Shootout at the CPDO corral!

Regarding my previous post on CPDOs, the delightfully tart Felix Salmon gets delightfully tart with, er, me. He writes:

It would seem that Waldman is rather smarter than anybody at any credit-rating agency.

Now I’m hardly as bright as your average bread mold, so Salmon is being a bit tough on the credit agencies here. Plus, the last thing I meant to do was accuse the rating agencies of stupidity. On the contrary, rating agencies are being quite as clever as the investment-bank CPDO issuers. They are both, in my opinion, playing the same game, which I’ll call “Keynesian sound banking”, after the Great Man’s famous quote:

“A ‘sound’ banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” [1]

Or we might refer to this as “Waldmann’s Rule” &mdash not my rule, for heaven sake I don’t deserve such a thing — but after Robert Waldmann, for what Brad DeLong learned from him:

What I learned from Robert Waldmann: Almost no professional portfolio manager worries about the lower tail, because if you are in the lower tail the whole world has gone to hell in a handbasket and people have other, more important things to worry about than whether one’s portfolio manager had appropriately hedged whatever risk is now roosting on the roof.

My claim is only that the same logic applies to credit-rating agencies and banks. I’m certain the best and brightest at the rating agencies thought of everything I thought of. Rating agencies earn revenue (from the issuing investment banks) when they get to rate a booming new class of credits. Rating agencies get egg on their face if an issue they rate highly defaults. But if that happens in the context of a widespread credit event? Well then it’s like Condi Rice and the World Trade Center. Who could possibly have foreseen terrorists flying planes into buildings!

Here’s Salmon:

One of the things which makes the CPDO model so robust is that the riskiest risk that it’s taking is six-month investment-grade credit risk. Since it’s pretty much unheard-of for a company to go from investment-grade to default in less than six months, the rating on the CPDO can be very high. What’s more, the CPDO, because it has leverage to spare, can continue to pay out its coupon even if that kind of default does happen.

Model risk is precisely the possibility that “the pretty much unheard-of” occurs. Plus, lightning fast “gap risk” defaults aren’t required to break CPDOs. A sequence of general credit-quality deteriorations over several rebalancings of the CPDO portfolio would be sufficient even without default.

During a widespread generalized credit event, or following a sequence of periods during which credit conditions continued to deteriorate rather than reverting to mean, CPDOs would no longer have “leverage to spare”. “Leverage to spare” is what Brian Hunter at Amaranth had for the first few meters as the bottom dropped out on the natural gas market, in a pretty much unheard of collapse.[2] Any strategy that involves continually increasing leverage to cover losses is exposed to multiple adverse movements in sequence. That is why the strategy is broadly referred to as “gambler’s ruin”. Gambler’s ruin can be a rational and very profitable strategy, but the whole game turns on the precise likelihood of long series of adverse events. Estimating that likelihood requires a model, and getting the model even a little bit wrong can be the difference between sure profit and sure ruin.

But, Salmon demurs…

[R]atings agencies try very hard to understand every single way in which the model might break, and then stress-test the model under precisely those conditions.

He’s simply wrong here. If ratings agency tried to take into account every way their models might break, they would be unable to rate. Ratings agencies are quite aware that there are questionable baseline assumptions they have to make in order to come up with a model at all. They publish their assumptions, and leave it to investors to accept their models or not. Here are some snippets ABN/AMRO’s presentation of Surf 100, the first CPDO (now a venerable month or so old):

  • Current modelling assumptions are unlikely to be consistent with actual performance of CPDO
  • Key modelling assumptions are set out in S&P/Moody’s base case assumption


S&P base case assumptions
…[10,000] Monte Carlo simulations …Expected defaults produced by CDO Evaluator 3.0 …Initial portfolio spread of 32bps with a volatility of 15%, meanreversion (MR) = 40bps at the end of year 1, and MR = 80 at the end of year 10
Moody’s base case assumptions
…[10,000] Monte Carlo simulations …Expected defaults produced by CDOROM

Here’s Fitch [3]:

In recognition of the sensitivity of credit CPPI and CPDO to spread widening and volatility, Fitch models spread path as follows:

  • exponential Vasicek model;
  • parameters based on stressful historical periods;
  • back-testing on historical data;
  • spread jumps incorporated if necessary

In all cases, the ratings agencies are being very honest with us. They are pointing out the limitations and assumptions of their models and tests. In no case do these tests qualify as “every single way in which the model might break”, and the rating agencies don’t pretend that they do. Why does Salmon?

I wrote that…

CPDOs appear to violate the core constraint of finance, the no arbitrage rule. If the ratings are accurate, selling short a portfolio of ordinary AAA debt and purchasing a portfolio of CPDOs would be a perfect arbitrage, earning risk-free profit for the arbitrageur with no net outlay of capital. Either the CPDO opportunity must be transient (because the number of issues that can be synthesized is limited, or because CPDO and AAA yields will soon converge), or the ratings must be wrong. Or else the wizards at ABN have invented an infinite free-money machine for well-placed arbitrageurs, the financial equivalent of a perpetual motion machine…

Salmon responds, and but again mistakenly.

And as for Waldman’s ratings arbitrage, where you go short French sovereign debt and go long CPDOs, yes, it does exist – but it’s not “the financial equivalent of a perpetual motion machine”. Rather, it’s just another carry trade. CPDOs are much less liquid than French government bonds, so they should carry a yield premium. Plus, the carry trade can move against you: if the price of CPDOs falls while the price of French government debt rises, you take a mark-to-market loss. And finally, the trade isn’t very profitable in any event, since you have to borrow those French bonds somewhere, and the repo rate isn’t likely to be much less than the extra spread you’re getting on the CPDO.

If indeed a CPDO AAA is statistically indistinguishable from an ordinary AAA, and if indeed a CPDOs consistently earn spread above ordinary AAA debt, then this would not not an ordinary carry trade. Going short a particular issue and long some CPDO would be a carry trade, as there would be price risk related to idiosyncracies of the two securities. But if a diversified portfolio of CPDOs (presuming the asset class takes off) behaves identically to a diversified portfolio of other AAA debt, then highly creditworthy financial institutions (not you, me, or your cousin’s small hedge fund) would indeed have a perfect arbitrage, until the spread between CPDO and AAA debt converges. This won’t happen, because it is a carry trade, there are different risk profiles to a diversified portfolio of CPDOs and a diversified portfolio of other AAA issues, and that difference is… CPDOs are riskier! And that’s exactly my point. CPDOs are risky issues that earn risky spreads, but look for bureaucratic purposes like conventionally “risk-free” debt.

I should comment on my use of the word “risky”, both in this and the previous piece. Salmon takes me to task…

First, on a factual level: Waldman says that the proceeds from CPDOs go into “a leveraged portfolio that includes high yield, risky debt” – which isn’t true if by “high yield, risky debt” you mean sub-investment-grade debt. The portfolio is all investment-grade; it just isn’t AAA.

I don’t mean, and didn’t previously mean, that current CPDOs are taking on “junk bond” risk. One could be forgiven for thinking my use of “high yield” implied that. I should have said “higher yield”. By “risky”, I mean non-AAA, since AAA is the category which is generally treated as nearly free of credit risk. The debt behind current CPDO issues is concentrated at the low-end of investment grade.

Finally, back to Salmon:

But if you’re still not comfortable with that kind of risk, no one’s forcing you to take it.

When banks use novel structured products to take on more risk than bank regulators anticipated, I am being forced to take that risk. We all are. Bank regulation is a complicated subject, and I don’t claim that existing bank regulation is anywhere near optimal. I don’t disagree with Salmon’s contention that while CPDOs might let banks game things a bit, this new gaming is far harder than it was under Basel I. There’s a cat and mouse game being played, between regulators getting tighter and banks getting cleverer, and that’s perfectly ordinary in its way.

I bother to write about this stuff not because I am interested in the arcane details of a structured credit designed especially for bank investors. I write because I think the game is going awry, the odds of systemic crisis at the collapse of a credit bubble are growing, and CPDO-based regulation skirting is the latest little crack in the dam. Reasonable people can disagree. Salmon clearly does, and he’s reasonable even if he is delightfully tart. But you can’t pretend that Moody’s has worked it all out and we can rest comfortably. There is no adequate model here. There is human judgment. Me, and Paul Volker, and Robert Rubin, a lot of us are worried. And those other guys are much smarter than bread mold.

By the way, if I were Goldman Sachs, I would short dollar-denominated CPDOs and purchase US Treasury debt. CPDOs aren’t really financial perpetual motion machines. They just get to look like it, for about two seconds.

Update: Felix responds.

[1] Keynes quote from “Consequences to the Banks of a Collapse in Money Values”, 1931. Hat tip to Calculated Risk, writing on Angry Bear.

[2] Thanks to Aaron Krowne in the comments of the previous post for suggesting the Amaranth analogy.

[3] “Rating Credit CPPI and CPDO”, by Linden, Lecointe, and Segger, available at, search for CPDO, free registration required.

Update History:
  • 14-Nov-2006, 1:36 p.m. EST: Added link to Felix Salmon’s response, and missing links that were missing from footnote 1 of the post.

CPDOs, Model Risk Spread, and Banks under Basel II

Another day, another derivative. This month’s high-finance innovation is the CPDO, or “Constant Proportion Debt Obligation”, and it is truly a wonder. In practical terms, a CPDO is nothing more or less than a synthetic bond. Investors pay money up front, receive coupon payments, and their principal is returned after a set period of time. Investors stand to lose if borrowers default or credit conditions deteriorate. But CPDOs work a secret miracle. These synthetic bonds are designed to score a “triple-A” grade from major bond rating organizations, while paying a spread of up to 2% more than “natural” AAA debt!

CPDOs appear to violate the core constraint of finance, the no arbitrage rule. If the ratings are accurate, selling short a portfolio of ordinary AAA debt and purchasing a portfolio of CPDOs would be a perfect arbitrage, earning risk-free profit for the arbitrageur with no net outlay of capital. Either the CPDO opportunity must be transient (because the number of issues that can be synthesized is limited, or because CPDO and AAA yields will soon converge), or the ratings must be wrong. Or else the wizards at ABN have invented an infinite free-money machine for well-placed arbitrageurs, the financial equivalent of a perpetual motion machine.

So is there a catch? And if so, what is it? Let’s first understand how a CPDO works. Despite the complicated acronym, it’s not rocket science.

A CPDO issuer accepts principal from investors, and commits up front to a coupon and principal repayment schedule. The issuer puts the money in a leveraged portfolio that includes high yield, risky debt (or credit derivatives), earning a yield higher than would be required to cover coupon payments to investors. In the most benign scenario, after a while, the CPDO portfolio earns enough extra money to trade in the risky debt for a risk-free portfolio of government bonds sufficient to cover the coupon and principal repayments promised to investors. Thus, the CPDO issuer has temporarily taken on credit risk to earn the promised excess spread, and then quickly locks in gains by putting investor assets into ordinary AAA bonds.

But what happens if something goes wrong? Suppose that while the CPDO holds its leveraged, risky portfolio, credit conditions deteriorate. Then the portfolio loses value, and the issuer’s ability to meet the agreed-upon payment schedule becomes uncertain! Wouldn’t this possibility translate into lower-than-perfect ratings by rating agencies? You might think so. But the CPDO-issuer makes a promise that offsets this risk. The CPDO-issuer promises that if the risky portfolio loses money, the CPDO will double-down, increasing the degree of leverage as required to make up for the loss and meet the structure’s promised payment schedule to investors.

Well, that makes me feel better. You? Let’s give the devil her due: This is a very model-tested approach. CPDO-issuers have carefully reviewed credit-spread history, and have come up with rebalancing-and-releveraging schemes that should nearly always manage to recoup losses. If there is no structural change in the bond markets, if the markets behave as models say they behave, then the likelihood that a CPDO will experience a sufficiently long sequence of adverse events to prevent the doubling-down strategy from recouping losses is very, very small, comparable to the probability of a default on an ordinary AAA-rated bond. And the independent bond rating agencies have double-checked this work. All of the bond industry’s prevailing models support the view that a “perfect storm” of deteriorating credit conditions sufficient to tank a CPDO is no more likely than, say, France defaulting on its sovereign debt.

But what are the odds that some structural change in credit markets occurs, such that industry-standard models no longer hold? There is no good way to attach a probability to that event. Structural change in financial markets does happen, usually accompanied by what from the perspective of earlier models look like improbable “long-tail” events. But there is no “meta-model” that we can trust to estimate their likelihood of structural change. We are left with nothing but human judgment to decide whether the model-generated AAA rating of a CPDO issue is in fact as sure as a the same AAA on a traditional “risk-free” bond, given market conditions likely to prevail in the future, rather than conditions of the recent past on which the models were based.

This is good news. There are no perpetual motion machines, no huge gaps in the theory of finance. We can understand where the extra spread in a AAA-rated CPDO comes from: It is a model risk spread. CPDO-buyers will rationally price-in model risk, the risk that despite what Fitch or Moody’s says, these complex, “gambler’s ruin”-style instruments might not handle a changing credit environment as well as traditional AAA debt. Taking model risk into account, CPDOs ought to have a rating somewhat below ordinary super-high-quality bonds. But when bond-rating agencies generate their ratings from their models, model risk is left out of the equation. And that fact is the loophole these instruments are really designed to exploit.

Who is buying CPDOs? Where is the excitement? If it were true that these instruments were every bit as safe as government debt, but paid a higher yield, nearly every investor would want them in their portfolio. But investors understand model risk. While there is general demand, a specific sort of investor is particularly enthralled by CPDOs. From a Fitch report on these instruments:

[The evolution from earlier principal-insured products (“CPPIs”) to CPDOs] …is mainly driven by Basel II: under the revised international capital framework, bank investors are likely to need a rating on both principal and coupon for their credit investments. [1]

Banks always face a trade-off between safety and profitability — the more risks they take with depositors’ money, the more profit they can earn. The Basel II regulatory framework requires banks either to hold less-risky portfolios, or to hold high levels of capital in reserve. Either approach exerts a drag on bank profitability (in the interest of depositor and taxpayer safety). Under Basel II, the safety of bank investment portfolios is judged in part by the ratings on the debt they hold. If a bank finds an instrument that offers an unusually high yield for its rating, that is an opportunity for the bank to increase its profitability without increasing reserves. If the rating of the offering understates its real risk, its availability effectively allows banks to circumvent the spirit of the Basel II reserve requirements.

Bank investors understand as well as non-bank investors that, due to model risk, CPDOs are not as safe as ordinary AAA bonds. But bank investors aren’t looking for safety. They are looking for ways to marry the appearance of safety before regulators with opportunities to enhance profits by taking on risk. One risk not included in credit ratings is credit raters’ model risk. The investment industry, constantly innovating to serve customers, has invented an instrument that exchanges credit risk (reflected in ratings) for model risk (excluded from ratings), allowing banks to have their risk and hide it too. If all goes well, banks earn more money. If all goes poorly, taxpayers cover depositor losses, while bank managers demur that they complied with regulatory requirements to the letter.

Truly, this is the golden age of finance!

[1] “Rating Credit CPPI and CPDO”, by Linden, Lecointe, and Segger, available at, search for CPDO, free registration required.

Update History:
  • 13-Nov-2006, 10:00 a.m. EST: Took superfluous “the” out of title: “CPDOs, the Model Risk Spread, and Banks under Basel II” becomes “CPDOs, Model Risk Spread, and Banks under Basel II”
  • 13-Nov-2006, 10:06 a.m. EST: Made some changes to properly reflect that CPDOs can offer variable (benchmark + spread) coupon payments, rather than fixed as initially implied. Changed “fixed coupon payments” to “coupon payments” in first paragraph. Changed “ordinary AAA bonds” to “ordinary AAA debt” in he second paragraph. Changed “ratings on the bonds they hold” to “ratings on the debt they hold in 3rd-to-last paragraph.
  • 13-Nov-2006, 10:10 a.m. EST: Changed first (nonquoted) use of “Basel II” to “The Basel II regulatory framework” to help less jargon-familiar readers.
  • 13-Nov-2006, 10:12 a.m. EST: Changed “…every bit as safe as government debt, but paid a higher spread…” to “every bit as safe as government debt, but paid a higher yield…”
  • 13-Nov-2006, 11:00 a.m. Tightening up some wording. Removed “else” from “…or else the ratings must be wrong.” Removed duplicate use of “event” in a sentence, “…usually accompanied by events that…” to “usually accompanied by what…”

How (not) to regulate investment funds

Today seems to be the day for waxing cynical about the prospect of hedge fund regulation. John Carney at DealBreaker writes:

It’s a pretty simple formula: regulate an industry and you instantly politicize it. Which is another way of saying that you monetize the industry for politicians…

All the other talk -— about “systemic risk” or pension funds or low-liquidity real estate millionaires -— is just the sound of a policy in search of a rationale. And that policy, of course, is the enrichment of politicians. That’s always the policy.

Of course loyal readers (hi mom!) will know that I think “systemic risk” is very real, and that it will hit us all like a rocket-propelled two-by-four, soon. But I quite agree with the cynicism about policy and politicians. So what is to be done?

Here’s a simple suggestion. Investment funds should not be permitted to be limited liability entities. As legal entities, they should be restricted to organization as ordinary partnerships.

This isn’t really regulation at all — It simply amounts to the state declining to confer the privilege of limited liability to certain kinds of organizations. Limited liability is rife with moral hazard problems, but most people (including emphatically myself) would argue that its advantages far outweigh its disadvantages for nonfinancial businesses.

But limited liability, like copyright, is a legal oddity conferred for a specific purpose: to encourage entrepreneurs to start and invest in risky but productive ventures. The businesses that investment funds put their money in should certainly be limited liability ventures. But the risks taken by the investment funds themselves are speculative financial risks. When a fund invests without leverage in a corporation, the fund’s own limited liability status is worthless. With or without limited liability, the fund can lose all of, but no more than, the value of its investment. But if a fund borrows from a bank to invest ten times its own money in that same corporation, the fund’s limited liability status is a big deal. It lets the funds investors reap investment gains from much more money than they own, while risking no more than the same meagre amount as in the unleveraged case.

There’s no reason the state should grant investment funds a special dispensation to encourage this kind of risk. Fund investors should be allowed to take speculative financial risks, sure. But fund investors should be responsible for all the money they lose if things go sour. They shouldn’t be able to let the bankruptcy of some shell corporation or LLP shield them from the consequences of speculative financial foolhardiness.

It’s one thing to socialize the risk faced by an entrepreneur starting a productive business. It’s quite another thing to socialize the risk of taking on leverage to achieve speculative financial gains. Limited liability is a privilege, not a right, and an oddity from a libertarian perspective. It should not be extended to leveraged investment funds.

Hedge funds should not be leveraged

My inner Roubini has been kicking the shit out of my inner Cramer for more than a year now. So it was with some surprise that I found myself nodding along and murmuring “Amen” to Cramer’s New York magazine piece on hedge funds, After Amaranth.

Cramer makes some pretty obvious, good points. Like, since hedge funds are supposed to be for highly risk-tolerant investors, pension funds oughtn’t be in the game.

(I know, I know. Asset allocation, low covariance, diversification benefits, yadda yadda yadda. With perfectly disciplined, reasonably informed investment managers, pension funds ought to be able to achieve more optimal portfolios with some exposure to this alternative investment class. But, star pension fund managers will always be more competitive than discipled, and hedge funds are too secretive for pension managers to adequately evaluate. Risk-taking by pension funds is particularly unethical since risk-intolerant pensioners are much more exposed to the downside than the upside of pension returns. See agency cost #4.)

Regarding pensions, Cramer offered the following suggestion:

The other way to regulate hedge funds is to say that you can’t borrow more than, say, 50 percent of the money you have under management to leverage up, if you are running pension money.

This got me thinking. Why should hedge fund be leveraged at all?

“What?!? Hedge funds are all about leveraged investment strategies!” I know, I know. But hear me out. Hedge funds are for rich people, with lots of capital and risk tolerance, right? So why shouldn’t hedge fund investors — people with sophisticated access to capital and credit markets — lever themselves, investing in unlevered funds with their own borrowed money? Theoretically, unless hedge fund investors are trying to take advantage of their creditors by forcing them to bear much of the risk, the return characteristics of a leveraged fund and those of an unleveraged fund purchased with borrowed money are exactly the same. And while investors may enjoy letting their bankers share much of the downside of their investments, there’s little reason to think this is good for the rest of us. It hardly seems fair for the public to bear systemic risk in order to enhance the private returns of the wealthy. If hedge funds were themselves unlevered, bank exposures to hedge fund risks would be much less (as investors would have to go bankrupt before banks could get stiffed), and better diversified (as the cost of a big fund meltdown would be spread among the many banks who lent to various investors, rather than concentrated in the one bank that lent to the fund). Also, investors could better tailor their hedge-fund investments to their own level of risk tolerance.

Finally, without leverage, hedge funds would have to compete based on the intelligence of their investments, rather than their ability cajole bankers into lending them too much money, too cheaply. In such a world, it might actually be true that these funds would fuction to squeeze inefficiencies out of markets, rather than highlight and take advantage of conflicts of interest between bank managers, depositors, and governments..

I’m not suggesting that hedge funds shouldn’t be able to borrow at all, as many hedge-fund strategies, like going short, require borrowing. And the implicit leverage inherent in many derivatives positions would represent a challenge to any regime that purported to regulate hedge fund leverage without otherwise limiting investment cleverness. Nevertheless, at least in theory, is there any good reason why limited liability investment funds for the rich and creditworthy should be permitted to take on high degree of leverage?

Update History:
  • 1-Nov-2006, 6:00 a.m. EET: Removed an unnecessary word. (“…pension managers to adequately evaluate them.”)

Agency Costs and Leveraged Investment Funds

With all the fuss about hedge funds and private equity these days, I think it’s worth cataloging in simple terms the multiple levels of “agency costs” associated with leveraged investment funds. [1]

  1. Agency costs imposed by fund managers on investors
  2. Agency costs imposed by fund investors on banks and other creditors
  3. Agency costs imposed by bank managers on bank shareholders, depositors and governments
  4. Agency costs imposed by investment managers on institutional investors
  5. Agency costs imposed by institutional investors on governments and the public at large

  1. Agency costs imposed by fund managers on investors

    As is widely discussed, many hedge-fund managers have a “two and twenty” fee structure, meaning they take as fees 2% of the funds they manage under any circumstances, and 20% of any profits achieved. Because fund managers see the upside of gains but not the downside of losses, a rational self-interested fund manager will take more risks than her investors would if they were managing their own money. Also, fund managers often compete on the basis of short-term apparent performance. A rational, self-interested fund manager may prefer a “get rich quick” strategy to a long career. Such a manager might take positions that trade high immediate returns for large future risks. Credit default swaps are an ideal vehicle for this sort of thing. A “get rich quick” fund manager might also aggressively value illiquid investments on the fund’s books, creating high phantom returns that cannot be realized when the positions are liquidated. Conversely, she might take-on “off balance sheet” liabilities, inflating the apparent value of the fund. Carefully written “derivatives” permit parties to assume contingent liabilities in ways that hide the leverage of the fund. [2]

  2. Agency costs imposed by fund investors on banks and other creditors

    Limited-liability creates a potential conflict of interest between investment funds and their creditors. If a fund is heavily leveraged, fund investors can reap large rewards by assuming risky positions with the understanding that if those positions go sour, a large fraction of the cost can be shifted (via actual or threatened bankruptcy) to the fund’s creditors. I’ve described this at length in a previous post.

  3. Agency costs imposed by bank managers on bank shareholders, depositors and governments

    Keynes famously wrote in 1931 that “a ‘sound’ banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” [3] There is no reason to believe that bankers are any less sound today then they were in the 1920s, or the 1980s. Banks earn money in a highly competitive environment by lending money, and bank managers are evaluated by the profitability of their operations in relation to those of peers. Leveraged investment funds have become a breathtakingly large clientele. They hold trillions of dollars of equity which they are in the habit of borrowing against aggressively. Since the mid-nineties, the scale of hedge and private equity fund investment has grown astronomically, and few banks have been burned by extending them credit. Suppose that after the late 1990s when the Long Term Capital Management famously blew up, a bank manager decided that future lending to investment funds would be done conservatively and only on the basis of extensive due diligence. How would her performance have compared to that of his peers who lent more freely? A rational, self-interested bank manager may well conclude that her best strategy with respect to the huge, lucrative investment fund market is to “see no evil” with respect to systemic risks. Rational managers would diversify their exposure among many funds, to reduce fund-specific risks, but would want to aggressively pursue business volume in the sector as a whole. This is a classic “tragedy of the commons”. By competing well for volume, bank managers exceed performance benchmarks and earn bonuses. But they also diminish the cost and increase the quantity of leverage available to investment funds, magnifying systemic risks. Should a “meltdown” occur, individual bank managers will point to their industry-standard, state-of-the-art risk management practices and demand safe harbor. A few managers with fraudulent books or eggregiously risky positions will be tarred and feathered. The rest will keep their bonuses, while bank shareholders, bank depositors, and eventually taxpayers eat their losses. [4]

  4. Agency costs imposed by investment managers on institutional investors

    Like any other sort of investment manager, the interests of those who manage funds for pensions, university endowments, and charitable foundations may diverge from the interests of their diverse clientele. In particular, rational, self-interested managers may determine that pursuing peer-competitive short-term gains is wiser than carefully managing the long-term risks of fund stakeholders. Managers of pension funds, for example, may “chase high returns” via risky, leveraged investment funds, hoping to maintain or achieve “fully funded” status so the plan sponsor can avoid transfers to, or pull cash out of, the fund. In this case, there are two levels of agency cost: the managers who try to please their employers at the expense of fund beneficiaries by implementing the strategy, and the plan sponsors themselves, who impose risks on beneficiaries to extract cash or avoid future payments.

  5. Agency costs imposed by institutional investors on governments and the public at large

    It is not only self-interested managers or pension-raiding corporations who impose agency costs on others. Institutional investors that increasingly invest in highly leveraged investment funds don’t do so only so fund managers can look good. Institutional investors impose agency costs on the general public, when institutions important to the public take risks whose benefit accrue to direct stakeholders but whose costs would be shared by the community at large. Suppose a university chooses to invest its endowment in highly leveraged investment funds in hopes of receiving outsized returns, which it will use to fund expanded programs, higher salaries, and other good things. The improved endowment returns benefit the university community much more than it does the general public. A catastrophic loss of endowment funds, however, imposes very large costs to the surrounding community, which may have to underwrite a bail-out of some form if important programs are threatened. A rational, self-interested university might choose an investment portfolio which provides high, steady returns in exchange for assuming a small but significant risk of catastrophic loss. In this way, the university community enjoys enhanced programs and salaries under the most probable scenarios, and forces public intervention on its behalf under less favorable scenarios. This sort of strategy can be rationally adopted by universities, important charities, pensions, any sort of institution willing to gamble that, within its own community, it is “too big to fail”.

[1] “Agency costs” is economist-speak for the damage done by conflicts of interest between decision-makers and those on behalf decisions are made. If the CEO of a firm acts to provoke an unsustainable spike in his company’s stock-price to enhance his annual bonus, the costs borne by stockholders (the inflated bonus, damage to the firm if the CEO’s actions fail to maximize is long term value) are agency costs. Other examples of agency costs are political corruption and doctors who over-recommend lucrative procedures to their patients.

[2] Again, credit default swaps are a good example. When it can be argued that a CDS is a simple “loan guarantee”, the writer of “credit insurance” may not be required to account for its position as a liability, creating the appearance that the “premiums” are pure profit. I have no idea how widespread this is in practice, but it is a very large loophole in theory.

[3] Keynes quote from “Consequences to the Banks of a Collapse in Money Values”, 1931. Hat tip to Calculated Risk, writing on Angry Bear.

[4] Note that bank managers can take profitable risks even when they appear to be shedding risk. When a bank purchases “credit insurance” in the CDS market, apparently the bank is reducing risk, and accepting a fixed cost to do so. But just as writers of credit insurance may seek to keep their positions off-balance-sheet, purchasers would want their positions on-balance-sheet, offseting the assumed of the insurance with an asset. Given a high willingness by investment funds to sell credit insurance, banks may be able to purchase this insurance at unduly cheap rates. When credit conditions change and banks revalue their assets, they can book a profit by upping the book value of their CDS positions from cost to fair-value. In a systemic crisis these positions may turn out to be worthless, as the highly leveraged funds that sold the insurance go bankrupt. (It’s oversimplifying, but not inaccurate, to suggest that the banking system is selling insurance to itself by offloading risk to leveraged investment funds. The banks expect to be made whole by the very same clients whose inability to pay off loans may trigger their need to be made whole. Individual banks are lending to and buying insurance from different parties. But banks as a whole are doing much of their risky lending to the investment fund sector, and buying much of their insurance from that sector.)

This is an elaboration of a comment I posted in response to an Economonitor post.

Update History:
  • 19-Oct-2006, 4:40 a.m. EET: Removed a repetitive phrase. (“…as a fund manager.”)
  • 20-Oct-2006, 8:17 p.m. EET: Minor grammar and typo fixes.

In what sense are markets “positive sum”?

Barry Ritholtz has a post about the zero-sum-ness of things. I think he’s right from the perspective of most traders, but forgets that capital and hedging markets are supposed to be positive sum for economies as a whole. I tried this comment on his site, but TypePad thinks I’m comment spam, and refuses to post. Good thing I have my own danged blog.

From a trader’s perspective, markets are a zero-sum game.

But equity and hedging markets, when they function properly, are positive sum games for an economy as a whole. That’s why “investing” is treated differently than “gambling” from a social welfare perspective, and legal even in Utah.

Here’s an example of poor zero-sum reasoning: “I bought 100 shares of WhizCo from Joe. The stock went up $10 per share therefore my gain is Joe’s loss.”

That’s true 99.9999% of the time (and the people who criticize Barry by implying opportunity costs don’t count are full of it). But the 0.0001% of the time when the seller is the firm or entrepreneur are what make capital markets positive sum.

An example: Here at WhizCo, owing to our unique mix of technology and assets, we have an opportunity to develop the ReallyCoolThing[TM]. But to do so, we require a lot if capital up front, and it’s a risky venture. So, we — the existing shareholders — sell part of our stake in WhizCo by issuing stock. With the money, we develop ReallyCoolThing, and it’s the best thing ever. It sells very, very well. WhizCo rakes in profits, and its stock skyrockets.

Clearly, the recent purchasers of WhizCo gained from our sale of stock. But did the sellers, the existing stockholders lose? NO, because they could not have realized the gain in stock price if they hadn’t sold. There is no legitimate opportunity cost inherent in the sale, because the stock price would not have gone up if WhizCo had not sold stock to finance its project!

Stock markets don’t exist for traders. They exist for firms to obtain financing for risky ventures at the lowest rational prices, so that wealth-creating ventures that might otherwise not have occurred do occur. Traders function is to price stock accurately. Traders play a zero sum game — Barry is right about that — that is esteemed more than betting horses only because it contributes to the positive sum game of discriminating between the worthy and the unworthy in the financing of risky ventures.

I would argue that stock markets have been doing a poor job of this recently for a variety of reasons, and that Barry may be right that there is so little reason behind price fluctuation now that it’s best considered a zero-sum game of guessing arbitrary moves in advance. But it was not always thus, and will not be thus for long. Financial markets that forget who they are financing and why have a way of undoing themselves.

Even futures markets, the prototypical “zero-sum game” where for every long there is a short, are not in fact zero sum. Futures markets exist for hedgers. The role of speculators is to price risk. An example:

WhizCo can take year-in-advance orders from European customers because they can hedge the currency risk. When an order is placed in Euros, WhizCo buys dollars for Euros via 1-year-ahead futures positions. Knowing exactly how many dollars they will receive in a year, WhizCo is able to price its goods without assuming currency risk. They would not be able to afford to enter the European market if doing so would require them to risk selling in Euros, but getting paid a fraction of their dollar costs because the Euro has plummeted by the time they make delivery.

WhizCo’s futures positions, in isolation, are zero sum games. Sometimes they gain on the futures, and someone else loses. Sometimes they lose, and someone else gains. But WhizCo does not buy futures in isolation. By hedging legitimate orders, it in fact neither gains or loses by entering into the futures trade, but exactly offsets the change in the value of its Euro revenues. WhizCo gains overall, because it would not have built a large, wealth producing business in Europe had it not been able to hedge.

Suppose, due to persistent dollar decline, WhizCo’s contracts turn out always to be losers. WhizCo still gains, because their European business is profitable, and they weren’t hoping for speculation gains. Speculators are happy, because they took money from WhizCo that WhizCo would never have earned if it hadn’t been able to hedge. This is a win-win scenario, positive sum.

By definition, market share, or any relative valuation, is zero sum. But stock markets and hedging markets are not about rankings. They are important institutions involved in positive sum wealth creation. The zero-sum games played by traders serve to increase the total absolute sum wealth of an economy relative to what would have been, had reasonably priced hedging and risk-tolerant financing not been available.

Note: This piece actually published 2006-10-11 09:21:19 EST, not on 10-10 as shown. I set back the date, because I want yesterday’s post to keep the top spot for a bit. Update: The date and ordering of posts is now correct. The previous post has had its time in the sun. (Date fixed 2006-10-15 6:28 p.m. EET)

Entrepreneurialism and the Opportunity Cost of Capital During an Asset Price Boom

If interest rates are low, that means capital is cheap, right? And if capital is cheap, that means more edgy, entrepreneurial projects get funded, right? In an era of low interest rates, shouldn’t we see a lot of experimentation in creating businesses with high long-term potential but uncertain short-term return? Chris Dillow asks these questions in a specific case (about which I know little and care less). But as a general proposition, I think the chain of reasoning above is less reliable than you might think. For an explanation, and a suggestive empirical result, read on.

Economics is founded on the notion of opportunity costs. But opportunity costs are frequently overlooked when discussing the “cost of capital”. Suppose real interest rates are at 0%, or even negative. Does that mean capital is “cheap” for an entrepreneur with a project expected to earn a positive real return? At first blush, one might shout “Yes!” After all, anyone with money in the bank would be better off investing in the project than earning interest that fails even to keep up with inflation.

But this reasoning is flawed, because earning quoted interest is not an investor’s only alternative to the proposed project. Suppose there exist many alternative investments that, for a similar level of risk, offer twice the real return of the proposed project. Then the real financing cost faced by entrepreneurs pushing the project is not a quoted interest rate, but the rate of return offered to investors by the alternatives. If the project cannot match those returns, it will not be financed.

In an idealized world, with no stickiness in prices or information, no non-market intervention in interest rates, and objective appraisals of project risk and return, the scenario described could not occur. The “quoted interest rate” for projects at the relevant risk level would quickly rise to approach the returns of the most profitable available investments, and interest rate benchmarks would accurately approximate the cost of capital.

But we don’t live in that idealized world. Interest rate metrics can and do vary in ways that don’t obviously track the expected returns of investable projects in the economy. The risk and expected return of projects cannot be accurately measured, and market participants must rely on a variety of strategies from hyperrational modeling to recent-past extrapolation to make investment decisions. I’d suggest that recent past extrapolation is a common approach.

Suppose an exogenous shock reduces benchmark interest rates beneath equilibrium levels. Financial assets should revalue very quickly in response to interest rate changes. But suppose that, because of stickiness, momentum or other effects, an asset price boom of some duration, rather than an instantaneous price change, results. How does this affect the cost of capital of a small entrepreneur with a speculative project?

Benchmark interest rates are low, so the headline cost of capital is cheap. But if investors, extrapolating from recent experience, expect high returns at low risk from asset appreciation, our entrepreneur has to compete with those expected returns. Her real “hurdle rate” is defined not by the headline interest rate, but by asset-boom inflated expectations.

For some entrepreneurs, this distinction between asset markets and available financing would be fictional, as it ought to be in theory. An entrepreneur within a large firm, for example, could take advantage of an asset market boom by persuading the firm to issue bonds, commercial paper, or shares to finance her project, achieving financing costs at or even beneath levels what headline interest rates would suggest.

But for many entrepreneurs, rasing capital by issuing securities in the broad market is not an option. Their projects must instead rely on bank financing or “angel investors”, who would require higher returns when broad market expectations are high. If I’m right, during asset price booms this category of entrepreneurs should face an unusually high spread between quoted benchmark interest rates and the rates of return demanded by banks or angels. This is a testable proposition.

Unfortunately, I’m unaware of good data on the average returns required of small entrepreneurs by banks and angel investors. But until the late 1980s, there was a published interest rate reflecting the borrowing cost of businesses that rely on bank financing, the US Prime Rate. Presumably, the cost of bank loans for small entrepreneurs included the (observable) prime rate plus some (unobservable) spread. Though not conclusive, it would be suggestive if the spread of the Prime Rate over a low credit-risk benchmark tends to increase when asset markets boom. Naively, one would expect credit speads and asset prices to be negatively related, as higher credit spreads mean higher financing costs, and usually a risky business environment. So a positive association between a high spread for bank-financed loans and asset prices would be both surprising, and consistent with the hypothesis that asset price booms increase financing costs for firms unable to sell securities into the boom.

Regressing the spread between the US Federal Funds Rate and the Prime Rate against monthly percentage changes in the Dow Jones Industrial Average shows a significant positive relationship, with a coefficient of 0.04 (p < 0.001). In other words, a 1% monthly gain in the DJIA was associated with a 4 basis point increase in the spread, consistent with the opportunity cost of capital hypothesis. 34 years of monthly data were regressed form September 1955 though August, 1989. R2 of the regression is small, at 0.04, as would be expected since DJIA returns are much more volatile than the Prime Rate/Fed Funds spread. (The data is truncated in 1989 because, starting in the early nineties, the Prime Rate was altered to a near fixed 3% spread above Federal Funds. It now has little relevance as a specific measure of the cost of bank loans to business. DJIA was chosen as a proxy for asset prices simply because it is the most famous measure, and therefore intuitively likely to influence capital market expectations. I’ve not tried a similar test against other potential asset market price or borrowing cost spread measures.)

This was a butt-simple, univariate regression on data taken from FRED and Yahoo, and is very preliminary. Correlation ain’t causation, and there could be a variety of other factors accounting for the observed relationship. It’d be nice to come up with a more complete model of the Prime/FF spread, and see whether it seems consistent with the high-opportunity-cost-of-capital in an asset boom hypothesis. But this very simple test provides at least a little evidence that asset booms increase the cost of capital to bank-dependent small entrepreneurs relative to what benchmark interest rates would suggest.

If you’ve read this far, thank you.

Update History:
  • 11-Oct-2006, 4:00 a.m. EET: Removed an unnecessary “indeed”.

Is the Prime Rate a Scam?

While researching something quite subtle (more on that tomorrow), I noticed something not at all subtle. Below is a graph showing the spread between the US Federal Funds Rate and the so-called “Prime Rate”. Do you notice a change in this series around 1991?

Source: St. Louis Fed (FRED)

When I was a kid, the “prime rate” was something they announced on the news like it was something important. They don’t do that any more, because the prime rate no longer is important. The prime rate is supposedly “the interest rate charged by banks to their most creditworthy customers (usually the most prominent and stable business customers)”. But the most prominent businesses no longer benchmark their loans against the prime rate. They use LIBOR instead. Only consumer and small business loans are typically indexed against Prime. LIBOR became prominent, well, around the early nineties I think.

Floating rate loans, whether to companies are consumers, are usually quoted as a benchmark rate plus a spread. Check your credit card documents: Your monthly interest rates are probably something like “the Prime Rate plus 3%”.

Now look at the graph above. The average spread between the Federal Funds Rate and the Prime Rate from August 1955 through August 1989 was 1.33%. From 1991 onward, that spread has been nearly constant at 3%. In the earlier period, the Prime Rate spread was what one would expect it to be, a variable, market-determined quantity reflecting the availability of capital and perceptions of risk even among “creditworthy” borrowers. Now it is a fixed quantity, more than double its average prior to 1989. At around the same time, sophisticated borrowers switched to an entirely different benchmark, leaving consumers and small businesses to pay the higher spread.

Of course, a benchmark is only a benchmark, and the various short-term dollar interest rates correlate strongly. In theory, a competitive lending market should force down bottom line rates, regardless of which benchmark is chosen. Nothing prevents a loan from being quoted as “Prime minus 1.5%”. But in practice, this doesn’t happen. Sophisticated consumers who know what the Prime Rate is supposed to mean understand that they should expect to pay a bit more than banks’ “most creditworthy, prominent, and stable business customers”. But I’ll bet that 99% of educated borrowers have no idea that the Prime Rate includes a spread roughly double what those best business customers actually pay. The Prime Rate to Federal Funds spread is now fixed, in both senses of the word.

Update: A bit of web searching turns up this (by Michael Evans):

…the spread between the Federal funds (and Treasury bill) rate and the prime rate widened from 1 1/2% to 3% in 1991. That was Greenspan’s gift to the banking sector to insure that major banks would not fail. You may recall at the time that rumors were rife — including some repeaed on the floor of the House — that Citibank was about to go under. By doubling the margin between the prime and the funds rate — and essentially increasing the profitability fourfold after taking into consideration the costs of processing loans — an inverted yield spread lost all its meaning. And it will never return.

Update (October, 2008): “Prime-minus” loans did eventually come to be advertised, for secured consumer credit. The first time I ever saw one was sometime in 2007 or 2008. Most consumer loans remain “prime plus”, though. The 3% fixed prime rate is a gift that keeps on giving.

the camel’s philosophy of the future

gillies, in the comments to a post of Brad Setser’s, writes a parable of the age:

the camel’s philosophy of the future.

the camel’s back will probably be broken.
– that is a fairly predictable future event.
the last straw will be responsible.
– that is for sure.
(it is a fundamental law of backs and camel loading.)
but which is the last straw
– that is not easily predictable.
and when it goes on the camel’s back
– that is not predictable at all.
therefore those who make their millions loading camels
– cannot easily be deterred from adding straw.

Reposted with gillies’ permission. gillies writes at, where a wealth of material awaits.

Pigou, or Pig in a Poke?

Gabriel Mihalache objects to Greg Mankiw‘s frequent invocation of Pigou in support of energy taxes he’d like to see enacted. In a thoughtful and eloquent rant, he makes an important point about the impossibility of implementing an optimal tax “scientifically”:

[T]hey draw you in under the pretense of restoring efficiency—what’s fair is fair, right?—who would argue against efficiency? That’s like saying you don’t like puppies!

But once they get you with the externalities/Pigou/efficiency argument, surprise! They don’t provide you with a practical formula for Lindahl pricing, an econometric/empirical test—this does not exist (yet)—and instead each of the members of the Pigou Club starts pushing his own political agenda: some, like Becker or Greenspan, want to see reliance on foreign authoritarians regimes reduced, others, like Mike Moffatt, want to equal-out the marginal effect of taxes, etc. But guess what, all these otherwise noble political causes have nothing to do with Pigou’s work.

I must strongly object to purely political proposals dressed-up as positive welfare economics/science.

[italics are Gabriel’s]

Read the whole thing (as well as my, er, eh-hem, lengthy and erudite comments) here.