Monday, March 24, 2008

These sound familiar...

Tyler Cowen, whose self-recognized economic brilliance is nonetheless real to me (I can understand about 37% of his posts) occasionally throws a shaft of light on topics that seem to apply to our little corner of the economy. Consider his recent words on what went wrong with the economy.
To understand the depths of the current crisis, let’s go back to an apparently unrelated episode in economic thought: the socialist calculation debate. Starting in the 1920s, Ludwig von Mises, the leader of the so-called Austrian School of Economics, charged that socialism was unable to engage in rational economic calculation. Without market prices, he reasoned, no one knows how much economic resources are worth.

The subsequent poor performance of planned economies bore out his point...The irony is that the supercharged capital markets of the American economy are now — at least temporarily — in a somewhat comparable position. Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.

Market prices have been drained of their informational value and thus don’t much reflect the “wisdom of crowds,” as they would under normal circumstances. Investors are instead flocking to the safest of assets, like Treasury bills.

The absence of trading is a big problem. Financial institutions have been stuck holding illiquid assets, whose value cannot be easily determined. Who wants to lend to the institutions holding them? No wonder there is a credit crisis and a general attitude of wait and see. [More]
I would suggest that the influx of various forms of investment/speculative/homeless money has overwhelmed the ability of the corn market for one to determine the price of corn. Further, the lack of confidence shown by customers like Cargill in the market as a reasonable arbitrator between buying and selling is proof of this failure. While commodities are not illiquid, can wheat really be worth $20?

To me this suggests that at least some of the action that will be taken to revalue questionable assets like CDO's and swaps might be useful to commodities. Then again they might not help at all, but I will be watching to see if and how some order is reestablished there for clues to the resumption of more normal trade in our world.

Another post-mortem offers fewer analogies for our sector.
The seeds of today's disaster were sown in the 1980s, when financial services began a pattern of growth that may only now have come to an end. In a recent study Martin Barnes of BCA Research, a Canadian economic-research firm, traces the rise of the American financial-services industry's share of total corporate profits, from 10% in the early 1980s to 40% at its peak last year (see chart 1). Its share of stockmarket value grew from 6% to 19%. These proportions look all the more striking—even unsustainable—when you note that financial services account for only 15% of corporate America's gross value added and a mere 5% of private-sector jobs. [More]
While it can be fairly argued that the growth in our assets like land and commodities is out-sized for our contribution to the economy (about 1% using the same measure as this article for the financial sector), the linkages to corporate pay and regulation don't seem that applicable to me.

Still another look back focuses on financial engineering - and the resultant failure of checks and balances within the financial sector.
This may sound odd, because two types of stakeholders in Bear Stearns were made to pay for their excessive risk taking. Shareholders have lost their shirts and thousands of employees will lose their jobs, which should teach Wall Street a grim lesson. But two other types of stakeholders have been given a huge break. As of 10 days ago, Bear's lenders did not expect to get their money back in full; thanks to a $30 billion credit line from the Fed, the lenders now look comfortable. Equally, Bear clients who had bought swaps and other derivatives faced the prospect of their contracts being rendered worthless; that danger has receded. Moreover, the Fed has announced that it is ready to provide emergency loans to other investment banks. The incentive for private lenders and buyers of derivatives to monitor banks' risk has to some extent been blunted.

This is a subtle shift, not a dramatic revolution. Lenders and derivatives traders have been bludgeoned in recent months; it's not as though they have zero reasons to be cautious. But the shift is disturbing nonetheless. The case for financial engineering was questioned by serious people even before we landed in this mess. And we have no good way of turning back the clock. [More]
The idea of devising market instruments that even those most knowledgeable pretend to understand doesn't really apply perhaps to simple puts and calls - which market advisers are badgering us to embrace. But I have not taken the time to become intuitively comfortable with them, and I suspect many who think they are may be mistaken.

Nor am I convinced that Fed intervention will lower the perception of risk by lenders in the future as Mallaby fears. The jury is out on the longer term fallout from the Fed action, but the pain will taint the memory of such products and schemes for some time, perhaps.

There may be little overlap between what's happening on Wall Street and LaSalle Street - other than the investors involved. Still it is hard to escape the impression our commodity pricing system is under power distortion from new forces of unprecedented size. The thing that tickles the back of my mind is our unfortunate tendency to adopt a less than optimal solution to the futures problem that will rapidly become entrenched to exclusion of better solutions. The first OK idea will drive out later great ideas as a rule.

But hey - this blundering along has gotten us this far. And given us the QWERTY keyboard, too.


Anonymous said...

I would imagine there is a lot of overlap between Wall and LaSalle. I read Bookstaber's book with great interest last summer as the Bear Stearns hedge fund woes began to unfold in mid-June and followed closely since then the ensuing deleveraging and far-reaching impacts.

There are many parallels. Credit was bid up (spreads very tight) as new market participants wanted exposure and Wall Street created it synthetically. The good news with derivatives is there are two sides to the trade with a net gain/loss of zero. The bad news is this can distort the price from the fundamentals when a large demand force steps in without a natural fundamental supply force. Instead the supply force comes from speculators. When the large demand abates and worse, they want out, that large force is reversed quickly and sometimes painfully.

I don't believe it is the instruments themselves that are the problem (puts, calls, futures, swaps) but rather knowing the current positions and type of investors holding them relative to the fundamentals and the resulting volatility and price trends. For the over-the-counter world that is currently very difficult information to get, but recent proposals have been made for changing that (PWG recommendations announced 3/13). For exchange-traded contracts you have the COT, which was expanded a couple years ago to capture the 'commodity index participants'. At least a start.

Another problem in credit was that after the exposure was created to satisfy the investors, the Street wasn't able to lay off all the risk. In effect they were the other side of the trade on super senior tranches with large amounts of leverage and not enough capital backing the trades to withstand a stressed event. In commodities, while exposure is being created synthetically for the Exchange Traded Funds or Notes, I don't believe the intermediaries are retaining that risk. Instead they are laying it off and bidding up prices in the futures market. When the investors want out those futures contracts will have to be reversed.

Two thoughts to perhaps bound the range of solutions - either limit the amount of synthetic exposure relative to some multiple of the physical underlying (the extreme being a multiple of 0) or increase the transparancy and let the market go.

John Phipps said...


I too have been entranced by the idea of "letting the market go" and "letting the chips fall where they may", but we never do, do we? Besides, my guess is greater transparency coupled with recent market action will scare the bejabbers out of potential derivative-product investors right now. I sometimes think they secretly enjoyed not knowing how deep the water was.

Free traders always invoke at the beginning a policy of suffering the consequences, but my take-away from Bear Stearns is they know they never will have to (completely, anyway). The government always steps in to stop the hemorrhaging that could lead to much bigger problems.

This strikes me as an economist dream in the face of history and reality.

I'm struggling to imagine what a fixed limit on the number of contracts would do to trading...

Nope - can't get around it yet.