Spreads and paradoxical liquidity

In my previous post, I suggested that “depth-weighted spreads” ought to serve as a measure of the uncertainty surrounding a asset’s future cash-flows. Felix Salmon quite correctly points out that quoted bid-ask spreads don’t in fact correlate very well at all with cash-flow uncertainty. Felix notes that the popular stocks often trade with one-penny bid/ask spreads, while you’d see much wider quotations on the more predictable bonds of the very same enterprises. So, what’s going on?

I’ll tell the story in pictures. Don’t be fooled though. Despite the presence of graphs, there is nothing scientific about this exercise. I’m trying to illustrate stylized facts as I understand them, not provide new evidence in support. If you think I’m wrong, let me know.

At about noon today, I took a snapshot of the limit order book for Coca-Cola stock (as presented via my brokers’ trading tool). The “quoted spread” was one penny, bid price $58.10, ask price $58.11. At the same time, I found a Coca Cola corporate bond for which a spread was quoted. The quoted spread on the bond was much larger by any measure: You could sell a bond for $1043.34, or buy one for $1058.85, for a quoted bid-ask spread of $15.42. One penny for uncertain equity vs $15 bucks for a bond whose cash flows are virtually guaranteed!

Obviously, this is not an apples to apples comparison, just given the face values of the bonds. It’s not surprising that you have to pay a market-maker more to take on $1000 of inventory risk rather than $60. (Remember, market-makers are “in the moving, not the storage business”. Their nightmare is that they buy something whose price moves against them before they can sell. You gotta pay them more to take a big risk than a small risk.) But, in per-dollar terms, the spread on one bond is still much higher than that one share of stock. You’d have to pay roughly two basis points (0.02%) in spread on every dollar invested in order to buy and resell a share of stock. To take a round trip on a bond, you’d pay almost 147 basis points! 2 basis points vs 147! So, stocks spreads are much smaller than bond spreads any way you cut it, right?

Wrong. The graphs below shows “half spreads”, the difference you’d pay from the current midpoint price to buy or sell the security according published price quotes. Here’s our view of the world so far:

But let’s broaden our horizons, shall we? What if we want to invest, say, $15,000 in Coca-Cola? Is the spread still cheaper on stock?

Probably not. Note how even very large, popular stocks are not quoted very deeply, even though the apparent spreads are very small. And note the shape of the cost curve: The cost on a per-dollar transacted basis always increases, and at an increasing rate. (Spread is a convex function of volume.) It’s obvious that if you were to extrapolate on the buy-side, you’d end up paying more for the stock than the near constant, 73 basis point bond spread that would lock in $15K worth of the bond. The quoted spreads on the stock are very narrow. But the price action is a bitch, if you want to transact quickly and in quantity. (Note the asymmetry of the curve. The obvious conjecture is that market-makers are net short, and would prefer to hedge by purchasing than to go shorter by selling. But at some point not very distant from the midpoint, the spread would take off on the bid side as well.)

Here’s an entirely fabricated, but probably more informative picture:

Which security has tighter spreads, the stock or the bond? For small volumes, the stock wins. But as volume increases, the stock’s spread increases much faster than the bond’s, reflecting the bond’s greater certainty of valuation.

Now, again, this is all terribly stylized. Limit order books are notoriously incomplete, and give little hint as to either market supply and demand or market-maker willingness to transact. Actual transactions often occur inside of spreads. Quoted spreads do correlate with various “liquidity measures”, but they are terribly noisy because they ignore depth, and the informativeness of a spread increases with depth. Also, lots of trading happens inside quoted spreads. Volume-weighted “effective” or “realized” spreads, that compare actual transaction costs to spread midpoints would be more informative.

But still. A market-maker in Coca-Cola bonds this morning had written the entire world a free option to buy $74,000 or to sell $18,000 worth of a bond at will. Stock dealers, on the other hand, put less than $5K on the line in either direction. The bond dealer’s spread reflected a less precise but far more confident estimate of the bond’s value.

The shallow, tight spreads on uncertain stock valuations are what I think of as “paradoxical liquidity”. Why do market-makers guesstimate very precise values for (some) stocks, while signaling “no confidence” by putting little money behind their guesses? Why do bond dealers offer looser estimates, but back them with a willingness to trade at high volume? Perhaps bond market-makers face higher fixed costs, limiting how tight they can pull spreads and still be profitable. Perhaps it is because stocks trade in less fragmented, more competitive markets. Competition forces market-makers to converge upon a single midpoint price (however arbitrary), and drives spreads towards zero. But as spreads approach zero, so does profit. Some stocks have penny spreads and other stocks don’t. How come market-makers stick around to drive spreads down to nothing for some equities, but not for others? Is it because low spread stocks can be more precisely valued than other stocks? Absolutely not. As Felix mentioned, even glamour tech stocks, whose prices rise and fall like soap opera divas, sometimes have one penny spreads.

Instead, it is active randomness rather than staid certainty that drives some stock spreads to be much tighter than bonds or shares of less popular firms. Market-makers derive profit from “noise traders”, from people buying or selling at market prices for their own reasons, but who have no better insight into the future value of the stock than the market-makers themselves. When dealers trade with investors who are better informed than they are, they lose money on average. To make up for this, market-makers seek out the business of “fools” (as Tyler Cowen put it, reminding us of the seminal paper by Glosten and Milgrom and inspiring Felix to coin a memorable phrase). Stocks popular with noise-traders attract multiple dealers, who compete spreads down to minimal levels, and then share slivers of profitable foolishness. In the academic model, fools and informed traders are indistinguishable to market-makers, so market-makers must keep spreads wide enough to offset their losses to insiders. But that needn’t be the case. Those making markets in stocks popular with noise-traders could instead try to separate clienteles based on order size, flow, and type. During “lulls”, dealer competition forces prices to converge to arbitrary values at minimal spreads. Dealers collect pennies on small trades as “fools” trade back and forth at market. But as soon as they catch the slightest whiff of informed trading — large order sizes, inventory build-up, rumor, whatever — market-makers ramp up spreads and shift prices until they find a new price point that is somewhere inside of more informed traders lack-of-confidence interval. They then compete spreads back down to an arbitrary price point, and return to happily collecting pennies. The particular price at which a stock trades, despite microscopic spreads, contains little information about the “true value” of the security, other than that the price is “close enough” so as not to draw the attention of informed predators.

“Paradoxical liquidity” is why I suggested in the previous post that “depth-weighted spreads”, rather than simple bid-ask quotes, ought correlate with valuation uncertainty. As quantities in a limit order book go towards zero, Newtonian finance gives way to the quantum spookiness and game theory. In general, we should treat spreads with more money behind them as more informative than those with less, and compare the relative valuation uncertainty of different instruments using high dollar spreads, rather than best-bid-and-ask. But even scale is arbitrary, and noise trading isn’t just about little tech-stock speculators. Another word for noise trader is “liquidity trader”. People who sell at market prices because they want cash, or buy at market because they want a place to park cash for yield, but who don’t analyze the hold-to-maturity value of the assets they swap are, from market-makers’ perspective, no different than sweaty day traders. When, for whatever reason, liquidity traders go away, market-makers find they have no pennies to compete for, and spreads revert to bounds that reflecting valuation uncertainty of people actually willing to bear the risk of ownership. Paradoxical liquidity is fun while it lasts, and consoles naive traders by offering visibly tight spreads in exchange for hidden price volatility. But in the end it serves no one but the middleman. When it “dries up”, withdrawal can be a bitch.

Update: I’ve struck the last couple of sentences. It’s always fun to end stuff with a punch, but I’m not sure it’s right that paradoxical liquidity “serves no one but the middleman”. The shape of the spread curve is probably not something to get too moralistic about. There are positives and negatives associated with what I’ve called paradoxical liquidity. As always, trader beware.

Update History:
  • 7-May-2008, 11:50 a.m. EDT: Struck last couple of sentences and added update explaining why.
  • 7-May-2008, 7:10 p.m. EDT: Edited away some small embarrassments — repeated use of “points out” in first para, mispelling of dealers, plural “spreads” where singular “spread” works better…

Liquidity isn’t apple pie

Yves Smith packs a powerful insight into an unassuming sentence:

Liquidity is not a virtue in and of itself unless it produces a benefit to the real economy.

Liquidity is often said to be the great lubricant of financial markets. Let’s go with that metaphor for a moment. Yeah, baby, liquidity. It’s high performance motor oil that turns hard metal to smooth silk and keeps the engine of capitalism firing on all cylinders! Pop the hood and pour that stuff in. Rub it onto the gears and axles, so nothing ever squeals, pops, or (God forbid) grinds to a halt. Slather it all over the tires, so that no friction comes between our purring metal machine and the sweet American road.

Ummm, wait a minute… Putting lubricant on the tires might not be such a great idea after all. Friction is precisely what tires need to do their jobs. Throw a lot of oil on the tires and, well, something bad might happen.

Similarly, in financial markets, we want liquidity at some times and in some places. But there are times and places where we want, even need (gasp!) illiquidity!

Illiquidity. That word is so ugly. What might be another word for the same phenomenon? How about “commitment”? When a person invests in something that is not very liquid, they are committed. They are necessarily betting on its fundamental value. Liquid securities can be bought or sold as a trend or a trade or a play for a greater fool. But if the thing you are buying can only be sold with a big haircut, you’d better hope for a really gigantic fool if you have no confidence in its underlying value. (Clever managers did find ways around this problem, but let’s put principal/agent issues aside for the moment.) When financial markets are too liquid, everything looks like cash. Superfluous distinctions — like the economic meaning of the assets bought or sold — fall by the wayside. Sure, investors always prefer liquidity to illiquidity. An option to buy or sell quickly and cheaply is preferable to an option to buy or sell slowly and with large transaction costs. But just because investors like something doesn’t mean that it’s good. Investors like rainbows and ice cream and free money from taxpayers. But the rest of us prefer that investors make serious, informed decisions about what is and isn’t of value, and that they be paid for evaluating and actually bearing risk, rather than artfully shifting it (or whining when it cannot be shifted, because omigawd-there-is-no-liquidity!). Of course there is a balance here, commitment is one thing but a ball and chain is another, if assets become too hard to buy or sell, the costs of financing genuinely useful enterprises would increase until even good risks are not borne at all. It’s not that liquidity is a bad thing. It’s a good thing of which there can too much.

But how much? Another word that should be attached to any conversation about liquidity is “accuracy”. There is, in some sense, a “right” level of liquidity, defined by the uncertainty surrounding the present value of an assets future payoffs. We laud markets for “price discovery”, their ability to distill complex economic facts into simple prices that put a value to unknowable future events. But we need markets to communicate the uncertainty surrounding those valuations as well. The depth-weighted spreads of assets whose values are nearly certain should be much narrower than those of assets whose payoffs cannot be accurately predicted. When that is not the case, it represents a market failure. The recently wide spreads on complex structured credits are not the crisis — those spreads accurately reflect the uncertainty surrounding what the instruments are actually worth. Nobody knows, so spreads should be wide. The real crisis was two years ago, when “oceans of liquidity” meant that whatever the underlying value of a thing, you could sell it quickly for near what you bought it, so spreads grew artificially narrow. Confidence is good only when confidence is merited. We need not only accurate prices, but accurate confidence intervals, accurate spreads, accurate levels of liquidity rather than simply more, more, more.

disappearances and derelictions

This wasn’t the first time, and I can assure you it won’t be the last of my sudden disappearances. I’d like you all to think that I am occasionally called off on super-secret assignments by an unacknowledged branch of an unacknowledged government. Or perhaps I have a penchant for being abducted by aliens. (Callisto is fabulous in the springtime. I highly recommend.)

But no. Behind this curtain is a disheveled lump of a thing, a satisficer in the guilt-minimization problem that each new day presents. For correspondences lapsed and everything else unwritten or undone, the least I can do is apologize. And thank those who do somehow manage to write and rewrite the world every day. I drink words greedily even when I offer none at all. Never, ever let them tell you there’s no such thing as a free lunch.


Update: The previous post, almost a month old, attracted some extraordinary comments. I hope to have more to say on several of the themes discussed — seignorage and the credit crisis, fiat vs commodity money and full or fractional reserve banking, etc. etc. But don’t wait for me. Others have said it all already, much better than I will.

Update History:
  • 5-May-2008, 3:10 p.m. EDT: Added update re previous post comments.

The size of the Fed’s balance sheet limits the scale of the public’s losses

Yves Smith points us to a couple of pieces discussing the Fed’s “balance sheet constraint”, the notion that the central bank may run out of treasury securities to exchange, whether temporarily or permanently, for the questionable securities held by private banks. This asset swap has emerged as the Fed’s core response to the current crisis, and is the essence of what James Hamilton referred to as monetary policy on the asset side of the balance sheet. In an excellent summary, Greg Ip describes the various options the Fed would have if it were to run low on Treasuries.

Fundamentally, the Fed would have two options: It could increase the size of its balance sheet by issuing cash, which would require sacrificing its target Federal Funds rate target and letting that rate drop to zero. This option is referred to in the trade as “quantitative easing”, but that’s just a fancy term for printing money and tolerating any inflation that results. Alternatively, the Fed could expand its balance sheet by borrowing from someone else — from the US Treasury, from banks with excess cash, or from the public directly. This would permit the Fed to increase the scale of its asset swaps without sacrificing its ability to conduct ordinary monetary policy.

If you want to understand the details, do read Ip’s piece. The Fed’s “balance sheet constraint” is not a hard limit. The Fed can circumvent it. But that doesn’t mean that the size of the Fed’s balance sheet is not important. Consider this, from Ip (emphasis mine):

The easiest would be to ask Treasury to issue more debt than it needs to fund government operations. As investors pay for the bonds, their cash moves from bank reserve accounts at the Fed to Treasury accounts at the Fed. The Treasury would allow the money to remain there, rather than disbursing it or shifting it to commercial banks who, unlike the Fed, pay interest. Because the shift of cash out of reserve accounts leads to a shortage of reserves, it puts upward pressure on the federal funds rate. To offset that, the Fed would enter the open market and purchase Treasurys (or some other asset), replenishing banks’ reserve accounts. The net result is that the Fed’s assets and liabilities have both grown but reserves and the federal funds rate are unaffected. This wouldn’t cost Treasury anything so long as it doesn’t bump up against the statutory debt limit. The loss of interest on its cash deposits at the Fed would be roughly offset by the additional income the Fed pays Treasury each year from the interest on its bond holdings.

It’s only true that this operation doesn’t cost the Treasury anything if what the Fed buys with the excess cash pays as much as the Treasury’s cost of borrowing, and there is no loss of principal. But if the Fed uses the cash (directly or indirectly) to buy or lend against market-shunned securities, then the Treasury is only made whole if those securities perform, or the loans against them are repaid. If the market is irrationally shunning these securities, then the Treasury will eventually break even. But if the securities turn out to be worth less than what the Fed lends or pays, taxpayers might be forced to eat the loss.

Fundamentally, the Fed’s balance sheet constraint is and should be a political constraint. The size of the Fed’s balance sheet defines how much capital taxpayers and holders of currency are making available to the Fed to do whatever it is it’s doing. Whether Fed’s balance sheet should be expanded is an investment decision — should the public throw more money at the project that the Fed is undertaking? There’s a real downside — losses by the Fed will eventually be borne either by taxpayers or by owners of dollar denominated assets (which means especially workers with little bargaining power, whose wages are negotiated in nominal dollars and would not rise with inflation). But bearing those risks may be less damaging than the harm that would result from turmoil in the financial system if the Fed loses its capacity to act.

I don’t know whether expanding the Fed’s balance sheet is a good idea, if it comes to that. There are risks and benefits associated with the Fed’s proposed use of funds, and reasonable people can come to very different judgements. What I do know is that a decision to expand the Fed’s balance sheet ought not be treated as technocratic monetary policy. However funds are raised, their repayment would be guaranteed, so all downside risk would be borne by the public. Expanding the Fed’s balance sheet would represent a sizable investment of the public’s wealth, and the public ought have as much say over that decision as over any other investment of public money.

Update: Now here’s some creative thinking! These so called “reverse MBS swaps”, under which the Fed would refill their stock of Treasuries by swapping back iffy securities wrapped with a Fed guarantee, would have no direct balance-sheet impact whatsoever, and if repeated would provide the Fed with a potentially infinite supply of Treasury securities to swap! Of course, the proposal is simply a scheme to create off-balance-sheet liabilities in order to evade what might be on-balance-sheet limits. Wow.

I frequently marvel about how, in order to respond to the credit crisis, the Fed as well FHLB, Fannie, and Freddie, are doing precisely what got private actors into their messes in the first place. Off-balance-sheet liabilities are a logical next step.

(This was reported in Greg Ip’s piece, but somehow I didn’t grok the implications until reading Lou Crandall’s description , “[The reverse MBS swap] is sufficiently exotic that it might sidestep some of the traditional legal issues.” That kind of line is a spur to really think things through!)

Update History:
  • 6-Apr-2008, 4:20 p.m. EDT: Added update re “reverse MBS swaps”.

Central banks are dangerous

I really thought that Michael Shedlock was overstating the case:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing…

Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem…

The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

But then I read this piece, by Robert Shiller (hat tip Yves Smith), and all of a sudden I’m frightened. It’s one thing when Hank Paulson proposes turning the Fed into the macroeconomy’s philosopher king. Paulson will be gone in a blink of an eye. But Robert Shiller is an increasingly influential economist. He’s already got Mark Thoma signed up for the plan. These guys are smart, they matter, and they will continue to matter next January. So let’s think about this very, very carefully.

Shiller points out that…

In recent years, central banks have not always managed macro confidence magnificently. The Fed failed to identify the twin bubbles of the last decade — in the stock market and in real estate — and we have to hope that the Fed and its global counterparts will do better in the future. Central banks are the only active practitioners of the art of stabilizing macro confidence, and they are all we have to rely on.

He’s right on both counts. For now, central banks are all we have to prevent a catastrophic unwinding of our unstable financial system. But they had everything to do with getting us here. It’s not just the Fed, with its famous “serial bubble-blowing”, its cheering on of any novelty as beneficial innovation, its absolute refusal to peer into the magical sausage factory that Wall Street had become. The problem with central banks is much bigger than that. If you haven’t been obsessing over every word Brad Setser has written for the past several years, you owe yourself an education. A growing “official sector” has largely defined the global macroeconomy in the first years of this millenium. In the USA, Japan, China, Europe, central banks have indeed been “active practitioners of the art of stabilizing macro confidence”. For most of those years, it seemed like they were succeeding. They were never succeeding. Call it what you want, call it “Bretton Woods II”, call it “financial imbalance” or a “global savings glut” or “exorbitant privilege”. Each central bank, while trying to stabilize its own bit of the world, found itself with little choice but to support and expand unsustainable financial flows on a scale so massive they have reshaped the composition of every major economy on the planet. As Herb Stein told us, what cannot go on forever won’t. “When the music stops, in terms of liquidity, things will be complicated.” Remember that? The music may have stopped already for Citibank, but it’s still playing for the USA. The record is just beginning to skip.

The Federal Reserve can keep every major US bank and investment house on life support for as long as it wants to. The “credit crunch” can be made to disappear in an instant, if we are willing to pay sufficient ransom to hostage-takers. But what the US economy produces is no longer well matched to what Americans consume, and we are structurally unprepared to generate tradables, goods or services, in quantity adequate to cover the difference. The Fed’s magic wand will be of no use if manufacturers in Asia and oil producers in the Gulf stop giving us stuff for free, using central-bank financial alchemy to hide their generosity.

Things may turn out okay. We’ve already begun to “adjust”, and knock on wood, we’ll manage a worldwide reequilibriation before things get too ugly. But it’ll be a close call. That financial alchemy by central banks is the ultimate source of skyrocketing inflation in China and the Gulf states, and an ominous sign that Stein’s Law is beginning to bite. We may yet escape, but we have been drawn very close to something very dangerous, to a genuine crisis of scarcity in the United States and a catastrophic failure of Say’s Law in China, to mass unemployment, social instability, and fingers and missiles pointed in both directions across the Pacific. This is serious stuff. And central banks are largely to blame.

Private, profit-seeking actors would not have generated the corrosive financial flows that have characterized this millennium. “Financial imbalance”, a euphemism for real resource misallocation, would have quickly been corrected, had Wall Street and the City of London not learned that the official sector could be their best customer. Less politically-independent monetary authorities could have leaned against unsustainable financing. A bit of capital-account protectionism might not have been bad policy for the United States during this period, but a central bank blind to obvious “facts on the ground”, accountable only to an economic orthodoxy, did not even consider such a thing.

As readers of this blog know, I’m not a laissez-faire, the-private-sector-is-always-right kind of guy. I like to think about the “information architecture of the financial system”. That leads me to dislike actors large enough to unilaterally move markets, especially when their motives might not be aligned with wise resource allocation. I dislike large private banks, and think they should be broken into itty-bitty pieces or turned into safe, regulated utilities. For the same reason, I dislike central banks. They have the power to act consequentially, but they do not have, and cannot have, the information or the wisdom to always be right. And when they are wrong, the consequences are devastating.

So, what to do? For now, we have no choice but to “use the army we have”. Our long-term plan, though, ought not be to canonize central banks, but to render them obsolete. It won’t be easy. The usual “sound money” trope, reviving the gold standard, is not a good idea. Much as it is suddenly out of fashion, we will need some “financial innovation” to build a new monetary architecture. Just because we’ve had a glut of snake-oil on the market recently doesn’t mean there’s no such thing as penicillin. We’ll have to do a better job of distinguishing novel idiocies from good ideas. But we will need the good ideas. We can and should liberate money from the bankers, central and otherwise.

Update History:
  • 6-Apr-2008, 9:45 p.m. EDT: Replaced “manager” with “manage”, ‘cuz I wanted a verb there.

Counterparty of last resort? Yes, but…

It’s official. The LLC that the Fed and J.P. Morgan recently formed to manage $30B Bear Stearns assets has taken over a portfolio of derivative positions along with those assets. Those positions involve both rights to receive and obligations to pay whose value may depend upon both circumstance and counterparty quality. Of course, if liabilities associated with those positions ever exceed the value of the LLCs assets, the limited liablity company could declare bankruptcy, so in theory, the Fed’s maximum exposure is $29B. But, if, out of reputational concern or to promote systemic stability, the Fed would inject capital rather than let the LLC default, then the Fed has indeed become a counterparty of last resort. However, the derivative positions are all claimed to be hedges related to the LLC’s “cash assets”. So, I guess the word of the day is basis risk.

Timothy Geithner’s speech yesterday amounts to the clearest narrative and strongest defense we’ve seen from an insider regarding the Fed’s management of the Bear Stearns crisis. (Hat tip Felix Salmon, Calculated Risk.) We learn that the assets effectively acquired by the Fed from Bear Stearns are

investment grade securities (i.e. securities rated BBB- or higher by at least one of the three principal credit rating agencies and no lower than that by the others) and residential or commercial mortgage loans classified as ‘performing’. All of the assets are current as to principal and interest (as of March 14, 2008).

However, these “cash assets” are bundled with “related hedges”. What are these hedges? It’s not stated explicitly, but the “Summary of Terms and Conditions” regarding the formation of the LLC, published with the speech, includes the following language:

[Bear Stearns] will sell to [the new LLC]… the assets identified by JPMC, the NY Fed and the Asset Manager as described on Schedule A hereto (the “Scheduled Collateral Pool”), together with the hedges identified by JPMC, the NY Fed and the Asset Manager [BlackRock] as described on Schedule B hereto (the “Related Hedges”) and including the Pre-Closing Date Proceeds Amount. For the avoidance of doubt, the Related Hedges include the amount that the Borrower [the new LLC] would have to pay to, or the amount that the Borrower would receive from, the applicable counterparty if the Borrower had entered into an identical transaction on March 14, 2008 based on the Bear Stearns marks as of such date (the “Transfer Value”), as well as all accumulated mark to market gains or losses thereafter and any cash proceeds as a result of Related Hedges’ being unwound.

[The new LLC] will assume as an economic matter the obligations under the Related Hedges and receive the benefits thereof by entering into a total return swap with the [Bear Stearns], such total return swap having an initial fair value as of the Closing Date equal to the fair value of the Related Hedges as of the Closing Date. The Controlling Party (as defined below) [the NY Fed] shall have the right to make all determinations related to the underlying hedges (e.g., whether and when to terminate) that are subject to the total return swap. At the request of the NY Fed, the Seller will use its commercially reasonable efforts to replace the total return swap with direct hedges with underlying counterparties through novation.

In English, Bear Stearns is selling various securities to an LLC controlled and largely financed by the Fed, but it is also transferring (“as an economic matter”) a portfolio of derivatives that are characterized as hedges of those assets. (In practice, these derivatives may be bilateral contracts not easily transferable to the Fed’s LLC, so the LLC and Bear are establishing a new contract, a total return swap, under which the LLC reimburses Bear for whatever is owed, and Bear forwards to the LLC whatever is earned, on positions that can’t be replaced with direct contracts.)

Specific information about the securities and the portfolio of derivatives has not been revealed. The schedules on which they are listed are not public. They could be credit default swaps on which the Bear Stearns had acted solely as protection buyer, which would be pretty benign. (These are like insurance contracts — the very worst that could happen is the LLC pays a regular premium, but when some of its bonds catch fire and disappear the insurer fails to pay up.) But lots of instruments could arguably qualify as a “related hedge”, some of which would be much riskier.

I would like to know general types and notional values of the LLC’s contracts, as well as the current exposures, gross and net. I know. I’d like a pony, too. Still I can’t see why the Fed should withhold this information other than potentially “bad optics”. Is this really a set of well tailored hedges to the cash assets described? How much counterparty risk has the Fed taken on?

There are some other interesting tidbits in Geithner’s speech. Geithner claims that, when the Bear crisis broke on Thursday, March 13, the Fed agreed to “extend an overnight non-recourse loan through the discount window to JPMorgan Chase, so that JPMorgan Chase could then ‘on-lend’ that money to Bear Stearns.” That differs from contemporaneous statements, which announced “a secured loan facility for an initial period of up to 28 days allowing Bear Stearns to access liquidity as needed.” The difference is important, as one of the big puzzles of the Bear collapse was why the firm, which had survived its public brush with bankruptcy by end-of-day March 14, suddenly had to be sold by Sunday evening. Most of us thought the crisis had been stabilized and the firm had 28 days to resolve it. (Bear insiders too: “We thought they gave us 28 days. Then they gave us 24 hours.”)

Another curiosity is this:

The assets [to be taken over by the Fed’s LLC] were reviewed by the Federal Reserve and its advisor, BlackRock Financial Management. The assets were not individually selected by JPMorgan Chase or Bear Stearns.

Does this give you any comfort? I guess it depends what you think the Fed wanted to do here, and what you think it ought to have done. Did the Fed cherry-pick relatively good assets and hedges, to protect taxpayers? Or did it knowingly take the riskiest assets that it could within its broad-outline criteria, intentionally making itself a risk absorber of last resort to forestall future crises? It may be a while before we know, if ever.

Update History:
  • 4-Apr-2008, 12:50 a.m. EDT: Removed a superfluous “that”, changed a “could” to a “would”.

The moral hazard of creditors

Ambrose Evans-Pritchard published a column this morning suggesting that the U.S may adopt the so called “Nordic model” of nationalizing insolvent banks. The piece has drawn a lot of blogospheric comment. [ Scurvon, Naked Capitalism, Financial Armageddon, Curious Capitalist, Across the Curve ].

You would think that moral hazard fetishists like me would applaud. The “Nordic model” is a very tough approach. When regulators deem a bank insolvent, they nationalize it outright, wipe out the equity holders, and unceremoniously can the incumbent management. That is harsh, as it should be. Managers who steward significant enterprises to ruin should not be rewarded, and stockholders, who earn high returns as compensation for risk, should be held accountable when they err by placing their money in the hands of gamblers.

But what you are hearing from me is the sound of one hand clapping. (Finally, an answer to that riddle!) An automatic policy that wipes out equity but makes all creditors whole creates a perverse incentive. It suggests that anyone investing in a bank should structure their investment as debt to capture the implicit guarantee. But highly leveraged balance sheets are a source of the brittleness that leads to banking crises in the first place! Our policy preference should be for equity rather than debt financing, as less leveraged firms respond much more flexibly to adverse shocks. Regulation can address this to a certain degree, but unless bank finances are kept very, very simple, probably not so much. Clever minds can come up with all kinds of contingent liability arrangements that would evade regulated balance-sheet ratios while serving as debt financing, even if “special purpose entities” are banned.

Since debt can substitute for equity, killing common stockholders while making whole even junior creditors amounts to a loophole by which lazy investors can shirk their duty of market discipline. It’s not easy to learn which firms are genuinely worthy of ones trust, but that work is precisely what investors get paid for when they earn better-than-risk-free returns. Bondholders, counterparties in derivatives transactions, and other creditors are supposed to assess the credit risk of the firms with whom they entrust money, just as stockholders evaluate business risks. Letting bank creditors enjoy high-returns effectively risk-free creates an obvious arbitrage: short Treasuries and lend as much as you can to any firm that is too big to fail!

There is one and only one class of creditors to whom we have, as a matter of public policy, agreed to make whole under all circumstances. Those are small depositors, and they should bear no risk or inconvenience whatsoever should a bank run aground. All other creditors knowingly assume credit risk when lending to banks, and should be forced to bear some downside when a bank goes south. Admittedly, reducing this theory to practice is walking a knife’s edge. The goal of nationalizations and bail-outs is to keep the financial system functioning smoothly. Too harsh a policy towards creditors might provoke self-defeating runs at the first whiff of trouble.

Can this circle can be squared? Probably. Creditors who try to accelerate replayment in advance of a firm’s insolvency can have the funds clawed back under the doctrine of preferential payments. Regulators can make clear that recently withdrawn funds will be pursued aggressively, in order to treat all creditors equitably. It makes less sense to stage a run on the bank if you know that the bank will come right back and stage a run on you. Creditors will hate all this. They will fume. Creditors are supposed to hate insolvencies. That’s the point. They should have thought about the risks ahead of time, and better supervised the firms they were lending to.

That said, creditors obviously oughtn’t be wiped out entirely like shareholders. The point here is to remind the market that on the liability side of a balance sheet lies a continuum of risk, not a bright line between junk and safety. The financial world does require a superhero, but not the Fed-on-steroids of the Paulson proposal. We want the bond vigilantes back. It’s probably sufficient to wipe out the equityholders (both common and preferred, there’s no basis to discriminate if the bank is genuinely insolvent) and let creditors suffer some delay and uncertainty prior to repayment, perhaps with a small haircut inversely proportional to seniority of claims if public funds need to be deployed.

Writing this stuff makes me feel mean, nasty, cruel, low. Isn’t it enough to take a pound of flesh from stockholders? Must we go after the creditors too? But remember, the creditors are mostly getting bailed out here, by you and me, the taxpayers. A bit of inconvenience and frayed nerves in the service of an important policy goal is not so much to ask in exchange. And there are few public policy goals more important in the financial world than getting more equity and less debt on corporate balance sheets, and encouraging all classes of investors to exercise a lot more adult supervision over the firms that they fund.

Update: See Dean Baker, who offers a similar view, more plainly and clearly expressed.

Update History:
  • 4-Apr-2008, 1:20 a.m. EDT: Added update re the Dean Baker post.

Don’t regulate, rationalize

I know it’s mostly bull, the hippie management bromide that “in Chinese, the word for crisis is danger plus opportunity!” I don’t care. We’re gonna go with it here. I see the current financial crisis as dangerous, but also a tremendous opportunity to fix a lot of things that have been broken for a very long time.

The “sophisticated” banking systems and capital markets that we’re always flogging to developing countries are like nuclear reactors of the Chernobyl design. Sure, they are very powerful, very sexy. When they work they can light up whole cities, and that’s gotta be attractive if you’re sitting in the dark. But they have deep weaknesses, structural flaws, inconsistencies that are resolved only with generous applications of duct tape. Everything seems to work most of the time, but they are an accident waiting to happen. When an accident does happen, there is a story, perhaps a true story, about the particular screw-ups that were proximate cause. But focusing on those misses the point. We ought to get the engineering right before trying to operate the plant.

Financial systems are much more massive enterprises than nuclear power plants, and much more important. We need to redesign our financial system not only to be more robust, but to be more effective. Lost in the flamboyant pain of the current crisis is a quieter tragedy. We have misallocated natural and human resources on a vast scale over the past few years, and it won’t have been the first time. The real economic meaning of financial losses in the housing sector is that hands and minds were squandered bulding houses when they should have done much better things. Timber was felled and oil wells pumped dry, and what we made turned out to be of less value than what we destroyed. We could have predicted and avoided that. A reasonable financial system would have predicted and avoided that.

Treasury Secretary Henry Paulson has mooted a variety of reforms in response to the present financial crisis. Reading through, those proposals amount to a rationalization of the hodge-podge institutions that regulate financial markets. That’s not unwelcome, but it’s not what’s needed. It’s like responding to the Chernobyl meltdown by issuing three-ringed binders filled with better procedures about how to manage the plant. Regulation can compensate for minor flaws. But it can’t overcome a design that is structurally unsound. Our financial architecture is structurally unsound, so our task is not to rationalize the regulatory regime, but the financial system itself.

That will require changes far more challenging to incumbent firms than what Mr. Paulson proposes. Institutions that are too big to fail and/or capable of moving market prices unilaterally don’t sit well with the theory of financial markets. Financial firms can be regulated utilities that handle essential plumbing but bear little risk, or they can be aggressive risk-seekers looking to play every angle and milk every opportunity. They cannot be both. The gentlemen at Mr. Paulson’s alma mater may not like the implications of that, but the principle is correct regardless, and we ought insist that it not be fudged. The “Nationally Recognized Statistical Rating Organizations”, and the constellation of professional norms and judicial safe-harbors that link their opinions to the behavior of institutional money are an abomination, a legal discouragement of the independence of judgment upon which accurate prices and market stability are based. Their special status simply has to go the way of the dodo. This has to go a lot farther than merging the SEC and the CFTC. Rather than placing our faith in the Fed as an ever-watchful superhero, saving us all when financial catastrophe strikes from outer space, we can and should better manage our affairs here on Earth to avoid those catastrophes in the first place.

These have been great times to be a cynic. But, at long last, appropriate cynicism is finally getting priced into the market. There’s not much intellectual alpha left there. When this all washes out, we do want an informationally efficient, market-based financial system. It’s time to start talking specifics about what we need to do to get there. Before very long, all options may be on the table. Let’s have some good ones ready to go.

Counterparty of last resort?

MacroMan has a nice find, in a post aptly entitled Timmy Geithner, SIV Manager!?. He points us to details of the “loan” being arranged by the Fed to support J.P. Morgan’s purchase of Bear Stearns.

It is not a loan at all. The Fed and J.P. Morgan are creating an investment fund, to be managed by BlackRock.

The New York Fed will take, through a limited liability company formed for this purpose, control of a portfolio of assets valued at $30 billion as of March 14, 2008. The assets will be pledged as security for $29 billion in term financing from the New York Fed at its primary credit rate.

JPMorgan Chase will bear the first $1 billion of any losses associated with the portfolio and any realized gains will accrue to the New York Fed.

The money that the Fed and J.P. Morgan will provide is startup capital for the fund. All of it is referred to as “loans”, but that’s facile. Obviously, somebody will own these assets, bear the risk of carrying them, and realize any gains on the fund’s portfolio.

Specifically, J.P. Morgan is offering financing of $1 billion dollars that is loan-like in one sense — the maximum it will be repaid is its initial investment plus interest (“the primary credit rate plus 475 450 basis points”, currently 7.25 7 percent) — but equity-like in another sense — J.P. Morgan’s billion bears the first loss.

The Fed’s ownership stake will be $29 billion, ostensibly in the form of loans at “the primary credit rate, which currently is 2.5 percent and fluctuates with the discount rate”. But, that is largely meaningless. If the investment company’s assets turn out to be worth less than the principal and interest due the Fed, then the Fed’s loan won’t be repaid. If its assets appreciate, J.P. Morgan gets paid out, and the rest belongs to the Fed. The only significance of the “interest rate” would be if, as the fund unwinds, asset values are high enough to make only a partial payment to J.P. Morgan. In this case, the interest rate would help determine the split between the Fed and JPM.

Essentially, the Fed will own this investment fund and the Bear portfolio outright. JPM’s position is basically a call option on the fund’s assets at $29B plus time-value whose value is capped at $1B plus time-value. (JPM is long a call option and short the same option at a higher strike price.) The Fed can deny all it wants that it is considering purchasing mortgage-backed securities. That is the economic effect of this arrangement. The Fed is buying up mortgage-backed securities and other unspecified assets at “the value of the portfolio as marked to market by Bear Stearns on March 14, 2008.”

But we already knew that.

I remain interested in precisely what sort of assets besides mortgage-backed securities this fund will hold. I think that MacroMan used the term “SIV” advisedly. The signal fact about SIVs is that, though they were formally off-balance sheet, limited-liability entities, in reality SIV sponsors bore downside risk beyond their legal obligations to the funds. Reputationally, the banks who sponsored these “independent” entities could not just let them fail.

I have a simple question, one to which I think taxpayers deserve a simple answer. Will this new “limited liability company” have contingent liabilities to any parties other than the Fed, J.P. Morgan, and BlackRock for ordinary management fees? Will its portfolio consist of any positions that would make the fund a counterparty, potentially with obligations to pay, not merely rights to receive, future cash?

If the answer is no, a plain statement of that would be nice. If the answer is yes, then don’t count on the “limited liability” of this investment company to provide taxpayers much protection. It’s strikes me as implausible that a fund backed by the Fed would default on obligations to third parties. We’ve had central banks touted as lenders of last resort, market-makers of last resort, and fools of last resort. We’d better think very carefully before letting the Fed become a derivatives counterparty of last resort. The very idea represents a subsidy to those we may not wish to subsidize. There’s never been such a thing as a risk-free derivatives counterparty. Every holder of a derivatives position has an implicit option to declare bankruptcy and not pay should circumstances move decisively against them. Parties who retain an option to default while the other side of the contract is taken by someone who cannot are gaining something of value, something I’m not sure we want to give. Should counterparty risk move from a theoretical bogeyman to an actual crisis, the scale of sums at risk could be large, even on a portfolio whose current net value is only a few billion dollars, as those owing the Fed refuse to pay while Fed is obliged to cover “offsetting” positions from the public purse.

Update: The Fed has corrected the rate of interest to be paid on J.P. Morgan’s $1B stake. It’ll be 4.5%, not 4.75% as originally reported. (Hat tip Alea, WSJ) Original values are struck and corrected in the text above.

Update History:
  • 25-Mar-2008, 4:20 a.m. EDT: Originally had a confused explanation of JPM’s implicit option. I’d written it was long a call and short a put, but that’s not right at all. JPM is long a call and short a call at a higher strike. I just changed it to long a call with a capped value. That’s much easier, I think.
  • 25-Mar-2008, 4:55 a.m. EDT: Put the corrected version of JPM’s option position as a parenthetical in the text.
  • 27-Mar-2008, 2:35 p.m. EDT: Modified the rate reported on JPM’s loan to be consistent with the Fed’s recent correction. Added explicit update re the change.

Could flight to safety in credits help boost equity prices?

Treasury securities are trading at bizarrely low yields, and Yves Smith offers an intriguing thought:

Since bill prices are used as the input into other pricing models (most notably the Black-Scholes option pricing model), the distortions in the [Treasury] market have the potential to feed into other markets (we’ve already seen problems with new issue bond pricing due to sharp increases in spreads and blow-ups of correlation models in the credit default swaps market).

The word “model” conjures fancy, expensive things tended to by rocket scientists. But for “value” oriented stock investors, simple discounted cash flow valuation still occupies a place of honor. DCF valuation models require two inputs: an expected stream of cash flows (projected dividends, free-cash-flow-to-equity, whatever) and a required rate of return.

One of the lovely aspects of fundamental stock valuation is that it lacks hubris. Everyone knows that stock prices fluctuate unpredictably, so trying to estimate anything to twelve decimal places is just dumb. Value investors look to get a ballpark estimate of a stock’s worth, and buy only if there’s a large margin of safety. If you have to call in the quants, it ain’t worth the risk. The required rate of return is often chosen in the simplest way you can imagine: Check the Wall Street Journal for a current Treasury yield, and call that the “risk-free rate”. Ask yourself how much more you’d need to earn for it to be worth your while to hold the stock, and call that a “risk premium”. Add the two together, and voila! You’ve got a required return by which to value the shares.

One of the channels by which Fed interest rate cuts affect the economy is to boost stock prices by reducing the “risk free rate”, and therefore investors’ required rate of return. But terror and turmoil in credit markets has goosed demand for safe Treasuries, driving yields well below what the Fed would expect given its current rate stance. In January of 2005, the Federal Funds rate was targeted at 2.25%, same as now, and a 3-month T-bill paid 2.21%. Today, we have the same Federal Funds rate, but the 3-month T-bill yields 0.34%. The 5-year Treasury paid 3.61% in Jan 2005. Today the rate is 2.37%. On any of the common proxies for a risk-free rate, flight to safety in the credit market has introduced a rate cut of between roughly 120 and 190 basis points beyond what Bernanke & Co would have expected based on the 2005 experience. If the marginal value investor hasn’t increased the premium she demands for holding equities by the same amount, then all the gnashing of teeth about a financial meltdown may actually be net supportive of equity values!

Now this is weird, since equity is supposed to be the high risk, first-loss side of investment universe. But a recurring theme in the current crisis is that whatever you always thought was safe is not safe. The familiar risks of stock investing might seem like a warm campfire compared to the blizzard of uncertainty on the fixed-income side. It’s not obvious that investors would demand an unusually high premium for holding equities right now.

The Fed is working hard to restore some semblance of normalcy to Treasury markets. It would be ironic if that were to inadvertantly remove an important prop from beneath stock prices. If there’s anything to our little valuation speculation (it is only speculation!), the Fed may wish to mingle some rate cutting with its efforts to satisfy market demand for Treasuries, in order to hold roughly constant the effective risk-free-rate for equity valuation.