Rethinking Markets

7 Comments

• brayden wrote:

  January 23, 2009 at 2:33 pm

  So if we’re satisfied with your answers are you going to start charging?

  This isn’t a very technical question, but I’m interested in your opinion nonetheless. What do you think of the too-big-to-fail argument? Is the relative size of the institutions the real reason that government are so interested in bailing out these banks? If it is size, then would the appropriate regulatory solution be to limit the size of banks in the future?
• Dan Hirschman wrote:

  January 23, 2009 at 3:12 pm

  I’m interested in your take on the role of bubbles in the current crisis and the “what-ifs”. In particular, how much of the current crisis can be blamed on the reaction of the Fed, and the rest of the financial system, to the dot-com bubble bursting? We hear a lot about the housing bubble and whether or not the Fed played a role in creating it, but much less about what should have been done differently to either prevent or ease the popping of the dot-com bubble. So, what went wrong in the late 90s/early 00s, how important is it now, and what could we have done differently? More broadly, what is the consensus now on what we should have done (and when we should have done it) to have prevented the current crisis?
• Zach wrote:

  January 23, 2009 at 3:32 pm

  Credit default swaps

  or more generally speaking: the buying of interest on top of instruments that grant interest.
• Peter wrote:

  January 23, 2009 at 3:59 pm

  Brayden -
  So, as you probably know, ‘too big to fail’ dates back to the mid-1980s (I think 1984 or so), when the Federal reserve stepped in an guaranteed all liquidity to the Continental Illinois Bank. It was then the 7th largest bank in the US, and the argument was that to stop a national bank run/crisis of confidence, regulators had to step in and do something.

  IMHO (as I suppose all these will be), too big to fail is a legitimate argument if you are interested in maintaining the system as it exists. That is, maintaining a backstop of last resort discourages systemic change. So if you argue that our current banking system ‘works,’ which is a legitimately unanswerable argument to be having, I would strongly argue that the failure of its largest participants would precipitate systemic failure. If you think that systemic failure would not be a bad thing (Screw finance! or Creative destruction!), then too big to fail is a stick in the wheels of change. I don’t believe in this last view myself, but it’s a reasonable thing to think.

  That said, I have strong opinions that ‘too big’ doesn’t mean what we think it means. Currently it means something like assets under management. So under these guidelines, you might argue that Citibank is too big to fail, but Lehman Bros. is not. This was actually the case. In 2006, Lehman’s market cap was $41.3B, and its book value of assets was $410B; Citigroup’s market cap was $274.6B, and its book value of assets was $1.494 Trillion. So from this perspective, it looks like Citi needs to stay, but Lehman can be allowed to fail.

  A more important measure is something that captures centrality. The top 10 investment banks accounted for 90% of counterparty risk in global credit markets. E.g., Bear Stearns’ losses were $2.6B but the notional value of its underlying positions was something like $13 Trillion. When Lehman failed, it had tentacles everywhere.

  So this is why I was (and am) in favor of bailing out AIG but not Citibank. I would be in strong strong favor of shoring up the Depository Trust and Clearing Corporation if ever it were in trouble. It’s the organization that clears trades in equity and bond markets, so it stands in between almost every market participant who buys or sells an equity or bond. Along with a small number of clearing firms at some of the world’s exchanges (and here, Citi is one as well, so in this respect, they should merit more consideration from me), DTCC makes it possible for me to not honor my trade and still have my counterparty not get screwed.

  In other words, within the confines of ‘our system is sucky but we want it to survive in its current form’, we should start thinking about ‘too central to fail’, rather than ‘too big to fail.’
• Peter wrote:

  January 23, 2009 at 4:29 pm

  Dan –
  This is kind of philosophical question, especially since bubbles are by definition retrospective. E.g., if you look at the Case Shiller index of housing prices, you’ll notice that between 1940-1950 prices jumped and then stayed there. So ‘bubble’ implies jump up and then jump back down, an unreasonable price activity more like the Tulip Mania than anything else. But it’s worth remembering that jump in the 1940s after WWII. Big structural shift, no bubble.

  But I’m hedging.

  I’m a little of the mind of the Giant Pool of Money argument. It goes that the Fed’s decision to reduce interest rates and keep them there in the 1990s led to a mad panic for global investors to find alternative arenas for investing massive amounts of money. The place it landed was in collateralized mortgages. In this respect, the Fed created conditions for a bubble but didn’t necessarily cause the bubble.

  In corporate finance, the same causal mechanism is identified by Neil Fligstein’s (1990) The Transformation of Corporate Control – governmental oversight (and then deregulation) provided the catalysts for different merger waves in the US. But my overall opinion about the Fed in the current bubble/crisis is more that they were catalyst-but-not-cause.

  I think that slowing down international finance is one thing the federal government could have done differently then, and should do differently now. If the simplifying and slowing of finance means less availability of credit, I believe that’s something we should accommodate ourselves to as consumers, businesses, and as a society.

  In 1999, Michael Lewis wrote a good debrief of the Long-Term Capital Management fiasco of 1997-8, and as part of that interview Robert C. Merton had this gem:

  It is interesting to see how people respond when the assumptions that get them out of bed in the morning are declared ridiculous by the wider world. There is obviously now a very great social pressure on the young professors to abandon the thing they cherish most, their hyperrational view of the world. In the coming months, they could very well be hauled before some Congressional committee to explain their role in jeopardizing the free world. Oddly, the question that occupies them is not whether to push on with their models of financial behavior but how to improve the models in light of what has happened to them. “The solution,” Robert Merton says, “is not to go back to the old, simple methods. That never works. You can’t go back. The world has changed. And the solution is greater complexity.”

  I think he’s wrong on this count, that greater complexity is the solution.

  I had in mind a longer post about de-linking abstract risk (which is what I think is one of the main problems). But the essential argument is that moving back to walled off institutions, like the Glass-Steagall Act of 1933 (which made it illegal for depository banks, investment banks, and insurance companies to engage in each other’s activities – repealed in 1999), is not going to work. Instead, we need to figure out ways to make more local and less abstract-able different kinds of risks. Ugh, this is more mud and less clear than I want, but let me give it a different post and see if I can clear it up.
• Peter wrote:

  January 23, 2009 at 5:08 pm

  Zach –
  Ok, your question is less clear to me than I would like, and getting towards the limits of my knowledge.

  So let me pass this off to the best, most concise explanation I have found. It’s an interview between Charlie Rose and Bill Ackman, the CEO of Pershing Square Capital Management. It is a hedge fund that made quite a bit of money short selling via credit default swaps.

  The interview is here, and I would check in at about 3:30 into it, where Ackman begins to explain how they sold companies short. There is also a transcript, which is what I am quoting from:

  BILL ACKMAN: A derivative, I guess the way to describe it, you can short a stock and bet that a stock will decline in value. Another way to make a similar bet is to buy an insurance policy on a company defaulting. That insurance policy is called a credit default swap. It trades on the over-the-counter market. You can call up Goldman Sachs or Morgan Stanley. They’ll make you a price on the probability of G.E. defaulting. Obviously, that probability has been perceived to be very low over a long period of time. The cost of the insurance is small.

  If you had the view that G.E.’s credit would deteriorate, you could buy that insurance policy and then sell it at a later date. Imagine if you could trade the insurance policy on your home, so when you first buy it, it would be relatively inexpensive. But as a brush fire occurred in the neighborhood, the policy would become more valuable. You could sell it on the market.

  So credit default swaps are a way to hedge or make a bet on a company’s credit worthiness, either to the positive or to the negative…It’s also a very efficient way to make a bet. It’s much more efficient than shorting a stock.
  …

  BILL ACKMAN: I was principally a long investor for the first ten years of my investment career. In 2002, I came across a company called Farmer Mac, which is a GSE, not that different from Fannie and Freddie, but that operates in the agricultural credit market. It was recommended to me as a long investment, something I should buy. The more I looked, the more I concluded that this was a good short. And without going into too many details, I bought a credit default swap and it turned into a profitable bet.

  Credit default swaps are structurally equivalent to shorting a company’s stock, because the same things that would cause a company’s stock to decline would also cause it to have a greater chance of defaulting on its debt. If you’re willing to buy GM bonds, for instance, they’re paying out an equivalent of 63% yield. I imagine that insurance on that debt (the credit default swap) would be very very expensive.

  It’s ‘efficient’ in the respect that you don’t have to go out and find someone who owns GM stock, borrow it from them, sell it, then repurchase it at a later date (which is what you need to do to sell a stock short). Or, you could buy tons of put options on GM stock, that would also accomplish the same thing. There are regulatory requirements in both of these places that don’t exist in the over-the-counter derivatives market.

  I hope this helps.

  Incidentally, thanks for the questions.
• Peter wrote:

  January 28, 2009 at 11:35 pm

  Zach- this might also help.