Friday, May 15, 2009

The Flight to Simplicity in Derivatives

Complexity is one of the demons that makes our financial markets crisis prone. Much of the complexity arises in the specter of derivatives and other “innovative” products. To reduce the risk of crisis we must exorcise this demon. We need a flight to simplicity.

Geithner’s proposal for new derivatives regulations, which includes centralized clearing and exchange trading for standardized derivative products, moves us toward this goal. A stated objection to this proposal is that the door remains open for complex OTC versions of swaps and derivatives. Or worse, that having the standardized products out in the light of day will only accentuate the demand for the more shadowy and opaque versions of the products.

I don’t think that is the way things will play out. More likely is that this proposal, properly executed, will be a major step forward in improving the transparency and efficiency of the market place, and will shore up the market against the structural flaws that derivative-induced complexity have created.

Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products.

Furthermore, the thought-leaders on the buy side will add their own hurdles to the more complex OTC products. I would not be surprised if many investors require derivatives taken on their behalf be of the standardized, exchange traded form, or that if an alternative is presented, it has to be approved by their firm’s CIO or risk manager. If this comes about, there won’t be too many instances where a complex OTC is pushed forward, because for most legitimate purposes the standardized products, on their own or in combination, will be found to do the trick.

Which gets us to the illegitimate purposes. Many of the complex innovative products are used for what might charitably be called non-economic purposes. Like allowing firms to lever when they aren’t supposed to lever, take exposure in markets where they are not supposed to take exposure, or avoid taxes that they are supposed to pay. I have discussed this more in an earlier post, My “Non-testimony” on the Regulation of Swaps and Derivatives.

If someone writes a history of innovative products, it will start with the golden era, when options and other derivatives were introduced to help investors better meet their investment objectives, allowing them to mold returns or, in the parlance of academics, to span the space of the states of nature. Then, somewhere along the line, an investor came to an investment bank and said, “Hey, I got a problem. You think you can help me out here.” His problem was something along the lines of, “My boss, he won’t let me trade mortgages, but I want to get my portfolio into these mortgages.” The ever-accommodating investment bank came back with an index amortizing swap.

Then – or maybe at the same time – the innovations went from "problem" solving to problem creating. Investment banks found clever ways to give their clients an extra twenty-five or fifty basis points by having them take on tail risks. These risks were subtle and infrequently occurring; most of the time things worked out. But every now and then, there were the blow ups; the likes of Orange County and P&G.

10 comments:

  1. Rick:

    One can only hope that "properly executed" is the way these things play out.

    After the way the Government (Treasury, etc.) muscled the "Non-TARP" lenders on Chrysler, I have - unfortunately - lost confidence in this Administration's ability to allow markets to work without interference. Hopefully, they will win that confidence back.

    Given that GM is now on the same road as Chrysler, I don't think that confidence will return in the near future.

    Aren't there still a large number of OTC products that operate side-by-side with market traded products?

    I'm thinking of the OTC forwards in FX that vary slightly from the market traded futures.

    Do you think a similar environment might develop for more complex derivatives?

    Do you expect that they will try to kill the existing OTC markets that operate in parallel (like FX)?

    Thanks,
    Larry

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  2. We could continue to have OTC versions of standard products that trade on an exchange. One reason I always mentioned non-standard or complex OTC instruments is because, as we have seen in other markets, there might be OTC versions of the standard instruments. Sometimes the OTC can be executed in larger volume, and then the broker lays off the risk gradually in the exchange.

    If a non-standard product turns out to be valuable, and develops in spite of the existing standard instruments, then that might be rechristened as a standard instrument and be added to the clearing corporation.

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  3. A tip related to the topic: In the Fed Atlanta conference last week in the famous Jekyll Island, Stuart Turnbull presented a new paper "Measuring and Managing Risk in Innovative Instruments." Not a systemic perspective but the within-firm challenge.

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  4. hi rick, I run a PRDC book. not sure you've heard of it, it's huge in Japan but non existent elsewhere. as I mentioned in other posts, this and other innovative produsts were essentially profit printing machines. every time you book a new trade and put risk on, your model says you are making a profit. it's very hard not to abuse the profit printing machine when your bonus is a percentage of those "hoped for" profits. right now these are another example of massive accumulation of one way risk. I think the first thing regulators have to do is not allow printers of wishful thinking profits to function. no matter what the model, the consensus or some thinly traded market says, and no matter how fancy the math, you have a profit only when you closed the position. realized vs unrealized essentially. none of this would have happened if there were stricter rules on profit recognition.

    a clearing house would be good for these PRDCs, in my view. currently there is no secondary market at all, and people still mark to some make belief "consensus". e4ssentially people should be forced to put their money where their mouth is. would still be difficult to function because each structure is unique, and would still be thinly traded and subject to serious price manipulation, but still, you could have several standard structures trading and those would be a good enough hedge.

    however, first things first. to stop this from ever happening again, the printing of profits must stop.

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  5. I just wanted to say that as an outsider (I'm in the technology industry) with some formal education and understanding of finance, I find these discussions about the CDS market really amusing. Replete with fair weather capitalists like Lawrence D. Loeb who complain about the government when they don't step-in and bailout their bond positions. After all Lawrence, how many times has Chrysler been restructured? How long has GM been losing market share? How long ago did GM burden their cost structure with benefits that impaired their viability? Lawrence's political bet on the unpopularity of letting a large employer like GM file bankruptcy blows-up on them and it's the government's fault for not bailing their bond losses. I call these people "fair weather capitalists"; the privatize profits and socialize losses crowd. They don't have anything worth contributing to the debate.

    Second, you have the "deconstructionists", folks like yourself who seem to think we just need to tweak the system a little here and there and all will be well. A little unwanted regulation over the kicking and howling of the financial lobby will make it all the more palatable, and after all, given Wall Street's death-grip on Congress there is plenty of time to tweak the rules. It only took a generation to substantially die-off and forget the Depression to undermine the regulation from that period. Of course I am referring to the Un-Glass-Steagall Act of 1999, among others.

    Third, there are the "r2's", who are at least refreshing about the nature of the business and the people in it. Everybody knows that Wall Street loves a bubble and kneels at the altar of the dollar. How "smart" can people like this really be? Another worn myth only a fool would believe.

    This isn't about structure and regulation, it's about trust and value propositions. What makes you think anyone trusts Geithner, Summers and the rest of those retreads? What is Wall Street's value proposition to the world without credibility and trust?

    IMO, the whole system needs to be rebooted. Regulation is not enough; too easy to manipulate. Apologists and deconstructionists are not enough, no matter how "reasonable" they may sound. Economic "experts" aren't enough; reliance on algorithms that have little to do with reality. Perhaps after the dollar has crashed and we enter our own lost decade you guys will wake-up. However, unless there is a packet to be made by pushing some paper I certainly wouldn't bet on it. I will bet that you are going to put yourselves out of business. You guys live in this surreal world of denial.

    I hear people say how "resilient" we are and how we will "bounce back" like we always do. I am an eternal optimist but this time I have serious reservations. Those of us who work and actually risk something to produce real products and services that have a real value in GDP, trade balances and competitiveness look upon Wall Street as a net liability. It doesn't really matter how or why; you guys have "screwed the pooch."

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  6. Anonymous:

    First, let me complement you on your bravery for attacking people while keeping YOUR identity secret. Tremendous Internet etiquette that greatly adds to your credibility.

    Second, I have no idea how you came up with my supposed complaints, positions, or beliefs.

    I have no interest in deconstructing your analysis, but whatever it is - extrapolating an entire philosophy from one or two comments is not a valid approach.

    You remind me of an ex-girlfriend who accused me of supporting attacks on abortion clinics because I ordered pizza from Domino's.

    I just wanted pizza (if you can call Domino's pizza that) quickly. I was hungry.

    She was of the belief that, since the founder, and then primary shareholder, contributed money to "Operation Rescue," then I was guilty of supporting that cause with my pizza purchase.

    Similarly, you've decided to attribute ideas to me that AREN'T MINE!

    1. One of my favorite books is Atlas Shrugged. I am very much in favor of capitalism and people being paid based on the value they contribute.

    2. I don't hold any bonds or CDS positions. Never have. Don't expect to get into the CDS game, personally or professionally, at any time in the future.

    3. I am appalled that the taxpayer has been put in a position where we have had to bail out banks and industrial companies.

    To the extent that the problems are based on market liquidity issues, and the assistance is truly temporary - and includes interest for repayment, I'm less uncomfortable.

    GM and Chrysler, on the other hand, have created a monster ... both management and the unions. They have managed to evolve into a company that can't make cars profitably and, by the way, nobody wants the cars they make.

    Nothing would make me happier than a Schumpeterian creative destruction cycle.

    GM and Chrysler deserve to be liquidated. The UAW deserves to be disbanded and any company that replaces them should pay people for the value they create. Union contracts that limit job descriptions, prevent firings for poor performance, and require no-work jobs.

    By the way, do you know who came up with the brilliant idea that industrial companies were competent to provide comfortable retirement for their employees? I don't believe anybody did!

    I believe it was a product of management/union negotiations where management offered to pay something in the future (which they weren't responsible for) and the unions were able to trumpet their victory in negotiating for these pensions.

    Defined benefit plans have created huge amounts of trouble, particularly since long term treasury interest rates fell to less than 4 percent. Companies under-contributed to those plans based on expected investment returns that were never generated.

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  7. Anonymous Part 2 (this limits to 4,096 characters):

    My willingness to see a need for government intervention to solve some of these problems solely is based on the chaos that NOT solving them would cause.

    If GM and Chrysler liquidated, there would be a huge increase in unemployment, which the taxpayer would have to pay for. Eventually those people would be redeployed, possibly in an economically feasible auto business, but not until we went through a depression as bad, if not worse than, the 1930s!

    Not only would GM and Chrysler employees be put out of work, but employees at the first, second, and third tier suppliers that rely significantly on GM and Chrysler for their business.

    As for CDS failures, since many of these over the counter contracts did not require the transfer of collateral to support changes in the price of the CDS, parties to these contracts are vulnerable to failure by their counterparties to live up to their commitments. Failure by one entity that was a large enough player could cascade through the system. The reverberations would be worldwide.

    Your brilliant wisecracks and attacks are extremely helpful, as are your nonexistent suggestions to fix the problems.

    I write this in full expectation that you will find some way to misinterpret it and put other words in my mouth (keyboard?).

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  8. don't want to interfere in your discussion guys, just one comment for anonymous (pls give yourself some nickname at least). I find it that the entire world is a bit too quick in claiming moral ground over wall street. the greed of the fat cats is to blame for all this, while honest citizens that have done nothing wrong have to pay the bill. I think this oversimplifies the picture and here is why. most people out there just haven't been presented with the same choices. would they have done differently if they had the opportunity to receive a 1 million dollar bonus, all perfectly legal, but derived from profits they knew were at least "high risk"? would they have said "greed is not good, it will lead the financial world to disaster, just give me 25 grand, you guys do something with the rest?". my guess is no, they would have done about the same. very quickly many of them would have started feeling entitled to receive that kind of money, considering it to be a reward for their hard work and intellectual superiority over people in other industries etc (which I think is bullsh#te). human nature is the same, we are the same DNA. big shots on wall street are not any greedier than any regular entrepreneur (judging from the small number of people I know personally). wall street just had access to a lot more money and to the profit printing press that I mentioned in the previous post, made possible by applying 100 year old accounting principles to today's complex financial products. to me it doesn't mean the rest of the world is any better or worse.

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  9. Actually Lawrence, the list moderator removed my name and email address. Sorry, but you don't remind me of anyone worth repeating a story about.

    As for "Atlas Shrugged", it is a simplistic tome that will go down in the annals of pop literature as the grocery-rack bestseller of all time. I'm quite sure it is on every bookshelf on Wall Street. I too am a capitalist, but not because I read Atlas Shrugged, but in spite of it.

    Nothing would make me happier than a Schumpeterian creative destruction cycle of Wall Street. But as you and many or your ilk like to shout-out from the rooftops in fear and horror, they are too big too fail! The pain will be worse! How do you know that? This "fear and dread" mantra suits the beneficiaries of the current system, because it is all they know and at bottom, they are the first ones under the table at the first sign of trouble. The similarities are striking to the auto industry of the past 20 years who ironically, you enjoyed pilloring for incompetence.

    As for your explanation of the legal nature of CDS contracts, that's not credible. It's one of those "convenient truths" bandied about under the rubric "rule of law." In fact, a principal reason these contracts are being supported by the Treasury and Fed is because of the political influence of the counterparties. And what good is a contract if you need a third party (taxpayers), who was not a party to the original contract, to provide performance? The contract only has value in so far as the parties are able to perform. That's the way it works in the technology business but I guess there is a "narcissism exception" for Wall Street.

    As to fixing the problems, just briefly, I would propose the following:

    1) Close the CDS market - compress all counterparty transactions to a net amount and let them sue each other in court to collect what is left, if anything. What is the real net amount of these liabilities if you get MS, GS and their "counterparties" in a room and start cross-eliminating obligations? I know they like opacity, but I know that it isn't $57 trillion.

    2) Schumpeterian creative destruction on Wall Street - this business model isn't worth saving. Go back to making banking the boring, risk-averse business it is supposed to be.

    3) Remove any vestige in law or politics of "moral hazard" - shareholders and debtors take the losses.

    4) Federal/public financing of Federal elections

    I completely disagree with you. What is being created now are zombie banks and a Japanese-style deflation scenario. The similarities, including the political and economic corruption, are striking. You should spend some time reading-up on that subject matter rather than trying to pass off dime-store novels as serious thought in the western tradition.

    Just to put it into perspective, what the CDS counterparty-zombie-AIG has already soaked-up in taxpayer funds is about the same as the market cap of ATT and Verizon combined, which represents about 80% of the US communications market. BTW, that's another monopoly/duopoly now too, thanks to Congress and Wall Street.

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