Opinion

Felix Salmon

Volatility: The flipside of moral hazard

Felix Salmon
May 17, 2010 14:26 UTC

Jim Surowiecki today looks at the flipside of the moral hazard trade: if you can’t count on governments to bail you out in extremis, then you’re likely to have volatile and unpredictable markets.

Political risk is hard to manage because so much comes down to the personal choices of policymakers, whether prime ministers or heads of central banks. And those choices aren’t always going to be economically rational—witness Merkel’s recent tergiversations. Similarly, the U.S. government’s failure to bail out Lehman Brothers in 2008 seems to have been in part the result of Treasury Secretary Henry Paulson’s desire not to be seen as Mr. Bailout. Investors, then, are being forced to read the minds of policymakers—not something they’re good at. Markets work best when there’s lots of information available and a historical track record to go on; they excel at predicting things like horse races, election outcomes, and box-office results. But they’re bad at predicting things like who will be the next Supreme Court nominee, as that depends on the whim of the President.

Surowiecki is saying not only that Merkel should have bailed out Greece with alacrity and that Paulson should have bailed out Lehman: he goes on to praise successful interventions in the markets such as the Clinton/Rubin bailout of Mexico, Hong Kong’s successful 1998 intervention in its own stock market, and the Obama Administration’s decision to preserve as much equity and debt value of the banking system as it could.

In all these cases, government intervention was used to prop up market prices — of Mexico’s bonds, of Hong Kong equities, and of US bank stocks and preferred debt. And yes, when there’s a government put, volatility goes down. But that doesn’t mean that government puts are a good idea: after all, it’s not the job of government to reduce market volatility.

What’s clear is that governments — and I’m including central banks here — have much less ammunition now than they did pre-crisis, even if they still have the willpower to intervene to save markets from themselves. And the willpower is evaporating rapidly, to boot. The result is that the moral-hazard play is becoming increasingly dangerous, and that volatility is sure to stay high.

The only thing keeping markets from plunging on worries surrounding European finances is faith in the political credibility of the European Union and the ECB. And on that front, there’s a lot more downside than there is upside, since we’re leaving a world of very high European cohesiveness and entering a world of much greater uncertainty. It’s already clear that the UK is going to be absent from the European project for the foreseeable future; the big risk is that the Germans will follow suit.

A lot of investors have made a lot of money from the moral-hazard trade over the past 15 years or so. When that trade comes to an end, expect the losses to be just as big, if not bigger.

COMMENT

Neither logic nor terminology of free market capitalism apply to what we’re seeing now, namely non-stop upward redistribution of wealth via convoys of hijacked vehicles that can’t even manage their own hot-air supply but suck the last drop of blood out of everything else on earth.

Door Number 1: Volatility? Bring it on. Let it burn itself out. Bleach the ashes and everything this tainted market has touched, that no spore of its cannibal virus remain alive.

Door Number 2: Would you rather Merkel had slept with it on the first date?

Door Number 3: Little something in between – ménage à GS, perhaps?

Don’t worry, Felix. Surowiecki can’t make up his mind, either.

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Why financial reform won’t hurt employment

Felix Salmon
May 17, 2010 13:39 UTC

Meredith Whitney is trying to make an updated case that we can’t pass financial reform because it would cost jobs. I don’t buy it, partly because I simply don’t believe her numbers, which kick off with two interlinked claims:

States will approach their June fiscal year-ends and, as a result of staggering budget gaps, soon announce austerity measures that by my estimates will cost between one million to two million jobs for state and local government workers over the next 12 months.

Typically, government hiring provides a nice tailwind at this point in an economic recovery. Governments have employed this tool through most downturns since 1955, so much so that state and local government jobs have ballooned to 15% of total U.S. employment.

First, there hasn’t been much ballooning going on. Let’s look at the numbers here: there were 17.3 million state and local government workers counted in the latest jobs report. That’s down from 17.6 million a year ago. In terms of percentages, state and local government now accounts for 13.3% of total nonfarm employment, unchanged from a year ago.

Does Whitney really believe that these very stable numbers are suddenly going to be upended over the next 12 months? Yes, many states have announced job cuts — but announcing job cuts is vastly easier than actually implementing them. To get a good idea of how difficult it is to shrink a mammoth bureaucracy, look at Citigroup, which has a storied history of announcing enormous job cuts only to see its total headcount rise: it took a good five or six attempts before it actually managed to shrink its total payroll. It’s simply not credible that state and local governments are going to reduce their total job count by between 6% and 11% over the next year.

Whitney then goes on to say, quite rightly, that small businesses are the best engine of job creation. But then her logic goes a bit skewy again:

Small businesses fund themselves exactly the way consumers do, with credit cards and home equity lines. Over the past two years, more than $1.5 trillion in credit-card lines have been cut, and those cuts are increasing by the day. Due to dramatic declines in home values, home-equity lines as a funding option are effectively off the table. Proposed regulatory reform—specifically interest-rate caps and interchange fees—will merely exacerbate the cycle of credit contraction plaguing small businesses.

If banks are not allowed to effectively price for risk, they will not take the risk. Right now we need banks, and particularly community banks, more than ever to step in and provide liquidity to small businesses. Interest-rate caps and interchange fees will more likely drive consumer credit out of the market and many community banks out of business.

Essentially, Whitney is saying that small businesses fund themselves with credit cards; that financial regulation will reduce the amount of credit-card credit; and that therefore financial regulation is bad for small businesses. What’s more, she applies this argument specifically to community banks.

It’s true that small businesses fund themselves with credit cards. But it’s not true that exorbitant interest rates of 30% or more are a result of “effectively pricing for risk” — instead, they’re a way of trying to extract as much profit as possible out of every cardholder. And it’s trivially true that a small business funding itself at an interest rate of something over 30%, where the proposed caps are going to kick in, is not going to be doing a lot of new hiring.

And while it’s also true that we need community banks to provide funding to small businesses, the fact is that the overwhelming majority of credit cards come from the giant too-big-to-fail banks. If a small business wants to get a loan from a community bank, it can and should do so the old-fashioned way, by getting a loan from its local community bank. Local banks have very little dependence on small-business credit-card revenue, and in fact if the big banks cut their credit card lines further, that might serve only to drive ever more small businesses to get loans from their local institutions. Community banks, in other words, have nothing to fear from financial reform: in fact, they have quite a lot to gain. And small businesses, too, should welcome anything which keeps their funding costs down and stops them being ripped off by their banks.

COMMENT

I get slightly different numbers than you do. Using seasonally adjusted data (fromt he BLS), I have state & local employment at 15.1% of total nonfarm employment in April, essentially unchanged from April 2009 (15.0%), with state and local employment down 170,000 from a year ago. On the other hand, I think the argument, that the growth in state & local government employment (up from about 9.3% in 1955) is attributable to employment expansions during recessions/recoveries, made by Whitney, is nonsense. State and local government employment has grown over this time period, but if that growth ins more rapid in recessions or early in recoveries, it’s certainly not apparent in the data. In fact, if anything, growth in state and local government employment tends to slow down or fall in recessions and early in recoveries. The budget squeeze being experienced now is, in fact, quite tyical, and the quite typical response has been cutbacks. Not large–certainly nothing as large as she suggests–but this time is certainly not an exception.

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Counterparties

Felix Salmon
May 17, 2010 06:57 UTC

Overnight markets: Sliding — Alphaville

Bill Clinton is actually, legally, running Haiti — Truthout

The WSJ’s ad campaign hits the L train in Williamsburg, misfires catastrophically — Twitpic

El-Erian on courage, vision and the dangers of short-term expediency — Alphaville

Waldmann vs Tabarrok — Angry Bear

Counterparties

Felix Salmon
May 15, 2010 04:57 UTC

Robert Mugabe sends ‘ark’ of animals to North Korea — Guardian

Chicago’s mayor “gleefully” declares that he’s going to start posting all FOIA requests online — Sun-Times

I win the American Statistical Association’s Excellence in Statistical Reporting Award — Columbia

Europe = Marge Simpson — Ritholtz

“A carbon market isn’t innovation; it’s just a regular old commodity market” — Economist

COMMENT

Congratulations Felix, but is this like a razzie or something? I looked back at the articles cited for the award and your calling bullshit on figures and your analysis, didn’t quite measure up to statistical excellence at all , although you have many articles which DO show careful measurement… I remain confused.

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Why it makes sense to fear Greek default

Felix Salmon
May 14, 2010 20:04 UTC

Is everybody overstating the consequences of a Greek default and/or devaluation? The Economist points out that Europe has seen quite a few defaults in recent decades (Russia, Poland) and also break-ups of currency unions (Czechoslovakia, Yugoslavia) — and that none of these events caused a lot of lasting damage.

I’m not convinced, if only because the Russia default caused the collapse of LTCM and a serious crisis; if it weren’t for tough arm-twisting by the Fed and billions of private-sector dollars from America’s biggest banks, it could have been much worse. And the end of the koruna and the dinar also meant the end of the Czechoslovakia and Yugoslavia, and the worry is very much that if Greece or anybody else were to exit the euro, then the whole currency union could fall apart, endangering the EU itself.

More generally, financial markets are good at taking the collapse of risky assets in their stride: what they’re bad at is dealing with the collapse of assets they thought were safe. And until very recently, Greek bonds were considered to be an interest-rate play, not a credit play. As a result, the institutions owning them can ill afford to see big losses on them.

The euro was designed to be a super-safe currency; as such, the repercussions of it falling apart would surely be many orders of magnitude greater than anything we saw in the wake of the collapse of the unlamented Yugoslav dinar.

Mike Kinsley also notes, in the North American context, that if you don’t have an economic union, then other issues tend to get worse — like illegal immigration.

All of which is to say that the great euro experiment seems to be unwinding, the Estonia news notwithstanding, and no one knows where it’s headed over the medium term. If economics and politics become fractious and nationalized across Europe, then within the region only Germany will any longer provide the kind of safety that investors are currently looking for; everybody else is going to start returning to their pre-convergence trade levels, which were a long way away from where we are now.

So anything which threatens the unity of the eurozone or the EU is surely going to have market consequences much worse than a single day drop of a few percentage points on European stock exchanges. And right now it’s far from clear that the political will to keep the union together is going to be sufficient.

COMMENT

No jhaskell, the phrase you’re looking for isn’t “welfare state” – it’s Social Contract. As long as you don’t violate it and mess with their basic expectations by gambling away their hard-earned cash, you can get as rich as you like and the plebs won’t drag you out of your gated community, torture and shoot you.

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When risk becomes uncertainty

Felix Salmon
May 14, 2010 16:28 UTC

It’s going to be another panicky weekend in Europe after today’s torrid market action: the positive effects of last weekend’s emergency meetings clearly didn’t last even until Friday, and the ever-weakening euro is now dragging down the continent’s bourses. This isn’t (just) a sovereign-credit issue any more: the financial markets have worked out that there’s a pretty simple trade-off between fiscal austerity and economic growth.

At the same time, markets clearly don’t believe that fiscal austerity is going to be a reality either: Greece’s CDS spreads are now back out over 600bp, and the rest of sovereign Europe seems to be gapping out too.

Most worryingly of all, the biggest losers today on European stock exchanges have been the banks — which means that we could be heading for a reprise of the 2007 credit crunch.

The big picture here is that risk, in Europe, is being replaced by uncertainty. The difference is that risk can be priced, while uncertainty can’t, and a market dominated by uncertainty is always going to be jittery and dangerous. No one knows whether the trillion-dollar bailout package announced last weekend will ever actually exist in practice; no one knows whether there’s a Trichet Put or not; no one knows whether the historic alliance between France and Germany, in which both of them do whatever it takes for the sake of European unity, still really exists; and everybody knows that the UK now has the most eurosceptic government since Margaret Thatcher resigned 20 years ago.

Meanwhile, on this side of the pond, we’re seeing large stock swings yet again, with the Dow down over 200 points and the VIX at 33: the uncertainty in Europe is clearly spilling over to the U.S., and this time a phone call from Barack Obama to Angela Merkel is unlikely to do much visible good.

This isn’t a second financial crisis yet. But the fact is that the world’s governments and central banks have much less ammunition than they did last time around if such a thing were to emerge. So the possible downside is enormous, especially given how much markets have rallied in the past year. If you can’t stand a lot of heat, then this particular kitchen is one to avoid for the time being.

COMMENT

Again, even if those amounts are correct and not just the Fed spinning a back-door bank bailout, it doesn’t inject money directly into the economy. If your mechanism requires credit creation to work – those added bank reserves turning into new loans – it is doomed to fail in this economy: the demand for credit just isn’t there. It’s credit demand that drives loan expansion – not reserves. Adding reserves by expanding the Fed’s balance sheet will strengthen banks (its real purpose) but it will not “bolster the economy.”

If $1 Trillion net was really injected into the economy we would see dramatic improvements in employment and capacity utilization. The Fed doesn’t have the ability to do that. Only the government can accomplish that through higher spending or lower taxes.

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The silliest derivatives probe yet

Felix Salmon
May 14, 2010 14:13 UTC

The civil and criminal investigations of Evil Financial Products Which Destroyed The World have now officially reached the stage of farce, with “federal regulators and state officials” reportedly investigating the fact that banks traded municipal CDS at the same time as underwriting municipal bonds.

The case here is so weak that I can only imagine that the ultimate goal lies in the shadow of the law, in the realm of a global settlement caused by the sheer weight of investigations. The banks can’t afford to laugh this kind of thing off, no matter how ridiculous it is on its face:

The probe is exploring potential conflicts of interest by banks that sell municipal bonds and then poise themselves to profit if those bonds fail, these people said.

A main thrust of their investigation is whether firms use their own money to bet against the bonds they sell and, if so, whether that activity is properly disclosed to bond buyers…

“It seems that when they are trying to sell CDS’s, they have to talk about the riskiness of the bonds, and that has some psychological impact on the investor’s view,” Mr. Lockyer said in an interview. “We might then pay a higher price to sell the bond. This isn’t right.”

That’s Bill Lockyer, of course, California’s treasurer, who started the ball rolling back in November 2008 when he was the prime source for a very silly ProPublica investigation along similar lines. But now he’s moved on from non-profit journalism shops to federal prosecutors, which means that his conspiracy theories are growing real teeth.

The crazy thing here, of course, is that the banks are damned if they do and damned if they don’t. The investigators are apparently trying to nail the banks for not disclosing that they had a short CDS position — but if they did disclose that, then the “psychological impact on the investor’s view” would be even greater, and California might need to pay even more to sell the bond.

What’s more, the WSJ seems happy to jump on the bandwagon, with editorial interjections like this:

Municipal credit-default swaps are still thinly traded, but their existence has the potential to spook investors in the same way investors have feared Greece defaulting on its bonds.

I’m not sure what this is supposed to mean. Is Ianthe Dugan implying that the mere existence of CDS on a certain bond can spook investors into thinking that the underlying credit is the next Greece? Is she saying that the CDS market was somehow responsible for Greece’s fiscal woes? Whatever she’s saying, she’s not making a lot of sense.

Blanche Lincoln would like to force banks to sell their swap desks, in a move which is opposed by a lot of regulators within Treasury, the Fed, and elsewhere. If that piece of legislation gets signed into law, then yes this kind of activity — trading in municipal CDS — would become illegal. But right now it’s perfectly legal, and investigating it is pure politics.

The important thing to remember here is that the effect of the CDS market on municipal borrowing costs, even if it’s non-zero, is exactly the same no matter who is doing the trading in CDS. If Goldman and BofA and JPM and the other banks caught up in this probe stopped making markets in municipal CDS, someone else would step in and take over from them. And if the trading moved onto an exchange, as it should, then that would only serve to make the CDS prices even more public, thereby spooking potential investors in municipal bonds even more.

But this investigation is political, it’s not based on coherent jurisprudence or financial logic. And as such, the banks’ responses are going to have to be political too. That global settlement is getting closer by the week.

COMMENT

There would be no problem with banks buying a CDS insurance policy on a muni, or any bond, if there was no way for them to actually PROFIT from the failure of said bond. Just like home insurance has a deductible, bond insurance should have some haircut for the bank, jut to keep them from being careless. CDS is a good thing as long as it is done to minimize loss, as opposed to making money on a default.

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Counterparties

Felix Salmon
May 14, 2010 03:26 UTC

Alex Tabarrok on the fragility of CDO models. Excellent — MR

The key to happiness: Hate your ex — Atlantic Wire

The Google Job Experiment. Clever. — YouTube

COMMENT

except the CDO model math is wrong, it doesn’t take correlation into account. waldmann at angrybear covers it.

also, in general, any time you have far out of the money options (in this case the cdo has an embedded short put) there are situations where a small change in the underlying price makes a big change as a percentage in the model price of the option.

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Lies, damn lies, and oil spill statistics

Felix Salmon
May 14, 2010 03:22 UTC

Justin Gillis has a great story about how no one with the ability to do anything about it seems remotely interested in measuring the severity of the oil spill in the Gulf of Mexico. The ubiquitous 5,000-barrels-a-day number seems to be a massive underestimate, and the stated reason for not getting a better figure is weak indeed:

A spokesman, David H. Nicholas, said in an e-mail message that “the estimated rate of flow would not affect either the direction or scale of our response, which is the largest in history.” …

“I think the estimate at the time was, and remains, a reasonable estimate,” said Dr. Lubchenco, the NOAA administrator. “Having greater precision about the flow rate would not really help in any way. We would be doing the same things.”

Why is the NOAA backing BP up on this? Knowing the size of the problem may or may not help in terms of being able to fix this particular problem. But it’s certainly going to be important going forwards.

What’s more, the current estimate could hardly have been friendlier towards BP if it had tried:

The 5,000-barrel-a-day estimate was produced in Seattle by a NOAA unit that responds to oil spills. It was calculated with a protocol known as the Bonn convention that calls for measuring the extent of an oil spill, using its color to judge the thickness of oil atop the water, and then multiplying.

However, Alun Lewis, a British oil-spill consultant who is an authority on the Bonn convention, said the method was specifically not recommended for analyzing large spills like the one in the Gulf of Mexico, since the thickness was too difficult to judge in such a case.

Even when used for smaller spills, he said, correct application of the technique would never produce a single point estimate, like the government’s figure of 5,000 barrels a day, but rather a range that would likely be quite wide.

Why release a point estimate? Well, if the NOAA had released a range — say 3,000 to 30,000 barrels a day — then the press would have gravitated to the higher number, and talked about a spill of “as much as 30,000 barrels a day”, and that would be the main number people remembered. But it’s not the NOAA’s job to do PR for BP. And it is the NOAA’s job to get as much good information about this oil spill as possible.

So let’s get down there and measure this thing.

COMMENT

alexhiggens: The riser pipe has a 20 inch interior diameter. However, the drill pipe that is actually sunk into the reservoir has a 9 inch diameter. That is the pipe that is relevant for determining flow.

It’s possible that the pipe may be structurally compromised, or there may be frozen crystals built up, etc. which would affect oil flow. Also, as the oil rises through the pipe, methane gas comes out of suspension as pressure lessens (like the carbonation in soda), so it’s tough to know how much is gas and how much is oil.

That said, the pipe into the well is 9 inches.

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