Author Archive
Goldman in the Dock
| Craig Pirrong |
I have several reactions to the SEC’s fraud complaint against Goldman.
First, some of the more sensationalist reporting emphasizes that Goldman was short the RMBS structures that it was selling to its customers. (Yeah, it’s the NYT, basing its opinion on reporting by Wretched Gretchen Morgenson, so take it for what it’s worth–meaning not much.) Well, that’s true, but Goldman was also long. After all, it was the counterparty, the protection seller, to Paulson’s CDS. It then entered into offsetting transactions. Goldman was essentially a conduit of risk between other financial firms and Paulson. Note paragraph 66 of the complaint, which indicates that Goldman paid most of the $840 million it received on short positions in the Abacus deals to Paulson. Goldman claimed in its response to the government’s Wells Notice that it was actually long because it retained a slice of the risk; the protection it sold to Paulson was for a larger portion of the potential losses than covered by the protection it bought from ACA Capital. (more…)
Why the Movie Industry Doesn’t Like “Trading Places” as a Reality Show
| Craig Pirrong |
The most recent derivatives/speculation kerfuffle involves something novel — futures contracts on movie box office receipts. Two entities, Cantor Fitzgerald and Movie Derivatives, Inc. have announced plans to introduce such contracts. The film industry is in a tizzy at the prospect, and has enlisted the help of the usual anti-speculation suspects on Capitol Hill.
The virulence of the reaction is interesting, and deserves explanation. Here’s my initial stab at the problem. (more…)
The Chris Dodd Strangle Entrepreneurship Act, or, Where’s Creative Destruction When You Need It?
| Craig Pirrong |
Back in January, Tool Time star Tom Friedman lamented that Mr. Cool had turned his back on the “amazing, young, Internet-enabled, grass-roots movement he mobilized to get elected.” Friedman all but begged Obama to spur entrepreneurship and innovation:
Obama should launch his own moon shot. What the country needs most now is not more government stimulus, but more stimulation. We need to get millions of American kids, not just the geniuses, excited about innovation and entrepreneurship again. We need to make 2010 what Obama should have made 2009: the year of innovation, the year of making our pie bigger, the year of “Start-Up America.”
How’s that working out for you, Tom? With all the taxes on capital in the health care law, and the implicit tax on business expansion in the law (e.g., insurance mandates on companies with more than 50 employees), and all the taxes to come (there are murmurs of a VAT), it is becoming the year of Shut-Down America. The whole Obama program is poison to entrepreneurship.
And that’s just the start. Dodd’s banking bill explicitly targets startups:
Dodd’s bill would require startups raising funding to register with the Securities and Exchange Commission, and then wait 120 days for the S.E.C. to review their filing. A second provision raises the wealth requirements for an “accredited investor” who can invest in startups — if the bill passes, investors would need assets of more than $2.3 million (up from $1 million) or income of more than $450,000 (up from $250,000). The third restriction removes the federal pre-emption allowing angel and venture financing in the United States to follow federal regulations, rather than face different rules between states.
And just what are the apparatchiks in the SEC going to do in that 120 days? Just what knowledge and expertise can they bring to bear in evaluating the funding plans? The question answers itself; this adds costs and delay, for no perceivable benefit. And what reason is there to restrict the free flow of capital from consenting adults with over $1mm to startups? (more…)
Price Level Shocks, uhm, Screwed Up Relative Prices, and Organization
| Craig Pirrong |
Peter’s post on the relation between inflation, vertical integration, and markets brings a couple of other thoughts to mind.
First, and most importantly, the number and characteristics of markets are endogenous too, and respond to changes in the amount of uncertainty in the environment, including the amount of uncertainty resulting from monetary shocks that (in Sherwin Rosen’s unforgettable in-class phrase) “f*ck up relative prices.” In particular, the number and variety of futures markets depends on the amount of uncertainty. The big boom in the creation of futures markets in the 1970s corresponds with, and was arguably caused by, the coincident inflation of that period, and the associated volatility in relative prices.
Second, although Peter’s point, and previous research, focuses on the implications of inflation on organizational choices and market vs. firm choices, in the current environment it is worthwhile pondering the implications of deflation. Certainly we have more research on the effect of inflation on the variability of relative prices due to our more recent inflationary experiences, and this was a major source of concern about inflation among Austrians, but the current situation makes it worthwhile to consider the effects of deflation on the pricing system, and firms’ responses to that.
Perhaps an examination of Japanese experience since 1990 would be worth some in-depth analysis.
Personally I am torn as to whether inflation or deflation is the greater risk in the near to medium term. The huge monetary overhang in the US and around the world (resulting from quantitative easing and other extraordinary monetary policies), and the inability of the Fed to commit credibly to drain reserves from the system when money demand picks up make me believe that it will be hard to avoid a burst of inflation. But all current indicators point to flat or declining prices.
It is hard to see things ending in a Goldilocks moment — just right. Thus, it is likely that that there will be a shock to prices generally, arguably a large one, and that this will disrupt relative prices for a variety of reasons. (Including, notably, the very likely case where these price level shocks lead to government policy interventions that distort relative prices.)
Thus, Peter’s research program may be rejuvenated, courtesy of the Fed, ECB, the Chinese Central Bank, etc. It is indeed an ill wind that blows nobody any good.
Measure for Measure
| Craig Pirrong |
The FT has an interesting article about the difficulties and uncertainties facing cap & trade schemes, even in Europe where they’ve been implemented. A good part of the article focuses on the loss of intellectual coherence in climate policy in Europe, as regulations and taxes are being mooted to reduce CO2 emissions. Such command and control bolt-ons are inconsistent with the basic concept of cap & trade, which is that by determining a price of carbon the market will induce efficient responses to reduce emissions on all relevant dimensions:
And the more the carbon market shrinks in its ambitions, the more it faces a broader threat: that of losing touch with its original objective. Credits could continue being traded in the old way. But if the main thrust of carbon reduction is tackled by other means, the market could face questions about its social utility.
But to me, the most interesting part of the article relates to the arcane area of offsets: (more…)
Stuck on the Methodological Hamster Wheel
| Craig Pirrong |
I’ve read John Cassidy’s New Yorker article (not available online) in which he described his journey to the freshwater provinces in his attempt to see whether the financial crisis had caused Chicago economists to reject their reactionary views. (With one exception, the answer is blessedly “no.”) I’ve also read his paean to Pigou in the WSJ. So I pretty much knew what to expect when I picked up his How Markets Fail. Let’s say I wasn’t disappointed, in the sense that my very low expectations were met.
The book is a very conventional, Stiglitz-esque critique of market economics and those who defend markets. The latter are always described with Homer-esque modifiers, just so you’ll know that they [we!] are retrograde knuckle draggers. (more…)
Corporations Are People Too
| Craig Pirrong |
Legally, in some respects, anyways. That was a key issue in the recent Supreme Court decision re McCain-Feingold (see Dick’s post). I don’t have a lot to say about the specifics of the decision, as campaign finance law is way too arcane for me. Suffice it to say that I am inherently skeptical about any regulation regarding elections designed by incumbent politicians. People yammer about conflicts of interest all the time, but there’s a colossal one for you.
I just wanted to make a quick point about a debate between Stevens and Scalia carried out in the opinion and the dissent. Stevens noted that the Founders were deeply skeptical of corporations. Indeed so. Scalia noted that there are so many corporations today. Also true. The interesting question is how we got from A (Stevens) to B (Scalia).
The story is told in the North, Wallis and Weingast natural-state book Violence and Social Orders I’ve blogged about several times over at Streetwise Professor, mostly in the context of Russia. The relevant chapter is primarily based on John Wallis’s work. The basic story is that hostility to corporations — reflected very well in Adam Smith’s Wealth of Nations — was due to the fact that historically, English corporations were created by the crown, and were essentially very profitable favors provided to the politically connected. They were, in NWW terms, part of the “closed order” of the natural state, in which access to certain contracting forms was limited to a select powerful few. This animus towards corporations was inherited in the United States, but in the early years of the 19th century, state legislatures confronting issues associated with the financing of new infrastructure turned the corporate form into a prop of an open-order system in which this contracting form was made available to all. Rather than limit the right of incorporation to an elite, they made it available to everybody. The system changed from one in which legislatures had to grant every incorporation, to one in which pretty much anybody could incorporate if they met a set of general, universally applicable requirements. Hence, the proliferation of corporations. (more…)
Deja Vu?
| Craig Pirrong |
Writing near to the event, in Capitalism, Socialism, and Democracy, Schumpeter argued that policy shocks, and policy uncertainty generally, lengthened the Great Depression:
The subnormal recovery to 1935, the subnormal prosperity to 1937 and the slump after that are easily accounted for by the difficulties incident to a new fiscal policy, the new labor legislation and a general change in the attitude of government to private enterprise all of which can, in a sense to be defined later, be distinguished from the working of the productive apparatus as such.
Since misunderstandings at this point would be especially undesirable, I wish to emphasize that the last sentence does not in itself imply either an adverse criticism of the New Deal policies or the proposition — which I do believe to be true but which I do not need right now — that policies of that type are in the long run incompatible with the effective working of the system of private enterprise. All I mean to imply is that so extensive and rapid a change in the social scene naturally affects productive performance for a time, and so much the most ardent New Dealer must and also can admit. I for one do not see how it would otherwise be possible for the fact that this country which had the best chance of recovering quickly was precisely the one to experience the most unsatisfactory recovery. [Emphasis in original]
Some of the specifics are different (e.g., health care legislation vs. labor legislation) but the overall thrust of Schumpeter’s analysis of the 1930s is quite applicable today. An “extensive and rapid change in the social scene” is currently in progress, and like Schumpeter, I believe that “policies of [the] type [being considered] are in the long run incompatible with the effective working of the system of private enterprise.” And even if you don’t buy into that, as Schumpeter notes, just the massive rise in uncertainty associated with this policy ferment is sufficient to impede measured economic performance because it is rational for businesses and individuals to delay investment and hiring decisions until the uncertainty is resolved.
Socialist Calculation Meets the OTC Markets
| Craig Pirrong |
A new Federal Reserve Bank of NY staff report by Darrell Duffie, Ada Li, and Theo Lubke, “Policy Perspectives on OTC Derivatives Market Infrastructure” has received a lot of attention in the press.
There are some good things in the paper. Notably, it is suitably cautionary about the potential systemic risks posed by central counterparties, and the consequent need for prudential regulation thereof. It also makes a good case for data repositories, and for the role of the Fed and other government agencies in reducing the costs that intermediaries incur to coordinate risk-reducing actions, such as portfolio compression and improvements in the process of confirming deals.
But overall the paper is extremely disappointing. Its tone is Olympian and prescriptive. The word “should” is used 61 times 21 pages of text (that includes several space-eating tables and charts).
This is extremely dangerous because these prescriptions and dictates are not based on a a rigorous analysis of costs and benefits. Most disturbingly, there is virtually no discussion whatsoever of the informational demands inherent in the prescriptions. We’re told that regulators should set the right capital and collateral requirements on non-cleared deals, and that CCPs should maintain “high collateral standards.” (more…)
A Tale of Two Papers, or, Humpty Dumpty Writes About Exchanges
| Craig Pirrong |
The American Economic Association/American Finance Association Meetings are just about over. I made a quick trip there to comment on a paper. Upon returning home, I downloaded a couple of the papers presented that seemed of interest. Good call on one, bad call on the other.
The bad one is “Centralized versus Over The Counter Markets” by Viral Acharya of LBS and NYU, and Alberto Bisin of NYU. Although the motivation of the paper is admirable, the execution is execrable, and is representative of a lot of what is wrong in the profession.
The motivation is to compare the efficiencies of alternative ways of organizing derivatives trades: centralized exchanges and over-the-counter (OTC) markets. Great. Big question. I’ve written a lot about it, and would be very interested in seeing other takes thoughtful on the subject.
The paper concludes that organized exchanges are (constrained) first best efficient, and more efficient than OTC markets. A quick review of the paper makes it clear, however, that they’ve rigged the game to produce that result. (more…)
Happy Keynesian New Year
| Craig Pirrong |
Keynes and Hayek were major adversaries in the 1930s, but it is interesting to note that they shared some important ideas in common, but drew diametrically opposed conclusions from them.
In particular, Hayek, and the Austrians generally, believed in radical uncertainty, in the sense that individual economic agents had too little information about the world to assess probabilities of states of the world, or even to identify the possible states. Keynes similarly believed in the inability of individuals to evaluate investments in a rigorous quantitative way. Keynes concluded that this made investors subject to radical shifts in sentiment and “animal spirits” that could cause an autonomous collapse in investment. (more…)
The Age of Constructivism
| Craig Pirrong |
I am reading Vernon Smith’s Rationality in Economics. I highly, highly recommend it. Largely a homage to Hayek, it explores the implications of Hayek’s distinction between constructivist rationality and what Smith relabels ecological rationality. It contains a wealth of methodological and substantive insights. Smith is knowledgeable and thoughtful. He is almost John Stuart Mill-like in his even handed and fair characterizations of competing views, even those he disagrees with. He integrates experimental economics, game theory, institutional economics, neoclassical economics, neurology, and much, much more.
What fascinates Smith is the ineffable process by which an ecologically rational order emerges from the actions of myriad imperfectly informed and incompletely rational (in the constructivist sense) individuals. This process — a sort of economic transubstantiation — is the most fascinating economic mystery. It is also, alas, one that has received far too little attention from economists whose formal tools permit them to analyze (constructively) equilibrium, but which are virtually powerless to analyze the process of getting there; the proverbial drunks looking for their keys under the lamppost.
We live in an era of constructivism regnant. In health care and finance, especially, constructivist schemes will reshape for better or worse — and almost certainly worse — vast swathes of the American economy. What’s more troubling still, this is constructivism refracted through the flawed lens of politics and public choice. Appreciation of the emergent order, the ecologically rational, is sadly rare. Vernon Smith appreciates it, deeply, with an almost religious sense of awe. Read his book and you will appreciate it too.
A Piece on Financial Derivatives Regulation in FT Alphaville
| Craig Pirrong |
FT Alphaville, one of the Financial Times’ blogs, kindly asked me to contribute a guest post on the financial-markets regulation legislation currently working it’s way through Congress. (Thanks, Stacy-Marie.) Here’s what I wrote:
Lawmakers in DC are due to resume debate on major financial-reform legislation currently working its way through the US House of Representatives. One closely watched aspect of that debate is sweeping overhaul of over-the-counter derivatives markets. Lawmakers are pushing to mandate that most derivatives be centrally cleared and traded either on exchanges or swap execution facilities. Professor Craig Pirrong of the University of Houston discusses some of the proposals.
In attempting to impose standardization on the ways that derivatives are traded, and derivatives counterparty risks are managed and shared, the legislation reflects a one-size-fits-all mentality (not to say fetish) that is sadly typical of most legislative attempts to construct markets. These standardization directives fail to recognize that market participants are diverse, with diverse needs and preferences, and that as a consequence, it is desirable to have diverse trading mechanisms to accommodate them. (more…)
Lynch ‘Em
| Craig Pirrong |
I’ve had several calls from reporters asking my opinion on the Lynch Amendment to Barney Frank’s derivatives-regulation bill. For some reason, Forrest Gump pops into my head every time that question is asked. You know, the part where he says “stupid is as stupid does.”
As I am sure you all know, the amendment, introduced by New Jersey representative Stephen Lynch, imposes restrictions on the ownership and control of the clearinghouses that the Frank bill will require the vast bulk of derivatives to be traded through. The amendment imposes similar restrictions on ownership of exchanges and swap execution facilities.
Specifically, the amendment defines a class of “restricted owners” that includes swap dealers and major swap participants, and limits the amount of a clearinghouse (or execution facility or exchange) that these restricted owners can own or control collectively to 20 percent. The justification for this limitation is to reduce conflicts of interest, the specific nature of which are not identified.
This represents yet another example of Congressional micromanagement of the organization and governance of financial institutions. In my view, it is incredibly wrong-headed. (more…)
Further My Last
| Craig Pirrong |
My previous post on the Acharya et al (AEFLS) assertion of the purported externality in bilateral OTC markets focused on whether there was actually an unpriced “bad.” I judged otherwise based on the fact that credit and counterparty risks are repriced repeatedly (and ruthlessly).
There is another reason to reject their analysis. It should be incumbent on one who justifies the existence of an externality to justify a particular policy to (a) identify the transactions costs that preclude internalization of this externality, and (b) demonstrate that their policy would create a net benefit, by, for instance, reducing transactions costs. AEFLS don’t even try to do this (another symptom of the Nirvana fallacy). And when one examines the particulars, it is highly doubtful that the costs of the purported externality are as large as AEFLS insinuate that they are.
The AEFLS story is that contracts between two counterparties to an OTC derivatives deal impose costs on other market participants, notably, the firms’ other counterparties to earlier derivatives deals, and the counterparties’ counterparties, and on and on. OTC market participants don’t take these costs into account, trade too much, and create too much risk.
Which raises the Coase Question: if these costs are so large, why don’t the affected parties craft a solution that mitigates them? If, as AEFLS argue, a central counterparty would reduce these costs, why don’t the affected parties create one to internalize the externality and enhance their welfare? (more…)
Nirvana Is Just a Band
| Craig Pirrong |
Last week I wrote about one justification for exchange trading and clearing mandates in derivatives markets — the market power argument. This week I’ll examine another argument, and render a similarly skeptical verdict.
In a chapter of Restoring Financial Stability, Viral Acharya, Rob Engle, Steve Figlewski, Anthony Lynch and Marti Subrahmanyam argue that bilateral transactions in OTC derivatives markets involve an externality. Their argument is not stated that clearly, but FWIW here it is verbatim:
[A]ll OTC contracts . . . feature collateral or margin requirements, wherein counterparties post a deposit whose aim is to minimize counterparty risk. The deposit is marked to market daily, based on fluctuations in the value of the underlying contract and the creditworthiness of the counterparties . . . . The difficulty, however, is that such collateral arrangements are negotiated on a bilateral basis. Parties in each contract do not take full account of the fact that counterparty risk they are prepared to undertake in a contract also affects other players; indeed, they often cannot take account of this counterparty risk externality in an OTC setting, due to inadequate transparency about the counterparty’s positions and its interconnections with the rest of the market. While bilateral collateral arrangements do respond to worsening credit risk of a counterparty, such response is often tied to agency ratings, which are sluggish in capturing credit risk information and potentially inaccurate.
An externality means that some cost or benefit is not priced. By invoking the concept of externality Acharya et al (“AEFLS”) are asserting that something — a bad in this instance — isn’t priced. They are a very vague on just what this is, but here’s my interpretation of what they mean.
A firm that has already entered into financial contracts affects the risk exposure of its existing counterparties when it enters into new deals. A firm that has a large number of commitments outstanding can enter into additional contracts that substantially increase its riskiness, thereby harming the incumbent counterparties. The cost imposed on these incumbent counterparties isn’t, in this telling, priced. (more…)
Just So Stories: Financial Regulation Edition
| Craig Pirrong |
All of the legislative proposals relating to over-the-counter derivatives would impose seismic changes on the way that these instruments are traded, and the performance risks related to them are managed. Indeed, it is fair to say that these proposals, if implemented would dramatically shrink the OTC market, and perhaps destroy it altogether. Under either the House (Frank) or Senate (Dodd) bills, most derivatives would have to be traded on exchanges, and be cleared. (Clearing is a way of mutualizing default risks. At present, default risks in a particular contract are directly limited to the buyer and seller.) (BTW, when you hear “Frank and Dodd” do you think Fannie Mae and Freddie Mac? I do. Does this inspire confidence? Self-answering question.) These efforts are strongly supported by Treasury Secretary Timothy Geithner, CFTC head Gary Gensler, and SEC head Mary Shapiro.
These legislative proposals are clearly predicated on a very strong belief: participants in the derivatives markets routinely chose the wrong institutional arrangements. That this immense market is and was in fact arguably the largest market failure in financial history. (more…)
On the Border*
| Craig Pirrong |
This is my inaugural post as guest blogger here at O&M. I am grateful for the opportunity.
In his very gracious introduction, Peter Klein noted that my research is at the border of finance and industrial organization. Quite true (and indeed, “borderer” is a good description of me overall.)
That border is very, very busy today. Indeed, so much is happening there that it is difficult to keep up. In the aftermath of the financial crisis, Congress and regulators are beavering away on laws and regulations that will completely reshape the organization and regulation of financial markets, and especially of the area of particular interest to me — derivatives.
I anticipate that many of my O&M blog posts will explore these issues, but I’ll start with something very topical. Senator Chris Dodd just yesterday heaved up a 1,136-page proposed financial regulation bill, and one proposal that is attracting considerable attention is his plan to consolidate banking regulators. Dodd is not alone in thinking along these lines. Even before the financial crisis, there were myriad proposals to consolidate various regulators, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission. These have only gained in popularity in light of the crisis.
In the modern financial markets, firms are big and complex, and operate in many markets (defined geographically, or by product). It is difficult to fit a big financial firm into any box. A Goldman Sachs deals in the securities markets and the derivatives markets. So it doesn’t fit comfortably in a securities box, or a derivatives box, so in the current system for regulatory purposes the firm is split into pieces, some of which are put into the securities box and others into the derivatives box (and there are many other boxes too for a big firm like Goldman).
This leads to potential for conflicting regulations, jurisdictional disputes, regulatory arbitrage, and other problems. So, the Dodd proposal — and most of the other consolidation proposals — advocate creating really big boxes, and in the extreme, one big box that regulates everything a financial firm does.
The problems of the seen are well known (though arguably exaggerated). What concerns me are the largely unexamined problems of the as-yet-unseen big-box alternative. (more…)
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