Guest Post: On Broken Trades and Bailouts

Rajiv Sethi

Back in 1980, Avraham Beja and Barry Goldman published a theoretical paper in the Journal of Finance that explored the manner in which the composition of trading strategies in an asset market affects the volatility of prices. Their main insight was that if the prevalence of momentum based strategies was too large relative to that of strategies based on fundamental analysis, then the dynamics of asset prices would be locally unstable: departures of prices from fundamentals would be amplified rather than corrected over time. More importantly, they argued that the relationship between the composition of strategies and market stability was discontinuous: there was a threshold (bifurcation) value of this population mixture that separated the stable from the unstable regime, and an imperceptible change in composition that took the market across the threshold could result in dramatic increases in volatility.

The Beja/Goldman analysis can be taken a step further: not only does market stability depend on the composition of trading strategies, but the profitability of different trading strategies, and hence changes in their relative population shares over time, depend very much on whether one is in a stable or an unstable regime. In a stable regime prices track fundamentals reasonably well, which makes it possible for technical strategies to extract information from incoming market data without going through the trouble and expense of fundamental research. Such strategies can therefore prosper and proliferate, provide that they remain sufficiently rare. But if they become too common, markets are destabilized, asset price bubbles can form, and the value of fundamental information rises. When a major correction arrives, it is the fundamental strategies that prosper, the composition of trading strategies is shifted accordingly, and market stability is restored for a time. This process of endogenous regime switching provides one possible interpretation of the empirical phenomenon known as volatility clustering.

From this perspective, it is critically important that technical trading strategies to be allowed to suffer losses when market instability arises. The cancellation of trades in almost 300 securities after the flash crash of May 6 did exactly the opposite, by providing an implicit subsidy to destabilizing strategies. The excuse that this was done to protect retail investors whose stop orders were executed as prices fell to insane levels is unconvincing. According to the SEC’s own report on the crash, most trades against stub quotes of five cents or less were short sales, and there was also considerable upward instability, with prices rising well beyond the reach of ordinary retail investors. (Shares in Sotheby’s, for instance, changed hands at ten million dollars per round lot.) The cancellation of trades was therefore a bailout of some funds (heavily reliant on algorithmic trading) at the expense of others, and this prevented a stabilizing shift in the market composition of trading strategies.

A similar argument could be made about the effects of the Troubled Asset Relief Program. It has recently been claimed, for instance by Alan Blinder and Mark Zandi, that TARP has been a “substantial success” because it averted a second Great Depression at a cost to taxpayers that is turning out to be much lower than originally feared:

The Troubled Asset Relief Program was controversial from its inception. Both the program’s $700 billion headline price tag and its goal of “bailing out” financial institutions—including some of the same institutions that triggered the panic in the first place—were hard for citizens and legislators to swallow. To this day, many believe the TARP was a costly failure. In fact, TARP has been a substantial success, helping to restore stability to the financial system and to end the freefall in  housing and auto markets. Its ultimate cost to taxpayers will be a small fraction of the headline $700 billion figure: A number below $100 billion seems more likely to us, with the bank bailout component probably turning a profit.

Yves Smith is unpersuaded by such figures, which she attributes to “back door, less visible bailouts, super cheap interest rates, [and] regulatory forbearance.” But even if one were to take at face value the Blinder-Zandi estimates of the revenue consequences of TARP, there remain potentially harmful effects on the size composition of firms and the distribution of financial practices. The institutions that were bailed out made directional bets that either failed directly, or were with counterparties that would have failed in the absence of government support. Smaller institutions making such mistakes were allowed to go under, while larger ones were bailed out. Quite apart from the unfairness of this, the policy could be severely damaging to the stability of the system over the medium run.

This point was made a couple of months ago in a speech by Richard Fisher of the Dallas Fed (and expanded upon by Tyler Durden and Ashwin Parameswaran shortly thereafter):

Big banks that took on high risks and generated unsustainable losses received a public benefit… As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition…

The system has become slanted not only toward bigness but also high risk… Clearly, if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult. In this manner, high risk taking by big banks has been rewarded, and conservatism at smaller institutions has been penalized…

It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises.

Fisher goes on to argue for strict limits on the size of individual financial institutions relative to that of the industry. So does Nouriel Roubini:

Greed has to be controlled by fear of loss, which derives from knowledge that the reckless institutions and agents will not be bailed out. The systematic bailouts of the latest crisis – however necessary to avoid a global meltdown – worsened this moral-hazard problem. Not only were “too big to fail” financial institutions bailed out, but the distortion has become worse as these institutions have become – via financial-sector consolidation – even bigger. If an institution is too big to fail, it is too big and should be broken up.

But were the bailouts really necessary to avoid a global meltdown? Blinder and Zandi argue that the alternative would have been completely catastrophic:

The financial policy responses were especially important. In the scenario without them, but including the fiscal stimulus, the recession would only now be winding down, a full year after the downturn’s actual end… The differences between the baseline and the scenario based on no financial policy responses… represent our estimates of the combined effects of the various policy efforts to stabilize the financial system — and they are very large. By 2011, real GDP is almost $800 billion (6%) higher because of the policies, and the unemployment rate is almost 3 percentage points lower. By the second quarter of 2011 — when the difference between the baseline and this scenario is at its largest — the financial-rescue policies are credited with saving almost 5 million jobs.

Here the baseline is the set of policies actually pursued (including fiscal and financial policies) and it is being compared to the case of “no financial policy responses.” However, as Yves Smith and Barry Ritholtz have pointed out, this is an absurd counterfactual. Barry argues that  the proper point of comparison ought to be what should have been done, which in his view is the following:

One by one, we should have put each insolvent bank into receivership, cleaned up the balance [sheet], sold off the bad debts for 15-50 cents on the dollar, fired the management, wiped out the shareholders, and spun out the proceeds, with the bondholders taking the haircut, and the taxpayers on the hook for precisely zero dollars. Citi, Bank of America, Wamu, Wachovia, Countrywide, Lehman, Merrill, Morgan, etc. all of them should have been handled this way.

The net result of this would have been more turmoil, lower stock prices, and a sharper, but much shorter economic contraction. It would have been painful and disruptive — like emergency surgery is — but its better than an exploded appendix.

And today, we would have a much healthier economy.

Whether or not one agrees with this assessment, Yves and Barry are surely correct in arguing that counterfactuals other than the hands-off policy ought to be considered before one accepts the emerging conventional wisdom that the authorities handled the crisis well.

What the broken trades trades of May 6 and the bailouts of 2008 have in common is that they were both impulsive decisions, designed to deal with immediate concerns, and executed with little regard for their long term consequences. As I said in an earlier post, these decisions were made under enormous pressure with little time for reflection, and mistakes made in such circumstances would ordinarily be forgivable. But to insist that the best available course of action was taken, and that any alternative would have had devastating economic costs, is neither credible nor wise.

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11 comments

  1. tinbox

    Excellent post.

    Even allowing that the bad decision to cancel trades was made under pressure, it is important to recognize that it is very harmful to a market system–otherwise there is no reform.

  2. Opinionated Bloviator

    The real question is what happens when the TBTF banks become so large and heavily indebted that they cannot be bailed out, ala Iceland, after all, when your Too Big To Fail whats to stop you doubling up your bets until this becomes reality?
    What’s really terrifying is that bank failures ala 2008 will now occur every 5 -7 years (according to Jamie Dimon JPMorgan Chase CEO) so when 2013 – 2015 rolls around the next Wall Street meltdown will be here or literally just around the corner.
    How many more bailouts can the United States withstand before it collapses? 1,2 or NONE.

    1. Some guy

      Lesson learn:

      If you are going to cheat the system, make sure it’s gigantic enough to bring down the entire system. You will be bailed out. And ends up making loads more money than ever, while the rest of suckers are left behind.

      It’s basic scam. The kind that entire continent suddenly decide to commit genocide against this or that group.

      1. nowhereman

        If you’re going to cheat the system, convince everybody that you are the SYSTEM, and if you go down they go down. Blackmail at it’s purist.
        (oh, and owning the politicians and the regulators also helps a lot)

  3. Oliver South

    ” The cancellation of trades in almost 300 securities after the flash crash of May 6 did exactly the opposite, by providing an implicit subsidy to destabilizing strategies. The excuse that this was done to protect retail investors whose stop orders were executed as prices fell to insane levels is unconvincing.”

    Those trades were not too big to fail – and so they failed. Better off at Harrah’s or Caesar’s Palace than trying to make an honest trade on NYSE.

  4. 0ut0f0rder

    I know this thread is about system analysis, I just thought it would be interesting to break it down on an individual level.

    I remember seeing a discussion on the shortage of resources and why people compete for resources as aggressively as they do on a Facebook community page http://www.facebook.com/thewatchmansrattle

    Why do we have a tendency to fight one another when we know sharing results in the most optimum outcome for everyone? Why does our biology cause us to hurt the ones we love, hoard resources and compete with one another?

    http://www.facebook.com/video/video.php?v=1493017207106

    1. aet

      Everything alive competes for everything: plants forlight, animals for food and mates, etc.
      Competition is built-in to biology:
      that does not mean that it cannot be mal-adaoptive at the level of the population, rather than at the individual level.
      This is why leaders need wisdom: to see beyond the needs of themselves. IMHO, anyhow.

  5. attempter

    I like the application of chaos theory, and of course everyone (including me in my post on it) has shredded Zany-Blindman’s absurd scenarios and lack of any moral sense.

    It’s a good post except for this part:

    What the broken trades trades of May 6 and the bailouts of 2008 have in common is that they were both impulsive decisions, designed to deal with immediate concerns, and executed with little regard for their long term consequences. As I said in an earlier post, these decisions were made under enormous pressure with little time for reflection, and mistakes made in such circumstances would ordinarily be forgivable.

    Financialization and deregulation, the will to subject us all under the tyranny of finance, is the policy of decades now. Nobody truly in charge of the policy really thought measures like the repeal of Glass-Steagal or the CFMA would make for a more stable system, or that TBTF wasn’t hard-wired into it. We already had the bailouts of the 80s Latin American loans as a template. Citi had been bailed out how many times? Not to mention the likes of the Chrysler bailout.

    Nor was “the Great Moderation” ever anything more than an Orwellian slogan. It always meant the steady, “moderated” flow of loot to a handful of gangsters, at the price of extremity, instability, war, famine, destruction, and havoc for the non-rich. Although this policy of destruction was first imposed on the Global South and then on Eastern Europe, it was always intended eventually to “come home” to the West itself.

    Come 2008, while the kleptocracy at first may have been clumsy and ad hoc in imposing particular Bailout measures, the basic policy impetus was textbook disaster capitalism. (“Stampede! By Monday we won’t have an economy! You need to make the Treasury secretary a classical dictator.”) That the execution was often fumbling at first doesn’t change the premeditated shock doctrine strategy.

    Every incident bigger or smaller, like selectively canceled trades, fits the same pattern. At every point the only question is, what benefits the big banksters?

    As for what chaos theory would say about the differences in time frames, whether the same pattern of policy which seems to benefit the banks on a given day could fall apart at greater time scales (i.e. that what seems to have a good consequence for the likes of Goldman yesterday, today, and tomorrow, could end up being against their interest, perhaps in terms of eventually helping provoke a revolution, if you project its effects over the next ten years), we’ll see.

    But in the systematic, premeditated mindset of TPTB, there is no policy difference between short term and long term; the one and only criterion is the boon of the banks. So there’s no “reflection” which could ever be relevant no matter how much time anyone had, and there are no “mistakes” in terms of doing things that hurt others. All the reflecting was done decades ago, and now the machine simply functions according to one basic algorithm. The only possible mistake would be if a robber forgot to load his gun or something.

  6. CingRed

    There is some evidence that the flash crash was set off by HF trading strategies that were designed to take advantage of a latency arbitrage situation. (see http://www.nanex.net/FlashCrash/FlashCrashAnalysis_NBBO.html

    As long as there is an implicit government guarantee on these high risk situations the markets will never properly adjust.

    And as for the person that made this statement… “The financial policy responses were especially important. In the scenario without them, but including the fiscal stimulus, the recession would only now be winding down, a full year after the downturn’s actual end… The differences between the baseline and the scenario based on no financial policy responses… represent our estimates of the combined effects of the various policy efforts to stabilize the financial system — and they are very large. By 2011, real GDP is almost $800 billion (6%) higher because of the policies, and the unemployment rate is almost 3 percentage points lower. By the second quarter of 2011 — when the difference between the baseline and this scenario is at its largest — the financial-rescue policies are credited with saving almost 5 million jobs.” …I would counter, since you are so good at predicting results based on actions or inactions taken, show me your predictions from 2006 about 2008. You probably made a fortune with your accurate predictions about that. I call your statement total BS.

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