Saturday, June 12, 2010

Story of a Bubble

Once upon a time, there were two people. Let's call them "you" and "me". Each of us had a penny. One day, a stranger came along and sold me a lump of clay. It was fun to play with, and I thought I might be able to make a clay pot out of it eventually. So I bought it with my penny. The next day, you saw I was having fun playing with my clay, so you offered to buy half of it from me, with your penny. The day after that, I realized that I had made a whole penny of profit off of buying a penny's worth of clay, so I thought buying back some of the clay would be worth a try. You agreed to sell me half of what you had. On day four, you notice that there's a hitorical trend, where the clay market pays a good return. You can see that this justifies reinvesting at a fair price, eight cents per lump. Each day, one of us made a profit, while the other prudently invested the previous day's profit.

In a few weeks, we were both clay-market millionaires -- even though all we had was still that same penny and that same lump of clay. It didn't require any artificially low interest rates, any increase in the money supply, any repackaging of clay-backed securities, any buying on margin, any phony bond ratings. It didn't take any particularly remarkable characteristics of clay. All it took was a market with no reality check.

Of course, it did require that disconnect from reality: it's completely unreasonable to think that a lump of clay is worth a million dollars, particularly when you bought it for a penny the month before. But the disconnect isn't normally so obvious. Lots of things really do grow exponentially, at least for a while, so it's not at all unreasonable to think that the price of houses or gold might do so. And a small difference in exponential growth rates will soon lead to a big difference in the actual numbers. All it takes is a market with no reality check.

Markets are magic. That's not just a quasi-religious belief of the financial elite in this country. It's a theorem. Not a theory, but a theorem: a precise mathematical statement with a proof. The problem is, the theorem doesn't say what the ideological doctrine says it does. With a theorem, you don't get to conclude the conclusion unless the hypotheses are true. Markets are very good at aggregating certain kinds of information. But the information has to come from outside the market: in effect, from reality. Producers produce, consumers consume, and the market connects the two so that the stuff is neither accumulating in inventory nor getting depleted from inventory. It can even still work if middlemen get paid to store inventory at harvest time and release it gradually over the course of the year, or if speculators get paid to bear more than their share of financial risk -- as long as it comes out even over the whole cycle, with demand ultimately from consumers and supply ultimately from producers. But if the demand for something comes from investors buying it to sell later, while the supply comes from previous investors disinvesting, to the point where any actual producers and consumers are irrelevant, then the whole thing has come untethered from reality. And it's free to go floating skyward, expanding until reality finally does intrude and it bursts.

Wednesday, June 17, 2009

Beyond 19: principle #22 for financial reform

22. No regulator shopping
Call it the principle of conservation of regulation. You shouldn't be able to sell insurance and be exempt from insurance regulations just because you also own a savings and loan. And the same should be true for any financial activity. Setting up shell companies and special-purpose thingamajigs should have no effect on the restrictions placed on actual economic activity. In physics it may be nearly impossible to follow the momentum of every particle in a complicated sequence of interactions. But every interaction obeys the principle of conservation of momentum, and concatenating momentum-conserving processes conserves momentum, so the total momentum remains the same. Likewise firms should be free to make a wide range of structural changes, but they should consist of elements that keep every regulation in effect that was in effect before the change.

Sunday, June 7, 2009

Beyond 19: principle #21 for financial reform

21. Anything with the de-facto force of law must be done by a legitimate process.
This time it was the ratings agencies, but it's not just them.

Thursday, May 14, 2009

This is worth quoting in its entirety

May 13, 2009

Regulatory Reform Over-The-Counter (OTC) Derivatives

The crisis of the past 20 months has exposed critical gaps and weaknesses in our financial regulatory system. As risks built up, internal risk management systems, rating agencies and regulators simply did not understand or address critical behaviors until they had already resulted in catastrophic losses. Those failures have caused a dramatic loss of confidence in our financial institutions and have contributed to a severe recession.

Last March, Secretary Geithner laid out new regulatory rules of the road to ensure we never face a crisis of this magnitude again. An essential element of reform is the establishment of a comprehensive regulatory framework for over-the-counter derivatives, which under current law are largely excluded or exempted from regulation.

As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response.

Today, to address these concerns, the Obama Administration proposes a comprehensive regulatory framework for all Over-The-Counter derivatives.

Moving forward, the Administration will work with Congress to implement this framework and bring greater transparency and needed regulation to these markets. The Administration will also continue working with foreign authorities to promote the implementation of similar measures around the world to ensure our objectives are not undermined by weaker standards abroad.

Objectives of Regulatory Reform of OTC Derivatives Markets

* Preventing Activities Within The OTC Markets From Posing Risk To The Financial System – Regulators must have the following authority to ensure that participants do not engage in practices that put the financial system at risk:
* The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCP):

o CCPs must impose robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.

o For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.

* All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include:

+ Conservative capital requirements
+ Business conduct standards
+ Reporting requirements
+ Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts
* Promoting Efficiency And Transparency Within The OTC Markets -- To ensure regulators would have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets, this new framework includes:

* Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:

+ Recordkeeping and reporting requirements (including audit trails).
+ Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.
# CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.
# CCPs and trade repositories must make data on individual counterparty's trades and positions available to federal regulators.
+ The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.
+ The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information.
+ The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

* Preventing Market Manipulation, Fraud, And Other Market Abuses The Commodity Exchange Act (CEA) and securities laws should be amended to ensure that the CFTC and the SEC have:

o Clear and unimpeded authority for market regulators to police fraud, market manipulation, and other market abuses.
o Authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets.
o A complete picture of market information from CCPs, trade repositories, and market participants to provide to market regulators.

* Ensuring That OTC Derivatives Are Not Marketed Inappropriately To Unsophisticated Parties Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. But the limits are not sufficiently stringent.

* The CFTC and SEC are reviewing the participation limits in current law to recommend how the CEA and the securities laws should be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.

Saturday, May 9, 2009

Beyond 19: principle #20 for financial reform

20. Properly value implicit options
Banks can't renegotiate mortgages that have been securitized and resold, even though they would be better off cutting their losses. For some reason, the option of doing so was apparently not taken into account when the assets were created. I don't know why, but at least it's something specific to point to as needing to be fixed.

Making commitments can be advantageous. A modern economy couldn't run without binding contracts. But option values are real too.

Friday, May 8, 2009

Should we support Senate Amendment 1021?

Information about bills and amendments, including full text, is available on But to display the information, it generates a temporary page in response to a query. If there's a way of getting a permanent link to particular text, I don't know it. So I'm posting this here to have the text.

This amendment is already passed, but no corresponding amendment has been introduced in the House, according to I don't know whether to support a House version.




(a) Definition of Agency.--Section 714(a) of title 31, United States Code, is amended by striking ``Federal Reserve Board,'' and inserting ``Board of Governors of the Federal Reserve System (in this section referred to as the `Board'), the Federal Open Market Committee, the Federal Advisory Council,''.

(b) Audits of the Board of Governors of the Federal Reserve System and the Federal Reserve Banks.--Section 714(b) of title 31, United States Code, is amended by striking the second sentence.

(c) Confidential Information.--Section 714(c) of title 31, United States Code, is amended--

(1) by redesignating paragraphs (2) and (3) as paragraphs (3) and (4), respectively; and

(2) by inserting after paragraph (1) the following:

``(2)(A) Except as provided under paragraph (4), an officer or employee of the Government Accountability Office may not provide to any person outside the Government Accountability Office any document or name described under subparagraph (B) if that document or name is maintained as confidential by the Board, the Federal Open Market Committee, the Federal Advisory Council, or any Federal reserve bank.

``(B) The documents and names referred to under subparagraph (A) are--

``(i) any document relating to--

``(I) transactions for or with a foreign central bank, government of a foreign country, or nonprivate international financing organization;

``(II) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, and open market operations; or

``(III) transactions made under the direction of the Federal Open Market Committee; or

``(ii) the name of any foreign central bank, government of a foreign country, or non-private international financing organization associated with a transaction described under clause (i)(I).''; and

(3) by striking paragraph (4) (as redesignated by this subsection) and inserting the following:

``(4) This subsection shall not--

``(A) authorize an officer or employee of an agency to withhold information from any committee or subcommittee of jurisdiction of Congress, or any member of such committee or subcommittee; or

``(B) limit any disclosure by the Government Accountability Office to any committee or subcommittee of jurisdiction of Congress, or any member of such committee or subcommittee.''.

(d) Access to Records.--

(1) ACCESS TO RECORDS.--Section 714(d)(1) of title 31, United States Code, is amended--

(A) in the first sentence, by inserting ``or any entity established by an agency'' after ``an agency''; and

(B) by inserting ``The Comptroller General shall have access to the officers, employees, contractors, and other agents and representatives of an agency or any entity established by an agency at any reasonable time as the Comptroller General may request. The Comptroller General may make and retain copies of such books, accounts, and other records as the Comptroller General determines appropriate.'' after the first sentence.

(2) UNAUTHORIZED ACCESS.--Section 714(d)(2) of title 31, United States Code, is amended by inserting ``, copies of any record,'' after ``records''.

(e) Availability of Draft Reports for Comment.--Section 718(a) of title 31, United States Code, is amended by striking ``Federal Reserve Board,'' and inserting ``Board of Governors of the Federal Reserve System, the Federal Open Market Committee, the Federal Advisory Council,''.

Thursday, May 7, 2009

Nineteen principles for financial regulation

1.Build a firewall.
The financial system exists to serve the real economy by allocating capital, providing information for other real-sector decisions regarding risk and the timing of saving and dis-saving, providing liquidity for current transactions, and facilitating some government interventions in the economy. But it doesn’t always work right. When it fails, nothing great is lost by its failure per se – but much may be lost as a result of its influence on the real economy. When the financial system functions well, its signals that certain firms should be liquidated are invaluable. But if it starts sending those signals wildly, the cost of liquidating valuable real capital can be devastating. Build a firewall that shuts down those signals when something goes badly wrong.

2.Limit aggregate leverage.
Debts don’t add neatly. Some cancel out; others are unrelated. In a complete, autarkic economy the total debt is always exactly zero: every debt is both a liability owed by someone and an equal-and-opposite asset owed to someone. But they don’t look that way on paper: the debtor must acknowledge the full amount of debt, whereas the debt-holder must acknowledge the risk of default. So on paper the total assets are less than the total liabilities. For any set of financial obligations – even if they’re not explicitly in the form of debt – this difference is what I call aggregate leverage. Aggregate leverage is one way of viewing a key difference between debt and equity: the obligation to shareholders is always exactly whatever is left on the liability side of the balance sheet and therefore changes freely in rough accord with the value of the stock to the shareholders, whereas bonds contribute to aggregate leverage. Entire segments of the economy can be financially insolvent despite possessing real assets in excess of their external financial obligations, if their aggregate leverage exceeds the difference. Even short of actual financial insolvency, excessive aggregate leverage can cause financial distress by limiting the ability to raise capital. Obviously, this is to be avoided. Regulation must ensure that it is.

3.Limit pricing feedback.
In an ideal market, prices are determined by supply and demand: in the event of a shortage or glut, the actual price is shifted back toward the price at which the market clears. In many real markets, however, this mechanism does not function adequately: the market value of the asset is whatever speculators say it is. Rather than linking producer and consumer, the market merely finds a consensus between speculators who buy at any given moment and those who sell. Such markets are subject to free-rider effects, where some participants buy or sell based not on their evaluation of the fundamental value of the asset but on what price others have been buying and selling for. Such an echo chamber amplifies noise as well as signal. If an increase (or decrease) in the price of one transaction leads to an equal total increase (or decrease) in the prices of subsequent transactions, any change will lead to a bubble or crash. Even at lower levels of feedback gain, there will be excessive volatility and persistent mis-pricing. Regulators must evaluate how financial markets function, and intervene as needed to limit pricing feedback.

4.Impose accounting requirements.
Accounting must produce comprehensible book values. These values will never reflect economic reality perfectly, and there’s an inevitable trade-off between the sophistication with which accounting mirrors economic reality and the ease with which it can be understood. However, there are also incentives to obfuscate. Voluntary accounting standards have failed to keep asset valuation comprehensible. Regulators must intervene as necessary to ensure that accounting is transparent.

5.Systematically recognize limitations of markets.
Academic economists have described numerous ways in which markets can deviate from the textbook ideal, and theorized at length about the effects of such imperfections. They also have theorized about what cannot be expected even from perfect markets. Regulators must systematically take such understanding into account when evaluating what regulation is required.

6.Regulate for systemic risk both ways.
There has been some debate as to whether it is necessary to have a new regulatory entity specifically charged with limiting systemic risk, or whether to require various regulators to assess the contribution to systemic risk from factors within the scope of their authority. The prudent course is to do both, and to include evaluation of other agencies among the responsibilities of the systemic-risk regulator.

7.Separate firms where warranted.
One of the factors implicated in the current crisis is the Gramm-Leach-Bliley Act, which repealed the mandatory separation between banks and other financial institutions provided by the Glass-Steagall Act. Such separation should be reinstated, but not necessarily in exactly the original form. Factors to consider include transparency and the incentives the combined firm and each of its components would face.

8.Provide guarantees as needed to break any contagious risk cycle.
Trouble at one firm can cause trouble at others. This can happen by outright failure, default during bankruptcy reorganization, financial leverage as described above, or effects in the real economy such as when a supplier who loses one customer no longer has the economies of scale to continue providing a product to another customer at an acceptable price. Regulators must be alert to all such possibilities and break the cycle before it becomes catastrophic, usually by providing some firms with guarantees against the losses incurred when another firm encounters trouble.

9.No implicit guarantees.
Part of the reason AIG caused as much trouble as it did is that firms counted on the government to bail it or them out if it couldn’t fulfill its obligations – and thereby created a situation where the government faced intense pressure to do so. The government must be clear about what guarantees it is providing, and what guarantees it is not. It must also ensure that it is able to follow through on its non-guarantees without catastrophic effects.

10.No promises you can’t keep.
Most of the reason AIG caused so much trouble is that it made commitments it had no means to fulfill. Firms must be forbidden from doing so.

11.No gaps in regulation.
There must be no significant players that go unregulated simply because they don’t fit any regulatory category. That may mean that some activities are entirely forbidden because they were not anticipated when regulation was devised. It may mean that regulatory schemes include catch-all categories for anything that doesn’t fit any other category. It may result in some loss of innovation, but the value of innovation is finite.

12.Policies must be predictable.
Regulatory systems will have to continue to adapt to changing circumstances and understanding. But such adaptation must occur at a limited pace so that firms will have a predictable regulatory environment in which to do business, and so that the system will not be excessively vulnerable to a wave of deregulation.

13.Too big to fail is too big to exist.
We must never be faced with another choice between a failure like that of Bear Stearns and a bailout like that of AIG. The first line of defense against this possibility should be the simplest: break up any firm that is too big to fail.

14.Risk must not just flow uphill.
Every effort at risk management has some assumptions. Those create an “unless” clause: the risk is contained unless something in the assumptions fails to hold up. When risk management is apparently perfect, nothing can go wrong – unless everything goes wrong. The classic example is the system of alliances before World War I, which seemed to have achieved “peace in our time” but in fact led to “the war to end all wars.”

15.Contagion must have a price.
Banks that receive FDIC guarantees of their deposits pay into the FDIC for the privilege of having those guarantees. The same principle must be applied in any guarantee provided under principle #8 above. The firms that receive the benefit should be required to pay the cost, to avoid distorting the incentives they face.

16.Ratings agencies must be formally part of the system.
Currently, ratings agencies can claim that they’re no different than a newspaper, exercising their rights under the First Amendment. That is not an acceptable basis for the role they play. Accounting standards should require ratings from an agency that is explicitly providing a service for a fee or otherwise taking a stake in the transaction, so that its legal position is different from that of a newspaper.

17.There has to be a reality check.
Interest rates and other rates of return theoretically reflect economic quantities such as the marginal product of capital and consumers’ marginal rate of substitution between current and future goods. In a goods or factors market, the reality check is provided by market clearing: if there’s a glut or a shortage, something is out of balance. But in financial markets when one side of the transaction is denominated in goods that don’t exist yet, this automatic reality check is not available. Regulators must devise some alternative way of providing one.

18.Profit for Wall Street is cost to Main Street.
When auto workers are making high wages, that’s widely understood to be good and bad: good because the workers get to have a high standard of living, and bad because means higher prices for consumers and lower returns for shareholders and bondholders. When the financial industry builds an Emerald City of skyscrapers, private jets, and luxurious offices, it isn’t as universally recognized that this means lower wages for workers and lower returns for Main Street investors. But it does. Maximizing “economic profit” isn’t the same as maximizing “accounting profit.”

19.If something sounds too good to be true, it probably is.
AIG was running what looked like an automatic sure-thing money-making machine. No such thing exists. Such impossible successes should be a red flag to regulators – not an automatic cause for action, because they can be mistaken about what’s too good to be true. But more often than not, further investigation will reveal that it was a wake-up call. When regulators find such a case, they must respond to it systematically, not just by addressing the particular case that drew their attention to it.