Relevant and even prescient commentary on news, politics and the economy.

Markets are "natural" …financial intermediation

Lifted from the comments from an Ezra Klein article in the Washington Post comes an interesting idea that is not only currently debated, but also ties into ‘markets are “natural” idea’…

Paul Andrews comments:
Yes – lots of saving and borrowing, often in goods rather than money. When money is included its often only a fiat monetary base exchanged by the government for goods, with no banking sector and therefore no deposits created by lending, no M1, M2, M3. No shadow banking sector etc.

Refer to this BIS summary on fiscal dominance from December 2011

A quote: “Starting with financial intermediation, recall that banks play no role whatsoever in macroeconomic models of the pre-crisis era. These traditional models are based on the distinction between nominal and real quantities, and there are interest rates. But the only friction is the one associated with nominal price changes, so inflation and inflation control become the focus. (If it is costly to change prices, inflation creates a deadweight loss.) And, since the model is devoid of banks, there is no private debt. As I suggested at the beginning, the macroeconomic models of the future, with their added focus on financial linkages, need to have a rationale for debt as distinct from equity.

We need to understand why the predominant financial contract is a loan or a bond rather than equity. In fact, we need a clear understanding of the optimal debt/equity ratio for the economy as a whole. We know that high levels of debt can lead to disaster for a society, but beyond notions from crude empirical work, we don’t have any idea what the right level of debt is. A rich enough macro/monetary/financial model will tell us the answer.”

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The assumption that markets are ‘natural’

by Brenda Rosser
re-posted from Econospeak with permission from the author

The assumption that markets are ‘natural’

I’ve just begun to browse the pages of David Graeber’s  2011 book entitled ‘Debt – The First 5,000 Years’.  Graeber is an anthropologist who makes no bones about the historical errors made by many economists on the evolution of markets and the use and nature of money.
On pages 44-45 Graeber writes:
“People continue to argue about whether an unfettered free market really will produced the results that [Adam] Smith said it would; but no one questions whether “the market” naturally exists….we simply assume that when valuable objects do change hands, it will normally be because two individuals have both decided they would gain a material advantage by swapping them.  One interesting corollary is that, as a result, economists have come to see the very question of the presence or absence of money as not especially important, since money is just a commodity, chosen to facilitate exchange, and which we use to measure the value of other commodities.  Otherwise it has no special qualities.
“….Call this the final apotheosis of economics as common sense.  Money is unimportant.  Economies – “real economies” – are really vast barter systems.  The problem is that history shows that without money, such vast barter systems do not occur….It’s money that had made it possible for us to imagine ourselves in the way economists encourage us to do:  as a collection of individuals and nations whose main business is swapping things.  It’s also clear that the mere existence of money, in itself, is not enough to allow us to see the world this way. …
“The missing element is in fact…the role of government policy…”

Graeber goes on to explain how government foster ‘the market’.  Laws, police, monetary policy, pegging the value of currency to precious metals, altering the amount of coins in circulation, regulating banks etc.
On page 49 Graeber asks a key question: “…what exactly was the point of extracting the gold, stamping one’s picture on it, causing it to circulate among one’s subjects – and then demanding that those same subjects give it back again?”
“This does seem a bit of a puzzle.  But if money and markets do not emerge spontaneously, it actually makes perfect sense.  Because this is the simplest and most efficient way to bring markets into being.”
Money brings markets into being.  Not the other way around, as most economists would have it.  If this is true then Graeber’s concluding thought has some authenticity:  “Perhaps the world really does owe you a living.”

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Default Events, Legal Contracts, Derivatives, and Greece

Barry Ritholtz, who generally knows better, blew a gasket at ISDA for yesterday’s ruling that Greek bonds are not yet in default. Specifically,

“The International Swaps and Derivatives Association said on Thursday that based on current evidence the Greek bailout would not prompt payments on the credit default swaps.”


Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called derivatives?

The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.

Let’s sidebar the reality—that there is no true “market” for CDS in general, let alone Sovereign Debt CDS; Donald R. van Deventer of Kamakura Corporation has been all over this, both on his blog and especially on Twitter—and just note that ISDA made the correct decision.

Greece has not, to borrow Barry’s phrase, “refus[ed] to make good on their obligations in full or on time.” ISDA did not declare a Default Event yesterday because there has not yet been a Default Event.

Default Event is a very specific term. The sample in Janet Tavakoli‘s Credit Derivatives and Synthetic Structures (a book to which I have referred before and undoubtedly will again) runs pretty much three full pages (pp. 88-91). But the general concept is straightforward: there is a minimum threshold (say, 10% of an issue), the principal or interest due of which the entity explicitly refuses to pay or fails to pay that then materially impacts the buyer of Credit Protection (CDS).

Greece has not yet refused to pay anything.*

There is a payment due on 20 March—19 days still in the future. The financial markets—heck, everyone who runs a diner in Queens—may well believe that no payment will be made on 20 March, but that hasn’t happened yet. And the Greek government specifically has not said it won’t make the payment; it has said, “Hey, take these bonds instead.”

It is true that, cet. par., the market value of the bonds being offered is about 25% the supposed economic value of the current ones. So anyone taking the deal would have to be assuming that the market value of the current bonds is somewhere around 25, just as the French and German banks have them marked.

The market may also agree that one of the reasons people may well accept the offer is that, otherwise, they expect that the Greeks will default on the current bonds.

But they haven’t yet, and this is not Minority Report (though we can all agree Phil Dick would recognize, if not approve of, the current financial world).

So ISDA correctly ruled—the key phrase is “based on current evidence”—that there is not yet a Default Event. If everyone says “we will tender our securities due 20 March for the exchange offered,” there will not be a default of those bonds.

You, I, and Bill Gross can all agree that the likelihood of this happening is about equal to the chance that Rick Perry will be elected U.S. President this year. But there has not been a Default Event.

Wait two or three weeks.

The thing Barry most overlooks is that yesterday’s ISDA ruling is, if anything, good for CDS buyers.

What will be the economic difference of waiting to holders of the CDSes? I don’t know for certain, but if you’re looking at the standard ISDA CDS contract, there’s a reasonable assumption that (1) the market price of the bond will not change for the better and (2) it is a certainty that the Accrued Interest on the bond will be greater when they declare a Default Event than it is now.

Keep in mind: in a standard CDS, declaration of default terminates the contract. Accruals end, market pricing is to be determined by calling a few dealers, and the only thing left is to go through the pockets and look for loose change.**

Yesterday’s ISDA ruling means the CDS buyers will be owed more Accrued Interest when (in two, or at most three, weeks) a Default Event is declared.

What about the principal repayment due? Recall again that the payment due is generally the net of the current market price subtracted from the initial principal amount (assumed to be par—100—but in any event greater than the current market value).

I’m inclined to argue there is optimism in the current market that will not be there in two weeks: it’s not that liquid a market, there is a floor on the price of the economic equivalent of the new offer, and there is time value in the option to convert.***

If ISDA had declared default yesterday—that is, assumed that Greece wasn’t just “mostly dead”****—they would have taken the current market price [P0]. Even before the delays and roundelays, that was likely to be greater than the market price of those bonds in a week or two[P1, when default is declared.

That is, P0 is greater than P1. And since the payment due is based on [100*****-Pt], the principal amount due to CDS holders when default is declared will also be greater.

ISDA followed the letter of the contract: the Greeks have not yet defaulted on an obligation, nor have they stated that they intend to do so. When they do—there are few, if any, in the market who would treat the clause as a possible “If”—a Default Event will be declared and the CDS contracts will be expected to pay as they are due. And that payment will, in all likelihood, be higher than the payment that would have been due if ISDA had ruled differently yesterday.

And if they don’t, then I’ll be agreeing with Barry that the whole thing was a scam from the start—though I would still argue that JPMorganChaseBear stealing more than $1,000,000,000 in customer funds from MF Global clients is a bigger one, which is something like saying that coprophagia is even worse in liquid form.

When the CDS contracts actually have to be paid, then the fun will begin. If potential for insolvency is your idea of fun. But that’s another story.

*They have seen S&P downgrade their credit rating, but that’s a separate issue.

**Obligatory reference. It will pay off.

***The Worst Case scenario is that you assume the new bonds are the only value in the transaction, and discount their value back over the cost of basically two-week money. The best case scenario is some combination of the price of the new bonds and expectations of either getting a better deal later and/or post-litigation gains. The lattice may be ugly, but it yields an expected value higher than the Worst Case, and therefore higher than the market price of the bonds as the time to exercise approaches.

****See ** above.

*****Or the other initial contract price; in any case, a fixed value greater than Pt.

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If You Believe the Market Reacts to Information

The bad news of the day is that about $5B ($5,000,000,000) more than previously believed went to buy goods made in China, Japan, non-major South and Central American countries, and other places outside the U.S. Per the Vampire Squid (tm Matt Taibbi), this should cause a revision to Q2 US GDP from 1.3% to 0.9%.

The good news of the day is that weekly unemployment claims were “only” 395,000. (Let’s ignore the detail that last week was originally reported as 398K—breaking the streak—but is now 402K.)

The net result, at least as of 2:00pm is that the major equity indices are up by at least 3.80% (DJIA). The early articles claim that was because of the “good” news.

And the scary thing is, they’re correct. In the 193 weeks since the recession started,* there have only been 39 where initial claims were below 395,000, and two (including the current, possibly-to-be-revised week) that were at that level.

But, especially as none of Harry Reid’s appointees to The Grand Ripoff appear to believe that Jobs would do more good for balancing the budget than the Super Commission, it appears that three-quarters of that August body will be working solely on the numerator, not the denominator, of the Debt/GDP ratio.

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Ratings QOTD

From Crash of the Titans, pp. 33-34:

The largest chunks of these [created by Merrill in the winter of 2006-2007] CDOs still carried triple-A ratings, at least in name, because the credit rating agencies hadn’t bothered to recalibrate their antiquated ratings models. But almost no one was willing to buy the triple-A portion of these bonds from Merrill because the rest of the marketplace knew what the credit rating agencies and [Osman] Semerci [then Head of Merrill’s FICC area] didn’t know: that the entire world of mortgages had turned into radioactive waste. [UPDATE: emphasis mine]

Two quick reactions:

  1. Sh*t, I knew that by late January of 2007, and I wasn’t being paid to know it.
  2. Note that this paragraph actually highlights an implicit disagreement that Robert and I have been arguing through on this blog for the past few years: whether ratings are a signal or the primary signal that investors use. Or, as Andrew Samwick—yes, this is my day for agreeing with conservatives (though not libertarians) on root-cause analysis—points out:

    I don’t think potential investors in U.S. Treasuries relied too much on its previous AAA rating in actively valuing the bonds and bills. And even if they did, they should be only minimally bothered by its current AA+ rating. Potential investors have plenty of public information on current and projected cash flows of the U.S. government. In those circumstances, there is little value added by a ratings agency’s grade.

When the market disagrees with the ratings, the ratings lose. So what has been happening today in the post-S&P bond market?

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Is the House Trying to Encourage Criminal Activity?

I left out of the last post why David Vitter (claims) he is blocking the two SEC nominees:

Sen. David Vitter (R., La.) will block two nominees to the Securities and Exchange Commission until the agency announces whether victims of R. Allen Stanford’s alleged Ponzi scheme are owed compensation from the Securities Investor Protection Corp….

“We’ve known for some time that the SEC waited far too long to take action against Allen Stanford, and now they’re dragging their feet in responding to the victims. I will continue to hold them accountable—including holding these nominations—until these fraud victims get an up-or-down answer from the SEC,” Mr. Vitter said in a statement.

Well, economics can help him here. Even old economics, such as the pieces cited by Casey Mulligan in a disingenuous piece he wrote for the NYT last week. (No NYT link from this non-subscriber. I believe the NBER pieces are ungated, but haven’t checked from a network without access.) As the Stigler piece notes, optimal spending should be based on your expectation of catching criminal activity.*

So I expect that David Vitter is up in arms about what his colleagues in the House are doing:

The Republican-led House of Representatives is poised to pass, as early as Wednesday, a sweeping spending bill that would slash funding for the regulatory agency responsible for policing against excessive speculation and price manipulation in oil markets.

This rather understates the CFTC’s purvey. As their website notes:

Congress created the Commodity Futures Trading Commission (CFTC) in 1974 as an independent agency with the mandate to regulate commodity futures and option markets in the United States. The agency’s mandate has been renewed and expanded several times since then, most recently by the Commodity Futures Modernization Act of 2000….

[T]he futures industry has become increasingly varied over time and today encompasses a vast array of highly complex financial futures contracts.

Today, the CFTC assures the economic utility of the futures markets by encouraging their competitiveness and efficiency, protecting market participants against fraud, manipulation, and abusive trading practices, and by ensuring the financial integrity of the clearing process. Through effective oversight, the CFTC enables the futures markets to serve the important function of providing a means for price discovery and offsetting price risk. [emphasis mine]

That’s right; the CFTC is responsible for regulating derivative trading activity. Which is why…

The Obama administration requested more than $300 million for the fiscal year that ends on Sept. 30, a steep increase because the CFTC gained sweeping new powers under last year’s broad revamp of financial regulation—short-handed as the Dodd-Frank Act.

This is pure Stigler. More responsibility, higher expectation of detecting malfeasance, higher budget necessary for optimal crime enforcement. Otherwise, you end up more criminal activity going undetected as the risk of being caught is reduced.**

So what is the House doing?

The House bill would provide $171.9 million for the agency, a decrease of about $30 million from the $202.2 million given to the agency the prior year.

With the duties expanded by around 50%, the budget gets cut by 15%. Within the Stigler framework, we should expect (without any multiplier effect***) that it will be 43% less likely that any given criminal activity that falls under the CFTC’s jurisdiction will be detected and prosecuted.

The House wants to make the Stanford Ponzi scheme, or something similar, more likely to occur. Will David Vitter be decrying this, even as he blocks nominees?

*That this concept is outdated at best is subject for a future post, but it’s a fine baseline assumption.

**As I said, it’s a simplified model, but functional if one assumes continuities.

***Short version: this is where the model needs to be revised. The incentives to commit crimes are greater (detection less likely). That Mulligan could find no better cite than these works as the defence of his idiocy (as noted, no NYT link from me) is damning.

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Liquidity, Markets, and Pricing: A Contemporary Example

A lot of trading in the Fixed Income (and especially FX) market is done for “liquidity” purposes. There is often an underlying goal involved (e.g., push prices higher with small lots, sell large ones at the elevated prices) and frequently such strategies are discussed as “algorithmic trading.” (Example: the algorithm estimates that you will need to buy 5 $100MM lots of JPY at incrementally higher rates to be able to sell $1B USD at the higher JPY level.)

The liquidity of the “markets” is facilitated by algorithmic trading: the seller for the first five trades in the above example doesn’t care about the purpose of the counterparty’s trade, just that the price bid is agreeable.

Then there are the times when algorithmic pricing goes terribly wrong:

Eisen began to keep track of the prices until he caught on to what was happening: The two sellers of that particular book — bordeebook and profnath — were adjusting their product prices algorithmically based on competitors:

Once a day profnath set their price to be 0.9983 times bordeebook’s price. The prices would remain close for several hours, until bordeebook “noticed” profnath’s change and elevated their price to 1.270589 times profnath’s higher price. The pattern continued perfectly for the next week.

The biologist continued to watch the prices grow higher and higher until they hit a peak price of $23,698,655.93 on April 19. On that day “profnath’s price dropped to $106.23, and bordeebook soon followed suit to the predictable $106.23 * 1.27059 = $134.97.” This means that someone must’ve noticed what was happening and manually adjusted the prices. [italics mine]

As a mathematical exercise, the shift from $106.23 to $23,000,000 and change is clear: one dealer must price their copy higher than the other dealer. (If both do so, you get to the same point or higher even quicker.) Similarly, if both dealers price at a fraction below 1.000 of the other, the price will converge toward $0.00 as the algorithm progresses.

Consider the implication for a potential third seller, though. Depending on when they check, they may believe they have a book that will make them (if and when sold) rich. But the “market” they see is two computers offering against each other—there is no bid-side shown, and pricing “to sell” (say, $850K when both of the others are offered at around $1.7MM) implies that the third potential seller is carrying that asset at an inflated value.

Market transactions do not require two entities to like each other, or even to understand what the other is trying to do. Indeed, if your alogirthm is buying at 85.3 JPY/USD and mine is selling at that level, neither of us necessarily cares why the other is transacting. And the rest of the market sees an actual trade against which they can adjust their pricing.

It’s only when the algorithms are trying to do the same thing that $23MM+ books are offered.

The implication for mark-to-market valuation seems obvious, and is left as an exercise to the reader.

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Thought-Experiment of the Day (6 April 2011)

I want to open a pizza place. I find an available space; a previous pizza place that went out of business. The only catch is that there are four other pizza places nearby, none of which is overcrowded, except at the peak of peak hours.

One–a block or two away, on another street–is the oldest and best: table service, other dishes, liquor license. The other three–two across the street, one up the block–all offer traditional and Sicilian slices and fountain and bottled sodas.

My store will offer regular and Sicilian slices, with fountain and bottled sodas.

When I use up all my capital and go out of business, is there any rational observer who would describe that as a “failure of the market”?

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Market Failure Cannot Be Resolved Without Regulation

Matthew Richardson, a professor at NYU Stern School of Business, offers his thoughts on risk management and the economy.

Market Failure Cannot Be Resolved Without Regulation

Matthew Richardson on November 23, 2010, 12:00 AM

I am all for free markets and not mucking them up with government intervention. But the economic theory of regulation tells us that if there is a market failure, it cannot be resolved privately. The public sector must get involved.

The most illustrative examples of such failures in U.S. financial markets were the frequent financial panics from the 1850s until the Great Depression. Those episodes taught us that when illiquid, asset holdings (e.g., loans) of the financial sector are financed short-term (e.g., by deposits), and are hit by a severe macroeconomic downturn, failures of financial firms can lead to system-wide runs on deposits. This in turn leads to a massive disruption of the system that provides credit to households and corporations. When economists bandy about the term systemic risk, this is the type of event they are referring to.

The market failure here is that, although each financial institution may have been behaving optimally on an individual basis, the firm had no incentive to take into account the effect of their actions on the system as a whole. In economics, we call this a negative externality and it is analogous to an industrial firm causing pollution. In the example above, financial failure of one bank increased the possibility of runs on other banks, leading to the system-wide collapse.

The government regulation to address the market failure in this case was to insure retail depositors against losses (today’s FDIC guarantee), thus stopping the cycle of bank runs. Of course, these government guarantees came at great cost, not least the resulting moral hazard. So the government had to enact offsetting regulation and charge banks premiums for deposit insurance, restrict them from certain risky activities, and subject them to prompt corrective action.

This served financial markets well for over a half century. As time passed, however, the regulation became antiquated. Over the last two decades, deposit premiums became mispriced, some financial firms like Fannie Mae and Freddie Mac grew so large that they became too-big-to-fail, and shadow banks—banks such as off-balance sheet vehicles, money market funds, and investment banks that operate outside of the system—proliferated, performing bank-like functions albeit with little or no regulation. In fact, in this financial crisis, we faced modern day equivalent runs on most of the shadow banking sector.

One might argue that the government is not capable of effective regulation and makes matters so much worse that it would be better to accept systemic risk and deregulate. But the legislative response to the Great Depression and its success would suggest otherwise.

And in terms of the government’s latest financial reform, the Dodd-Frank Act is clearly well intended by focusing regulation for the first time on systemic risk. Moreover, the legislation plugs some obvious holes in the financial system like off-balance sheet financing, OTC derivatives, rating agencies, and mortgage underwriting, among other areas. That said, the legislation ultimately falls short in both its approach and focus.

After a recent presentation to 170 or so risk management executives on Dodd-Frank, I took a quick poll and the vast majority believed another financial crisis was going to occur within the next ten years. This should not be surprising. The legislation does not charge systemically risky firms upfront for the systemic risk imposed upon others; instead, choosing to penalize surviving firms when a crisis occurs. This creates a free rider problem which will lead to a race to the bottom. Moreover, in terms of moral hazard, the legislation leaves in place mispriced government guarantees, and, with respect to excess leverage, conditions for regulatory arbitrage persist. There is also no attempt to create a level playing field by regulating shadow banks and banks similarly

Nevertheless, while there is little doubt that regulatory failure played an important role in the crisis, the solution should not be to walk away and leave systemic risk in place. I would still take Dodd-Frank over the current system or, more extreme, a world with zero financial regulation and frequent financial panics. But we still have plenty of wood to chop on the regulatory front. This is just the middle innings of a very long game ahead.

Matthew Richardson is a professor of finance at NYU Stern School of Business.

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