Home > Economic policy > The worm in the bud

The worm in the bud

October 6th, 2009

I finally read Gillian Tett’s Fools Gold

, an account of the development of the derivatives industry centered on credit default swaps (CDS) and collateralised deposit obligation (CDOs) that collapsed so spectacularly last year. The discussion is excellent, but still, I think, too charitable to these instruments and their creators. Tett’s main source is the group at JP Morgan who pioneered many of these derivatives and, largely, got out before the crash. Their line, unsurprisingly, is that the problem was not with the concept as they developed, but its abuse by latecomers.

But a close reading of Tett’s account yields a different story. These innovations were defective from day one.

The crucial thing that made all these deals work was the so-called ‘super-senior’ tranche of debt that was supposed to be almost completely immune to failure (until, of course, it failed). This stuff was rated better than AAA, with the result that lots of banks were willing to carry it on their own books, using Enron-like special investment vehicles to skirt the Basel 2 requirements for capital adequacy. The alternative was to find a supposedly risk-free backer, such as an insurance company (AIG) or that contradiction in terms, a “monoline” municipal bond insurer willing to diversify into insuring exotic derivatives (Ambac and MBIA). The JP Morgan crew were never comfortable carrying huge volumes of debt, even allegedly riskless debt on their own books, and that’s why they ultimately left the field to others. But according to Tett, the very first deal that was done involved transferring the super-senior debt to none other than AIG, whose threatened collapse forced the Fed into the trillion dollar bailout of 2008. So, the worm was in the bud – there never was a sound basis for the whole idea.

Another important implication is that, thanks to the massive size and complexity of modern financial markets, fundamentally defective innovations need not be weeded out quickly, and can grow to astronomical size before they are. Bernie Madoff’s Ponzi scheme is a straightforward illustration of this. When it was exposed, quite a few commentators suggested that no one could run a Ponzi on this scale for nearly 20 years, as Madoff did. The alternative explanation, which was shown to be baseless, was that Madoff must have initially run a speculative strategy, turning to a Ponzi only when that ran into difficulties.

This is one instance of a more general point emerging from discussion of the financial crisis. As Felix Salmon observes, the extraordinary profitability of investment bank can most plausibly be explained by the hypothesis that risk is being shifted, without compensation, to someone else. Salmon focuses on the case of ignorant buyers, sold products they don’t understand. But, as Arnold Kling observes, an equally important source of investment banking profits is regulatory arbitrage at the expense of governments, and, ultimately, the public at large.

There are two main ways these problems can be resolved. To protect both ignorant buyers and the public, it would be necessary to regulate investment banks in the same way as other banks, and much more tightly than either was regulated pre-crisis. In particular, the idea of letting Goldman Sachs get the protection of a commercial banking license while operating as an investment bank is an obvious example of the kind of regulatory arbitrage that needs to be stopped. Properly done, regulation of this kind would kill off investment banking of the kind with which we are familiar.

The alternative is to assume that the buyers of investment bank products can look after themselves, and focus on protecting citizens from being made to repeat the bailout disasters of last year. The only way to do this is to reinstitute a much tougher version of Glass-Steagall, raising high barriers to all kinds of transactions (ownership, financing, joint venture) between investment banks and the core financial system guaranteed by government. Something of this kind will have to be done with respect to hedge funds and similar outfits if we are not to have a repeat of LTCM somewhere before long.

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  1. Freelander
    October 6th, 2009 at 10:10 | #1

    I quite agree with this. The idea was defective and the whole scheme operated like a Ponzi scheme by getting the ‘suckers’ to think they were getting a good deal to keep the money rolling in. People buying what they thought were high grade and other bonds at probably slightly higher rates of return, and home buyers buying houses they could never have afforded but in a way that they thought they now could and in conditions in which they thought they could get out of things if things went wrong. The CDSs didn’t offer anything new. The same thing could have been acheived by issuing insurance. The reason CDSs were created was to flout the regulations that would have been encountered if insurance was used. Also, actuaries would have looked at the insurance product and may not have thought that insuring the CDO tranches was such a good idea because of the systemic and systematic risks involved. Because of the ‘good’ deals everyone who ultimately boor the risk thought they were getting, the over-heated housing market, and the rule that that which is unsustainalbe cannot be sustained, it was inevitable that it would collapse. But if you dream up these things and/or get paid commissions, or bonuses on the (anticipated) profits from issuing CDSs, CDOs and the morgages, who cares? The old story of ‘other peoples money’.

  2. Alice
    October 6th, 2009 at 10:50 | #2

    We should never have pursued financial de-regulation to the extent we have globally. To me, that was a monumental mistake and likely enabled and facilitated the sheer speed of the risk shift from these derivatives across the globe. I suppose many financial institutions thought that once the risk had been shifted beyond their jurisictions, they couldnt be called to account anyway..how can we possibly hope to prevent financially fraudulent activities when the laws that govern financial capital are not global. It only says one thing to me…enter these financial markets at your own peril. People need to realise the global sharemarkets have become a Casino. Caveat Emptor.

  3. Ikonoclast
    October 6th, 2009 at 11:07 | #3

    Clearly, the financial system needs to be regulated much more firmly. JQ’s post makes the case as have posts in the past by Ernestine and others on this blog and Steve Keen in his blog. I think this view is also pretty much mainstream by now.

    Just as over-regulation stultifies genuine innovation and real progress so does under-regulation. Under-regulation allows fraudulent schemes and reckless speculation to flourish, leads to bubbles and then on to the inevitable busts. Financial resources go into speculation and asset price bubbles rather than into genuine productive investment.

    Consumers do need to be protected against toxic products. Financially complex products are opaque to the average conusmer and average business person just a tin of baked beans is opaque. The only way to be safe is to have legislated and supervised standards that ensure safe manufacture, safe packing and safe distribution of products. This basic principle applies to financial products as much as to baked beans. Individuals are not set up to test each tin of baked beans for toxicity nor are they set up to test complex financial products for ‘toxicity’. Individuals require social solidarity and government led cooperation for the greater good to maintain governance of these standards.

  4. October 6th, 2009 at 12:09 | #4

    John, do you think that regulation of the type you suggest would have prevented the finance crisis, and then its spillover into teh productive economy? I wonder. Maybe it was a disaster looking to happen. In any event the resurgence on Wall Street and the confidence the financial markets have seems to see us (or more accurately them) repeating the problematic risk taking and gouging of the public and Government with Government sitting on its hands. The fictitious capital of the casino – what to do about it?

  5. Freelander
    October 6th, 2009 at 13:05 | #5

    John, I was just looking at your wiki and had a thought about chapter order. I was thinking that “The Great Moderation” could be Chapter 2. That way, you could use it as a presentation of the idea that at least some economists thought that their version of economics had solved all problems, or at least all problems in macroeconomics (to the extent that they could be solved), but that presumption was abruptly challenged by the GFC. Then the following chapters could deal with some of the zombie ideas that had persisted and had shaped their thinking. I would also move “The Cult of Central Banking” to be chapter 5 and move “Trickle Down” to be Chapter 7. That way the macro themed chapters form the front half and are together and then the privatisation, trickle down tells the story of the hands off, disenfranchising the voting public, and ignore distributional concerns aspects of the Zombie Economics. I think, ordering the chapters this way will provide more opportunity of running a strong narrative through the book which will assist the non-specialist reader.

    Also, with the Great Moderation as chapter 2 and the Irving Fisher quote leading it off, in EMH as chapter 3, where you say

    “Few economists have been successful investors, and quite a few have been disastrous failures. But after a narrow escape from disaster early in his investing career John Maynard Keynes made a fortune for his Cambridge college by speculating in futures markets It is a striking paradox that Keynes was among the most scathing of all economists in his assessment of the role of financial markets.”

    you could mention Irving Fisher, for example, as a disastrous failure who had amassed a fortune thanks to several successful inventions, but lost it, with substantial damage to his professional reputation as an economist, in the great crash.

  6. Freelander
    October 6th, 2009 at 13:23 | #6

    Something that could be worth mentioning in the EMH chapter, following discussion of Black-Scholes is ‘copulas’, the use of which allowed much more complicated ‘innovative’ derivatives to be ‘priced’, or so practictioners thought. This fueled the creation of new exotics. See, for example http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all for a discussion.

  7. Joseph Clark
    October 6th, 2009 at 14:52 | #7

    This point amounts to saying that credit was mispriced. I’m not sure that you can draw any further implications. Nobody ever said super senior tranches never default. I’m not even sure you can say the credit was mispriced. Almost everything is mispriced after the fact because the price changes from the old price to the new price. You could equally say that the Melbourne cup was mispriced because the winner wasn’t paying 1/1 at the gate.

    I have a question. I gather that you would like credit instruments to be heavily regulated or possibly banned. If this happened people could easily create the positions synthetically in which case the regulation/bans would be ineffective. How would you stop people from doing this?

  8. Freelander
    October 6th, 2009 at 15:24 | #8

    @Joseph Clark

    The point is that the new exotics couldn’t even be ‘priced’ at all before a (flawed) method was dreamed up to do so. As for ‘people could easily’, not really, in many cases, expecially with exotics, not so easy at all. Also, in the cases where they could, this would usually be better than the use of derivatives because there are limits on the physical assets available to create the synthetic positions but there are no limits to the writing of derivatives, with the consequent creation of counterparty risk. The real purpose of derivatives is to provide a cheap vehicle for gambling. When you gamble at the casino the government extracts a sizeable tax. If you use derivatives, you get a much better deal.

  9. jquiggin
    October 6th, 2009 at 15:42 | #9

    Joseph, it takes impressive faith in markets to look at the current mess and conclude “I’m not even sure you can say the credit was mispriced.” I doubt there is much point in arguing with you on this.

  10. Ikonoclast
    October 6th, 2009 at 15:59 | #10

    Joseph, I don’t think anyone in this thread has yet argued that credit instruments should be banned. As for “heavily regulated”, I would substitute “firmly regulated”. I think there is a clear difference (for the most part) between credit instruments used for productive investment and credit instruments used for financial speculation with little or no positive effect on the real economy.

    It us not beyond our collective wisdom to draw the regulatory lines along the appropriate boundaries between productive investment and speculative bubble blowing. Indeed Australia did a better job than the US which is why are not in quite the mess they are. That said, we still have a huge housing price bubble.

  11. Joseph Clark
    October 6th, 2009 at 17:59 | #11

    I’m not saying that it wasn’t mispriced. I’m just saying that price changes don’t necessarily imply mispricing.

    As for the point of arguing, I certainly don’t think I’ll convince you of my point of view. But I do feel my views become richer when I am forced to defend them. And occasionally I learn something from the other side :)

  12. Joseph Clark
    October 6th, 2009 at 18:02 | #12

    Also the synthetics argument is a very real problem for regulators. Banning short selling or trying to control leverage directly have the same problem.

  13. Freelander
    October 6th, 2009 at 18:30 | #13

    @Joseph Clark

    When ones view concerns a matter where the view can be either correct or incorrect, true or false, like a view about reality, or a logical or mathematical argument, the real objective ought not to be simply to defend that view, unless you happen to be correct, and have very solid ground to think so, but rather, should first be to examine one’s own and other’s arguments and evidence with the intention of ending up with the correct view.

    Out of interest, how would you (easily) create a synthetic position to short sell a stock if short selling were banned?

  14. Joseph Clark
    October 6th, 2009 at 18:39 | #14

    Shoring is easy. You just have to find someone who holds thing (whatever it is), borrow it from them, and promise to give it back later. Then you sell it at market and buy it back before loan is due. A short is just one side of a forward sale contract. If you agree to buy some corn with a price fixed now and settling next week you are short corn for the week.

    If I want to short a particular stock and nobody wants to lend it to me, or they can’t because of a ban, I can short the entire index (with a future) and buy back all the stocks that I don’t want to short. You can get a pretty effective short by buying up the main stocks in the index against the short future. There are a few other ways but these are the easiest.

  15. Freelander
    October 6th, 2009 at 19:09 | #15

    Come on, although imaginative, that is extremely expensive and has massive transaction costs relative to the banned short selling of the stock. Hence it is impractical and certainly doesn’t show that you “could easily create the positions synthetically in which case the regulation/bans would be ineffective”. In the words of McEnroe “You can not be serious”.

  16. Joseph Clark
    October 6th, 2009 at 19:24 | #16

    It’s not so difficult. Another way it is to sell an in-the-money option on the stock. Come to think of it that’s probably the easiest way.

  17. Joseph Clark
    October 6th, 2009 at 19:25 | #17

    (an in-the-money call)

  18. Joseph Clark
    October 6th, 2009 at 19:40 | #18

    For example if I want to short a stock trading at $100 I sell a call option with a strike price of zero. The option will sell for almost exactly $100. Such a contract is effectively a short futures position on the stock. At expiry I will have to pay whatever the stock is worth. If it is worth $90 I make a $10 profit (plus a bit). If it is worth $10 I make a $90 profit.

    Ideally I sell the option to the guy who is banned from lending the stock to me since he has a natural hedge. The arrangement is equivalent to the banned short sale.

    The moral of the story is trying to regulate things in the financial markets is tricky (sometimes almost impossible) and you can’t do it effectively if you don’t understand the instruments.

  19. Joseph Clark
    October 6th, 2009 at 19:48 | #19

    I’d like to believe that anybody who understood enough to construct that trade would realise that banning short selling is silly and counterproductive. But then again I’m very optimistic about humanity.

  20. Freelander
    October 6th, 2009 at 19:48 | #20

    But if these instruments were banned, would this ‘easy’ option still be available? Also, if the futures market was not available, or required that you actually have the deliverable or a forward contract to buy the deliverable from someone who actually has the deliverable at a point in time at or before the date of future contract, is it still so easy? Likewise if you had to back your selling of a call option by having that stock to back it, would it still be so easy?

  21. Joseph Clark
    October 6th, 2009 at 20:02 | #21

    I’m not sure what you saying. Requiring forward contracts to be completely collateralised would defy the point of a forward market. But then again a short sale is one (necessary) side of a forward contract. Banning the short is the same as banning the forward. A zero strike call is effectively a forward so you would have to ban that too. Is that what you’re suggesting?

  22. Ernestine Gross
    October 6th, 2009 at 20:25 | #22

    Shadow banking:

    I can’t remember who used this term and exactly when during the past 2 years. However, I remember clearly that I did hear it and it occupied my mind as to what it could mean.

    It couldn’t have as straightforward a meaning as the following – or could it?

    For a long time I have argued that risky debt at the time of issue is not debt but equity.

    Setting aside all other problems with risky debt portfolios (eg the condition of continuous time trading), the slicing of portfolios of debt into risk categories amounts to duplicating a ‘debt/equity’ structure – or so the idea might have been. ‘High grade’ slices are ‘debt’, ‘low grade’ slices have the characteristics of pure equity. By selling these slices, the said banks could keep their ‘debt/equity’ ratios looking respectable while institutions outside the formal banking sector where taking on the role of shareholders of highly leveraged banks. Here we are: shadow banking.

    Makes sense to me – what about you, JQ and others?

  23. Joseph Clark
    October 6th, 2009 at 20:33 | #23

    @Ernestine Gross
    Robert Merton would agree with you. As would everyone who hedges CDS with equity.

  24. Alice
    October 6th, 2009 at 20:36 | #24

    Robert Merton – manager in Long Term Capital management. A fine resume?. A mistaken nobel award?.

  25. Joseph Clark
    October 6th, 2009 at 20:37 | #25

    And everyone who calls the junior CDO tranches ‘equity tranches’…

  26. Alice
    October 6th, 2009 at 20:41 | #26

    @Ernestine Gross
    Yes it does make sense to me Ernestine and it would to accountants who are well aware of all the means that corporations utilise to keep up appearances on their balance sheets for their creditors and others (and shift those nasty transactions to some small disclosure only off balance sheet small print)…some methods highly questionable and very much part of the “accounting problem.”
    Since the 1960s many have asked how can companies fail when only the year before they had sound profit and losses and balance sheets. Cashflow can be such a nuisance at times.

  27. October 6th, 2009 at 20:48 | #27

    John, it seems to me that you`re missing an important part of the picture (that Arnold Kling and others point to): namely, the “information problem” that limits the ability of regulators to notice, much less keep fingers in, all of the holes in the dike, along with the federal interventions in banking that have provided the chief moral hazard problems and the chief demand for the products that investment banks sourced.

    BIS and investment standards created for the purpose of limiting the risk that the government put on taxpayers via deposit guarantees instead fuelled demands for products that provided higher returns at than other assets at the same risk-weightings, and for “investment-grade” products – but where the sellers perversely arranged/paid for the rating, instead of buyers. This nonsense is still continuing; even as the FDIC is closing banks right and left, banks about to fail can attract “brokered deposits” from investors chasing higher interest rates than are available at the safer banks (as deposits remain guaranteed), as management gambles for returns that will keep them in office.

    The unregulated buyers of CDOs and CDs should of course be left to suffer the consequences of their own investments; the Fed`s intervention in support of LTCM (and the investments by insured banks and investment banks) simply contributed to the “too big to fail” massive risk shifting that has come home to roost.

    Federal regulators should be reconsidering their fundamental preconceptions, and moving away from trying to micro-manage risks in a futile whack-a-mole enterprise, toward one that places more responsibility for risk analysis on depositors and investors. Otherwise, we will see simply empty promises, and more risk shifted to taxpayers.

    http://mises.org/Community/blogs/tokyotom/search.aspx?q=limited+liability

  28. wjd123
    October 6th, 2009 at 20:54 | #28

    Thank’s John Quiggin for not buying into the financial services’ public relations. If we are ever going to get financial services back on sound footing more articles like yours need to be written.

  29. Freelander
    October 6th, 2009 at 20:56 | #29

    @Joseph Clark

    Bans on short selling are about banning selling what you don’t have and have to borrow from someone else to do so.

    If you have what you promise to deliver at some point in the future, or have another contract which says that you will be delivered some physical at or before that delivery date, exactly how is that forward contract (your promise to deliver) a short in this way? If you are on the other side of the contract, you are buying at some point in the future, how is this a short in this way? That is, in the way that banning short selling is intended to stop? In the words of that famous Australian, “Please explain?”

    @Ernestine Gross

    “risky debt at the time of issue is not [simply] debt but [includes a large component of] equity” True, because if there is default the debt holder is inheriting a claim on the equity and is therefore getting purely equity type returns. As the risky debt gets more and more riskier this is taken into account in a rational model and the debt instrument morphs more and more into equity behaviour.

    This aspect of debt is discussed in the Corporate Finance literature, and I think from memory, in the original Black and Scholes and Robert C Merton papers on option pricing. The trick that was being used, in the recent debacle, to turn junk (risky) debt into better grade debt was the CDSs.

  30. SeanG
    October 6th, 2009 at 21:15 | #30

    Are you guys debating forwards or futures? There are short selling in futures because someone is taking a long position while the other is the short position. I think there might be a communication breakdown here.

  31. SeanG
    October 6th, 2009 at 21:22 | #31

    Sorry, I was meant to say that in forwards there is a short position and that there is short selling in futures because they are standard contracts. Are you two talking about the same thing here?

  32. Ernestine Gross
    October 6th, 2009 at 21:23 | #32

    Alice @25, Yes, there is something called ‘creative accountig’ but it is news to me that slicing a joint probability distribution is part of their skill set.

    Freelander @28, I am familiar with the application of option pricing theory to bankruptcy in corporate finance. But this is not what I had in mind. I had in mind how a shadow banking system could be created by systematically selling pure equity as debt (tax benefits in the USA). CDOs are the driver.

    Joseph Clark, suppose the price of 1kg of apples is $5.– and the price of 1kg of pears is $2.– If someone manages to sell pears under the name of apples would you call this ‘underpricing’? How would you call it?

    Robert Merton is a puzzle to me because I know that Merton knows about the theoretical conditions for trading risky debt portfolios – he did original work in this area. My question to practitioners in Finance and to physicists: Is it possible to have continuous time trading?

  33. Michael of Summer Hill
    October 6th, 2009 at 21:53 | #33

    Ernestine Gross, Paul McCulley is being credited with coming up with the term ‘shadow banking’ but the real credit should go to the original thinkers writing on the shadow economy.

  34. SJ
    October 6th, 2009 at 22:02 | #34

    Ernestine Says:

    I can’t remember who used this term and exactly when during the past 2 years. However, I remember clearly that I did hear it and it occupied my mind as to what it could mean.

    Just as a factual matter, it’s attributed in Wikipedia to Paul McCulley

    The term “shadow banking system” is attributed to Paul McCulley of PIMCO, who coined it at the 2007 Jackson Hole conference, where he defined it as “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.”[7][8][9]

    Krugman first used the term, I think, early in 2008 which cemented it in mainstream use.

  35. Michael of Summer Hill
    October 6th, 2009 at 22:21 | #35

    SJ, you will find there are earlier writers besides Krugman who should be given credit but Paul McCulley is been credited with coining the term ‘shadow banking’.

  36. OrganicGeorge
    October 6th, 2009 at 22:39 | #36

    When investors can use Graham & Dodd again to make money then and only then will the markets fair for all investors.

    The fact that the market moves based on the action in derivatives shows the markets are on longer functioning properly.

    Please remember that these same brokerage houses killed the commodities markets for “real” hedgers whey they bought some token grain storage bins from Cargill just so they could hold more futures contracts that the law allowed speculators to hold. They result was that they ran up the prices of commodities beyond any fundamentals just so they could bust out the shorts, farmers and grain elevators, when they could no longer afford the interest on their margin calls.

    These financial wizards just break down where ever financial system they chose to play in. Nobody invests, they just smash and grab.

    We must regulate the financial system to the benefit of the total economy not just so traders can make exorbitant amounts of cash, by not producing anything of value. Liquidity/speculation is the grease of commerce, not the source of commerce.

  37. SJ
    October 6th, 2009 at 22:47 | #37

    Michael, my post wasn’t intended as a correction or response to yours, you just happened to post yours while I was typing out mine. I’m not disagreeing with you.

  38. gerard
    October 6th, 2009 at 23:57 | #38

    Ten years ago in 1999 the Basel Committee on Banking Supervision proposed to rectify the original Basel Accord’s deficient treatment of riskiness of the assets used to determine capital requirements. The problem was that while Basel 1 hardly even differentiated between assets at all, Basel 2 thought that the riskiness of individual assets corresponded to the ratings agencies’ highly compromised “external” risk-assessments, and the banks’ highly complex and dubious internal risk-assessments.

    The whole point of the original Basel Accords was that banks cannot in general be trusted to manage their own risk. This is because there is an inverse relationship between safety (the banks’ equity capital) and return on equity (profits divided by equity). For a private bank whose motivation is firstly to increase shareholder return, there is always a motivation to have more assets and less capital, coupled with a tendency to underestimate their own private risks while also totally ignoring the enormous social externalizes involved in the realization of these hypothetical losses. A bank fails when its assets (loans and investments) have to be written off. The bank’s equity capital is its assets minus its liabilities (deposits), so when the value of assets suddenly drops, the capital drops by a corresponding amount. If the amount of capital ever hits zero, the bank is bankrupt, so the point of capital adequacy regulation is to make sure that there’s enough capital there to match the size of the assets. But imposing a simple leverage ratio doesn’t suffice because when all assets have the same weight, banks get around the ratio using “capital arbitrage”; taking on riskier assets to increase return, which increases the probability of default.

    It took the Basel Committee from 1975 to 1988 to come up with their first 26-page accord. For a global banking regulatory system it is absurdly simple. It divided the capital of banks into two tiers. 50% of the capital had to be of Tier 1, of which at least 75% had to be “Fundamental Tier 1” (ordinary shares, general reserves, retained earnings, foreign conversion reserves), the remainder “Residual Tier 1” in perpetual non-cumulative preference shares. Tier 2, was the lower quality capital; cumulative preference shares, convertible notes and subordinated debts. For a capital base consisting of only Tier 1, there was a minimum capital/risk-weighted-asset ratio of 4%, and 8% for a capital base with mixed Tier 1 and Tier 2.

    Assets were split into four classes. The “riskiest” class was commercial lending with a weighting of 1 (so for every commercial loan, 8% mixed-Tier capital was required, whether the loan was to Microsoft or 1999 start-up “catfood-deliveries.com”. Portfolio diversification was not taken into account. Mortgages, no matter how “subprime”, had a weighting of 0.5 – requiring 4% of their value in capital. Interbank lending and lending to municipal governments had a weighting of 0.2, while sovereign debt had a weighting of 0, requiring no capital. Zimbabwe government bonds were classed as less risky than Queensland government bonds.

    Basel 2 attempted to get around this obvious risk-insensitivity by changing the capital requirements, as well as introducing a supervisory review process and mandatory information disclosure (the “three pillars”). But now instead of ignoring the differences in risks within asset classes, they brought in the for-profit ratings agency oligopoly, complete with obvious conflicts of interest, to decide what the risks were. Each borrower’s credit risk was graded by the agencies, with the supervisor providing a grid of conversion from agency ratings to risk weights. Corporate loans were now split into 4 possible risk categories (based on agency ratings) instead of 1, sovereign debt split into five. This was the “standardized” approach.

    Basel 2, being “flexible”, also gave banks the options of an “Internal Ratings Based Approach” allowing banks to use their own models estimating risk components. The risk-weight function coefficients are lower to give banks an incentive to improve their risk assessments. This was supposed to align bank capital management with “best-practice” risk-sensitivity analysis. But that was before we realized how dubious this “best-practice” actually was. These risk assessments were underestimating the correlation of defaults to a deadly extent, causing undercapitalization rather than preventing it.

    Basel 2 exceeded 500 pages and was unpopular with the banks. Its implementation was postponed, ironically, until the onset of a crisis of the sort that it had been designed to prevent. The EU switched to it in 2008 but in the US it has been limited to a minority of banks and postponed to 2010. Despite this, Basel 2 has become a convenient whipping boy for those who like to argue that “Regulation” worsened the crisis.

    It is actually a credible argument, and not only because the regulations established the ratings-agencies and banks’ private models as the official arbiters of risk. It is easy to see that such capital adequacy requirements as are involved in Basel 2 can have a pro-cyclical effect, with risk-sensitive weightings fluctuating with the business cycle. During a recession the risk of assets increases, which increases the capital requirements in a risk-weighted system. Couple this to mark-to-market accounting, where the assets on the balance sheet are valued given their immediate resale price, and a market slump can wipe the value of a bank’s capital right out. This forces banks to cut lending, reinforcing the crisis, while attempting to raise capital from either issuing equity (at the worst possible time), borrowing from other banks (none of which want to lend), or calling in loans (which pretty much kills your bank’s future business on the spot). This leaves borrowing from the Central Bank as the only option left. Of course blaming Basel 2 for all this ignores the fact that Basel 2 was not even implemented in most centers at the time of the crisis. But they explain why Basel 2 is likely to be short lived, with the G20 scheduling talks next year to come up with a Basel 3

  39. Joseph Clark
    October 7th, 2009 at 00:27 | #39

    @Freelander
    I’ve lost you again. It is short selling in the way I explained. Banning short selling means banning the rental of shares. The act of renting is equivalent to borrowing something you don’t own and paying it back later.

    @SeanG
    Right. But people will generally only take a short position in a forward if they have a short physical position to hedge it, which they can’t under a short selling ban. You may be right about the communication breakdown though.

  40. Hank Roberts
    October 7th, 2009 at 01:20 | #40

    There’s an analogy in the news:
    http://www.nytimes.com/2009/10/04/health/04meat.html

    “… Ground beef is usually not simply a chunk of meat run through a grinder. Instead, records and interviews show, a single portion of hamburger meat is often an amalgam of various grades of meat from different parts of cows and even from different slaughterhouses. These cuts of meat are particularly vulnerable to E. coli contamination, food experts and officials say. Despite this, there is no federal requirement for grinders to test their ingredients for the pathogen.

    The frozen hamburgers that the Smiths ate, which were made by the food giant Cargill, were labeled “American Chef’s Selection Angus Beef Patties.” Yet confidential grinding logs and other Cargill records show that the hamburgers were made from a mix of slaughterhouse trimmings and a mash-like product derived from scraps that were ground together at a plant in Wisconsin. The ingredients came from slaughterhouses in Nebraska, Texas and Uruguay, and from a South Dakota company that processes fatty trimmings and treats them with ammonia to kill bacteria.

    Using a combination of sources — a practice followed by most large producers of fresh and packaged hamburger — allowed Cargill to spend about 25 percent less than it would have for cuts of whole meat. …”

    ——

    What if financial industry bonuses were paid solely “in kind” as proportional slices of exactly the profits or losses on the same contracts the individual sold or bought, and the financiers were required to hold the payment on their own personal account books for, say, five years?

    As in, you eat it first and we’ll watch you and see if it’s okay.

  41. Freelander
    October 7th, 2009 at 02:45 | #41

    @Joseph Clark

    Not to worry, I’ve followed you and the short is, it ain’t so easy to do, to synthetically duplicate and to flout regulations. If that’s not where you have ended up, I suppose we can only agree to disagree and leave it at that.

  42. Ernestine Gross
    October 7th, 2009 at 05:46 | #42

    Michael and SJ, thank you for the reference.

    According to the Wiki entry you provided SJ, my description of shadow banking via CDOs during the first decade of the 21st century corresponds to what van Hayek talked about more than 50 years ago, setting aside the labels attached to the mechanism for creating leverage. Each time the regulatory system fails. Isn’t it just possible that the regulators, bound as they are to the financial accounting model, don’t have relevant data because the financial accounting model cannot deal with financial risk?

  43. Alice
    October 7th, 2009 at 06:58 | #43

    @Ernestine Gross
    Ernestine – slicing a joint probability distribution is not likely to be an ordinary part of accountants normal skill sets, I agree, but then who says accountants skills do not overlap into finance??. They most certainly do these days – especially when it comes to ensuring the debt / equity ratio does not place the company in breach of the debt contract. There are accountants out there who are dedicated to finding loopholes (and well remunerated) in the accounting standards. I would suggest there is a strong interrelationship between accounting and finance in the financial sector and many accountants would be seamlessly skilled in both.

  44. Alice
    October 7th, 2009 at 07:10 | #44

    On a side issue – I note Gittins today has a taken a swipe at the Productivity commissions inmvestigation and recommendations for executive remunerations. Good on him – a quote
    “The commission cant bring itself to claim the huge growth (in executive pay through the 1990s and noughtie) is the product of an efficiently functioning market, but neither can it admit the glaring truth: there is no way these guys are worth what they are being paid, nor any way their worth could be increasing so much from year to year.”

    There is only one solution here. If the Government is too gutless (and gutlessness it is) to take real measures to stop the blatant rip off (thats what it ammounts to) then claw it back by raising the personal income tax rates on the wealthy and at least put it to better use than the elite playing the stock market into to a brick wall.

    As Gittens notes – the orthodoxy of the Productivity Commission (JHs boys still??) doesnt help.
    They havent got the stomach, the inclination, or the good sense to deal with the issue in any tangible fashion. Pathetic. Pathetic. Pathetic. Ruined my breakfast.

  45. Ernestine Gross
    October 7th, 2009 at 07:33 | #45

    JQ,

    “There are two main ways these problems can be resolved. To protect both ignorant buyers and the public, it would be necessary to regulate investment banks in the same way as other banks, and much more tightly than either was regulated pre-crisis. …

    “The alternative is to assume that the buyers of investment bank products can look after themselves, and focus on protecting citizens from being made to repeat the bailout disasters of last year. The only way to do this is to reinstitute a much tougher version of Glass-Steagall, raising high barriers to all kinds of transactions (ownership, financing, joint venture) between investment banks and the core financial system guaranteed by government. ”

    I doubt that a focus on regulatig institutions will prevent a repeat of the disaster. I doubt it because the same or similar schemes will emerge under different labels.

    I would put my bets on restrictig the types of financial contracts that can be legally issued and the quantity of each legally allowed financial contract. Furthermore, I suggest we need a new record keeping system which is capable of describing the characteristics of financial securities in a language other than words such that proverbial bags of pears can’t be sold as bags of apples only because of the verbal label.

    To illustrate my point, both equity and plain vanilla securities have linear pay-off functions; derivatives have non-linear pay-offs. While there are empirical studies which provide some evidence of chaotic behaviour, there is a paucity of explanation as to the origin of chaotic behaviour. As you know, a necessary but not sufficient condition for chaos is non-linearity. The financial ccounting model cannot deal with securities with non-linear pay-offs. Thus, crucial information cannot possible be recorded in balance sheets.

  46. gerard
    October 7th, 2009 at 07:42 | #46

    Government gutless? Seems like the shareholder boards are pretty gutless as well, or maybe rather than gutlessness they’ve just been gripped by a personality-type cult that elevates senior managers to a superhuman status, seemingly based on golf-playing and networking ability.

    while we’re on the subject of raising taxes, we wouldn’t even need to ban short selling if we’d just whack a big enough tax on it to discourage speculation – as opposed to hedging.

  47. Freelander
    October 7th, 2009 at 08:10 | #47

    @Alice

    What is a worry is that from my quick read of the draft report it is clear that those who wrote it just aren’t across the material at all. Of course, the average punter out there assumes that the Productivity Commission is full of highly competent experts but the truth is that the output from the place is highly variable, quality-wise. Box 1 in the overview is drivel. It is not risker pay if the pay outcomes stocastically dominate the pay they would have gotten under the old (non-bonus/non-option) system. What they got was what they would ordinarily be paid as their base and then the bonus on top, not a fall in their base pay. That is not more risky. In box 1.5 on page 13, their spin on what David Gruen said doesn’t seem consistent with the paper he delivered. (Or maybe I read that paper wrong?) Box 2.1 page 20 it says the theory of the firm starts with Coase. No, Coase’s theory of the firm starts with Coase. The discussion of limited liability starting page 21 is just crap. Clearly ignorant of its historical development and that the limitation of liability that ‘owners’ enjoy, is created at the cost of, in at least some cases, others who do not benefit on the upside bearing some of the remaining liability. Box 2.2 page 24 is crap, dispersed shareholders are not effective ‘owners’ and those who own the superanuation that is used by institutional investors have no say whatsoever and they are the ones that own that capital. Other than that, clearly whoever wrote this did not have the foggyest concerning the Fama quote. One thing Fama may have been pointing out is that the owners of capital don’t need to be the owners of the business. Of course, a share-cropper is an example of this. Or a farmer who rents the land and accomodation. There are various ways that business can be organised. There are various factors of production and the ‘owner’ of the business need not be the owner of the capital. Also, Fama talks about security holders. A security can be debt or equity and they come in various forms. This report is really substandard. But the important point that is skirted is that for most public companies the mom and pop shareholder has effectively no say whatsoever in the long or short run. Typically those who have the most say are the institutional investors and that money isn’t even theirs so it is all a cosy symbiotic relationship between directors and executives which is what Bebchuk and Fried’s research demonstrates. Bebchuk and Fried are, of course, the experts on all this.

  48. Ernestine Gross
    October 7th, 2009 at 12:19 | #48

    “Box 2.1 page 20 it says the theory of the firm starts with Coase. No, Coase’s theory of the firm starts with Coase.”

    Good one. And the rest of #47 makes sense to me too.

  49. October 9th, 2009 at 23:37 | #49

    @Hank Roberts
    Hank, the financial sector is much worse than the ground beef case, since the government assumes (and shifts to taxpayers) the risks of banks failing, and the products being sold are designed to provide products to increase returns – but where the traders, executives, originating firm and buying insured banks can also slough off the downside risk to taxpayers.

    The ground beef, peanut butter and mad cow cases all make it clear that government regulation provides only limited safety, while providing barriers to entry to smaller and safer operations.

  50. Michael of Summer Hill
    October 10th, 2009 at 06:59 | #50

    TokyoTom, the world is envious of Australia’s prudential regulator and economic performance and I don’t think we will go down the Libertarian path to destruction.

  51. Alice
    October 10th, 2009 at 20:53 | #51

    There is an interesting book out at the moment and I cant recall the author because I am holidays and so is my mind but he was a trader at Lehman and he essentially blames the crisis on the removal of glass steagall and the other act that was changed in the US earlier this decade…
    It is telling because it comes from someone who worked within the finance industry in Lehman’s US for many years as a successful trader. Well worth a read. I will get the title later but the CEO Dick Fuld of 26 years and his lieutenant comes out looking not too healthy.
    In other words irrational deregulatiuon caused irrational exuberance. One interesting quote was from a senior (very senior exec) who said “you cant model human behaviour with mathematics”. Maybe he knew something so many economists dont. The VAR model failed because it had no history in its models. Thats whats wrong with modern economics as well. (by modern I mean the past thirty years of the profession’s rapture with elegant mathematical models with increasingly little reference to real world historical data. What is that but economic history???? It doesnt even exist as a subject in most universities. The profession is almost as detached from reality as happened at Lehmans (also reliant on mathematical models ie VAR for its real estate CDO operations which ultimately along with Fuld’s poor management appear to have caused the collapse).

  52. October 11th, 2009 at 15:37 | #52

    @Michael of Summer Hill
    Michael, thanks; I can`t say I have much familiarity with (much less envy of) Australia`s prudential regulation, but the “path to destruction” to which you refer wasn`t at all libertarian, was it?

    Maybe Australian regulators are more godlike, but elsewhere we have a continuing pattern of prudential regulation making everyone act imprudently. We might have a little more caution where more people, banks and firms have to shoulder more of the burden of risks that are realized, instead of presuming that government and taxpayers have their back. In other words, a healthier system is one where their is more freedom to fail, and more caveat emptor in place of caveat taxpayer.

  53. jquiggin
    October 11th, 2009 at 16:24 | #53

    TT, I doubt that you are going to persuade people to go back to a situation where they could be wiped out by bank failures, as in the days before deposit insurance/lender of last resort facilities, and I think people are right in their preference.

    So, you need to make sure that regulated institutions don’t take too many risks, while not precluding risk-taking altogether. The obvious solution is narrow banking, with a sharp separation between regulated+guaranteed and non-regulated institutions (for which no bailout should be considered), as argued in the post.

  54. stockingrate
    October 11th, 2009 at 17:28 | #54

    My reading of the following from Wayne Swan today is that he is looking at WIDE banking:

    “To further encourage private investment in RMBS and complement independent issuances, I have asked the Treasury and AOFM to consult with industry on the merits and commercial feasibility of delivering part of the support through a fee-based liquidity facility rather than direct investments by the AOFM.”

    In other words prearranged socialisation of losses for holders (some foreign some local) of domestically originated RMBS.

    http://ministers.treasury.gov.au/DisplayDocs.aspx?doc=pressreleases/2009/108.htm&pageID=003&min=wms&Year=&DocType

  55. Michael of Summer Hill
    October 11th, 2009 at 18:00 | #55

    TokyoTom, Libertarians would be better off pursuing more Goo Goo legislation closing loopholes and making governments more accountable rather pursing something which is unreal. And as for prudential regulation what can I say but once bitten twice shy.

  56. October 11th, 2009 at 18:32 | #56

    @jquiggin
    John, who`s trying “to persuade people to go back to a situation where they could be wiped out by bank failures”? I`m just pointing out that the core of the problem is moral hazard created mainly by deposit insurance and subsequent absence of market discipline, with opacity and risk spreading systemically (and globally) as a result of inadequate regulation.

    At least in the US, the requirement that bank investments be “investment grade”, but without pressure from depositors to make sure that ratings were actually meaningful, as opposed to a sugar coating paid for by the asset seller, is a good example of the resulting rot.

    Even just a little more market discipline would be helpful. A good start would be to revise deposit insurance schemes by limiting the “insurance” to a percentage of the deposit over a particular floor (such as, say 80-90% of amounts over $10,000); this would immediately generate depositor pressure on banks to make more meaningful (and transparent) analyses of investments.

  57. October 11th, 2009 at 18:35 | #57

    @Michael of Summer Hill
    Michael, do we “make governments more accountable” by making depositors, shareholders and counterparties LESS accountable, or are we just leaving taxpayers holding the bag?

  58. Michael of Summer Hill
    October 11th, 2009 at 19:34 | #58

    TokyoTom, the majority of Australians still truly believe in an egalitarian society, and even though our legislators do get things wrong our system works well.

  59. October 11th, 2009 at 23:32 | #59

    MoSH,
    Yet, although they “get things wrong” you want to give them more and more power? Go figure.

  60. Alice
    October 11th, 2009 at 23:55 | #60

    @Ernestine Gross
    Just to come back to Ernestine’s comment on shadow banking. In this account of an Lehman traders version of the collapse of Lehman I have been reading – the author refers to shadow banks as those without any deposits or funds of their own to lend from. In other words they borrowed from other banks to perform lending services and as you can imagine, their numbers multiplied rapidly in the US real estate / credit boom.

  61. Michael of Summer Hill
    October 12th, 2009 at 05:29 | #61

    Andrew Reynolds, governments are not perfect but at least we still have universal health care, aged pensions, etc. As for more power, well I’m all for Father Brennan’s recommendation of a charter of rights modelled along the Victorian and the ACT where each piece of legislation accompanied by a ‘statement of compatibility’ with human rights obligations. In otherwords public officials must repect your human rights above anything else.

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