...Archive for November 2008

Should “bad” financial contracts be banned?

Despite all that’s gone down over the last few years, I’m an enthusiast of “financial innovation”. I think it essential that we remake our financial system into something so different from what it has been that we would hardly recognize it. Doing so will require a lot of innovation.

But there’s no question that the current financial crisis was abetted and largely enabled by many of the “innovations” that became ubiquitous in the financial sector earlier this decade — CDOs, SIVs, (arguably) CDSs, etc. To square the circle, I resorted to an old cop-out: the revolution hasn’t been tried. There’s good innovation and there’s bad innovation. The stuff that didn’t work was the bad stuff. Lame as that may be, it is what I think, and I did try to put some flesh on how we could distinguish good from bad going forward. Then Dani Rodrik came back with some fair questions:

OK, now that we have collectively gotten over our finance fetishism, and are willing to accept that some innovations can be bad, what does this mean for regulatory and supervisory approaches?

For example, it is one thing to say that good innovations are those that are transparent, and another to figure out how policy sorts out the degree of transparency of innovations and how policy makers treat innovations of different kinds. Does this line of thinking imply that some degree of paternalism in regulation is unavoidable (“no, you cannot issue this particular complicated derivative!”)

I think we need to discriminate here between the structural and substantive terms of financial instruments. A contract is “structurally” transparent if, conditional on any set of observable real economic outcomes, it is clear what cash flows are compelled of all parties. A contract is “substantively” transparent if the economic outcomes that determine the cash flows are themselves susceptible to analysis. A mortgage-backed security, for example, might be structurally transparent but substantively opaque: Knowing the performance of the bundled mortgages, it might be easy to calculate the cash flows payable to all tranches. But as a practical matter, it might be impossible to estimate the performance of a thousands of heterogeneous loans in a volatile housing market. Common stock is arguably both structurally and substantively opaque: Even if one knows with certainty the long-term performance of a firm, the cash flows due a stockholder can be difficult to predict. And the future performance of a firm is itself very hard to estimate.

I think a strong case can be made for regulatory promotion of structural transparency. Contracts can be made arbitrarily complex, and there is little reason to think that skill at crafting and understanding challenging legal documents overlaps with peoples’ ability to evaluate economic risks and outcomes. It would be useful to have standardized contracts so that those not expert in the law of finance can participate in financial markets without fear of getting screwed because their lawyers missed something. Also, I think regulators have a legitimate interest in ensuring that investors do not accept contingent liabilities foreseeably beyond their capacity to pay. To do so, regulators must be able to estimate the liabilities that counterparties could be called upon to bear. The potential extent of those liabilities should be evaluable without a lot of analysis or guesswork.

That said, I don’t think the best approach would be to forbid nonstandard contracts. Instead, regulators could “bless” certain contractual forms as well-defined, while creating penalties for those who offer contracts that are structurally opaque or that serve to hide embedded leverage. Parties who have good reason to deviate from very standard contracts would have the ability to do so, but would risk of being punished if those instruments are deemed to have violated standards of clarity. In other words, instead of eliminating “bad” contracts, regulators should take on the role of organizations like ISDA and proactively define “good” contracts that meet needs they identify by monitoring “exotics” that gain prominence in the market. Unlike ISDA, however, regulators’ primary mandate would be to ensure that the contracts they bless are well thought out from the public’s perspective: that “catastrophic success” of those contracts would not create fragile networks of counterparties or other hazards. “Blessed” contracts might well include obligations to periodically report contract valuations notional and net, and collateralization to a public registrar. They would rely upon collateral much more than counterparty for security (to restrict embedded leverage), and provide for standardized means of termination or novation, to prevent the emergence of economically useless but systemically hazardous multilaterally offset positions. They might work proactively to encourage the formation of centrally cleared exchanges, to permit counterparty neutrality with less collateral or risk of early termination, as new forms of contract grow popular.

The case for regulatory promotion of substantive transparency is much weaker. Economic problems that appear inscrutable to distant regulators might in fact be quite tractable to those “in the know”. (Pace Arnold Kling and Richard Serlin, it’s important to point out that when I take “transparency” as desirable, I am not suggesting that people should be compelled to reveal hard-won information without compensation. People who can predict economic outcomes should be paid for doing so. But contracts should generally be structured so that the relationship between economic outcomes and contract cash flows is clear. How much “inefficiency” is desirable, meaning how slowly contract prices should respond to information revelation, creating opportunities for the informed to profit, is a complicated question. We need to balance the interests of uninformed investors, whose capital may be required for large projects, and information workers, who need incentives to evaluate competing projects.)

Suppose a group of people learned that, in the near future, there would be an incredible economic need for COBOL programmers, and looked for a way to monetize this. Noting that former COBOL programmers are much more creditworthy than their FICOs suggest, they might wish to buy up the loans of this dispersed, obscure population. Knowledgeable individuals would not want to buy up individual loans: instead they would want diversified exposure to the pool of COBOL programmer loans, since individual circumstances vary widely. Our cabal only knows that on average COBOL programmer loans are underpriced.

So, our insiders should hire up some financial engineers, and construct an asset-backed security containing a pool of consumer loans to COBOL geeks. They could each take diversified shares of the pool, with some assurance of having bought undervalued assets. Once the ABS is established and divvied up, they would have every incentive to reveal their information, explain to the world why COBOL is the next big thing (and how their ABS was structured), and sell to the world at fair-ish value for a quick profit.

This chain of events is informationally idyllic: Knowledgable people are compensated for revealing hard-won information, and economic assets become more accurately priced, which should feed forward into better decision-making. But if regulators are empowered to evaluate the “substantive transparency” of investment contracts, they would certainly have nixed an ABS made up of loans to an eclectically selected population of individuals without justification. Up-front revelation of the justification to regulators, however, might leak and allow a larger player to buy up the whole pool, eliminating the opportunity.

Also, consider common stocks. No rational regulator concerned with substantive transparency would approve of common stock, if it were a novel investment vehicle. It guarantees no cashflows whatever, its “control rights” are so weak for most purchasers that representations thereof should be viewed as fraudulent. Empirically common stock behavior is very weakly coupled to the performance and health of the firms that stocks fund. The only instrument in wide use more substantatively opaque than common stock is fiat money.

I think common stock is a deeply imperfect instrument, one that we should work to improve upon and eventually replace. But, there’s little question that over the several hundred years between the invention of joint stock companies and the advent of information-technology that might make more fine-grained claims practicable, common stock served a useful purpose, both in terms of pooling capital and risk, and promoting information discovery and revelation.

Still, much of our current catastrophe was caused by investors investing overeagerly in securities whose structures were clear enough, but the economic substance of which they were entirely incapable of evaluating. Rather than banning such securities, we should turn our attention to understanding why they did this. A lot of very opaque securities (both substantively and structurally) were invented, sure. But how did they vault from idiosyncratic experimentation to widespread implementation? This had to do with the structure of financial intermediation, and it is there that I believe that regulatory energy should be focused, rather than on evaluating the terms of contracts.

Flawed financial instruments only become policy issues when people responsible for investment on a significant scale decide that what they don’t know won’t hurt them. This can happen by virtue of fads and fashion, the madness of crowds: consider internet stocks, or blind faith in diversification and “stocks for the long run”. But most poor investment, in dollar-weighted terms, is not taken by foolish individuals placing their own money. Bankers and institutional investors are on the one hand granted the power to control investment on a very large scale, and on the other hand make consistently awful choices. Delegated money, rather than trading off return and safety, often trades return for safe-harbor. Absurd contracts that appear to offer high returns are very attractive to money managers of all stripes, if they offer a veneer of safety and “prudence”, or better yet, if they become conventional.

Getting regulators in the habit of banning some classes of contracts (or worse, requiring them to approve novel contracts) would have the perverse effect of certifying the instruments that are permitted. A better approach would be to eliminate safe-harbor for intermediaries by insisting that they be substantially invested in the funds they manage, and on the hook — financially, not just reputationally — for losses as well as gains. (Obviously, we should eliminate safe-harbor that derives from rating agency certifications or statistical risk models. But that won’t be sufficient — professionals will always manufacture “best practices” and find safety in numbers, or hide behind consultations with experts and representations by prestigious sources.)

Fundamentally, the agency problems associated with financial intermediation are deep, and it will take a lot of reform — and innovation — to find good solutions. Regulation to promote structural clarity in investment contracts and manage leverage and counterparty risk may help limit the damage, but won’t be nearly enough. I think we need a fairly wholesale restructuring of financial intermediation, one that limits the scale and leverage of intermediaries, segregates transactional balances and noninformational savings from informational risk investment, and ensures that those who do manage large quantities of wealth land in penury or in prison before the taxpayers are on the hook to make private losses whole. But having regulators review and restrict the substantive terms of financial contracts strikes me as a bad idea.

Apology to commenters

The last couple of posts have generated some very high quality comments, many of which I’m still itching to respond to. I usually try to participate in comment threads. I very much enjoy the conversations, and learn a great deal from the give and take. But my participation has been limited and will probably continue to be so, at least for the next couple of months.

I do read every word (and usually follow the links too). And I very much appreciate your taking the time to read, and to write.

It’s actually a bit silly for me to apologize for my nonparticipation, though. I’d only bring down the level. I’m honored that you choose to chatter here.

“Investing” in AIG et al

Ceci n’est pas un post.

I don’t have time to post right now, and besides, I promised myself that the next post would be a disquisition on regulation, in response to Dani Rodrik. (My two neurons are working real hard on that.)

But, today I am white-hot mad over AIG, and I need to vent. Yves Smith has done a beautiful job of describing the ridiculous awfulness of today’s “restructuring”. More importantly, she uses words with the appropriate intensity and valence: “banana republic”, “looting”, “Mussolini-Style Corporatism”.

For so many years, Milton Friedman passionately argued that there is a relationship between economics and political life. In particular, he believed capitalism to be uniquely compatible with a free society.

What kind of society is compatible with an economy managed by a cadre of large, politically connected firms whose operations and those of the state are intimately connected, and which cannot be permitted to fail since that would bring “chaos”? Friedman would have remembered. “Mussolini-style corporatism” can’t be quarantined at the corner of Liberty Street and Maiden Lane. Trillion dollar bail-outs represent claims on scarce resources. If times get hard, the idea of scarcity will become a lot less abstract. The state will be called upon to enforce “property rights”, including rights to the property that the state is right now giving away (and which in turn are being given away to the truly deserving). First there are economic emergency measures. Later there may be emergency measures of a different sort. Mixing my libertarians, there is more than one road to serfdom.

It is so odd, how we are becoming inured to these sums, $150 billion for AIG, $140B in tax breaks to encourage consolidation into bigger and more dangerous banks, the hundreds of billions in equity infusions under the modified TARP plan, etc. The Fed’s balance sheet has expanded by more than a trillion dollars over the course of several weeks, almost all of which is used to offer one form or another of covert subsidy to financial firms. A bit hyperbolically, I thought, I once compared the scale of the Fed’s interventions to the direct cost of the Iraq War. Now that seems quaint. The scale of the government’s response to the financial crisis now completely dwarfs the direct costs of that war, as well as any plausible estimates of the indirect (financial) costs. (Obviously, the real costs of war are not financial, and run much deeper than our economic problems. I hope the comparison doesn’t seem flip.)

Of course, we are constantly told, all of this is an “investment”, no money has been spent, the taxpayer may even turn a profit.

That’s an argument that sounds reasonable only until you give it a moment’s thought. Nearly all “government spending” (outside of entitlement transfers) is investment. When we build schools, run head start programs, buy fighter jets, and fund our court system, that is not “consumption”. We don’t do those things because we enjoy them, but because they create ongoing payoffs that we believe outweigh the opportunity cost of our funds.

When a firm purchases inventory, when it installs new machinery or operates a research lab, we don’t claim that it has “consumed” its wealth. Investment is something we do in the real world. Financial claims are only faint, imperfect echoes of real investment. There is a bitter irony in the fact that, precisely when bankers have profoundly debauched the value of paper claims, taxpayers are being told that they are not spending, they are investing, when they buy unmarketable securities. Of course it would be “spending” to build a power grid or an airport.

Now, perhaps the government is a very poor investor. But do we have reason to believe that it is more skilled or less corrupt when it invests in financial claims rather than real projects? I find the case for a 16% real return on early childhood education far more compelling than the case for 5% nominal coupon on Goldman preferred stock.

It is likely that taxpayers will turn a paper profit on their paper claims against financial institutions. But that’s not because they are good “investments”. It’s making these investments good is now a constraint on government action. The Fed cannot behave in ways that would compromise the value of the trash on its balance sheet. Once AIG was too big to fail, it cannot fail, no matter how big the black hole grows. Once GM enters the penumbra, very soon now, it also must not fail. Of course, we will not count this terrible loss of policy freedom as a cost.

That cost may be quite large. A commonly held view is that yes, the Fed’s interventions are extraordinarily expansionary, and yes that could lead to inflation sometime far in the future. But for now we have D-leveraging, D-flation, D-pression to worry about. The Fed retains its traditional tools to fight inflation with, when the time comes. It will be able to sell Treasury bonds for cash and “mop up” all this “liquidity” it has “injected” into “the system”.

But wait. The Fed doesn’t hold very many Treasury securities any more (see Kady Liang). It would have to sell off some of the other stuff. Maybe we get lucky, and by the time we need to fight inflation, all those “money good” CDOs turn marketable again. Maybe not, though, and then the Fed will have little choice but to tolerate a great inflation or watch its own balance sheet implode. When the inflation comes, bright investment bankers will have already converted the bonuses we paid them into real property. It will be ordinary savers, and especially workers without bargaining power, who will be stiffed with the bill.

I think either a great inflation or a catastrophic deflation are pretty much unavoidable. It’s the distributional effects that have me white hot with rage. We are sowing the seeds of inflation by making those most deserving of catastrophe whole, while doing nothing for those whose wages may soon achieve purchasing power parity with the emerging world. I’m actually cool with inflation — hey, all my money’s in gold. A sharp inflation would be a kind of large-scale Chapter 11, a systemic debt-to-equity cramdown, debtholders get their claims devalued but the firm’s nation’s economic life goes on. However, inflation is a wealth transfer, and we should be conscious of from whom and to whom. For every dollar of Federal largesse that goes into the Wall Street bonus pool, three dollars should go into extremely generous unemployment benefits, paid sabbaticals for workers to return to school and retool, anything and everything to give people bargaining power to negotiate higher wages without all the hassle a union. Let’s pass the “Take this job and shove it act of 2009″.

Because the only thing worse than a great inflation with a wage/price spiral is a great inflation without one.

If we only had a financial system…

Here’s Paul Krugman:

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine’s plea: “Grant me chastity and continence, but not yet.” For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.

…The capitulation of the American consumer, then, is coming at a particularly bad time. But it’s no use whining. What we need is a policy response.

…[W]hat the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

Tyler Cowen responds:

Krugman… calls for fiscal stimulus… I am more inclined to think that consumers need to cut their spending now. It is widely understood that consumers have been living beyond their means. Let us say instead that consumers maintain their spending (say through fiscal stimulus, a cut in sales taxes, or sheer exhortation) but that everyone knows consumer spending will fall in three years time. In three years time, the “liquidity trap” (not exactly how I think of it) will be over, but in the meantime investment commitments will be lackluster, given that people will be waiting for the economy to digest the forthcoming change. Maybe we need to spend less now and get the adjustment over with more quickly, even though that will be painful.

I love this exchange, because it beautifully dances around the elephant that is not in the room.

Krugman’s point is that, ordinarily, a dip in consumer spending could be offset by an investment boom, courtesy of the Federal Reserve. As always, there’s model just behind Dr. Krugman’s words, summarized in this case by an accounting identity:

Y = C + I + G + NX

If C (consumer spending) contracts, and I (investment) cannot be made to grow, then Y (GDP — truth, goodness, and happiness) must fall, unless we start messing with G (government spending) and NX (net exports). Hoping for an export boom during a global recession seems daft (although NX shifting toward zero from recent negative values may help), so we are left to work with G. It’s time to ramp up government spending.

You can almost hear the words of Hayek echoing in Dr. Cowen’s rejoinder: “Mr. Keynes’ Krugman’s aggregates conceal the most fundamental mechanisms of change.” Cowen’s rather subtle point is that if we artificially support current patterns of consumption by having the government spend money into people’s pockets, we won’t know what future, sustainable patterns of consumption might look like. Without that, we won’t know what to invest in. Paradoxically, we might exacerbate the short-term problem by suppressing private investment. Longer term, we cannot run the economy off of government spending indefinitely, and if we just postpone the pain, we will find ourselves with fewer resources when we have to deal with the underlying problem.

The elephant that is not in the room is a financial system. By a financial system, I don’t mean the tottering cartel of banks and insurers loudly sucking newly printed cash into “collateral postings” and “deleveragings” and other meaningless nonactivities. That is no financial system at all. It is an ecology of intestines and tapeworms, tubes through which dollars flow and are skimmed en route to destinations about which the tripe-creatures have little interest or concern.

No, a financial system would be forward-looking. A financial system would be interested in the world, rather than fascinated by the patterns that formed behind its own mathematical eyelids. A financial system would hunger for information. It would leave no human preference overlooked and no technological possibility unconsidered. A financial system would embrace us all, would want to learn from us all. It would not be something external, something outsourced to specialists in London or Manhattan. It would want “savers” to express what they plan to do, how they hope to live, rather than offering generic claims on money along a disembodied spectrum of “risk”. It would thirst for proposals, ideas, business plans designed to meet the preferences thus expressed, or to achieve possibilities not widely considered. A financial system would be creative. No stock exchange could contain the vast and multifarious tapestry of investable ideas a financial system would educe. A financial system would offer us opportunities to invest not in distant opportunities where we are disadvantaged, but in projects that are informationally, if not physically, near to us. A financial system would be ruthless. It would allow us to have a voice in the most important decision we collectively make, but would force us each to bear the costs of our errors.

We simply do not have such a system. We don’t have anything remotely like such a system.

If we did, Dr. Krugman’s preferred remedy would have worked five years ago, when the Fed still could, and did, stimulate an investment boom. If we had a financial system, we would not have invested in luxury housing and disinvested from tradables while our current account deficit ballooned. We would not have securitized current consumption, and the called it “investment”. Extrapolation is not foresight, and Ponzi schemes do not generate wealth. We did not have a financial system on 2003. That is how we got to 2008.

If we had a financial system, we wouldn’t require the world economy to collapse, just so we could learn how it might be put back together again (with expectations sufficiently lowered). Our financial system would be considering a wide array of possible futures, and using us all to push the world toward to a future that actually makes sense. If we had a financial system, we would be saving by spending to enable future production, not by making sure our dollars are in the kind of bank accounts the government guarantees. Strained consumers would shift from C to I without depleting Y, by purchasing claims on future goods and services, which investors would sell while funding projects designed to ensure the production of those goods. The very act of cutting back current consumption would generate new information about the structure of future consumption, as nervous savers factor price into claims on the future and nervous investors compete to offer claims at prices low enough to sell but high enough that they can ensure profitable fulfillment through an uncertain future.

Of course, this is a kind of dumb utopianism. If we had a magic wand, we’d have better options too. But I suggest you look at it the other way around: the “financial system” that we actually have is an awful dystopia. Yes, it will be impossible to create the perfect massively decentralized optimizer of collective and individual human futures. Screw perfection, but we should at least go for mediocre. Right now, banks don’t even bother to sell themselves to savers on the basis of their superior acumen in choosing real investments. Investors in mortgage-backed securities never believed there was a deficiency of luxury exurban housing. People don’t invest in index funds because they have a considered belief that the projects available to listed firms are superior on average to other projects that might be pursued. We have methodically erased information about real-world activities from the financial decision-making process. We’ve created an intrafinancial mandarin class, treated as experts, entrusted with wealth, but lacking knowledge of anything other than the arcane wheels and gears of finance, as if the finance exists apart from the workaday world of producing and consuming, serving and being served.

There will never be a perfect financial system. But the system we have is so far from reasonable that it must be undone, or it will be our undoing. We should not be propping it up. We should be tearing it down, and using all these hundreds of billions of dollars to replace it with something sensible.


By the way, as a policy matter, in this world as it is, I don’t mean to criticize either Krugman or Cowen. I think they are both right. Per Krugman, for now we have little choice but to have government do a lot of spending, since we have no financial system to convert present savings into real investment. But, for the reasons that Cowen highlights, I think we should channel any stimulus towards basic consumption by those facing hardship (e.g. unemployment benefits, food stamps, etc.) and obviously necessary infrastructure investment (fixing bridges, dams, power grids, etc.). In any reasonable future, everybody will eat, so offering money to those struggling to put food on their table or a roof over their heads will create less uncertainty about future tradeoffs than subsidizing discretionary consumption by those better off. And it’s a cliche, but a true cliche, that our public infrastructure is crumbling. Pulling forward restoration projects that will be necessary unless there are radical changes in the structure of American life also introduces relatively little noise.

But the most important thing we should be doing is building a real financial system.


Update: This post has attracted an extraordinary comment thread. A lot of bright people are looking past all the logos and glass-and-steel towers that try to persuade us that what we have is permanent, a fact of nature, necessary. Some are so old-fashioned as to try to build a better mousetrap and outcompete the slime creatures. (It would be peevish to point out that trillion dollar subsidies and captured regulators may leave upstarts with a not-quite-level playing field.)

Update History:
  • 10-Nov-2008, 5:50 p.m. EST: Added update re comment thread.