This sounds scary

by John Quiggin on November 26, 2008

I haven’t had time to digest the implications of this story which has been around for at least a month, but only now seems to be attracting attention (I’ve seen it in a few different places today). Apparently, short sellers in the US Treasury bond market are failing to deliver the securities they’ve sold. As long ago as 1 October, the shortfall was more than $2 trillion by one report. Via Felix Salmon, here’s Helen Avery in Euromoney.

I’m not an expert on this stuff, but it seems to raise the question of whether bond markets can or should continue to exist in their current form. Maybe the US and other Treasuries should be selling bonds directly, and offering repurchase options to provide liquidity, perhaps using the banks they’ve already part-nationalised to handle the mechanics.

{ 43 comments }

1

Ginger Yellow 11.26.08 at 12:14 pm

By the way, it’s important to note that this isn’t really about short selling in the speculative sense. It’s not about institutions taking substantial one way bets. It’s about dealers promising bonds to clients but failing to deliver them on time, in other words market making gone wrong. That’s not to trivialise the problem – the Treasury repo market is the bedrock of the financial system and had until recently remained mercifully functional – but it doesn’t really make any sense to mix it up with moral arguments about short selling.

2

John Quiggin 11.26.08 at 12:51 pm

I don’t have any moral views about short selling; in fact, I see no particular reason why betting that stocks will go down is problematic. But it seems pretty scary to me that dealers can promise, and not deliver, bonds to the value of trillions of dollars. I mentioned short selling only because, if it weren’t for short sales, the problem of non-delivery would not arise or at least would be much more easily fixed.

3

J Thomas 11.26.08 at 1:26 pm

I don’t have any moral views about short selling; in fact, I see no particular reason why betting that stocks will go down is problematic.

This is a side issue for your post, but I think it’s wrong for specialists to be allowed naked short selling. It’s an invitation for abuse, it goes from betting that stocks will go down toward manipulating stocks to go down. Similarly with brokers who can short-sell their customers’ stock without informing the customers. That turns brokers into fractional-reserve brokers which is emphatically a bad thing.

I think it would be much better to get rid of short sales but let people bet that stocks will go down on a prediction market.

So if you bet a million dollars even odds that ILM will be below 100 on 01/26/09, and somebody takes your bet, then anybody can look at it and figure you’d be willing to lose half a million or so manipulating the price to below 100, and the other guy might be willing to lose the same to stop you. And they can look for ways to profit from that.

On the other hand if you bet a million dollars that ILM will be below 100 for the whole month of february, people are likely to look at the fundamentals. Maybe they’ll take your bet, or pile in on your side, your bet might influence whether they buy at 120 today or not.

If you make a public bet it will probably influence the ILM market. But that’s a far cry from being a specialist or broker who invisibly sells a million ILM shares cheap that you don’t own, expecting that you can buy them back even cheaper after you’ve driven the price down.

4

Rich Puchalsky 11.26.08 at 1:51 pm

Reading the article all the way down to the bottom, it looks like there is no penalty for failing to deliver the bond you’ve promised — whether you’re a market maker or short seller. That’s astounding. Why not short sell if you can put off payment indefinitely?

This looks to me like a classic example of the bezzle, as you wrote earlier. People make easy money short selling and never having to pay. Then there’s a market crash, and suddenly people are looking at these things and saying, hey $2 trillion has gone missing.

5

Ginger Yellow 11.26.08 at 2:34 pm

It’s an invitation for abuse, it goes from betting that stocks will go down toward manipulating stocks to go down.

I think it would be much better to get rid of short sales but let people bet that stocks will go down on a prediction market.

If the prediction market is at all liquid and widely used, then it will be just as liable to manipulation. People in the “real” market will look to the prediction market for price signals, thereby moving the “real” price.

“Reading the article all the way down to the bottom, it looks like there is no penalty for failing to deliver the bond you’ve promised—whether you’re a market maker or short seller. That’s astounding. Why not short sell if you can put off payment indefinitely?”

It is pretty astounding, yeah, but I assume the reasoning was that if you got a reputation for failed trades people would stop using you as a counterparty. That used to be enough. Nowadays everyone’s reputation is shot so there’s nothing to lose. I would guess.

6

Ginger Yellow 11.26.08 at 2:37 pm

“People make easy money short selling and never having to pay. Then there’s a market crash, and suddenly people are looking at these things and saying, hey $2 trillion has gone missing.”

Except that we’re talking Treasuries here, for which yields are very low and falling. Nobody in their right mind would be actively shorting Treasuries (unless they’re playing the maturity curve, but that wouldn’t account for the volume of failed trades and the article gave no indication that it was particular maturities that were failing).

7

Bill Gardner 11.26.08 at 2:50 pm

“It is pretty astounding, yeah, but I assume the reasoning was that if you got a reputation for failed trades people would stop using you as a counterparty. That used to be enough. Nowadays everyone’s reputation is shot so there’s nothing to lose. I would guess.”

As a layperson trying to understand this, I would assume this means that short selling would stop on its own if this were true. Does this have implications for other transactions involving bonds?

8

Ciarán 11.26.08 at 3:05 pm

it goes from betting that stocks will go down toward manipulating stocks to go down
But isn’t that just what markets are anyway, except with the word ‘up’ normally replacing the word ‘down’?
I thought that one of the lessons of the markets since Enron has been that, once the system lacks anyone with a strong interest in the long term well-being of companies, hype and speculation on the trajectories of share values in any direction can end in tears. So what makes shorting so specially awful?

9

lemuel pitkin 11.26.08 at 3:12 pm

it seems to raise the question of whether bond markets can or should continue to exist in their current form.

I’ve heard a number of smart folks — including some econ PhDs from top-tier schools — musing about whether the upshot of the crisis is that we don’t need a private financial system at all, at least not for many of the functions it currently performed.

The problem is, institutions and classes that lose their function don’t necessarily lose their power and status and income along with it. One can imagine financial capital following the same kind of trajectory as early modern nobilities after they lost their role as professional soldiers, and persisting as aristocracies supported by (and in control of) the state.

10

Ginger Yellow 11.26.08 at 3:21 pm

Bill, as I’m trying to explain, the article isn’t talking about short selling in the sense that most people understand it. It’s talking about clients demanding Treasuries from dealers in repo trades (which is how dealers and leveraged funds finance most of their holdings), who then fail to deliver them on time. By agreeing to deliver them without necessarily owning them at the time, dealers are effectively short selling. They’re financing less liquid holdings.

“Does this have implications for other transactions involving bonds?”

These are other transactions involving bonds. These are the most fundamental transactions involving Treasury bonds. This is the oil that lubricates the whole global financial markets. That’s why it’s such a serious problem.

11

Ginger Yellow 11.26.08 at 3:27 pm

To clarify a bit: they’re effectively short selling, but they’re not necessarily betting that the price will fall. They’re making markets and/or financing their own holdings., but for whatever reason (and there are many potential reasons, some innocent and some nefarious) not coughing up the security when they promised to. Maybe another of the dealer’s counterparties didn’t deliver when they were supposed to (this used to be the most common reason for failed trades). Maybe the trader is cynically holding on to the bond for use in another, more profitable trade. It’s impossible to say based on aggregate numbers.

12

Ginger Yellow 11.26.08 at 3:32 pm

There’s a primer on the Treasury repo market here (PDF), which explains things more clearly than I have.

13

J Thomas 11.26.08 at 4:39 pm

If the prediction market is at all liquid and widely used, then it will be just as liable to manipulation. People in the “real” market will look to the prediction market for price signals, thereby moving the “real” price.

Sure. But it wouldn’t be a secret. Anybody could see you do it and draw their own conclusions.

But isn’t that just what markets are anyway, except with the word ‘up’ normally replacing the word ‘down’?
I thought that one of the lessons of the markets since Enron has been that, once the system lacks anyone with a strong interest in the long term well-being of companies, hype and speculation on the trajectories of share values in any direction can end in tears. So what makes shorting so specially awful?

When you sell something you don’t own, you’re secretly manipulating the price. When you’re in the special position that you can sell a whole lot of stuff you don’t own without having to cover, then you can manipulate the price easily. Supply and demand — artificially increase the supply now, later you buy back before the price adjusts.

I just like it better when it takes an actual owner to sell. If the official price is too high but nobody wants to sell, why not let that official price sit wherever it wants? If there aren’t any buyers then it will go down when somebody wants to sell. Why let a third party come in and drive the price down by selling without actually owning the stock.

Well, of course, specialists and brokers prefer stocks that have a lot of volume of trade, and that’s easier when the prices have a lot of volatility. That benefits them. But how does it benefit anybody else?

I think we’d be better with a government-owned stock market. The computer technology isn’t all that exotic these days. You put in limit orders or market orders, at any given time you can see all the limit orders that are in place and the recent history of market orders. If you want a broker (like you might want a tout at a horse race) then hire one. If you want to borrow somebody else’s stock so you can sell short, that’s fine, they won’t do it unless they trust you.

…once the system lacks anyone with a strong interest in the long term well-being of companies…

If there’s a 100% tax on stock profits when you sell within 2 months of buying, and say bring it down to 70% for 6 months and reasonably low for a year, and very low for five years, then investors will have a strong interest in the long term well-being of the companies they buy stock in. Let the guys who’re planning their retirements do it without the guys who’re playing casino. If you want a casino then go to a casino.

But this is a side issue for the topic of people who sell government bonds and don’t deliver.

14

mickslam 11.26.08 at 5:33 pm

There is a solution. Make the system whole from the bottom up. Suspend payroll taxes for an indefinite period. This would push a huge amount of extra cash into the system – about $20B a week – and allow consumers to balance their balance sheet, not the balance sheet of the banks. This would quickly start to bring all of the credit markets into place.

The problem is that by selling treasuries, the Fed or treasury would be draining cash from the system. They don’t want to drain cash from the system right now, so they won’t sell more treasuries. The problem is that there is not enough total cash and treasuries in the system. Changing from cash to treasuries(cash equivalents) doesn’t solve the basic problem of not enough people being able to make their payments. That is why banks are worried about counterparty risk – they don’t know if the counterparties customers will be able to make their payments. We’ve tried making the system whole from the top down, and it isn’t working. The system needs solvency from the bottom up.

Trickle up economics, rather than trickle down.

15

Bill Gardner 11.26.08 at 6:24 pm

Ginger,
Many thanks for the patient explanations.
Seems like a lot of social capital has been destroyed along with ordinary asset values. I wouldn’t be able to judge whether that is a symptom or a cause.

16

ffrancis 11.26.08 at 7:46 pm

Wow, Mickslam (# 13), I like that. It’s cheaper even for a year than the US government has already committed to spending at the top end. And if consumers don’t use the extra money to balance their personal balance sheets – and many probably won’t, given past habits – they will no doubt inject it into the retail economy, giving a huge burst to consumer spending and thus jump-starting the global economy again…

17

NotedScholar 11.26.08 at 8:17 pm

Hmm. Interesting. I guess this means that the fears of the harshest critics have come partly true! Hopefully this will not continue. Or hopefully there will be an upward bull swing in the market.

NS
http://sciencedefeated.wordpress.com/

18

Kenny Easwaran 11.26.08 at 11:12 pm

What’s the effective difference between suspending the payroll tax and having some sort of cash payout stimulus package like the one last April? For $20B a week, you could give everyone something like $60 a week.

19

J Thomas 11.27.08 at 3:28 am

Kenny Easwaran, you are talking about sending the same amount of money to each individual american. That seems fair. So a family of 4 would get around $260/week.

And lots of individual families would spend the money fast. So that’s good.

But here’s a problem. Some people might use the money to pay down their credit cards. That would be very bad for credit card companies. It would be deflationary. Credit card companies would be stuck with cash they couldn’t loan out.

So maybe we could have a rule that any week you get the federal money, you can’t pay down any credit cards? You could use the money to pay interest on your credit cards, but not to actually reduce your debt. That way we could do good to US citizens but also be fair to the lenders.

20

Michael Turner 11.27.08 at 5:23 am

lemuel pitkin writes:

I’ve heard a number of smart folks—including some econ PhDs from top-tier schools—musing about whether the upshot of the crisis is that we don’t need a private financial system at all, at least not for many of the functions it currently performed.

An interesting idea. I don’t think it’s going to happen, and I don’t think it should happen (not yet, anyway — maybe in a few more decades, depending), but the socialization of finance isn’t a silly idea at all.

The rationale for bailing out the big financial firms has been that they are special, that they aren’t the kinds of economic organs that can be allowed to die, that can grow back (though I’ve heard the “grow back” argument from at least one economist), or that we can even live without for very long. Is it even capitalism, without organs dealing in liquidity and its derivatives? You can live without your kidneys for a week or so; with special equipment you can live without your heart; without certain parts of your brain there is no “you” to be considered alive in the first place. To the extent that the financial system is metaphorically more cardiac than neural, you might consider “artificial” (governmental) substitutes, but I’m not sure anyone knows just where to draw the line. (For that matter, Fannie and Freddie were supposed to be a pair of sturdy kidneys, but look at them now!) Better regulation, and the overhanging threat of more regulation — pacemakers, if you will — still make more sense to me than the heart-lung machine as a permanent solution.

Still . . . it’s not a dumb idea, not at all. Right now, even though any given financial entity might be private, the industry overall serves a governmental role in capitalist economies. If the crisis had been among electricity producers facing spectacular bankruptcies, you wouldn’t hear much controversy over nationalization. Admittedly, blackouts are far more tangible failures, and we have a long tradition of the regulated-monopoly utility. And the credit crunch isn’t something you can feel directly, mostly, at the moment. If left to its own trajectory, however, it could lead to lights literally going out. Credit isn’t that different from electricity. All societies institutionalize trust somehow. Large scale, complex societies do it through money; money needs its stores, buffers, and conduits; and nobody’s going to maintain that infrastructure for free.

The problem is, institutions and classes that lose their function don’t necessarily lose their power and status and income along with it.

Institutions and classes wouldn’t be losing their function. They would just migrate into government. People who are in it more for the money than anything else could move on to some industry that would reward them richly for their brains and gall. (I hear there are openings for skippers off the coast of Somalia these days.) Status? “I used to be a trader for Lehman” isn’t giving anybody much career traction now, probably doesn’t get you many party invites either. The money they’ve already made? A lurking threat (see below), but as the old saying goes, one generation makes it, the next spends it.

Insofar as executive compensation is a function of profit that can’t be indefinitely sustained, isn’t it possible that power and status can become adequate substitutes? And as long as the power is checked and balanced, who cares if they do? Especially if the result is financial services rendered more cheaply?

Indeed, when Schumpeter outlined what he considered the most likely and least disruptive transition (inevitable, he concluded) from capitalism to socialism, he assumed that declining investment opportunity meant that princely executive pay would steadily evaporate. It would have to, because profit margins were becoming ever thinner. He proposed that power and status would be incentive enough. What do you think highly paid executives buy with all that money, anyway, except expressions of power and tokens of status, anyway? And those things are, after all, always relative, not absolute.

I can see it. But as I said, I’m against it. For now.

Finance might be a good candidate for the early stages of a Schumpeter-style transition to socialism, except for one thing: it’s not at all clear (to me, anyway) that the industry has run its course in terms of socially valuable innovation. Far from it, actually — waves of innovation in electronics and networking, and looming environmental crises, are promising useful markets that couldn’t or wouldn’t have existed before. (This includes some marketizations of what are ordinarily considered government functions. Congestion pricing is one interesting example, emissions trading another, and I don’t think that’s nearly the end of it.) It would be unfortunate if the present crisis makes democracies so afraid of financial innovation that they legitimize only some ossification of a core subset of practice, strangle the rest in lumbering bureaucracy, and outlaw new practice outright. Schumpeter recognized that bureaucracy is anathema to innovation (unless innovation itself could somehow be effectively bureaucratized), and that capitalism owes far more to innovation for its contribution to the general welfare than it does to pure price competition. A world in which it’s all about lowest price is eventually a world of monopolies, which might as well be socialism.

There’s also the problem of how you get there from here, in a nation-state world. It’s far from clear to me that you can have “financial system socialism in one country.” We’ll have to see what sorts of new institutional arrangements gel out of the current crisis. There is certainly plenty of discussion of new arrangements, a new Bretton Woods, etc. If finance does start becoming increasingly socialized, it might be more at the international level. (Evoking, of course, typical right-wing paranoia about world government. “Black Helicopter Money”, anyone?)

One can imagine financial capital following the same kind of trajectory as early modern nobilities after they lost their role as professional soldiers, and persisting as aristocracies supported by (and in control of) the state.

Were it not for certain socio-political innovations like, uh, “democracy” and (what’s the other one, oh yeah) “equality of access to education”, I’d say that would be a risk worth seriously considering. Schumpeter recognized the inevitability of a semi-hereditary political class, but he was specifically talking about elected leadership and its scions. With a financial system, whether governmental or otherwise, you’re talking about technocracy. That’s a sphere in which expertise and competence will almost always trump bloodline, because you can’t really afford nepotism when so much is at stake, and voters instinctively know it. A socialized financial system will probably have its Bob Rubin-style godfathers, but I think the torch will tend to be passed meritocratically, not to Bobby Jr.

If there’s a danger, it’s that this class of government servants could be tempted to corruption by those who got wealthy (or whose parents got wealthy) in financial markets that predated financial socialism. That’s where I think Lemuel is at least half-right: you don’t want Wall Street gajillionaires turning into mandarins, still able to game the system (and maybe even more able, because it’s concentrated in government, among people earning only government salaries). All the more reason to wait, I think, until financial innovation has clearly run its course, and time has sent their fortunes into decline. For that matter, you might want to wait until there’s a general decline in investment opportunity, leading to a general narrowing of wealth gaps.

To put it another way: the problem might not be so much the impossibility of “financial socialism in one country” as it is “attempted socialism in one sector — finance — of the global economy, while any other sector is still generating new billionaires who could corrupt the finance officials.” It that’s the case, then finance might be the last industry you’d want to socialize, not the first. You can argue it either way.

I’d argue that we mainly need to learn better where to cut — what parts are candidates for socialism, what parts to leave only regulated or carefully watched — and that this crisis provides an invaluable opportunity to learn. Come to think of it, I seem to recall that even Hayek, a little crestfallen, came to the some vaguely similar conclusion about the Great Depression and its remedies. Not that you’ll find many Libertarians quoting Hayek on that point.

21

John Quiggin 11.27.08 at 6:46 am

Ginger Yellow, thanks for the helpful primer. What struck me is that a description of the auction rate securities market at any time prior to February this year would sound very much like this.

22

Michael Turner 11.27.08 at 2:56 pm

With my too-long comment on the balance between socializing finance and encouraging better financial innovation still sitting around in moderation limbo, this comment might appear out of sequence. Still, FWIW, here’s Seeking Alpha in dialogue with Dani Rodrik suggesting that there’s still plenty of useful innovation ahead of us, even in a world that understandably demands more transparency.

23

mickslam 11.27.08 at 3:22 pm

Kenny,

the difference between the one time payment and the suspension of payroll taxes is that with the suspension, this is an ongoing addition to disposable income that can be maintained as long as the stimulus is necessary, while the one time payment may not be enough. With the ongoing additional spending, businesses can reasonably plan on future cash flows for the duration of the suspension, which can be maintained in 3 month increments. Note we can also slowly ratchet up the suspension to a 50% suspension if we begin to believe that the stimulus is taking effect and to prevent huge income swings.

J Thomas,

Paying down credit card debt is not an entirely negative outcome. If people had stronger balance sheets, lenders would be more willing to lend, and credit card companies with additional cash will want to put this cash to work in their core business of lending money to people with solid credit, which there will be far more of 1 year from today if payroll taxes are suspended. Basically, at some point, there won’t be much more debt to pay down, and the money will then be saved or spent. As about 50% of the population lives paycheck to paycheck, a large and significant amount will be spent or used to reduce debt.

Note that a single payment is much more likely to be used to pay down debt due to the uncertainty of getting another payment.

Additionally, as a moral issue, we should probably not be telling people how to spend their money. We would like to have an economy based upon reasonable spending patterns. Note that the suspension will begin to reorganize some part of our economy around building and producing for lower and middle income citizens.

24

mickslam 11.27.08 at 3:31 pm

ffrancis,

If you like the idea, please let other people know about it. It is not my idea – it is Warren Mosler’s idea.

I think it has huge advantages over most other plans out there, some of which I’ve outlined here. I like to think of it as Trickle up economics. Make the middle and lower classes economically stronger and richer to build a strong economy, one that will usher out the last 30 years of financial capitalism.

25

Ginger Yellow 11.27.08 at 5:04 pm

“Paying down credit card debt is not an entirely negative outcome. ”

Far from it. For one thing, it’s the least painful way for a bank to delever. Sure you give up some future interest, but that’s way better than having to sell the credit card portfolio (or some other asset) at a huge discount.

26

J Thomas 11.27.08 at 5:33 pm

Paying down credit card debt is not an entirely negative outcome.

Mickslam, it’s a sad commentary on our times that my comment was not obviously sarcastic.

Doesn’t it seem obviously insane that the US government would try to require voters to stay in credit card hell in an attempt to be nice to banks?

There’s an old saying that goes, “If the Devil did not exist we would find it necessary to invent Him.”. Well, if the US banking system in its current form did not exist would anybody have the slightest incentive to invent it? It is a travesty, a peculiar institution that exists only for historical reasons, that no one in his right mind would want unless he personally shared in its grabbings.

I want to note that you at least argued in favor of an economy that benefits its citizens, as opposed to merely claiming that your proposal would in fact be good for banks. Thank you.

27

John Quiggin 11.27.08 at 11:25 pm

Michael, I’ve rescued your post from moderation. A lot to chew on there, but I’d like to challenge you on innovation. Looking at the innovation surrounding the Internet, it’s surprising how little it owes to the financial sector. The Internet itself and the Web are both public sector innovations that beat out private competition. And during the dotcom boom, the financial sector threw hundreds of billions at the likes of Pets.com while missing just about everything that makes up Web 2.0 (blogs and wikis being the most obvious examples).

And while the optical fibre that was rolled out by Worldcom and its competitors came in useful in the end, the process was the opposite of the kind of rational investment allocation financial markets are supposed to deliver, and much more reminiscent of the kind of thing that makes a Five-Year Plan then tries to deliver it in four.

The biggest innovations to which the financial sector has contributed are its own, and look how that has turned out.

28

PHB 11.28.08 at 5:02 am

There are many problems here, not least the tax handling. Alice holds $1 million in tax free state bonds, Bob borrows the bonds and sells them short to Carol.

At this point the state is getting a $1 million loan but Alice and Carol are BOTH getting tax free income from them. And Bob is not repaying that tax.

29

Michael Turner 11.28.08 at 6:39 am

John, I think you’re reading me wrong.

Looking at the innovation surrounding the Internet, it’s surprising how little it owes to the financial sector.

I can’t see where I said it did.

The Internet itself and the Web are both public sector innovations that beat out private competition.

Can you point to where, in my post, there’s anything to suggest I believe otherwise?

And during the dotcom boom, the financial sector threw hundreds of billions at the likes of Pets.com while missing just about everything that makes up Web 2.0 (blogs and wikis being the most obvious examples).

You mean, they threw money at ideas that looked like they might actually make money, and ignored stuff that pretty obviously couldn’t? (Blogs and Wikis, both of which appeared years before anyone uttered the silliness that is “Web 2.0”, are somehow Web 2.0? At this rate, they’ll be calling the QWERTY keyboard Web 2.0.)

Also, if we’re talking about innovation, tell me what’s innovative about Pets.com? Selling stuff over the web? It had already been done. That wasn’t innovation. There was no technology risk. It was pure marketing risk. You might as well call a gold rush “innovation”. It was speculative mania as well. The Tulip Bulb bubble wasn’t based on innovation. It was based on a plant, and the belief in a Greater Fool willing to pay more for that plant.

And while the optical fibre that was rolled out by Worldcom and its competitors came in useful in the end, the process was the opposite of the kind of rational investment allocation financial markets are supposed to deliver, and much more reminiscent of the kind of thing that makes a Five-Year Plan then tries to deliver it in four.

Uh, as I understand it, Worldcom engaged in fraudulent accounting practices under the cover of ordering and installing much more IP switch capacity and lines than it needed, and the rest of the telecom industry, seeing how much Worldcom seemed to be spending on fixed capital, decided that Worldcom’s (implicit) estimate that the Internet was growing by a factor of 8 or so every year must be right. Because, after all, if it wasn’t right, Worldcom must be engaged in, well, massive fraud. Or it was completely out of its mind. And how likely was that? So those other telecom providers also overinvested to try to keep pace. They just didn’t know they were overinvesting, because Worldcom had already gobbled up so much of telecom, everybody else was small compared to Worldcom. Seems like we could have avoided a lot of confusion with better antitrust enforcement.

I think I’ve made it very clear that I believe transparency, regulation and accountability are very important in ensuring the benefits of innovation. Let me go WA-A-AY out on a limb, here: much of what we regard as social dividends from private investment in innovation can also be attributed to public investment in the form of taxes that pay for regulation to make sure that those innovations are acceptably safe, or at least to make sure that buyers are informed of the risks.

The biggest innovations to which the financial sector has contributed are its own, and look how that has turned out.

Sigh. Did you actually read what I wrote? Someone, please, can you tell me why a CDS or a CDO is bad in itself? Subprime lending, done right, can be both a boon to lower-income would-be homeowners and make decent money for the lenders. We know this because, prior to the housing bubble, subprime had been performing pretty well on both counts, where it was practiced. Tell me why all this wasn’t more a failure of regulation and oversight, as well as an expression of speculative mania? Tell me why it’s somehow innovation itself that’s the culprit?

30

mickslam 11.28.08 at 7:58 pm

J Thomas,

Nice one. It is pretty sad that I didn’t catch it. I am new to the comments, so maybe now I will be more aware of your personal style.

It is a sad that for decades the mantra has been we can’t afford to bailout the consumer, but once a crisis hits the banks, we write $7T worth of checks in a few months. That this hasn’t solved the problem isn’t being talked about in a serious manner by our press. That this huge amount is a direct transfer of wealth from taxpayers to financial institution shareholders is glossed over. We still have people decrying ‘class warfare’ on raising taxes very little on the richest among us. It is a tragedy that these people are being taken seriously.

We have had rich people for millenia. They have always had good food, drinks, and were able to travel, had servants and the like. Our progress happened when we decided to begin to enrich the lower classes. Cell phones are impossible without many people using it, and same with the internet.

Michael Turner,

There are no problems with the CDS and CDO as theoretical instruments for trading and investing respectively. There is problems with these structures when plugged into a financial marketplace where almost any amount of leverage is possible. Worldcom on its own was fradulent, but the problem being talked about here isn’t their criminiality, but rather the demostrated difficulty for markets to allocate resources with effectively.

It is important to avoid this systemic risk. Right now, questioning the validity of the products themselves is compeltely logical. Clearly there is a problem in something about these markets. Telling the people who warned everyone that these instruments are problematic when plugged into the system that the problem isn’t the CDS specifically doesn’t change the fact that there is a massive problem that now must be rectified.

31

Michael Turner 11.29.08 at 10:41 am

There is problems with these structures when plugged into a financial marketplace where almost any amount of leverage is possible.

And how did we get to a point where any amount of leverage (up to 33-to-1) was possible? That’s a clear failure to regulate. Hard to pin blame for that kind of thing, sometimes. Especially when the specific problematic loosening (or failure to tighten) was in some huge package of legislation like the 11,000-page Commodity Futures Modernization Act of 2000.

But with innovation, precisely because inventors tend to be proud of their inventions, you can almost always pinpoint the actual innovators. There’s nothing nebulously “systemic” about origins. So, y’know, let’s pick on those people. For example, that woman credited with inventing the CDS, who was reportedly so obsessive-compulsive about her beloved “financial weapons of mass destruction” that she kept monitoring them through her cellphone even as she was going into labor in the hospital. Except, oops, they got that story wrong.

It turns out, there was an explicit decision to not regulate the CDS market (thank you Phil Gramm, et al.), in the above-mentioned bill, one that Alan Greenspan endorsed warmly. Later on, he seemed to blame CDS’s. But when I look at how CDS’s actually work, it seems to me that a transparent, well-regulated market for them, starting from not long after their invention, could have saved us all a lot of trouble. Such a market could have provided a pretty objective indicator that a huge housing bubble was forming. Instead of Alan Greenspan poo-pooing the housing bubble threat earlier, then later shifting the blame onto the CDS market, we might have had Greenspan warning of a housing bubble, as reflected in the CDS market. Or we might have had someone persuasively testifying that Greenspan was full of it when he continued to ignore the signs, pointing to the CDS market as evidence.

Isn’t it funny how stuff that’s frighteningly toxic and radioactive can be so useful and lifesaving when it’s installed in X-ray machines, properly contained and monitored? Oh, but no, let’s just say it’s poison, brewed up by witches who give birth to babies with “666” birthmarks on their scalps. While they thumbtype on their cellphones to continuously monitor the bubbling in their cauldrons.

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J. Michael Neal 11.30.08 at 4:28 am

This is a side issue for your post, but I think it’s wrong for specialists to be allowed naked short selling.

The answer to this question depends upon whether you want to have market makers. I don’t mean that in a sarcastic way; I could be convinced that we can live without them.

It’s possible that the Treasury market is different, and my views are overly concerned with the fact that I made markets in stock options. As the newbie, I got stuck with all sorts of crappy illiquid stocks. When something went REGSHO, trying to make the markets was a disaster. Your ability to price was entirely dependent upon whether you were long or short the underlying. If you wanted to be able to hedge the delta, you couldn’t let yourself buy calls or sell puts. I put all sorts of crazy fake dividends into the system to keep it from happening.

As for the specialists, sure they can manipulate the market. They don’t need naked short selling to do that. Specialists fuck you. That’s their job description.

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John Quiggin 11.30.08 at 10:38 am

Michael, my view (expressed in my article with Stephen Bell well before the current crisis) is that we need a process by which innovations are proposed, regulations are designed to deal with possible adverse effects and, if the combination appears to constitute an improvement, the innovations are approved (more precisely, regulated and guaranteed institutions like banks are allowed to introduce or finance the innovations).

The current proposal has the burden of proof reversed. Some bright spark comes up with an innovation that gets around existing regulations and regulators can either acquiesce or scramble to design new regulations.

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Michael Turner 11.30.08 at 11:38 am

John, I guess the opposite view was Greenspan’s, before his recent humbling: there was no point in more regulation because people would just “securitize around it.”

I’d take a middle position: monitor the market for the appearance of new instruments, perhaps requiring at most some sort of registration process, at most, but keep a close watch thereafter, designing and amending regulation as you go.

Would this mean more regulators? Would it mean you’re constantly chasing innovation to see if it’s good or bad on balance? I suppose so. The question isn’t one of good or evil, but whether the achievable benefits are worth the costs, including the social costs. Settling that sort of question might be virtually impossible before the fact. A certain amount of damage might be inevitable, but as long as you catch up to it not long after, you’re not flirting with disaster.

I think Greenspan’s position was simply, “more regulators, bad.” At one point, it was proposed that the Fed play a greatly expanded role in overseeing mortgage lending. Greenspan’s objection was that it would mean vastly expanding the number of bank examiners. (I think his objection before that one was along the lines of “That’s not what we’re here for,” but it turned out there really was no legal reason why the Fed couldn’t have been doing that job.) I can’t really understand his objection, unless it was of some virtually religious adherence to small government and reducted regulation.

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andrew cooke 11.30.08 at 1:01 pm

In the discussion above is there some confusion between regulation and registration? Or am I just not following?

My limited understanding suggests that the financial products themselves were not the direct problem. Rather, the fundamental source of the problem was a lack of information about them, which made risk assessment difficult. Registration might make things more transparent, but does not necessarily imply any explicit restriction (which is what I think “regulation” means).

The arguments for regulation above seem to be, mainly, arguments for registration. And the arguments against regulation do not seem to be against registration.

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Michael Turner 11.30.08 at 1:50 pm

Andrew, I’m not even sure what I mean by “registration” except “reporting to some agency that might or might not choose to make rules about what you report.”

A general sense of the word “regulate” might include self-regulation. Self-regulation could take the form of markets behaving more rationally (without central direction) when there’s more transparency. Or it could be a case of industry choosing to self-regulate (supply its own central direction) in the interests of the industry’s general reputation. What I mean by the above is “government regulation”. However, where the government mandates transparency, or always threatens to step in if industry self-regulation doesn’t work, I suppose even those scenarios should count as “government regulation”, however indirect.

Hyman Minsky (apparently very prescient about what we’re now going through) pointed out a generation ago that globalization and securitization were both very much enabled by computerization. Another way of saying that: financial information management costs were trending towards negligible, making possible whole new classes of transactions that might heve been forbiddingly expensive before. The marginal cost of handling more information crashed, courtesy of Moore’s Law. It can make for astonishing volatility in a crisis. However, the same technology also potentially enables much more regulatory oversight than could have been practical before, because government can participate in those same cost savings. Maybe it’s about time. Have reporting requirements caught up with Wall Street technology?

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J Thomas 11.30.08 at 2:25 pm

I’d take a middle position: monitor the market for the appearance of new instruments, perhaps requiring at most some sort of registration process, at most, but keep a close watch thereafter, designing and amending regulation as you go.

What’s wrong with caveat emptor? Tell people not to buy financial instruments they don’t understand.

Well, what's wrong with that is that when it's very profitable to invest in financial instruments you (probably) don't understand using other people's money, then people who trusted you with their money can lose it all.

They should have known better than to trust you. Caveat emptor.

Well, but people didn't know they were trusting you. They thought they were trusting their bank or pension fund. It's wrong for lots of innocent people to lose their money.

They shouldn’t have trusted their banks or pension funds. When you have the money yourself, you can invest it in local businesses that you can watch. Of course then you lose when your local economy tanks, but if you invest globally you’re gambling that way too. At least local investment helps improve your own community. When your employer says he’s putting money into a pension fund for you, but you don’t actually get the money until a lot later, you might as well write it off in these times. Or if you think times like these might come back before you get the money.

Well, but it's so simple to just buy a CD. You pay the bank and the bank pays you back with interest. Your money is guaranteed unless the bank goes broke, and if the bank goes broke then things are pretty bad, right?

Right. Things are pretty bad. Trusting that the banks won’t fail worked for a long time. No longer.

And for as long as I can remember the smart financial advice was to buy no-load mutual funds. Small investors can't pick stocks, so invest in everything and the winners will outweigh the losers. It worked adequately.

But it quit working.

We need to regulate so innocent people won't lose their money.

I’m going to put aside the hypocrisy. This crisis is the ending of a giant ponzi scheme. People are being polite and not calling it that, as if it happened by accident, but that’s what it is. Can we expect the government to regulate every ponzi scheme, when the whole point of them is to find something people will strike at without seeing the hook?

We already saw this stuff in miniature with Enron, run by Bush’s friend Ken Lay. They squeezed lots of money out of the public, and then when they couldn’t serve up an even bigger encore they faked the accounting. How do you catch it early when they lie? You’d have to actually check the facts on the ground, which in general no one has the legal right to do.

When poor people have a chain letter going, and they’re mailing $100 bills to people they’ve never heard of on a list, the government announces it’s a scam and shuts it down. What would you think if the government announced that the chain letter was perhaps overheating a little and they were going to revise policies to give it a soft landing?

What would you think if the government refused to act because if the chain letter failed there would be a panic?

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J Thomas 11.30.08 at 2:36 pm

I’d take a middle position: monitor the market for the appearance of new instruments, perhaps requiring at most some sort of registration process, at most, but keep a close watch thereafter, designing and amending regulation as you go.

What’s wrong with caveat emptor? Tell people not to buy financial instruments they don’t understand.

Well, what's wrong with that is that when it's very profitable to invest in financial instruments you (probably) don't understand using other people's money, then people who trusted you with their money can lose it all.

They should have known better than to trust you. Caveat emptor.

Well, but people didn't know they were trusting you. They thought they were trusting their bank or pension fund. It's wrong for lots of innocent people to lose their money.

They shouldn’t have trusted their banks or pension funds. When you have the money yourself, you can invest it in local businesses that you can watch. Of course then you lose when your local economy tanks, but if you invest globally you’re gambling that way too. At least local investment helps improve your own community. When your employer says he’s putting money into a pension fund for you, but you don’t actually get the money until a lot later, you might as well write it off in these times. Or if you think times like these might come back before you get the money.

Well, but it's so simple to just buy a CD. You pay the bank and the bank pays you back with interest. Your money is guaranteed unless the bank goes broke, and if the bank goes broke then things are pretty bad, right?

Right. Things are pretty bad. Trusting that the banks won’t fail worked for a long time. No longer.

And for as long as I can remember the smart financial advice was to buy no-load mutual funds. Small investors can't pick stocks, so invest in everything and the winners will outweigh the losers. It worked adequately.

But it quit working.

We need to regulate so innocent people won't lose their money.

I’m going to put aside the hypocrisy. This crisis is the ending of a giant ponzi scheme. People are being polite and not calling it that, as if it happened by accident, but that’s what it is. Can we expect the government to regulate every ponzi scheme, when the whole point of them is to find something people will strike at without seeing the hook?

We already saw this stuff in miniature with Enron, run by Bush’s friend Ken Lay. They squeezed lots of money out of the public, and then when they couldn’t serve up an even bigger encore they faked the accounting. How do you catch it early when they lie? You’d have to actually check the facts on the ground, which in general no one has the legal right to do.

When poor people have a chaln letter going, and they’re mailing $100 bills to people they’ve never heard of on a list, the government announces it’s a scam and shuts it down. What would you think if the government announced that the chaln letter was perhaps overheating a little and they were going to revise policies to give it a soft landing?

What would you think if the government refused to act because if the chaln letter failed there would be a panic?

39

J Thomas 11.30.08 at 2:37 pm

My comment got moderated. I wonder if it was because I marked some sections as code?

Like this!

Or did I include the wrong keywords?

40

mickslam 12.01.08 at 12:57 pm

“Can we expect the government to regulate every ponzi scheme,..”

Yes. We can expect the govt to regulate every trillion dollar ponzi scheme.

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Michael Turner 12.01.08 at 4:00 pm

I wish you hadn’t marked some of those sections as code, J Thomas. My browser executed them as code, and as a result, it silently logged on to my brokerage account and unwound all my short positions. Then, because you double-posted, my browser tried to do all that a second time. Unfortunately, this inadvertantly exploited a vuln in the brokerage’s database back-end, resulting in all of Norway’s government employee pension funds being liquidated and wired to a resort owner in Ghana. I’m sure you didn’t intend any this, but I still think your HTML tagging on CT comments should be regulated by the SEC.

I’m not sure what to make of your comment on my comment. Analogously, you could argue there’s no point in having police because, even though we have cops, we still have crime. Even unsolved crime. And corrupt cops. And even some unsolved crimes because of corrupt cops. So — cops: forget ’em. What’s the point?

Now, there is a fair question in all this, and Brad Delong, among others, has asked it more than once: How could so many different things have gone wrong? Is there an underlying cause for most or all of these failures of vigilance?

I don’t know what that single cause would be. My best theory isn’t very good, and isn’t complete, but has the virtue of being pretty simple, at least, and rooted in causes everybody can intuitively understand.

(1) Memory, Babe: People trying to repeat something good when it’s actually unrepeatable. By the late 90s, things were a lot better than anyone had any right to expect. Trying to get back there (so soon, anyway) was an attempt to return to the unsustainable. In the process of getting back up there, very few questioned whether it was a realistic place to be, and most who did were treated as alarmist Chicken Littles.

(2) School of Hard Knocks, R.I.P.: People not believing in the possible repeat of something bad, because they haven’t seen it. Living memory of trying to feed a family after losing one’s job in the Great Depression was evaporating fast in the first half of this decade. Seeing is believing; not-seeing is not-quite-believing. If you were, say, 16 years old in 1930, contemplating early entry into the labor market, you’d have been 92 in 2006. I think Paul Samuelson is 93, now. It’s interesting to read what he has to say about all this. Brace yourself first, though.

(3) Busted Boomers: Baby boomers not benefiting by habits of thrift that one might ordinarily develop in periodic hard times, and later trying to catch up faster in retirement planning than all of them can catch up, at least in the same decade. For many boomers, the main extended experience of a bad economy — the stagflationary 1970s — saw inflation not only eroding existing savings but making it harder to save appreciably. There’s been a lot of get-rich-sooner-than-is-probable investment in the last decade and a half. Such malinvestment has a strong incentive: comfortable retirement for the boomers will require catching up fast to where they should have been by now, financially — and where they feel entitled to be, both because of the example of older generations now in retirement and because of late-1990s prosperity expectations.

Now, I’d argue that all three of these factors led to a pervasive psychological environment where almost everybody in a position to wake up, get alarmed, and throttle their part of the scary feedback loop relaxed a little too much. Those in the “Watchdog Class” felt they could safely assume any possible problem area was somebody else’s job, a job that was getting done. Or they felt it was a job that didn’t need doing anyway, because no really bad history was going to repeat, but good history might — actually, uh, it kind of had to repeat, or else forget the idea of annual Club Med jaunts in retirement, and a couple or five skiing weekends every winter, etc. Those things were coming because they had to be coming. Because we have them coming. (Um, don’t we?)

Well, that’s my sketch of it, anyway. Try your hand at yours. The blind philosophers all need to stand back and ask themselves, What does the elephant smell like? They’ll probably answer, “Why, it smells like . . . air freshener! Which means — we’re in a room! What the hell is an elephant doing in a room?!?” Then they’ll be halfway to the answer, because they’ll be asking about the environment, not so much about the beast and its curious behavior and features.

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J Thomas 12.01.08 at 11:58 pm

Analogously, you could argue there’s no point in having police because, even though we have cops, we still have crime. Even unsolved crime. And corrupt cops. And even some unsolved crimes because of corrupt cops. So—cops: forget ‘em. What’s the point?

Actually, I kind of like that. There used to be two different approaches to law enforcement. One way, everybody pitches in. The other way, professionals do it all. The former is inefficient, cheap, and high-morale. The latter is inefficient, expensive, and low morale for everybody but elite police.

So, you do something criminal in a bar and everybody says a crime has been committed and let’s all get it sorted out. Maybe they argue it out among themselves and decide you aren’t so bad, or yes you are. Maybe they take you in to the authorities. Maybe they disagree enough it turns into a free-for-all. People *care* about crimes when it’s up to them.

You get some famous criminals that hardly anybody’s ready to go up against. Some brave people get a big reputation by taking them on. Famous criminals. Every man has the idea he might need to stand up for himself and do the right thing, or else cravenly tiptoe away.

With professional police you get less bias. Somebody picks a fight with you in his favorite bar where everybody likes him and you’re a stranger — when the police get there they’ll be more impartial than the guy’s friends. On the other hand, if you have an in with the police then you have an in wherever they show up, not just your favorite bar.

With professionals you get more competence. Everybody waits for the professionals to arrive, and then they’re very competent. They look down on everybody else except the rich, who scare them.

With professionals you get more impartiality. Everybody worries when the police arrive. But the times they aren’t impartial and are on the other guy’s side, you’re completely screwed.

Police can control things for the government. So why would any government give up having as many professional policemen as the tax base can afford? They enforce the laws the government wants and not the common law that the citizens understand and agree on. Without arbitrary laws stringently enforced, would lawyers be so important? Would the writen law be so important? Get individual ad hoc vigilantes deciding whether there’s a crime worth prosecuting, and all of a sudden the nation’s capital is a very distant place. Local law gets real imminent, though it’s usually fairly easy to discourage vigilante hangings.

Without professional police there would be many more known criminals walking around. Both because it takes somebody real tough to arrest them, and because nobody has a professional interest in catching somebody — anybody unimportant — to charge with the crime to close the case. Without professional police there would be many more chances for righteous tough guys to make a name for themselves as good tough guys. Without professional police the legal system would be devoted to dealing with criminals that some individual human beings wanted to get caught, and not so much with people who inconvenienced the central government.

I think it might be an improvement. But I see no possible way to convince any government of that.

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J Thomas 12.02.08 at 12:07 am

Now, there is a fair question in all this, and Brad Delong, among others, has asked it more than once: How could so many different things have gone wrong? Is there an underlying cause for most or all of these failures of vigilance?

How about this one: If you can’t beat them, join them.

If you see a catastrophe coming when it’s too late to prevent it, should you work hard to mitigate it or should you pile on?

If you work hard to mitigate it, all sorts of influential people will attack you for saying there’s a problem. If it’s your job to mitigate it, they will try to get you fired. You will have a miserable time and then the catastrophe will happen anyway.

If you join in, you can make a big pile of money in the short run, and if you play your cards right you can walk away with a big pile of money when the catastrophe comes. That pile of money might be very useful during and after a catastrophe. Or you can think about what you’ll need and buy it sooner. Buy land on a tropical paradise? Generators, fuel supply, MREs? A talented woman to share it all with? All stuff you wouldn’t have if you spent your time trying to block the other team’s advance when they’d be happy for you to join them.

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