Eric Posner and Glen Weyl are making a big splash with their proposal for An FDA for Financial Innovation.
As you might guess, I think it's a terrible idea. But let me try not to be predictable. I do think there are financial products that need to be regulated if not banned. Interestingly, Posner and Weyl completely miss these elephants in the room. (What are the dangerous products? I'm going to make you wait so you'll read more of the post.) That observation alone seems like a good argument against their FDA as a structure for financial regulation.
That's the real question. The question is not, "should there be some financial regulation?" The question is, "what form should it take?" "What institutional structure should it follow?" For example, see a previous blog post distinguishing law, rules-based regulation, and regulatory discretion. The question is, "does it make sense to legislate an FDA-like structure, in which all products are presumed guilty until proved safe to the satisfaction of a regulatory agency's discretionary judgement?"
The two missing ingredients
Though the FDA is not immune from criticism, the real FDA has two things going for it that the Financial FDA can only dream of: A clear and objective definition, and an objective method for testing products against that definition. Drugs either help patients to get better, with few side effects, or they don't. And we can evaluate that ability with randomized clinical trials. The Financial FDA has neither.
Posner and Weyl want the financial FDA to separate products that are used for "investment" or "hedging" from those used only for "speculation," and ban the latter.
The agency’s fundamental standard would be whether the welfare gains from insurance allowed by a new product exceeded the likely costs created by the speculation it facilitates.But there is no consensus on "hedging" vs. "speculation" for existing securities like stocks and options, after 400 years of actual experience! And, not having that experience, or an objective method like clinical trials, Posner and Weyl propose that panels of experts can make the call and decide how much "speculation" vs. "hedging" a new untried security will give rise to.
Posner and Weyl aren't really able to express what's so terrible about "speculation" anyway. OK, some people lose money. For example, they decry "heuristic arbitrage-based speculation".
A large literature establishes that people’s trading strategies often reflect simple heuristics (buy a stock that has recently increased in price) that can be easily exploited by hedge funds. By considering such heuristics and how they interact with the product’s characteristics, the agency could project demand based on heuristic arbitrage."Easily?" I know a lot of hedge funds that are losing money. About 1 in 5 goes bust every year. They (and our endowments that invest in them) only wish it were so easy to "project demand." And even if so, where is the social problem here? It's a zero sum game played among grownups.
Yes, some people think "speculation" makes prices too volatile. The puzzle is, by definition "excess volatility" provide opportunities for others to speculate against them and make money. Another 400 year argument with no consensus, at least not one ready to be written into Federal Law after selectively citing only one side of the debate.
Speculation
I've got bad news for Posner and Weyl. Almost all stock and option trading is "speculative." Exchanges exist to facilitate "speculative" trading. Options were designed and invented purely for "speculation." Their use for "hedging" was a much later discovery, and remains a minor part of trading.
Let me explain. A call option gives you the right to buy a stock at a given price, but not the obligation to do so. For example, you might buy for 5 pounds the right to buy East India Company stock for 100 pounds. (A deliberately 1700s example to emphasize how long this has been with us.) Now, if East India company stock goes up to 120, the value of your option will increase dramatically, maybe to 22 pounds.
So, suppose your spies see the latest boat floating up the Thames, deep in the water with spices. What do you do? You want to buy lots of stock. But you only have 5 pounds. You could try to borrow 100 pounds to buy the stock, but the lender doesn't want to do that, because if the stock goes down you won't pay back the loan. Buying the option lets you speculate on the stock as if you borrowed 100 pounds, but you can only lose the 5 pounds. The trader on the other side (whose spies say the boat is just leaking) is perfectly happy to enter that contract. It is a perfectly designed security... for speculation.
"Speculation" has important social functions, as everyone since Adam Smith has recognized. Suppose you want to sell some stock in a hurry. If "speculators" are banned, it becomes much harder to find a willing buyer. It is "speculation" that provides "price discovery" and "liquid markets" for the rest of us.
Posner and Weyl recognize this, to some extent:
An investor who buys Facebook stock is making a bet as to how much money Facebook will earn by providing a service in the real economy. If people could not buy stock in this “speculative” manner (or make loans, etc.), then businesses with good ideas would have a great deal of trouble implementing those ideas and thus providing benefits to consumers, while companies with poor ideas might receive capital because no one would ensure that the price of their stocks or bonds remained low. Thus, financial market activity that helps prices adjust to their true value can influence the allocation of capital among potentialSo far so good. But then they go on...
products and thus improve economic efficiency.
However, improving the informational efficiency of prices is only useful to the extent that it reflects the fundamental (social) value of the asset and affects the allocation of capital in the real economy. When fluctuations are too unpredictable, too driven by expectations of other traders’ behavior or shifts in prices over too short time-scales to have any impact on the real economy, they cannot have value under this argument.Very nice. But which commissar can tell the line between "fundamental (social) value of the asset" and excesses? Given we can't do it for existing assets, with 400 years of data, how is a panel of experts supposed to figure this out, ahead of time, for new products that we have not seen yet?
The hopeless task for the panel of experts
You really need to read the paper, not just the opeds, to get a sense of how pie-in-the-sky this faith in experts is. Remember, we are talking here about evaluating categories of new products, like "stock" or "call options," products that don't exist yet.
The crucial step would be to determine the speculative costs of the new instruments, based on how many individuals would be interested in speculating on them and at what volume. The key to a careful analysis is to break down speculative demand itself into several categories: disagreement-based, regulatory arbitrage-based, tax arbitrage-based, and heuristic-exploiting.That is indeed the "crucial step." Sort of like "Here is where the magic happens." "The crucial step would be where the Easter Bunny comes in the middle of the night and gives the children chocolates."
Continuing, they offer a taxonomy of speculation to be forecast:
Pure disagreement-based speculation. This is perhaps the hardest of all the forms of speculation to project demand on, as so much depends on what catches the imagination of potential participants. Luckily, a large historical track record of past products offers a rich data set on which regressions using ex-ante characteristics of products can be run to project ex-post speculation, which can be measured fairly easily based on observed volumes compared to the demand accounted for by the other sources demand (both hedging and other speculative forms discussed below).Nobody has ever done this for existing products.
For example, one natural predictor of speculative demand, proposed by Simsek is to survey professional forecasters for their estimates of the value of the security. If, for example, the forecasters agree on the value of the security, then it cannot be used to speculate. If the distribution of estimates is sufficiently wide, however, it can be used to speculate.Give 100 analysts all the company data you want but not the stock price, and see how many of them can come within a factor of 10 of the actual price.
Other predictive factors may relate to how prominent the phenomenon that the derivative is based on is in the public mind or in commonly used financial models. These can be quantified using new tools of automated text analysis, such as Google’s nGrams Viewer.41 By harnessing data on past products and the speculative demand they generated, indicators like this could be used to form clearer expectations of likely speculative demand, in conjunction with documents that the proposer will submit about the sources of demand they anticipate and projections by similar but disinterested market players.
OK, this went on a bit, but is the pie in the sky nature of this clear? Nobody has ever credibly run even one of these regressions for existing securities, let alone proposed securities.
Let me try to be positive. The main thing Posner and Weyl could do is to actually produce one such evaluation, that survives widespread scrutiny and determines the amount of "speculation" vs. "hedging" in even an existing security, to the level of certainty required for us to bring down the heavy power of the Federal Government to ban it.
Regulatory and tax arbitrage: Catch 22
Posner and Weyl make one good point: some financial innovation is undertaken for regulatory or tax arbitrage. Mortgage backed securities were bundled into special purpose vehicles with off-balance sheet guarantees as a dandy way to get around capital requirements. Institutions required to hold AAA securities found ways to construct such securities to hold more risk than regulators wanted.
Alas, a Financial FDA blessing new securities would be hopeless to stop this sort of thing. In these cases, as well as Posner and Weyl's other examples, the securities had perfectly valid other uses. They were invented for other uses. Securitized debt also goes back hundreds of years. (When you get bored here, go explore Geert Rouwenhorst's History of Financial Innovation website)
Most of all: Catch 22. Posner and Weyl's complaint is that financial engineers are one step ahead of regulators, who can't see how they're using financial products to get around regulations and taxes. Well, if the bank regulators and tax authorities can't figure out, often for 10 years or more after the fact, how a product is used to avoid regulation and taxes, how in the world is the Financial FDA's panel of experts supposed to figure it out ahead of time? If that were possible, the regulators themselves would be able to stop the practices! This is an airtight logical proof that the idea can't work.
Junk bonds are another good example. Poser and Weyl write of them approvingly,
A financial instrument may lower the cost of capital to firms and individuals. Such reductions in the cost of capital result from the ability to spread the risk more evenly. For example, prior to the securitization of “junk bonds” in the 1980s, many small firms could draw only on very wealthy investors for financing.But junk bonds were also used for regulatory arbitrage. In the 1980s, savings and loans wanted to add a lot of risk. Regulation said they could only buy "bonds" but the S&Ls wanted to double or nothing by taking on the risk and return profile of "stocks." Junk bonds fit the bill perfectly, and let the S&Ls evade risk regulation. Posner and Weyl didn't notice this after the fact. Good luck to their Financial FDA to notice it ahead of time.
More regulatory arbitrage just gets around silly regulations. We subsidize debt by making interest payments tax deductible to companies while dividends are not. No surprise, companies do a lot of engineering to take advantage of this tax deduction. Big banks want huge leverage, then engineer their way around capital ratios. But it would be a whole lot easier to remove the subsidy for debt in the first place.
The Nature of Innovation
Who is going to run all these regressions?
This information should be available from the firm seeking approval; after all, it should be incorporated in the demand analysis the firm uses to decide whether to market the financial product in the first place.This quote reveals a deep confusion on how markets work and how new products are invented. New products typically start as one-on-one agreements. Company A calls Goldman Sachs asking for a new kind of swap contract. Others find it useful, over the counter trading increases, some contracts get standardized and traded on exchanges, then clever ducks figure out how to use them to get around regulation, and traders start "speculating."
Stocks, bonds, credit default swaps, catastrophe bonds, insurance itself, reinsurance, mortgage backed securities, securitized debt all started this way. They did not start with some big "firm" planning to "market" some new security like an iphone. Some consumer financial products start that way, but there's no "speculation" in credit cards.
Trading vs. Products
Posner and Weyl go on a bit on the evils of high freqeuency trading. This is particularly curious. Their FDA is supposed to analyze products. But high frequency trading is a practice, for a product that's been around 400 years. Or is the Financial FDA supposed to preemptively approve or disapprove every "trading practice" whatever that could mean?
Assuming all transactions that only occur when possible at sufficiently low cost are wasteful, one can combine this “elasticity” with the expected reduction in cost created by the new instrument to estimate the number of harmful transactions likely to be createdThat's an interesting assumption to be written in to the Federal Register.
A Reflection on Law.
A financial contract is a contract. It's just an agreement between two parties: if X happens, I pay you money. If Y happens, you pay me money. That's the most basic kind of contract there is.
In essence, Posner and Weyl are advocating a dramatic change to contract law as we've understood it for hundreds of years. (OK, I'm not a legal historian, but you know what I mean.)
At heart, their proposal is to declare that any private contract involving money is illegal until the Federal Government authorizes it. As you see in their discussion of high speed trading, financial practices are illegal if Posner and Weyl can't understand their social function.
And the determination of "social utility" comes from a politically-appointed regulatory body with wide discretion, no clear definitions, no clear procedure, and thus essentially no recourse. (If the panel says no, how can you prove your security is useful?)
Aside the issue of basic liberties, constitutional limitations, and all that old-fashioned stuff, it doesn't take much to imagine how quickly such an operation would become politicized, captured, or corrupt. Even the FDA doesn't do so well when big political interests are involved.
That's rather astonishing, especially coming from across the Midway at the University of Chicago
(The dangerous contracts? Short term debt, demand deposits, and now broker-dealer relationships. Contracts which induce runs. These have plain externalities: if I run, it makes the institution less liquid, so you have an incentive to run. We just had a big run in the shadow banking system. That is the problem to be fixed, not "heuristic-exploitative" hedge funds, no?)
Junk bonds and leveraged buyouts were all about tax arbitrage.
ReplyDeleteInterest rate swaps started out as regulatory evasion.
The size of the markets for interest rate swaps and credit default swaps are so large relative to the underlying markets we can be relatively sure of two things:
1) they are used primarily to game tax, accounting or regulatory systems;
2) they create enormous systemic risks (and the less systemic risk they create the more certain we can be that they are being used for tax frauds).
If we wanted to reform finance, outlawing naked interest rate swaps and naked Credit Default Swaps would be the place to start.
I don't really get any of this. I thought interest rate swaps were a cheap way of adjusting maturity or currency risk without calling and then reselling a corporation's entire debt. I'd be curious to hear how they "started" as regulatory evasion, and how a financial FDA might have foreseen that.
DeleteAlso, I don't follow the logic that large size by itself implies bad behavior or systemic risk. Large size can simply imply great efficiency.
You thought correctly, Mr. Cochrane.
DeleteThere is too much uninformed blather and far too many conspiracy theories about finance. I suppose it's natural to create myths to soothe oneself in the absence of knowledge or at least to get another chance to weave in cool words like "heuristic", "exploitation", and "ex-post, ex-ante"...oh, and "tax arbitrage". That usually ensures some credibility with the pitchfork wielding masses and dopey politicians.
Of course the regulators these two clowns (what else could people publishing such nonsense be?) want to rely on to forecast the effects of future products do not understand how the current 400 year old products work. Sure, they kinda have some sort of idea, but not really. And they have no incentive to care either. Years after their creation, the SEC still can't understand how an ultra-long or ultra-short ETF works either.
Professor Cochrane
DeleteThank-you for replying. I agree with your original post that an FDA for financial products is a terrible idea. To explain my points:
Leveraged buyouts were driven in large part by "tax arbitrage" in the sense that if a tax exempt investor like a pension fund (or University endowment) owns corporate shares then some of the economic profit of the business goes to corporate taxes. If a pension fund finances a leveraged buyout to replace equity with debt then more of the economic profit can flow tax free to the pension fund.
If you do an Internet search for "interest rate swap exchange controls" you will find multiple assertions that interest rate swaps were first developed to circumvent exchange controls.
I believe that the size of the derivatives markets tells us there is something improper going on. There is approximately 90 Trillion in outstanding bonds globally. The banks report that there is over 300 trillion in notional interest rate swaps and over 200 trillion in credit default swaps. To create an interest rate swap for a notional billion dollars you need two billion dollars in underlying debt. Not everyone who borrows or lends money will want an interest rate swap. Not everyone who lends money will want a credit default swap. Even if you allow for some double counting of derivatives in the reporting process the reported size of the derivatives markets is still out of all proportion to the underlying markets.
The derivatives market cannot be legitimate - it is simply too big.
The banks report that they have their derivatives portfolios are so exquisitely balanced that they have almost no net exposure. If the banks are not carrying the ultimate risk - who is?
Given the disproportionate, and growing, size of the derivatives markets it seems likely to me that derivatives are being used for some improper purpose - evading taxes or regulatory rules somewhere in the world. Perhaps they are being used to move reported income to low tax jurisdictions. Perhaps they are being used to move income out of China or Russia. Perhaps they are being used to misrepresent the public accounts of Greece or Orange County. Perhaps they are just being used to delay or accelerate reported income.
The derivatives markets are simply too big to all relate to risk re-allocation and the only real alternative explanation is that they are being used to mislead someone.
The huge inter-bank liabilities that derivatives create generate risk out of thin air. If there is a banking crisis the counter-party liabilities will increase the damage (and if the banks have perfectly balanced their liabilities that is just evidence that the whole thing is a sham.)
The most urgent challenge for regulators is to rein in fraudulent uses of derivatives while leaving as much of the legitimate economic use in place as possible.
Sorry for being long winded.
Perhaps we could use a vocabulary from my world to make my core point: the disproportionate size of the derivatives market relative to the debt market is not conclusive proof that the derivatives market is a sham but it gives rise to at least a strong, albeit rebuttal, inference that the derivatives market is primarily a sham.
DeleteAbsalon is accusing LBO investors of the same sin as municipal bond investors. Oh, woe. I take issue with the arbitrage claim, but will leave that alone for now.
DeleteTo create an interest rate swap for a notional billion dollars you need two billion dollars in underlying debt.
That is incorrect. You and I can enter into a swap agreement without ever having anything to do with the underlying.
For example: I think Ford Motor Company's bonds will outperform GM bonds over a set period of time and you think the opposite. Over dinner, we agree to swap the returns of the bonds. If Ford does better than GM, you will pay me. If GM does better, I will pay you. Voila! An OTC market in a total return swap is created. Neither of us need own either bond. We're just betting. Speculating. What's so improper about this?
Even if you allow for some double counting of derivatives in the reporting process the reported size of the derivatives markets is still out of all proportion to the underlying markets.
Big deal. The futures market in oil is larger than the spot market. A larger market, as professor Cochrane has already implied, is more liquid and thus, less volatile and more efficient.
The banks report that they have their derivatives portfolios are so exquisitely balanced that they have almost no net exposure. If the banks are not carrying the ultimate risk - who is?
Who is? The risk is spread among the speculators and hedgers. The banks are usually just the bookies.
Like all bookies, the banks are exposed to counterparty risk (which is why you and I are going to have to do our swap agreements on our own since neither of us are a AAA-rated institution).
The banks can and do easily balance their derivatives book.
Example: A customer expects interest rates to go higher and would like to pay a fixed rate. Another customer expects rates to go lower and wants to receive a fixed rate. The bank will enter into transactions with both customers. The bank's net risk will remain zero so long as the pay and receive fixed customers are balanced. And if they don't have customers to balance it out? They can enter into swap agreements with other banks who have the opposite imbalance. Voila! A balanced derivatives book.
Of course, counterparty risk remains - the risk that any customer will breech the contract. However, it is impossible to hedge all risk (despite what the government tells you) and counterparty risk is one of those risks. The larger and more diverse the bank's portfolio, the less of an impact any one counterparty will have in any one interest rate derivative. The beauty of diversification.
Your indignation over the use of derivatives to possibly get around certain unnamed (and usually counterproductive) regulations implies that you think that if a tax or regulation exists it is also moral and good and if someone is trying to find a way around these thefts and restrictions, they are doing something evil.
DeleteYet another example: I think that stock XYZ is undervalued, so I'd like to buy it. there is "edge" in doing so. I also know that stock ABC is highly correlated to stock XYZ and I think that stock ABC is fairly valued (no edge). I am afraid that changing market conditions might result in a loss for me if I buy stock XYZ to capture the edge, so I'd like to short stock ABC in order to hedge myself against general market moves and capture the edge in XYZ with less risk.
Unfortunately, because of the SEC's idiotic prohibitions on shorting, my broker cannot locate any ABC shares for me to borrow and short. So, I go to the options market and I sell a call and buy a put on stock ABC. In doing so, I have created a synthetic short position in stock ABC. I have hedged my long position in stock XYZ with my synthetic short and I am able to buy more XYZ because I am able to hedge my downside risk.
How exactly is this evil or fraudulant? I have circumvented a regulation that makes the market less efficient. I have provided liquidity by bidding for XYZ and I have aided in keeping stock XYZ from trading too far below its fair value, thus reduced volatility for the stock. Moreover, for me to successfully buy shares of XYZ, I had to outbid my competitors, so I have also reduced transactions costs and volatility by narrowing the bid/ask spread. If I couldn't hedge, I would have been willing to do less size or I would not have bought any XYZ at all.
Where's the impropriety?
The derivatives markets are simply too big to all relate to risk re-allocation and the only real alternative explanation is that they are being used to mislead someone.
No, they are not. The explanation is that derivatives markets are simply used to make levered bets as well as to diffuse risk.
There's a legitimate debate about the dangers of levered risk taking (particularly in some new derivatives products which are poorly constructed), but there is NOTHING fraudulant about making bets. In fact, because so many people do, the cost of actual hedging is reduced!
More than anything else, derivatives markets are used to speculate about the future and that speculation conveys enormous benefits to all of us.
Incidentally, Absalon, preventing people from getting around regulation that prevents these same people from acting in their own best interest is futile. The Soviets couldn't do it with executions and Gulags and the SEC is outmatched by those in industry. Usually, if you're at the SEC it's because you're not smart enough to be in the industry it regulates.
DeleteBut even if the SEC were filled with the best and brightest, they would not be able to have such perfect vision and vast knowledge to even predict all possible outcomes, let alone prevent them.
If such a thing were possible, 2008 would have never happened.
Methinks
DeleteArtificial transactions which have no purpose beyond gaming the tax laws are illegal in some jurisdictions; if they lead to misleading financial statements they are probably illegal for any publicly traded company; and governments have a perfect moral right to try to shut down mechanisms used to circumvent regulations or tax laws.
(I don't care about publicly traded put and call contracts on publicly traded securities.)
What is an "artificial transaction"? That entire mess of an argument hinges on it.
Deleteand governments have a perfect moral right to try to shut down mechanisms used to circumvent regulations or tax laws.
Might is right. It's not the first time I've seen that argument. By your logic, Nazis had every moral right to capture, imprison and murder Jews since they wrote the laws that dictated what is to be done with Jews. Schindler, in circumventing these laws was a dangerous criminal and should have been shut down. We all know that all belongs to Caesar, right?
Governments have the right to pass and enforce laws. If you believe every law is the equivalent of the Nazi persecution of the Jews then you and I simply do not have the common ground for any sort of discussion and in fact do not have the common ground to live in the same society. I hope you like Somalia - it will be more to your liking.
DeleteI thought the definition I used was pretty clear:
"Artificial transactions which have no purpose beyond gaming the tax laws ..."
No, we probably don't have common ground to live in the same society. I don't think I belong body and soul to the state. You do. So, in your world, any laws the state passes are all moral - no matter how immoral they are. I'm not equivocating tax laws with genocide, I'm taking your argument to its logical conclusion.
DeleteUh...no. Those are not "artificial transactions". Those are "beneficial transactions". "Artificial transactions" are ones that never took place. In other words, fraud.
There are all kinds of vehicles to reduce one's tax burden, which as a happy slave of the state, I'm sure you don't take advantage of, right? I mean, you would never dream of investing in a tax-advantaged security like a Municipal bond would you? And I'm sure you never defer the sale of your stock to avoid paying taxes in a given tax year. I bet you don't even take advantage of the home mortgage deduction. And, of course, you would never dream of entering into a non-taxable barter agreement and report all of your purchases on the internet to the state so that the state can collect sales tax from you. And I won't even mention estate planning, using vehicles like trusts as that wold be totally out of the question. Doing any of that would be unpatriotic tax avoidance. None of those activities have a purpose other than avoiding taxes. After all, the founding fathers always envisioned us to be serfs of the state.
There are ways to use derivatives to reduce the burden of taxation, but they are all legal and above board. So, you don't have much of a complaint.
Well, you don't have much of a real complaint, anyway. You understand derivatives so poorly that the best you've been able to muster is a series of spooky scenarios where derivatives are used to mess up Greece and move money in and out of China. Who knows? Maybe you think derivatives are sitting in your closet constructing a dirty bomb while you sleep. It's okay. I get it. Things you don't understand can be scary sometimes.
The FDA analogy is actually deeper than it seems.
ReplyDeleteThe FDA regulatory principles are that in order to be approved the treatment must be effective and safe. On the efficiency side - no objective method can say whether 2.9 months of life extension is "not efficient" enough or 5.1 is (The Avastin case). On the safety side, no treatment is (or can be shown) to be completely safe, so the FDA says that the benefits must outweigh possible negative health effect. There is no (and possibly cannot be) objective method to weigh negative health effects with respect to the positive benefits of the treatment.
The FDA has long outlived its usefulness, its objective methods like "statistical significance" actually harm more than help. Creating the Finance FDA "by analogy" is unwise.
Yeah, I was sorely tempted to delve into the, er, imperfections of the FDA, but the post was getting too long already.
DeleteI think the Posner-Weyl plan has it exactly backwards. The problem in financial markets, if any, is not new products.
ReplyDeleteOne real problem, mentioned in the article, is bank runs and counterparty risk. New products can actually help with that, by devising new ways to distribute risk. To be sure, if regulators are foolish enough, they can get around rules such as deposit insurance capital regulations. The proper response, though, is to act like the IRS does with tax shelters: if a bank tries to get away with some ultra-complicated way to evade capital regulations, say "No: you're just trying to get around the regulation", but don't ban it for speculators and everyone else too, or for banks trying to *reduce* risk.
The second potential problem is the Hirshleifer (1967) problem that talent and energy devoted to figuring out asset pricing has a hard-to-measure mix of social and private benefit. Socially, it improves capital allocation; privately, it transfers money from people a little less clever to people a little more clever. That's a real puzzle, which is why the possible benefit of asset-trading taxes is a legitimate issue. New products, on the other hand, do require talent and energy to create, but it's practically always inputs well spent: new products thrive only if someone finds them useful.
"One real problem, mentioned in the article, is bank runs and counterparty risk. New products can actually help with that, by devising new ways to distribute risk."
DeleteYes! I would love to see a financial system with more mortgage-backed securities and fewer (huge, opaque, government-guaranteed) banks. The MBS get held in mutual funds, at net asset value, as part of our pension investments, not funded by overnight debt. Lots of mortgages, no runs. Not the place to delve in to this (another blog post someday) but the fact that innovation can spread risk around and repair pathologies -- often in ways that a regulator would never anticipate -- is worth stressing.
the fact that innovation can spread risk around and repair pathologies ... is worth stressing.
DeleteI think the debate has moved way beyond that.
I think I agree with this post.
ReplyDeleteI think I have legitimate concerns about another meltdown by an AIG, Enron Long-Term Capital Management.
These meltdowns of highly leveraged private-sector players seem to macroeconomic consequences.
I do wonder about this: If you can leverage 100-to-1 or more, and you are a young guy by a computer screen, it makes sense to make a bet and leverage it 100-to-1.
If you win you are rich for generations. If you lose, you lose your equity---but not your house, wife, your children are not sold into slavery etc. No prison time. Indeed, the LTCM guys got news gigs almost immediately.
If someone would back me 100-to-1, I would right now make a bet on something---that oil prices will crack, and leverage to the moon.
Enron had nothing to do with leverage or counterparty risk. Fraud and too much leverage are not the same thing. LTCM melted down just fine without causing more than news stories. Its creditors got together and dealt with the issue - and without TARP.
DeleteBut, LTCM was levered only 70x. Nobody has been crazy enough to extend such leverage since.
Want to guess what the leverage is on a 0% down mortgage for an unsophisticated Bubba to purchase a single, enormously expensive and illiquid asset?
And who thought it was a brilliant idea to lever every Tom, Dick and Harry to infinity so they can gamble in the illiquid real-estate market? Why, the very same politicians who will be hand-picking the wisemen who will sit on this financial FDA. What foresight we can expect them to have.
BTW, if you can find someone to extend 100x leverage to you, call me. On rare occasions, I've seen 30x, but even that's rare and only for fully hedged options market makers with a long history and excellent credit. The most a young guy with a computer on his kitchen table is going to get is 6x leverage and that's if said guy has at least $100,000 deposited with his broker and meets certain other qualifications. Creditors aren't that stupid.
On the FDA, see the article I cite below, which discusses the dubiousness of the FDA's requirement, established midway in its history, that drugs be "effective" as well as "safe". Somebody should estimate the number of lives lost because of that requirements, which says it is not enough that a doctor thinks a new treatment might work: the FDA has to amass enough evidence to defend itself against political repercussions if the new treatment has some unexpected bad effect. Think about the incentives of the Financial FDA with respect to the simple home mortgage if that were a new product. If it bans them, the benefits remain speculative; people will just have to be virtuous and save up to buy a house instead of borrowing. If it allows mortgages, it knows there will be hundreds of thousands of people who will buy homes and lose them. Is there any doubt where the safe bureaucratic decision lies?
ReplyDeleteJULY 25, 2011
WSJ
By MICHELE BOLDRIN
AND S. JOSHUA SWAMIDASS
A New Bargain for Drug Approvals
A system that puts safety
This comment has been removed by the author.
ReplyDeleteIt is the function of government to determine whether any human activity is worth the risk. We have speed limits on highway curves, set by the government.
ReplyDeleteHaving worked in and around banking and finance for 35 years, it is easily observed that more than adequate tools exist for ascertaining whether individuals and business ought to be allowed to gamble or engage in insurance transactions without an insurable interest.
The difference is that highway curves don't have paid lobbyists and captive business school professors around to misinform and lobby for the casino owners.
My problem with Rasmusen is more fundamental. An FDA would just be another needless gathering of government employees who will show no more leadership than our current crop.
We don't need more regulations or a different approach to regulation, or rules regulation as opposed to discretionary regulation.
What we need are regulators with backbone and they are not about to appear. The casinos (Goldman Sachs, et al) have so much money that they operate like black holes of evil, pending most human will long before one even knows that they near the Event Horizon.
We will not get such regulators until we adopt the Pelosi Amendment and rewrite the Constitution to what the Founding Fathers intended---that the individual rights and freedoms apply to people, not corporations.
Given the $$$ now in politics, it makes no difference what regulatory approach one takes. Every approach will be circumvented by the faceless inhabitants of our regulatory agencies who all harbor visions of early retirement, followed by a new gig on a Goldman Sachs desk
The only time risk is an issue to the public is when government provides a backstop (moral hazard).
DeleteThere is an implied "safety factor" that government regulations supply the market. Absent this implied safety factor, and the subsidy it provides to transaction costs, investors et al would presumably take greater care in investment and purchase decisions.
Would the 2008 sub-prime crisis occurred had previous government directions/regulations not explicitly incentivized private sector risk while implicitly guaranteeing an ability to socialize losses?
M.H.
DeleteSeriously, from what planet did you come?
Risk extends far beyond backstopping.
In fact, backstopping (for example FDIC and Fannie Mae guarantees have been a minimal part of the cost).
That's the whole point of the Fall of 2008. You have casinos operating where trillions in bad bets were made and when the dice came up snake eyes, millions of people lost their jobs, homes, and future.
JLD, you ever wonder why the casinos were willing to take so much risk? Could it possibly be that it was backstopped by taxpayers?
DeleteI mean, real casinos in Las Vegas with no government backstops don't blow up, do they? they seem to manage their risk rather well. Yet, our highly regulated, ostensibly safer financial system can't seem to hold it together.
curious, no?
Methinks,
DeleteThe Casinos (Goldman Sachs, etc.) operate as they do because our corporate and securities laws let the inmates, the employees, gain control over and run what becomes an insane asylum. Pure unadulterated agency problem.
The fact that we, as taxpayers and otherwise, have to bail out the casinos has nothing to do with what causes the behavior. Even if we refused a bailout, the agents on Wall Street would not change their behavior. They are playing a heads they win, tails everyone else loses game. IOW, you have confused correlation and causation.
It would make too much sense to do what ought to be done and that is make owners and operators of such firms, and their spouses, personally liable as surties and guarantors for the losses of their firms.
There is no God given right to limited personal liability. A truck driver who runs off the road faces the personal consequences of serious injury or death. At a minimum, some who runs an investment bank ought to face the same liability, if they drive too fast around a financial curve.
As for real casinos, they do blow up and go broke, but not from the gambling where the odds so favor the house they cannot loose or where, like in operating a horse track, the house share is just a fixed per cent of the take. In sum, you are factually inaccurate, as always
JLD,
DeleteI don't think you understand how this limited liability thing works. I know for a fact you have no idea what banks do. See, the reason that Bernie Ebbers and Scott Sullivan were imprisoned is because not all liability is limited. If an officer commits fraud, for instance, the corporate veil is pierced. If they simply make bad business decisions but with no malice and with no intent to defraud then, no. It's a little more complicated than that, but that's the general idea.
But, I like your idea. If one of my employees makes a mistake that causes me to lose money, I think I should be able to bankrupt him to recover my losses. I'm sure you wouldn't mind being similarly liable to your employer. Right? The whole idea of being able to bankrupt people for missteps sounds great to me.
I think it's interesting that you equivocate making financial mistakes that don't cost life and limb with truck drivers killing people. Losing money and death are exactly the same thing. In that case, all politicians should be in prison!
Still, I find it quite interesting that the casinos in Las Vegas not backstopped by government don't turn into insane asylums. Lots of other financial firms don't turn into insane asylums either. Why IS it that the insane asylums are restricted to highly regulated, taxpayer backstopped, Too Big To Fail Banks?
I will just point out that the basically unregulated money market funds and commercial paper markets all blew up in the financial crisis and had to be rescued on an ad hoc basis.
DeleteAbsalon, I can't tell anymore if you're just kidding around or you really are this ignorant.
DeleteNeither market is unregulated and neither "blew up".
General fear sparked by the bankruptcies of politically protected, highly regulated and backstopped Too Big To Fails resulted in freezes in commercial paper and assorted interbank lending. Issuers of commercial paper couldn't find buyers. A market that takes a minute to re-assess risk during a banking crisis is not "blowing up".
Money Market funds didn't blow up either. One or two MMF's that lent to Lehman at the time of Lehman's bankruptcy "broke the buck". That is, they lost value. They didn't "blow up". And, although breaking the buck is rare, 2008 wasn't the first time it happened either.
You don't seem to understand what blowing up means. LTCM blew itself up. Lehman blew itself up. Bear blew itself up. MMFs lost a little value, buyers of commercial paper didn't want any more. Neither of them "blew up".
When we talk about "blowing up", we mean going bankrupt. That didn't happen.
Methinks - we disagree about what we mean by "blow-up". You want to use it in a different sense than I did, fine - that does not make me wrong.
DeleteThe commercial paper markets broke down and the government had to intervene - that will do as a "blow-up" for me. It was not just a matter of taking a minute to re-assess risk taking.
LTCM is an excellent example of an unregulated entity blowing up and almost taking the market with it. Greenspan intervened to save the market. I think Greenspan made a huge mistake and we are still paying the price.
Uh, no. We don't "disagree". Words have meaning. If you don't know what jargon means, then you shouldn't use it or people will laugh at you.
DeleteI think Greenspan made a huge mistake and we are still paying the price.
That's because you haven't even a whisper of a clue what happened with LTCM, but it has become apparent to me that your sheer ignorance doesn't stop you flapping your gums.
Methinks
DeleteWould you stop flapping your gums, writing about matters of which you have no idea what you are talking about.
There is no god given right to do business as a corporation with limited liablity. The simplist way to regulate bank conduct is to prohibit banks from operating as corporatations or other limited liablity companies. Require the firms to be sole proprietorships or general partnerships. Losses flow right through to the owner, when you don't have a corporate shield.
Or, we could let them be corporations, but eliminate the business judgment rule and make the directors and officers liable for their negligence, as the truck driver is now. Or, we could require written indemnities against loss or damage. Or best yet, a combination of all the above.
I cannot imagine that you have employees, but if they fail to use due care, they are liable, now, to you for the losses they cause. Of course, in your case they would have defense---your contributory fault for not properly training, instructing, paying, having appropriate working conditions, a sound business model, etc.
To whom did you think losses and gains accrue? Ben Bernanke? Godzilla? Santa Claus?
DeleteLiability refers to legal liability, not the P&L of the firm. Sole proprietorship! LOL!!! You have no idea what a bank is, do you, JLD?
Thanks to all for the informative blog & comments. I've learned a lot today.
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