The trouble with the commercial is that the dog, after seeking out ways to protect his most prized possession, finds a solution in purchasing insurance. Keep it on your person? Too hard. Put it in a bank? Too risky. But with insurance, you can just leave it out in plain sight and go out to play.

This is of course a problem known as moral hazard. The shifting of risk from the original owner of an interest to an external organization causes the owner to act in ever more risky ways. Imagine if everyone just got insurance and then instead of protecting their business/car/house went outside to play. I mean, what the hell, if you’re paying for insurance you might as well not worry about it.

In the real world, insurance companies protect themselves against moral hazard by doing things like dropping you from your car insurance if you make more than 3 claims in a 5 year period. Or penalizing you (or dropping you) on your health insurance for gaining too much weight. In the finance world, we can arguably trace some of the roots of the 2007-now financial crisis to the fact that banks laid off their risks onto someone else, allowing them to take some fees and sleep better at night.

In short, the ad with the dog is almost exactly what insurance companies do not want you to do. What they want is for you to continue to act paranoid, but after doing everything possible to reduce your own risk, not worry about what’s left over. The thing is, carrying some risk – maybe a lot, maybe some – makes you more responsible. This crazy mutt has no more skin in the game…

Prices in financial markets are not like prices in other kinds of markets. When you buy gas, you see prices posted for the various grades of gasoline. These prices are for buying gas; theoretically speaking, this is: a) a posted, fixed price – as opposed to a barter or negotiated price); and b) this is a market-taking rather than a market-making price – the price is for something that you can only buy, but not sell. You can only take what is offered, not make your own market.

By contrast, financial prices (and I’m going to use stock prices and financial prices interchangeably, though they are not necessarily interchangeable) are negotiated prices for a continuous auction. There is no single price for a futures contract, a stock issue, or a derivative. Instead prices consist of four main elements: bids, offers, bid quantities, and offer quantities. Buyers provide a price and quantity at which they would be willing to purchase a stock (a bid), while sellers provide a price and quantity at which they would be willing to sell (an offer). When these bids and offers “match” – if a buyer is willing to meet a sellers offer, or a seller is willing to meet a buyers bid – a trade will take place, until there are no longer any bids or offers at that price. If the bids and offers are not matched, there will be no trade, and the current “price” is understood to be the currently-best bids and offers.

For example, if there is a bid to buy 100 shares of Intel stock (INTC) at a price of twenty, and an offer to sell 50 shares at a price of 21, the current “price” is “twenty bid at twenty-one offer,” or 20-21. If the potential buyer and seller decide to stay at their respective prices, no trade will occur; the market will simply stay 20-21 for as long as they hold out. If, however, the buyer decides to raise her bid to 21, a trade will take place: she will buy the 50 shares that the seller was willing to offer, and have 50 shares left over still to buy. Those 50 shares left over would become the currently-best bid. The price would move to “21 bid.” If the next best offer were 22, the price would be 21-22. If the next best offer were 23, it would become 21-23. This process continues throughout the trading session, with the market constantly fluctuating depending on the bids and offers available to trade.

In this fashion, the last reported price is a useful piece of information, but much less than complete. More complete is to know the current best bid, best offer, and the quantities associated with them.

Even more complete would be to know the entire list of bids and offers behind the currently-best ones.

Why is that? Well, you could imagine that you think you’re looking at a market like the snaily one here:

If this were the case, perhaps you might say that there is mildly more shares on the buy side than the sell side, or upward pressure on the price. If you were a seller, deciding whether or not to take the best bid available (in the hopes that the share prices were falling, or simply trying to sell your existing shares at the best possible price), you might think you’re making a decision based on a relatively small bid. My willingness to buy or sell at a particular price is contingent not just on my own absolute feelings about the stock price, but also on how much I think I can get for it – which is a question about not just my intentions, but others’ intentions as well.

Because, what if you knew that the market looked like this snaily-cat one?

If this were the case, where there is relatively strong resistance at 19 (lots of people wanting to buy, or a single big buyer at 19), your decision-making process might be different. And knowing the intentions of buyers and sellers not yet in the marketplace makes a huge difference.

Each trade involves a trade-off, between being first and getting the price you want on the one hand, and signaling your intentions to the rest of the world on the other. Since most financial markets work with some version of a ‘First in, First out’ algorithm (or FIFO, meaning that at the same price, earlier orders get filled before later orders), making your intentions visible early gets you a good spot in the FIFO sequence, ensuring a better price.

But, any time you signal that you want to buy or sell something, other people can react to your desires, potentially changing their own in the process. This might get you a worse price, if you ‘tell’ other people you are a buyer, they might raise their offers as sellers. And vice versa. If you know that someone is itching to buy 10,000 shares of stock you own, you may decide to sell at a higher price. And so, better/faster price vs. signaling your intentions and getting a worse price.

How much of the total buy and sell orders are shown varies dramatically by market. Some exchanges only reveal the size at the best bid and offer, others show their book 10 or 20 prices deep. Here’s the trading screen from the Swiss Exchange:
Here you can see bids, offers, and quantities well above and below the current market price. Other places don’t show any bids and offers.

And it’s between transparency and non-transparency that the arguments about dark pools of liquidity. Dark pools are alternative trading systems that report trades but not bids, offers, and quantities. They are trying to solve the problem of large orders moving the markets too much in their execution. But they are doing it badly.

That said, I would take issue with this particular story about how Goldman sold tons of mortgage-backed securities to investors while shorting the housing market themselves. It is a problem endemic to any financial institution with both an investment banking function (packaging financial products to sell to investors) and a proprietary sales desk. Sometimes there have been walls between these two functions, sometimes not. But it’s unsurprising that the banks takes opposite positions to the ones it sells to clients. For goodness sake, there is evidence that they shorted their own position in the sub-prime derivatives market.

And here’s the thing: the ultimate responsibility for the losses incurred by purchasing products sold by Goldman Sachs resides firmly with the people who purchase products sold by Goldman Sachs. If you can not trust the seller, do not buy their product. Financial services companies are dependent to a shocking degree on just-too-smart-for-their-own-good managers of large pools of money all over the world. Pension fund managers, state comptrollers, corporate treasurers, there are too many people who grew up wanting to be in a prestigious investment firm just like Goldman Sachs. So when GS comes along with dog and pony investment shows, these investment managers fall for it all the time.

The book has not yet been written on how poorly these investment agents all around the world get routinely hosed by the likes of Wall Street, in turn subjecting the real economy to risks it does not want or need.

Here are some of the things I’m looking at. Let’s start with the finance side, that is, where banks and other lending institutions might be extending credit or risking capital to promote economic growth.

Well….venture capital has been pretty miserable.

Levels of funding for venture capital are about at the levels seen just past the dot-com bust of 2001. So not much is going on there.

And the more traditional banking sector?

Well, the federal funds rate, which is the baseline rate at which banks can borrow from the US government remains at 0 to .25%. That is, banks can borrow money from the federal government pretty much for free. For free!

And how are banks responding? By tightening or leaving unchanged their willingness and standards for lending. That is, banks can borrow money for free and are not willing to lend it out to anyone but their most risk-free clients. What does this mean? It means that banks are collectively still massively worried about the losses and their ability to operate.

And they should be! The top tier of housing markets are now accounting for 30% of all foreclosures – it’s not all poor people with subprime credit loans. In fact, there is a fresh wave of foreclosures and financial losses linked to housing coming up around the corner. A set of loans known as option ARMs, or ‘pick-a-pay’ loans, whereby you pick the amount you will pay per month, deferring the principal payments down the road. The resets on these loans are, frankly, scary as hell:

Many people with these loans are going to see their monthly payments jump significantly right about….now. And since the real estate market as a whole has slumped, the homes are worth much less than the mortgages. How bad will this get? Well, Wells Fargo sees 60-70% loss severity on option ARMs. Pretty scary stuff.

In fact, delinquency rates on not just housing, but all forms of credit are pretty scary. In the most recent quarter: 8.8% of residential real estate loans are 30+ days delinquent; as are 6.7% of loans via credit card.

I’m not including the employment picture (awful); nor am I looking at the long-term fiscal state of, well, the State (awful). And of course, things can change pretty dramatically.

But I would say this:

1. If you are a bank and can figure out how to suss out the people who will pay you back from the people who can not, you should be making a gigantic boat-load of money right now
2. If you are looking to purchase a house, and are sitting on cash, you could buy now, but you don’t have to be in a hurry. There is no sensible reason to believe that things are going anywhere but sideways for the next year at least
3. Banks are on the brink. Still. And any ‘profits’ or ‘bonuses’ that they report are due almost exclusively to the fact that money costs them zero. Or, in some cases, because they are the last players standing in what are now less competitive markets (for, say, Government bond brokerage)
4. Lots of people are hurting, and they are likely going to hurt worse. If this recession has not affected you or someone in your immediate family, it probably will soon.

So, now you know why I’m not saying much about all this.

The whole shebang is worth noting, for its effects on behavior and its bigger-issue demonstration of the contextualization of rationality. Plus, honestly, it’s a fun video. I don’t know that I’d like all my trash bins singing at me, but I’m trying to imagine how this might work for a classroom, or for finance, etc. Obviously, this is a field that has been trodden upon before.

I think the experiment is interesting, and I am deeply committed to understanding those brackish waters between the sweet rivers of culture and the salty sea of markets. But there are some flaws here that seem about to be brushed under the rug in favor of the ‘measuring the objective value of culture’ story line. First, a typical description on eBay looks something like this:

The final line reads:

Note: The significance of this object has been invented by the author; see SignificantObjects.com for details. (Winning bidder also receives a copy of Cintra Wilson’s story about this object. Opening price represents the free-market value of the object prior to its invented significance…

And to me, the implications of that last line is where this whole thing falls apart.

First, there is a small but real element of misdirection here. People come to the objects from two sources: 1) from eBay itself, and 2) from SigObjects, Design Observer, BoingBoing, or any number of other culturally-hip blogs/feeds/twitters.

For people in the first category, the item is listed under sporting goods > team sports > basketball > other. And the notice that the “significance has been invented by the author” is small and unusual enough to be unclear to some people coming to the object. So it may not be clear exactly what one is purchasing when one is bidding on the object. My guess is that this accounts for a handful of bids (and maybe not more).

For people in the second category, it is also mis-categorized. Because it should not be under ‘team sports’, it should be under Contemporary Art. This is where the project is something of a failure. Because for people coming to the object via the Significant Objects site or some other culturally in-the-know place, bidding on the object is participating in performance art, and purchasing the object itself is more akin to purchasing a piece of contemporary art.

It’s for the same reason that this is not a big plywood box of Cornflakes:

It would be unusual for us to subtract the cost of the materials Warhol used to construct this piece (silkscreen ink on plywood) from the hammer price of the piece ($482,500) in order to somehow acquire the ‘objective’ value of significance. Unusual because it implies a kind of hedonic pricing model: that the object’s overall price can be derived by combining prices of its individual attributes – cost of materials + time + signficance. And it is possible to do so, and to thus come up with an ‘objective’ value of significance. With these measurements, so far significant objects has created and measured significance that has increased market value by almost 2300%. But as Brayden once said a long time ago, in the art world hedonic value falls to something more like transcendent value.

There’s a longer comment about the validity of lots of alternative pricing models, which depend not so much on specific notions of efficient markets (sociologists’ favorite straw argument), but on the notion of objective value. In the meantime, I think the significant objects project is completely interesting, but well, not quite significant.

By contrast, finance has become enamored of quantification to an unexpected degree. Value at Risk (VaR), the now-ubiquitous way to measure market risk, volatility, and assess capital requirements for financial trading, is a quantified measure of commensurated risk. That is, the various conditions around different sorts of assets are transformed (and made comparable) via this quantified metric. Stocks, bonds, private equity, mortgages, consumer credit, currencies, all are transformed into risk-measurable assets.

But the problem with VaR has become somewhat evident in recent history, and there are some moves afoot to replace VaR with something…well, something resembling the ‘expertise’ and intuition-based measures found more often in the Art World than on a trading floor:

What should replace VaR? We should reintroduce the spirit behind the way we calculated risk before VaR took over on trading floors and in the offices of regulators in the early 1990s. That means using intuition and experience-honed common sense. It means accepting the principle that toxic assets should be considered riskier than liquid assets—and that fancy math and past performance can be deceiving predictors that often deliver a lethal dose of leverage. We need rules and risk committees that limit a bank’s “bad” leverage by requiring much more capital to cushion, say, a subprime collateralized debt obligation than to offset Treasuries. It’s time to give up analytics so that real risk can be revealed.

On one level, I’m astounded by the call to ‘give up analytics’ in order to reveal real risk. On another, it’s a reasonable shift away from quantification, and back towards a kind of ‘qualitative’ commensuration.

The CMBS’s that have disappeared of late are securities backed by commercial loans (that market seems to have disappeared for now). It is interesting to note: a) that structured finance is not gone, and that b) it looks like something like $12B worth of securities have been issued using funds guaranteed by the federal government.

I could imagine, but don’t really know for certain, why a bank would prefer to securitize debt from the TALF funds. If it were my institution, I would pair the TALF assets with non-TALF monies (which are potentially much more dubious, given that delinquency rates on these kinds of loans are also climbing sharply), call it gold, or at least gold-plated, and then sell these to investors. I would make money on the transaction, get some of the loans off my books, and make that low-low-cost, low-low-risk Fed money work for me.

I know it’s too soon to start thinking about the ‘lessons’ we are learning from this crisis/event, because we’re still in it, but I am struck at this point by the way banks are trying so hard to return to business as usual. It may not happen, and we will almost certainly have some new oversight over the next year or three. But those expecting a ‘new’ Wall Street, or the ‘end’ of Wall Street, in my humble opinion, could not be more wrong.

Now, a number of representatives are asking good, pointed questions about this exemption (the link is a .pdf):

In the fall, Goldman Sachs secured access to government funding by converting from an investment bank into an ordinary bank. Despite this shift, the CFO of the company, David Viniar, said last week that the company is continuing to operate as if it were still a high-risk investment bank: “Our model really never changed,” he noted in a quote to Bloomberg. “We’ve said very consistently that our business model remained the same.”

This statement seems accurate. Earlier this year, the Federal Reserve granted a temporary exemption to Goldman Sachs from standard bank holding company Market Risk Rules, allowing the company to continue operating as if it were an investment bank. The company and its employees have taken full advantage of its new government subsidies, and the retained ability to bet big. In its most recent quarter, Goldman Sachs earned high profits of $2.7 billion on revenues of $13.76 billion, with 78 percent of this revenue derived from high-risk trading and principal investments. It paid out much of this revenue in compensation, setting aside a record $772,858 for each employee at an annualized rate. The company’s own measurement of risk, its Value-at-Risk model, recently showed potential trading losses at $245 million a day, up from $184 million last May.

Despite its exemption from bank holding company regulations, Goldman Sachs has access to taxpayer subsidies, including FDIC-backed bonds, TARP money (since repaid), counterparty payments funneled through AIG, and an implicit backstop from the taxpayer that allowed a public equity offering in a queasy market. The only difference between Goldman Sachs today and Goldman Sachs last year is that today, the company is officially gambling with government money. This is the very definition of “heads we win, tails the taxpayers lose.”

The letter is a pdf, worth reading for some of their questions about VaR vs. SEC models of risk management. I guess we’ll see what happens.

In the meantime, although I am about as critical as anyone about Goldman Sachs, I was convinced by a friend (Doron) to rethink my complaints about GS compensation. He said that one thing he appreciates about Goldman is that they pay their workers the profits they generate. I may find the source of those profits objectionable, but the compensation itself should be something I should support. After all, if Wal-Mart directed much of its profits to its employees, I’d be happy about it – why shouldn’t the traders who make the dough get the dough? And you know what? He’s right. I’m still annoyed that their profits come at the expense of the rest of us, and that the company doesn’t give much of a crap whether its cutthroat activities put the financial system itself at risk. But by all means, pay your profit-generators your profits.

This issue is not new as such, as speed of electronic trading (in the form of co-location, or having your servers physically located nearer to an exchange to eliminate tiny latency times in execution) has been an issue for years. See the industry magazine here (from March of this year) and here (from 2007) [both are pdfs].

I have three things to add:

1) Liquidity is bullshit. This has always been the case, but the use of volume and ‘continuity of price’ as a proxy for liquidity is increasingly ignorant. There is a historical trajectory here – the shift from locals making money off of institutions (who provided liquidity) to institutions making money off of locals (who provide liquidity), but the cat-and-mouse nature of high frequency trading means that a terrific amount of traffic in quotes with little value added for price discovery. The metaphors of financial markets being ‘deep’, ‘liquid’, whatever, are inadequate to the task of capturing what is the value of a working market. I don’t think there are replacements yet.

2) Markets are sausage, and exchanges, regulators, and large financial services firms are the sausage-makers. This is definitional, and important. The HFT article peeks at the varied ways that exchanges provide incentives for some players over others. To wit, a large all-or-nothing order at the CME/CBOT doesn’t have to go into the normal queue of orders. Ok, so the people trading 1000 lots can just screw first-in-first-out. The NYSE privileges high-frequency-traders by incentiving them to ‘make markets’ (liquidity providers, right!). Regulators privilege bulls over bears by making it harder to sell short than to buy long.

All of this is true, and yet whatever ugly, improbable, unfair (or too fair) set of practices, rules, and activities that comes out of this process is, by definition, a market. A market is whatever exchanges, the SEC/CFTC/Fed, and financial firms say it is. It is a Durkheimian ’social fact.’ That is, it is factual but not ‘real’ in the sense of pre-social.

3) Insiders win. All of the technological and financial innovation that might theoretically make markets more accessible, more democratized, more ‘fair’, simply do not. In absence of a real idea of what a market should be, and an acknowledgment that whatever the current sausage-making apparatus spits out defines what a market is, we in fact have an edifice that benefits insiders by design.

That electronic trading consolidates power rather than democratizes it is not a new thing to point out, but I wish there was a bit more attention paid to this dynamic.

Scholars learn to fear the literature in graduate school. I remember Professor Louis Wirth, one of the distinguished members of the Chicago school, putting Erving Goffman, then a fellow graduate student of mine, in his place with the literature gambit. It was just what we all feared. Believing Wirth had not given sufficiently serious attention to some influential ideas about operationalism, Goffman challenged him in class with quotations from Percy Bridgeman’s book on the subject. Wirth smiled and asked sadistically, “Which edition is that, Mr. Goffman?” Maybe there was an important different between editions, though none of us believed that. We thought, instead, that we’d better be careful about the literature or They Could Get You. “They” included not only teachers but peers, who might welcome an opportunity to show how well they knew the literature at your expense.
-Becker, p. 136

I’ve run across a varient of this problem often in discussions of finance, risk, regulation – though it’s common enough in most arenas. The problem is this: you need to have some knowledge of a subject to speak intelligently about it. But if the knowledge required to legitimately speak is set too high, then only experts are able to participate in consequential discussions that affect many, many people. Do you have a degree in finance? Spent ten years working on Wall Street? No? Then why should I listen to you?

This contention manifests in various guises. ‘Friedrich Hayek dealt with that’, or ‘your suggestion needs to take into account the Modigliani-Miller theorem.’ Or (as in the overrated Animal Spirits) a more subtle variant that posits all possible economic activity and politics on a continuum between Adam Smith and John Maynard Keynes. All of these are fair to a point – after all, reinventing the wheel is a waste of time, and we really should allow for the fact that some people know more than others when it comes to understanding (understanding what to do about) modern finance.

But these are also exclusionary tactics, and we should not overlook the fact that ‘experts’, particularly experts in professionalized fields (finance, law, academia, medicine) are susceptible to normative isomorphism – a fancy way to say that when everyone gets their MBAs from the same top 25 management schools, their language, outlooks, ideas, opinions, will tend to converge. This is the massively problematic aspect of having all of our regulatory officials coming out of the same Wall Street firms they are regulating. Not that they are necessarily ‘captured’ out of the box, but that everyone in the field’s assumptions tend to converge. And so someone who proposes, say, to simply do away with derivatives altogether, is seen as too much an outlier to be taken seriously.

As to solutions, I think there are two ways to deal with the problem. The first is to make participation in the conversation not dependent on performing some kind of requisite wink-and-nod to the dominant literatures/language/assumptions. This can get ugly, as Lena pointed me to a recent episode of TAL, which deals with people representing themselves. And if you peruse the political landscape of opinion, it’s more than a wee bit daunting to take seriously the people who suggest we should abolish the Federal Reserve. But then again, the ‘experts’ have completely screwed the pooch over the last decade, and why should we continue to listen to them?

The second approach means making the debate more accessible for more people, so that you can argue with the professionalized assumptions of your discipline, but these cannot be assumptions so rarified that you can dismiss people because they don’t want to stipulate at the outset to your formula and the assumptions it contains. That is, you need to make arguments that are accessible and make it possible for people to legitimately disagree with you. The ‘bar’ for legitimate participation cannot be a PhD and a decade of experience, but a good-faith effort to learn enough about a subject that pointed questions can be debated.

Perhaps this is asking too much. I’ll end with Becker:

The literature has the advantage of what is sometimes called ideological hegemony over you. If its authors own the territory, their approach to it seems as natural and reasonable as your new and different approach seems stragne and unreasonable. Their ideology controls how readers think about the topic. As a result, you have to explain why you haven’t asked those questions and gotten those answers. Proponents of the dominant argument don’t have to explain their failure to look at things your way.
-Becker, p. 147

And his solution? We should require serious people to routinely look at their subject matter in different ways, sometimes vastly different ways. Be respectful to experts, but don’t be crowded by the them. Use the literature, but don’t let the literature use you.

The first approach, then, would impose regulation on financial services organizations. I would include a pretty wide range of organizations: commercial banks, investment banks (not that there are any of these left), hedge funds, pension funds, mutual fund (and holding) companies, private equity funds, futures trading companies, REIT funds. This is a partial list. But conceptually, it’s any organization that participates in the keeping and investing of customers’ funds, business funds, or state funds.

Some organizations are multi-headed hydras in this sense – Citigroup does all of these things and more, nationally and internationally. Goldman Sachs trades its own accounts (called proprietary trading), brokers government bonds, manages mutual funds, and manages financing for its clients (Mergers & Acquisitions, bond issuance, etc). But your local probably does more than one of these things, and your state’s pension fund does too.

This episode of This American Life captures some of the regulatory gamesmanship that happens between federal/state financial regulatory agencies and the organizations they are supposed to be overseeing.

Still, if you think the problem is that these are sprawling organizations that are too big to fail, too big to manage, too influential to be regulated, then the answer is to break them down into their constituent parts or else to regulate them all as the simplest thing – banks. This is the reason why Galbraith’s suggestion is to give over regulation of systemic risk to the FDIC: “If institutions like hedge and private equity funds are to be considered as posing systemic risks similar to banks, they can be declared to be banks, and regulated as such. Money market mutual funds, which are now subject to insurance, can be reconstituted and regulated as narrow banks…The problem of regulation will be simplified, if we recognize that the crisis presents an opportunity to simplify, restructure and downsize the entire structure financial system.”

The challenge with this approach is that financial institutions can differ pretty dramatically, while at the same time fulfilling the same financial function. So OTC derivatives traded by a pension fund are monitored differently than the same trades by a commercial bank.

The alternative approach, which is more in line with what I would want to do, is to care less about the institutional forms of financial firms and more about the activities that they engage in. For instance, in order to securitize debt it is necessary to create a new corporation to transform that debt into investor shares.

no limited liability corp, no securitization

If we had a functioning rating system, we could use it to price these derivatives independently of the financial services organizations selling/buying them. Still, one alternative is to create an independent entity that doesn’t just slap a ‘good to go’ label on the things, but actually values them. But there remains the problem that, if a pension fund in Wisconsin needs to have a bond rated AAA in order to buy it, financial services orgs will try desperately find a way to slap a AAA rating on it (sounds like hot dog-making to me).

Or, if the SEC wanted to exceed its authority, or if we wanted to make life more difficult for financial services orgs and easier for the rest of us, we might consider disallowing these kinds of limited liability corporations. First, they are in the Caymans and other places only because tax liabilities are lower and secrecy is higher. It is just another form of regulatory arbitrage. And if there is just no possible way to structure derivatives in the US, another alternative is to simply disallow OTC derivatives altogether and have everyone trade stuff on existing exchanges. The analogy for me here is that 99% of us seem to get by with the denominations of $1, $5, $10, $20, $100, etc. It is not perfectly efficient. But the benefits of standardized, transparent commodities I think outweighs the costs to the tailored efficiency for individual firms. (this deserves its own argument, and it’s provocative: it may be the case that the public benefits of derivatives is small. Period.). The fact that Tim Geithner can say he receives letters from firms who argue they need OTC derivatives notwithstanding, we do not need them.

I don’t know how we might accomplish these goals, but at minimum, one suggestion is transparency. We ought to know who controls these limited liability corporations, what assets back them, and a plain-english translation of their values. And if that is not possible, if the only people who can accurately gauge the value of these assets are their issuing organizations, then these instruments should be disallowed.

Don’t pay attention to those last few sentences, though. The $13 billion government subsidy via the bailout of AIG, and the $28 billion in free money backed by the FDIC. Trading prowess! Embracing risks! Clap louder!

At the end of last week, James K. Galbraith testified for the Subcommittee on Domestic Monetary Policy and Technology. And it was pretty awesome. First, it was a takedown of the Fed’s potential role as the main regulatory body in charge of system risk (which he thinks would be a bad idea because it should be the main, not secondary goal of the regulatory body; and because the Fed kind of historically sucks badly at identifying systemic risk). Second, he went on to talk about ‘too big to fail’:

Would the country be worse off with a smaller, simpler financial system, largely operating out of institutions called banks and thrifts, themselves reorganized, downsized, broken up, more competitive and less profitable than the financial sector has been in recent years? I can see no reason to permit the continued existence, let alone to foster the market dominance, of financial institutions so large as to be unmanageable by their own top leadership, let alone efficiently regulated by public authority. Edward Liddy, CEO of AIG, has written that he realized quite early on that the firm was “too complex, too unwieldy and too opaque” to manage as a going concern. In general, “too big to fail” is a synonym for “too big to manage” and “too big to regulate.” Such institutions exist, in part, to help with international tax evasion, to evade regulations, to project political power, to facilitate the kind of “financial innovation” that is the essence of systemic risk. They are intrinsically unsafe. An appropriate goal of public policy would be to shrink them, permitting other institutions of more reasonable size, more conservative practice and greater alignment with public purpose to grow into their market space.

I agree so much with this perspective in general and this statement in particular. It’s worth a longer, more sustained argument to suggest that financial services organizations are not entitled to their business model just because it’s ‘working’ for them. But for now, compare Galbraith to the statement by Robert C. Merton looking for a way to mush-mouth an apology for financial innovation:

You’ll hear in this case as in the past, “Look at all this financial innovation or financial engineering–it’s caused too much complexity, and now the system has run off the tracks.” To that I would say, structurally, one would expect that in the case of a successful innovation, the infrastructure to support it properly will lag behind. Why is that? It’s because if you have 100 innovations, maybe 2 of them will be successful. So it is not practical to build a full infrastructure–regulatory, educational, et cetera–for all 100 innovations. Innovations are going to run ahead of the infrastructure. That, we have to recognize, is structural. It’s not about bad people, it’s not about incompetent people, it’s not about greedy people. It’s not about having a market system or a nonmarket system. Whether the problems are addressed by external regulation or a combination of that along with internal regulation–whatever set of ways, we have to be prepared when innovations come in to have some degree of oversight modulation. If you do too much of that and you stifle innovation, that’s not good. If you do none at all, that’s not good either. So there’s something in between. Sometimes we don’t do enough of it, or the growth of innovation is too quick, but the point is that there is a reason why you will typically find that financial crises are often connected with what are perceived as new things, big changes–innovations.

For Merton, the problem is just that we have so much great innovation and we can’t tell which ones are going to be successful, that we couldn’t possibly have infrastructure and regulation to support them all.

It’s just that Galbraith’s argument is just so much more convincing.

The article is about the problem of size and complexity in financial services organizations. Watts argues that we ought to pay attention to:

a general trend toward building ever larger and more complex networks. In recent years, hundreds of millions of people have rushed to join online social networks, while billions more rely on e-mail and cellphones to stay connected to friends and coworkers all day, every day. Technologists wax lyrical about “Metcalfe’s Law,” which posits that a network’s “value” increases in proportion to the square of the number of people or devices in it. And system designers revel in the ability of networks to improve a system’s overall efficiency by dynamically distributing computer-processing load, power generation, or financial risk, as the case may be.

And the answer is that we should prevent firms from becoming big and complex enough to be deemed “too big to fail.” For Watts, too big to fail is too complex to exist. Fair enough. But this is suggested in a complete absence of any content of what financial services firms, hedge funds, or other trading organizations actually do. For instance, are we speaking about proprietary trading positions in various markets that tie them together, like multi-strategy hedge funds (.pdf)? Or are we speaking about a firm that acts as a clearing member for a bunch of other firms, as it was the case in 2007 when the top 10 investment banks were counterparties to 90% of all credit market trades? Or are we speaking of firms that are/were wildly leveraged, like Bear Sterns (or its subsidiary, the magical Everquest Financial and its CDO-squared monster Parapet)?

In other words, Watts’ version of systemic risk only makes sense if we just put brackets around a disparate set of practices, encompassed in varied institutions, and call them all “a series of complex, interlocking contingencies.” Well, sure, a complex system of interlocking contingencies does indeed sound like it might create systemic risk. But it doesn’t say much else. And let me be clear that I’m on board with the problem of systemic risk. I just don’t know why it makes sense to think of financial markets as the same as email, and electric grid, or an epidemiological event.

So what instead? First, I think we need people with substantive knowledge of what financial services organizations do. This is not a way of saying that only finance people and economists should be figuring out what to do (these are the people, after all, who made this disaster), but it is a way of saying that abstract knowledge of risk or organizations or networks is insufficient. Securitization is not just an interlocking contingency – or rather, it is, but that’s saying almost nothing. The roots of that contingency, including the measurements of risk in the creation of new assets (as Yuval Millo would suggest) and the institutional and legal conventions of creating a limited liability trust incorporated in the Caribbean to launder asset-backed securities into invest-able shares (as I would suggest) are where the action is.

The market value of outstanding warrants held by the Treasury is around $6 billion, CBO estimates.¹⁴ Of the total, about $1 billion is from warrants issued by the 10 banks that recently repaid their TARP funds. However, those calculations are sensitive to the assumptions used in CBO’s models—particularly for treating the volatility of future stock prices (that is, how widely stock prices fluctuate over a given period).

14. CBO uses a Black-Scholes options-pricing model to price TARP warrants that relies on observed stock prices, estimated dividend yields, and historical data on volatility compiled from weekly securities returns for a period of 10 years.

Because what other methods are you gonna use?

Interestingly, the current estimate of the amount of ’subsidy’ from $700+ billion TARP (that is, the part we’re not going to get back) is $159 Billion. Cost is weird here, since there are three main sources of governmental assistance: 1) asset guarantees; 2) very cheap loans; and 3) payments not going to get paid back.

And in particular (ahem, Goldman Sachs), $35 Billion to AIG in loans and stock purchases, lots of which went directly to pay off GS and others’ credit default swaps. Another $40B lost to the auto industry, and $50B to the as-yet-established mortgage relief plan.

Now, Democrats and environmentalists embrace C&T as the greenest thing around (well, other than structurally-similar carbon taxes), and Republicans deride it as a massive tax increase.

It (still) is what it is: an incremental improvement on environmental pollution, mobilized by a (probably flawed) market mechanism, that will increase costs (but not as much as if the EPA began regulating carbon by itself).

It (still) is not economic Armageddon or a serious solution to environmental degradation.

On the contrary, their ability to bring in profits over the past quarter are almost certainly the result of near-zero federal funds rates and an alphabet soup of government support programs.

The FDIC has been providing a Temporary Liquidity Guarantee Program (.pdf) since November 2008 (guaranteeing unsecured senior debt of eligible banks); the Federal Reserve’s Commercial Paper Funding Facility (CPFF) purchases three-month unsecured and asset-backed commercial paper from banking institutions; the Fed’s Asset Backed Commercial Paper (ABCP) Money Market Mutual Fund (MMMF) Liquidity Facility and the Money Market Investor Funding Facility (MMIFF) buy asset-backed debt to support money market funds; the Fed’s Term Asset-Backed Securities Loan Facility (TALF) supports “the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).”

There are two effects here, one practical and one theoretical. The practical effect is to make money cheap and relatively risk-free, or at least to transfer the risk to the federal government and the profits to the private sector. So think about what this means, not for the 10 banks whose free money is putting them above the ’stress test’ line, but the rest of the banks (Citi!!!) whose free money isn’t.

The second effect, which is more interesting from the point of view of economic sociology, is that the federal guarantee of almost any risky asset held by a private financial institution effectively alters the information contained in the market price of these institutions and assets. I would almost but not quite suggest that the state has effectively transformed the toxic assets held by banks into US Treasury bonds, but it’s not not doing that.

More specifically, you might ask: what the price of an asset is that is guaranteed by the federal government? How valuable is it? How much risk does it embody? These questions are unanswerable, and in this sense, the alphabet soup of programs and supports have significantly reduced the signal-to-noise ratio of credit market prices. This is a momentous shift in the financial system.

A couple of interesting data points here. The first is a chart from EHnet (in a well-cited article:

What happened between 1970 and 2002?

As you can see, the total amount of produced grain trends upwards, but the amount of speculation trends exponentially. More data points would help, of course. But I can provide an educated guess that in the mid-1970s the modal speculator in futures was a rich, risk-taking individual; by the 1990s it was corporate and financial institutions; and in the 2000s it’s been financial firms big and small.

And why might rich folks have taken note of futures trading through the 1970s and into the 1980s? Taxes, baby.

There are numerous ways that uses of futures markets for tax avoidance purposes are practiced by people who have income from “unrelated sources,” such as real estate, stock transactions, etc. Brokerage houses and advisory services have promoted these tax avoidance ideas among high income persons. And such uses have been growing.

A common method is the “tax straddle” and its many variants. Essentially, these are spread positions in pairs of futures delivery contracts that fluctuate closely together – most commonly in pairs of delivery months for the same commodity – handled in such a way as to create paper losses in the current tax year, with offsetting gains deferred until the next tax year (and repeatable in the following tax year). Also, it enables short-term capital gains to be converted to long-term capital gains.

The precious metals futures markets have become rife with such transactions, as well as other types of tax avoidance maneuvers, but so have interest-rate futures markets and perhaps some agricultural commodity markets, like soybeans. All futures markets are subject to tax avoidance transactions and many have been used for that purpose by traders in such markets.

The Treasury estimates that in 1981, about $1.3 billion will have been lost by taxpayers’ use of futures markets to defer taxes and to convert tax obligations from ordinary income and short-term capital gains rates to long-term capital gains rates. The IRS has been challenging such taxpayer claims in the courts and believes it will win most cases but wants to plug the loopholes now through legislation (see “Statement of the Honorable John E. Chapoton, Assistant Secretary for Tax Policy Before the Committee on Ways and Means, House of Representatives,” U.S. Congress, House, 97 Cong. 1 sess., given 30 April 1981, unpublished transcript).

There seems to be general agreement that futures markets should not exist for tax avoidance purposes but there is apprehension in agricultural circles that the liquidity of agricultural commodity markets would suffer if the successful speculator in futures could no longer count on sheltering income from speculating in futures from high tax rates. They argue for exclusion from any modifications in the tax laws.

- pg. 301, fn 8 in Paul, Allen B. 1982. “The Past and Future of the Commodities Exchanges.” Agricultural History 56(1): 287-305.

Interesting, no?

Probably the greatest difficulty the exchange forces faced was the task of differentiating between a simple option and a futures contract. Options permitting fulfillment by settlement of differences alone were regarded by the courts as gambling contracts and hence unenforceable, so it was vital that the brokers draw a careful distinction between futures contracts, their principal form of business, and these illegal options. In theory the difference was that a simple option could always be settled by cash, whereas the purchaser of a futures contract could demand delivery of the actual product. In practice, however, the distinction was meaningless, because futures contracts were settled just as simple options – by the payment of differences. In only 3 per cent of the futures trades was there actual delivery; in fact, to demand delivery was to brand oneself a miscreant and led to ostracism by the brokers.

This distinction might have seemed tenuous to the layman, but it was fundamental according to prevailing legal thought. The right to require delivery, contained in the futures contract, made it possible to say that the seller at the time of the sale intended to make delivery and therefore, his intent being legitimate, the contract was legal and binding. The simple option, on the other hand, was inescapably a wagering contract because the purchaser could offer no intent other than a desire to profit by a price change. The intent to profit, where no goods were exchanged, was held to be socially unjustifiable. Thus it was only the delivery provision in the futures contract that enabled traders to refer to themselves as brokers and speculators rather than gamblers, and decided whether – at least in the legal mind – they were assets or liabilities to society.

Two things are important here. The first is that it was necessary to create a fiction that allowed early exchanges to distinguish speculation from gambling. Because the public found ‘risk transfer’ (or rank market speculation) unconvincing. And second, a failure of economics as a discipline was (here at least) its imposition of ‘market efficiency’ as a socially desirable end in and of itself. By late 20th century, speculation as a form of risk transfer was promoted as a way to make markets more efficient. And market efficiency obviated the need for some kind of ‘real economy’ justification.