends causing them to build up capital.

Clause 4 is not populist vengeance. My guess is that even investment bankers trust each other enough to keep track of unofficially assigned bonuses, so that when they are finally free of the preferred shares, they will get bonuses based on performance during the period clause 4 applies. This has the effect of making officers of banks loan money to the bank when the bank really needs money. It also penalizes them for not repurchasing the preferred shares. In particular, informal promises to pay are attractive to corporate predators who profit by violating implicit contracts. The combination of no dividends on common shares and implicit debts to managers would make the banks very attractive takeover targets. This would create an incentive to buy back the preferred shares.

The 2% extra interest which must be paid no matter who is secretary of the treasury is partly to cover the losses from banks that fail and partly to get all that the market will bear for the Treasury.

The phrase Pony Plan TM belongs to Atrios. Illustration after the jump.

Photobucket

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