Credit Default Swaps Outstanding Shrinks as Dealers Tear Up Agreements

The International Swaps and Derivatives Association reported that the notional amount of credit default swaps outstanding fell from $62 trillion to a bit under $55 trillion as dealers worked to eliminate offsetting trades.

This is a step forward, although it is hard to assess how significant it is. While the reduction in systemic risk is almost certain to be less than the fall in outstandings, eliminating offsetting contracts still eliminates possible points of failure. And if these offsetting contracts were not bi-lateral (ie between the same two dealers, which I would assume to be true in most cases), the net reduction is risk is greater. The fewer moving parts, the better.

Of course, this clean-up effort also comes as threats to regulate the market are getting louder. Nevertheless, a market like CDS is no stronger than its weakest link, which is this case is its shakiest large dealer. But how large you have to be to threaten the daisy chain is an unknown. Let's hope we don't get the answer via real-world experience.

Any comments from those with direct knowledge would be very much appreciated.

From Bloomberg:

The credit-default swap market, used to hedge against bond losses and speculate on corporate credit risk, shrank for the first time as efforts to eliminate duplicate trades cut contracts outstanding by 12 percent.

The volume of outstanding trades fell to $54.6 trillion from $62 trillion in the first half, the International Swaps and Derivatives Association said in a statement today. It was the first decline since ISDA started surveying traders in 2001.

``This decrease primarily reflects the industry's efforts to reduce risk by tearing up economically offsetting transactions and demonstrates the industry's ongoing commitment to reduce risk and enhance operational efficiency,'' ISDA Chief Executive Officer Robert Pickel said in the statement. ``We expect to see more effects of this over time.''...

The market has likely shrunk even more since ISDA's poll after one of the 10 largest market-makers, Lehman Brothers Holdings Inc., filed for bankruptcy this month. ISDA's survey captured trading as of June 30.

``I would expect that if they were to re-poll next week, you would see an even smaller number from netting activities and trade cancellations surrounding the Lehman Brothers default,'' said Brian Yelvington, a strategist at CreditSights Inc. in New York.

After the March collapse of securities firm Bear Stearns Cos., 17 banks that handle about 90 percent of the trading in credit derivatives agreed to a list of initiatives to curb market risks. That included tearing up trades that offset each other, which cuts down on the day-to-day payments, paperwork and monitoring by bank staffs and reduces the potential for errors. It also may reduce the amount of capital that commercial banks are required to hold against the trades on their books.

The first stage of compression, completed Aug. 27, with the participation of 14 dealers, reduced contracts submitted on North American telecommunications companies by 56 percent, Markit Group Ltd. and Creditex Group Inc., which are processing the tear-ups, said this month. The second stage, completed Sept. 4, with 15 dealers, cut contracts on European telecommunications companies by 53 percent.\

Too much risk?

One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on "too much risk" in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.

Consider the risks that were not taken during the recent credit and "investment" boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage. Despite a "global savings glut" and record-breaking levels of "investment" in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed "uncompetitive" in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.

I don't pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn't take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn't the problem here. In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a "market outcome". But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.

The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up "super-senior AAA" tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed 'em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was "safe", so who cared what it was funding?

Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, "What should we do?" A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a "risk-free return". But that's a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today's capital. If they don't, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic "safe" instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn't work out?

Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won't be enough. We've trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I've nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.

Investors' childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

Crossposted from Interfluidity.

Welcome Willem Buiter and Mohamed El-Erian to the Banana Republic Club!

The time has come to announce the formation of the Banana Republic Club. Membership is open, with the sole requirement being that nominees correctly discern behaviors in advanced economies that resemble those of corrupt developing countries, which for sake of convenience are referred to as banana republics. Members are eligible to receive a Carmen Miranda hat, although they are not required to wear it.

Brad DeLong has his Ancient and Hermetic Order of the Shrill. Why should he have all the fun?

We broached this line of thought in a post last year, "America: Banana Republic Watch." Today we have two well regarded economists pick up the same theme, so it seemed time to commemorate this trend.

Readers are encouraged to nominate other candidates.

Since the US of A is likely to get a disproportionate number of citations, some readers may consider comparing America to, say, Argentina, to be disloyal. We refer them to Frederick Douglass:

A true patriot is a lover of his country who rebukes and does not excuse its sins

Put it another way, if someone is obese, we think we are doing them a favor to tell them that throwing out the scale and getting a fun house skinny mirror is no solution.

Now to the nominees. Willem Buiter adopts a take-no-prisoners stance in his post, "The rescue of Fannie and Freddie by Hankie and Feddie." Buiter has been a frequent and highly vocal critic of the Fed's response to the financial crisis (including a less than charitable assessment at a Fed-sponsored conference in New York this May).

But the rescue (if one can call it that, since little concrete has happened) of Fannie and Freddie elicits a new level of scorn:

The bail-out of Fannie Mae and Freddie Mac by the combined forces of the US Treasury and the Federal Reserve Board is the ugliest exercise of its kind I have ever observed outside early transition economies and mature banana republics....

The Treasury has taken another big step on the road to Utter Fiscal Obfuscation. It is doing everything it can to disguise the fact that it is entering in commitments that create potentially massive contingent liabilities for the US tax payer. Even if the purpose served by this increase in contingent liabilities is worth the cost, the manner in which it is done is designed to avoid fiscal accountability. This is as welcome to the Executive as it is to the Congress.

The continuing corruption of the Fed’s mission through its growing use as a quasi-fiscal agent of the US government is deeply worrying. Admittedly, this latest extension of list of eligible counterparties at the primary discount window is small beer when compared to the creation in March 2008 of the off-balance sheet vehicle/SPV in Delaware which houses $30 bn of Bear Stearns’ most toxic assets, all but the first $ 1billion of which represent a contingent exposure of the Fed. If, as I expect will happen, the range of eligible collateral Fannie and Freddie can offer at the discount window is widened in the future, and if the maturity of the loans available to them at the discount window is extended, this latest enhancement of the Fed’s role as a lender of resort will be a further step on the road to the Fed as quasi-fiscal recapitaliser of first resort.

Since 1997, the Fed has long been the least operationally independent central bank in the industrial world. This latest episode suggests its main current purpose is to be an unaccountable quasi-fiscal agent for the US Treasury. If that is correct, the Fed’s capacity to deliver price stability in the future may have been fatally impaired.

Note that the post discussed alternatives for coping with the Freddie/Fannie crisis at some length.

While Buiter enjoys throwing thunderbolts from Olympus, El-Erian, co-president of bond giant Pimco and respected investor and academic who writes from time to time for the Financial Times, typically strives for a cool-headed, analytical tone, and provides sophisticated, nuanced discussions of markets, economic trends, and policies.

However, El-Erian's previous comment at the Financial Times, a mere week ago, by the standards of his dispassionate style, was positively alarmed, although it did contain a bracing "Fortune favors the brave" speech. This week, in "Crisis and coherence: finance remains vulnerable," the concern was even more palpable, the mention of opportunity in risk absent, and the comparison to unseemly third-world behavior a noteworthy departure from his normal anodyne stance:

In a few years, we shall look back at this time as one that redefined the landscape of the US financial system and, by association, the workings of global capital markets. The process is inevitably chaotic as it is driven by “crisis management” reactions.... Yet it is possible to make specific predictions.

The financial system is at a crossroads. At current market prices, the system remains under-capitalised despite some $350bn (€220bn, £176bn) of capital-raising over the past 12 months. More over, given the collapse in their equity prices, a growing number of institutions, including such behemoths as Freddie Mac and Fannie Mae, the mortgage agencies, are essentially un able to raise capital without government help. The longer this situation prevails, the higher the risk the financial system will face difficulties in raising other financing critical to day-to-day operations. This would accelerate forced sales of assets into illiquid markets, leading to another downward leg in an already vicious negative spiral.

This realisation drove the recent emergency policy statements from Washington. It is the second time this year that such dramatic announcements were made on a Sunday – a phenomenon historically reserved for developing countries rather than industrial ones. It reflects the understandable eagerness to minimise forced and disorderly deleveraging in a part of the economy that is deeply interlinked with virtually everything else. The financial system is like the oil in your car. Without the oil, it no longer matters whether you have a solid engine, good brakes or fancy safety features. The car will not function....

Accordingly, look for the official sector to encourage further capital-raising and work even harder to isolate the most vulnerable financial institutions and limit the negative spillover effects...

This is a practical approach aimed at striking that delicate balance between laisser-faire and government control. Yet it has important limitations. It does not work for large institutions such as Freddie and Fannie – thus the need for Sunday’s announcement of contingent equity and debt financing from the authorities. Also it cannot handle a large number of institutions facing difficulties. It is likely that additional steps will be needed, lest these limitations end up transforming the current economic and financial dislocations into something even more sinister.

Over the next few months, look for the Federal Reserve to face additional pressure to strengthen the emergency liquidity windows for systemically important institutions. Look for Congress to be asked to appropriate funds to support Freddie and Fannie more directly. Look for innovative mechanisms to raise additional capital for the financial sector through public-private partnerships. And look for other fiscal stimulus measures to counter the increasingly vicious spiral in housing and, soon, consumer demand.

Many of these steps involve distortions to the efficient functioning of markets over the longer term. Implementation is difficult and, in the absence of strong leadership, may not be timely enough. Yet the cost of doing nothing may be even higher. The key is whether all the ad hoc crisis management steps eventually evolve into a coherent and sustainable policy outcome. The jury is still out on this.

In other words, brace yourself for the officialdom making things up as they go along and hope they go to the trouble of cleaning it up later.

Guest Post: How a Systems Perspective Can Help Financial Reform

With the financial system on the exam table, it has been more than a bit troubling, that certain questions are neglected in serious academic/policy debates.

The discussion of possible remedies focuses on regulatory solutions, everything from requiring mortgage brokers to be licensed to increasing financial institution capital requirements and having much greater harmonisation, as the Brtis like to put it, of banking and brokerage firm oversight.

While these measures individually and collectively could be salutary, no one seems to be willing to consider the fundamental question: did the push to facilitate the free flow of capital, both domestically and across borders, play a role in this crisis? For the last 15+ years, the push in policy has been towards increased efficiency, which means lower transaction costs, less supervision, little interest in considering whether so-called innovations benefit anyone beyond their purveyors (Martin Mayer observed that, "A lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.").

It's important to examine this question, because many in this society have come to believe that regulation is bad and ever to be avoided. Yet markets like the equities markets, where participants trade an ambiguous promise anonymously, depend on regulation. Thus, the question should be, "What level of regulation is optimal?" rather than "How much regulation can we eliminate?" The problem with the latter approach is that it can take years for problems to develop, and when they do show up, since the tools to stop them have been thrown away, a full blow crisis has to develop for corrective measures to be implemented.

One perspective on this issue that has generally been given short shrift is thinking about the financial system as a system and looking for lessons and analogies outside the realm of money.

Reader Richard Kline has been pondering this issue in a series of posts (see here, here, here and here) from a complex systems perspective rather than the traditional finance/markets vantage point. The discussion below summarizes his argument; a fuller treatment can be found here.

In this post, Kline addresses possible solutions. As you will see, viewing the problem from a different axis leads to some fresh observations (some run the risk of eliciting outrage) that will hopefully stimulate thinking and comment.

From Richard Kline:

In speaking of ‘remedies’ for financial system instability or outright speculative excess, the images which come to mind are regulators in tired suits and thick spectacles, and statutory limits and penalties hidebound in Moroccan. To be sure, the financial systems needs such hard limits. Fundamental contributory factors to the present financial crisis include insufficient and imprudent capital reserves and excessive leverage. Both factors are directly contributory to every bubble you will ever research, are known as such, and act in wholly linear fashions. Harder and higher statutory and administrative limits including mandatory public oversight of capital and exposure are required because participants simply won’t act with restraint without regulation; we see it now as we have seen it time and again.

Beyond this, in systems in general, and the financial system as a specific example, high connectivity is associated with undampened propagation, massive correlation across nodes, and tight couplings between subsystems. All these outcomes are known to diminish systemic stability through cascade effects. Cascades can certainly be limited by outright compartmentalization such that portions of the system communicate through overtly controlled ‘gates.’ This is highly inefficient however, and moreover difficult to achieve in the case of the financial system which is highly fragmented into many nodes. Soft compartmentalization may be more effective, especially through constraints which scale.

In systems in general, self-modulation is evidently associated with throughput overshoots of nodal capacity, and potentially of systemic capacity. Hard limits on the volume of throughput are again inefficient, and moreover will be hard to enforce in the global financial system. Concentrations of throughput---capital, debt, and risk---need to be closely monitored, but systemic connectivity must be considered in tandem due to its capacity to shift stress from system locations of obvious concentration. In general, interventions which serve as ‘capacitors and resistors’ to throughput may have the largest potential value.

Financial markets do have a history of developing effective ‘prudent practices’ which require no centralized intervention. Good examples are margin calls, asset diversification, and subsidiary liability firewalls. These examples: a) all apply at the point of exposure concentration; b) are locally triggered rather than centrally activated; c) require offsetting action without mandating investment purchase or sale; d) generate a verifiable (and certifiable) paper trail, or should; e) residually promote system stability through braking exposure concentration, which to a degree forces differentiation and hence discorrelation. By no means all structural remedies can fit this profile, but together they suggest an optimum design where applicable. The following are several broad concepts of how to implement controls in a many node system, from which specific policies could be drawn.

Dynamic constraints: The optimal form of a ‘control’ in the financial system would be trend active, threshold passive, and nodally focused. That is, when some variable of local concentration reaches a pre-set level, say the volume of a certain asset held, or the shift in value of a certain obligation, a mandatory adjustment is initiated. The thermocouple in your thermostat does this: it automatically trips off, and should you disagree you must overtly act to override the setting. A margin call or a stop-loss sell order both function in this way. In principle, many financial practices are made to look like this, such as mark to market accounting or regulatory reserve capital; in practice, those with the open position have considerable practical discretion regarding when to act, i.e. they are not tightly coupled to re-set. Implementation must be formally automatic, with any steps to delay or cancel being overt and subject to approval.

Now, hard sudden braking at a threshold can be disruptive, both locally and systemicaly; this is why those lending on a margin may be understandably reluctant to call, or slow to act. The solution to this is two-fold: a) more frequent but initially smaller restraints which, however, b) scale progressively larger. Thus, for example, loss reserves should not just increase proportionately at large intervals but rather increase exponentially but gradually over shorter intervals. Leverage may be high for small volumes, but scale down exponentially against large volumes. The onset of a dynamic constrain best acts more as a warning than a brake, but it should promptly build to more a brake than a warning.

Modulate flows: Modulation of throughput rather than outright barriers offers a high return of effect for a low investment of cause. However, interventions must counter-trend. For example, the more money lent or borrowed for involvement in a single market, the higher the interest rate should be for successive increments. This acts against maximum profit, and so seems counterintuitive; however, this also acts against concentration of loss in one node, and correlation of risk in one type. This is ‘inefficient’ but more stable: notice the direct relationship between those conditions. As another example, the larger a position, the less one may hedge (or insure) it and the more one must reserve it. The more of a specific product one moves, the greater the duration between further offers of set volumes of the same. Modulation can be scaled back in a like fashion. Actions to modulate flows can apply node by node, but these also can be used at the macro level by central banking institutions or clearinghouses of various kinds. The point of modulation is less to bar actions outright since ‘the perfect level’ or risk/reward is often ambiguous---or shifts. Rather, the goal is to circumvent faulty guessing about perfection and instead raise costs and lower velocity steadily to dissuade further involvement (and the reverse on the downswing).

Scale flows: Research with many biological systems indicates that they maintain overall stability by power-scaling structures of common form but varying size, often by quarter-power exponents. The applications of these findings need wider consideration for financial system nodes and flows, but two observations serve here: a) restraints on flows must scale exponentially and progressively rather than as now proportionately and abruptly, as mentioned above; b) different levels of constraint should apply at different levels of the system. For example, after adjusting for risk the same interest rates in principle apply to ibanks and used car purchasers. Power scaling implies that participants of smaller scales should be able to borrow more cheaply than those of large scales. There is secondary evidence which implies this in that small borrowing is known to better stimulate overall demand while large borrowing manifestly concentrates risk. Again, small investors can concentrate everything in a single asset without risking system stability, while this is less true of very large investors.

The takeaway on scaling flows and stability is that the larger the concentration of capital the more it should face higher costs and constraints whereas at present the reverse is true. This is a major reason why open capital systems are inherently unstable: they scale the wrong way.

Dis-correlation: Large concentrations of capital concentrate risk. They also tend to correlate investment. They have maximal connectivity on the whole, and so propagate those risk factors systemically more than do smaller nodes. They are minimally adaptive to systemic change. If they cannot necessarily achieve outright monopolies---a Bad Thing unless closely regulated, and often even then---they have the potential to squeeze prices. Moreover, few large participants are more likely to distort flows or markets, though self-correlation alone if not outright collusion. When truly large, they create node-dependency within the system. It is difficult to find a single countervailing positive for large capital concentrations, let alone an offsetting advantage set.

Market de-concentration needs to be strictly enforced, both by market participants and by overt regulation, if markets and the financial system as a whole are to retain ongoing stability; this cannot be over-stressed. Firm sizes, market share limits, asset concentration, and the like all require monitoring and strict caps. Current large players will hate this, but we all need it. Where large concentrations of capital are needed, syndication can serve quite well. Syndicates are likely to be slower to move, and are special purpose rather than ongoing: these are desirable outcomes for system stability, features not bugs. In a nutshell, empires are bad, city-states good (or at least less bad).

Mid-term counter-cyclical restraints: Modern macroeconomic flows are profoundly pro-cyclical, as several commentators have argued. Investor-speculators are too loose and liquid on the upswing and too tight and sticky on the downswing. Prolonged expansions tend very much to concentrate investment and cumulate risk; both developments have undesirable outcomes. In principle, central banks act counter-cyclically, but in practice they are successfully pressured to be slow and timid on the upswing, and fast and reckless on the downswing; i.e. they partially correlate with pro-cyclical movements even when acting against them. Moreover, central banks have discretion to act, can get it wrong, and are inordinately swayed by exogenous impacts; in consequence of these distortions, they typically act too late.

Beyond this, markets which optimize for short-term outcomes may be inherently exposed to mid-term divergences, and so optimize themselves away from long-term stability. Bankers, central and otherwise, famously do not optimize for the long-term. What is to be done, went the famous question?

It is too little understood that systems which oscillate are stable systems; put another way, the financial system can ‘expand’ continuously or it can be stable but not both. One remedy, imperfect but impactive, would be for macroeconomic policy to adopt the same schema of dynamic constraint suggested above: trend-active, threshold passive, scale to exposure, overt override. Small but certain and regular increases in top tier interest rates, mandated reserve increases, and required deconcentration begin with every upswing. The same reverse with every downswing. Central bankers and other regulators if they certify the need (a brake on too ready intervention) can act to stay or accelerate such trajectories---but not to reverse them. Some flexibility in timing would likely be desirable, but not much. Exogenous events will produce salient changes in trend, and one might leave a ‘declared emergency’ option to respond to abrupt trend reversals---but only by moderate increments. Markets and investors would have a clear profile of forward macroeconomic intentions. Turning points are not clear, and there is no perfect formula for this. Perhaps such an ‘invisible governor’ could skip an increment if the inputs are unclear, but must re-set one way or the other on the next re-set term. The advantage of this approach is that it can be driven by logistic trend deflection points in flows, concentrations, correlations, and duration of trend against historical norms which are typically evident before severe asymmetries have time to develop.

Such a concept again seems counterintuitive; central bankers are ‘supposed to act.’ The evidence is that they tend to miss the mark, and that in attempting to support the impossible---permanent expansion---they act irrationally against system stability time and again. Dynamic counter-cyclical action can act gradually where at present central bankers and political actors can’t bring themselves to act. There is the lesser implication that official rates should move away from quarter or half point intervals to decimal ones which have finer resolution, but which through greater variability may serve as a moderate constraint on financial market anticipation.

Compel savings: All debt and no savings means that there’s Hell to pay; call it Faustian capitalism. So how to induce savings? Requiring everyone to pay into a 401k builds better brokers’ bonuses but delivers rather less than advertised over the long-term. Moreover, this actively hurts banks, and inflates ‘liquidity’ in a way that is likely systemically destabilizing. Besides, large net worth participants don’t save anyway: they invest, i.e. more money in motion where less may be ‘more better.’ Further, the investor class cannot be induced to put their money into social needs voluntarily, especially those with long time frames, such as infrastructure, education, and low income housing.

It is time to consider the return of the forced loan. Above a set level of taxes, further premia should be assessed against income and gains where money is borrowed at nominal interest rates and repaid at or over a set term. Payees having the option to roll over their funds, perhaps with a tax incentive. This should start with high net worth, but eventually directed loans should be assessed against all earners in some amounts; whether to apply this to businesses is debatable. Developed in antiquity, the forced loan was a favorite of pre-banking societies; it’s principal use was to finance warfare, an admittedly bad precedent which should be specifically barred by statute. Furthermore, government falls in love with income sources, and revenue flows grow constituencies, so care needs to be given to the destination of such capital. Most certainly directed loans should be partitioned from general fund expenses.

Bonded sovereign debt has a critical function in the capital markets; no new scheme should replace a significant role for public debt. Directed loans cannot ‘replace’ taxes anymore than debt can replace revenue. They can serve to finance long-term, low risk social needs rather than borrowing on the capital markets at higher cost. More importantly, directed lending may serve to shift some societal capital away from speculation at the high end and consumption in the great fat middle into capitalizing the social and financial systems indirectly. This concept needs more development than it will receive here, but it can promote system stability while having some individual benefit.

Relational models: Discussions of the financial system are relentlessly cause and effect in reference. However, cause and effect does not operate the same way in systemic relationships . . . It is more accurate to speak of modulation, catalysis and emergence. Inappropriate conceptualization reliably yields poorly fitting analysis and false conclusions. Much of current macro-economic reasoning is defective because it is overly concerned with lower dimensional supply and demand factors rather than inherently higher dimensional systemic flow and concentration factors; more accurately such reasoning is only locally effective, not globally (in both the figurative and literal senses). This is why we presently see neoliberal macroeconomists inside the Fed and out jamming away at the ‘demand stimulus’ button on their adding machines with puzzled looks on their faces while nothing happens where they are but the system shorts out elsewhere (presently behind the NYMEX panel). If and as economists use models, we need to see more of long-running relational models (that is a technical term) and less of short run linear models. This should be a focus of government level statistical research.

And while we’re at it, good models need good statistics. Going forward, it would be better to concentrate the compilation of critical statistics away from regulatory agencies and Executive control specifically and toward neutral agencies without larger policy briefs. The GAO and even more the Comptroller of the Currency come to mind. No remedy will do much good if it’s cut with baby laxative while someone’s thumb is on the scale.


James H. Brown, ed. 2000. Scaling Laws in Biology.
John H. Bodley. 2003. The Power of Scale: A Global History Approach.

[The papers in Brown’s collection have important implications for systemic organiztion. Bodley’s text is an anatomy of how scale factors adversely structure political economy, an invaluable work.]

Mohamed El-Erian Hoists Hurricane Flag on Risk

Mohamed El-Erian, co-CEO of Pimco, usually strikes a cool, rational tone in his periodic comment pieces in the Financial Times.

Today's article, "Traversing wild market swings," is a noteworthy departure. Or maybe it isn't. El-Erian keeps to his detached, analytical style,but the guts of his message is so blunt that the packaging is secondary:

Successful risk management must reflect the fact that markets are now in the grip of three distinct but reinforcing forces that will play out over a number of quarters.

First, look for further balance sheet contractions in the financial sector that will continue to suck oxygen out of, and undermine risk appetite in credit and equity markets. This is part of a long-term process of de-risking that is currently driven by markets but will soon have a more important regulatory dimension.

Second, markets are yet to adequately price the morphing of the credit crunch into a full-scale US economic disruption. Prepare for even stronger headwinds fuelled by declining real income and eroding household wealth.

Third, there are no easy policy solutions. Instead, policy makers face an extremely difficult situation in which any action, no matter how well-intentioned, entails unstable feedback loops and impose distortions elsewhere. Collateral damage cannot be avoided, yet its exact characterisation is uncertain given the extent of still-hidden vulnerabilities in both the real economy and the financial sector.

Yikes.

Now El-Erian continues with what amounts to a "in times of great disruption, there is great opportunity," speech. Misvaluations will abound. But reading between the lines, the picking will go to the big fry. Ah, why is it just about inevitable that the rich get richer?

He warns that anyone who goes into the deep end of the pool now needs to have more than adequate reserves, a cast iron stomach (volatility will be high), high tolerance for intermediate losses, and a willingness to consider all sorts of cats and dogs ("a process that accommodates opportunities that, in some cases, do not fit well into traditional classifications of asset classes").

For the rest:

....you are well advised to stay on the sidelines, focused on the probability that these same markets will also be treacherous for at least the remainder of this year.

On Banks Ignoring Risk Warnings From the Troops

I'm a bit perplexed at a Gillian Tett piece in the Financial Times in which she is shocked, shocked that managers didn't heed warnings from subordinates that risk models weren't all that they were cracked up to be. Her article wouldn't seem odd, except it focuses on a really basic shortcoming, namely that many models (Black Scholes, Value at Risk being some of the best known) assume a normal distribution of risk (also known as Gaussian or a bell curve). Anyone who knows the basics is aware that markets deviate from a normal distribution: they exhibit skewness (results are not symmetrically distributed around the mean) and "fat tails" or kurtosis risk (extreme events are far more probable than in a normal distribution).

Yet Tett reports that telling, or more accurately, reminding management of these failings is a career-limiting move:

A few years ago, Ron den Braber, an outspoken Dutch mathematics geek, was working in the risk department at Royal Bank of Scotland when he became alarmed about the models being used to price collateralised debt obligations.

Most notably, he concluded that the so-called Gaussian Copula approach then in use at RBS (and many other banks) significantly underplayed risks attached to the most senior pieces of debt - creating a danger of future, large losses.

So he duly tried to raise the alarm. But, as he tells the tale, he faced hostility. "I started saying things gently - in banks you don't use the word 'error', but the problem is that in banks . . . people just don't want to listen to bad news," Mr den Braber recalls.

Now, every corporate tale has many sides - and RBS, for its part, vehemently denies that it ever ignores challenges or stifles debate. It says it could not find any record of strong warnings about the Gaussian Copula model, is aware of its shortcomings, and, while it has recently suffered CDO losses, these relate to products acquired after Mr den Braber's time...

Or as one senior risk manager writes (anonymously since he remains employed): "[My] institution has now taken multibillion writedowns - job losses result and significant share price erosion - and I wonder how this can have happened? Upfront we did express to senior management that we lacked the analytical skills . . . and highlighted deep concerns about the approach colleagues in the market risk area had taken . . . I feel responsible for not doing more, but I really did push my views, risking my immediate career."

Yves here. The second example, although less specific, is more troubling. Misplaced faith in analytical models is more understandable than handing risk management responsibility to a team that tells management is it not up to the task.

Back to Tett:

But, if nothing else, this saga shows the great blind spot that still haunts many banks. This decade, financiers have invented so many brilliantly clever mathematical tools to repackage risk that the industry has slipped, almost unthinkingly, into an assumption that "credit" is a collection of abstract equations, stripped from any human context.

Thus banks have become so dazzled with their powers that they have ignored how they interact with the rest of society - or how the tribal aspects of their own institutions can create dangerous traps.

Meanwhile, the cult of models has become so extreme that banks have believed them even when this collides with common sense. Yet, as any Latin scholar knows, the word "credit" hails from credere: "to trust". It is, in other words, also a social construct.

And bankers forget this human dimension to their cost - no matter how impressive the abstract numbers might seem. Or as the same risk officer says: "The billions involved were so hard to contemplate that we almost certainly lost sight of the possible consequences [of our credit business] until it was too late."

So, as the banks nurse their credit losses, they certainly do need to review why some of their clever mathematical models failed. That geeky Gaussian Copula stuff, in other words, matters hugely.

But, most important of all, they need to work out why the human processes around the models failed, too.But, if nothing else, this saga shows the great blind spot that still haunts many banks. This decade, financiers have invented so many brilliantly clever mathematical tools to repackage risk that the industry has slipped, almost unthinkingly, into an assumption that "credit" is a collection of abstract equations, stripped from any human context.

Thus banks have become so dazzled with their powers that they have ignored how they interact with the rest of society - or how the tribal aspects of their own institutions can create dangerous traps.

Meanwhile, the cult of models has become so extreme that banks have believed them even when this collides with common sense. Yet, as any Latin scholar knows, the word "credit" hails from credere: "to trust". It is, in other words, also a social construct.

And bankers forget this human dimension to their cost - no matter how impressive the abstract numbers might seem. Or as the same risk officer says: "The billions involved were so hard to contemplate that we almost certainly lost sight of the possible consequences [of our credit business] until it was too late."

So, as the banks nurse their credit losses, they certainly do need to review why some of their clever mathematical models failed. That geeky Gaussian Copula stuff, in other words, matters hugely.

But, most important of all, they need to work out why the human processes around the models failed, too.

Tett is on to something that a lot of professionals in banking no longer want to hear: credit worthiness depends on character as well as ability to pay. But assessment of character is subjective, and somehow institutions are not only reluctant to make assessments on a case-by-case basis, but distrust qualitative analysis.

One of the oddities of the banking industry is that despite all the talk of economies of scale, it's utter rubbish. In the US, banks above a certain threshold (different studies draw the line in different places, but all come to the same conclusion) banks show a slightly increasing cost curve, meaning big banks are more costly to operate per dollar of assets, despite considerable cost efficiencies in certain areas (transaction processing, access to interbank funding). My pet, unproven view is that smaller banks know their communities better (is the hardware store a good business?) and make greater use of old-fashioned credit processes and that in the end, they are no more costly than quantitative, multi-level credit review processes (but if a big bank tried to revert to old-style lending, it might impose more costs for the same procedure than a small bank because it would have more portfolio/supervisory reviews).

Another FT writer, John Dizard, had a more cynical take on why financial firms continue to rely on demonstrably flawed Gaussian models:

As is customary, the risk managers were well-prepared for the previous war. For 20 years numerate investors have been complaining about measurements of portfolio risk that use the Gaussian distribution, or bell curve. Every four or five years, they are told, their portfolios suffer from a once-in-50-years event. Something is off here.

Models based on the Gaussian distribution are a pretty good way of managing day-to-day trading positions since, from one day to the next, risks will tend to be normally distributed. Also, they give a simple, one-number measure of risk, which makes it easier for the traders' managers to make decisions.

The "tails risk" ....becomes significant over longer periods of time. Traders who maintain good liquidity and fast reaction times can handle tails risk....Everyone has known, or should have known, this for a long time. There are terabytes of professional journal articles on how to measure and deal with tails risk....

A once-in-10-years-comet- wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a "résumé put", not a term you will find in offering memoranda, and nine years of bonuses.

On FAS 157 and Measurement Fallacy

Roger Ehrenberg has a great post today, "Straight-talk on FAS 157: Blackstone and their Banker Buddies Have it Wrong," which I suggest you all read.

Although I was taken with the entire discussion, the last paragraph caught my attention:

So why do risk managers and bank managements' so consistently make bad decisions? Probably because there is an over-reliance on measures that are seemingly quantifiable. They can measure delta. They can measure vega. They can measure theta. They can measure gamma (or at least they think they can). They can estimate credit loss ratios. But what about liquidity? When you are quantifying factor exposures, how exactly do you model liquidity as other risk factors change? It is a very, very hard question. Sometimes risk management requires judgment beyond computers, which is hopefully one of the biggest take-aways from the current credit melt-down. My sense is that there is currently a fear to manage without a machine telling you what to do. It is kind of like the drunk looking for his lost keys by the streetlight, simply because this is where he can see. But the likelihood of his keys being within the illumination of the streetlight is very, very low. Some of the best risk managers, guys like Gus Levy of Goldman Sachs and Ace Greenberg of Bear Stearns, didn't rely on computers but relied on instinct, savvy and experience. We need more of this. It's called leadership. Let's not cloud the issue. It's not about FAS 157 or any other accounting rule. It has been and always will be about management.

If that viewpoint resonates with you, you might enjoy a longer-form treatment in Across the Board (Conference Board) article, "Management's Great Addiction."

Warning: Credit Default Swaps May Not Work As Advertised (And That's Even When They Do Work)

Satyajit Das has a very useful post, "The Credit Default Swap (“CDS”) Market – Will It Unravel?," in which he describes some of the ways that CDS may fail to perform as expected in real world situations, ie, when companies start getting in trouble. While this work isn't quite at the Tanta Uber-Nerd level of detail, it does get more granular than most discussions, which I thought was useful.

Two aspects of Das' article merit mention. First, he goes through what most may find a surprisingly long list of various ways CDS might not fully cover the risks they are supposed to guarantee even before getting to the big bugaboo of counterparty failure. One case that Das has mentioned elsewhere is that in the one big test of the CDS market to date, Delphi. CDS protection buyers got 37 cents on the dollar when the recovery value on the senior bonds was set by Fitch at 1-10%, meaning the fall in the value of the credit was 90+ cents per dollar, yet the CDS holder got only about 40% of that. That's a considerable shortfall.

Second, he alludes to rather than spells out the coming-to-a-courtroom-near-you battles over defaulting LBO debt. In this world of covenant lite deals, creditors lack the big stick they had to force either bankruptcy or a restructuring of the debt, namely, if you breached the covenants, the lender could accelerate (demand payment of) the debt. Now if borrowers don't pay, creditors don't seem to have much (any?) leverage.

How does this affect CDS? Per Das, for many CDS, non-payment is NOT an event of default. So what good is insurance if it doesn't cover the most likely outcome for the debt in question? This will make for some interesting theater.

This post also provides some third party estimates of possible losses from CDS counterparty failures. From Das:

The CDS contract and the entire Structured Credit Market originally was predicated on hedging of credit risk. Over time the market changed focus – in Mae West’s words: “I used to be Snow White, but I drifted.” The ability to short credit, leverage positions and trade credit unrestricted by the size of the underlying debt market have become the dominant drivers of growth in the market for these instruments...

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. The key issue is will the contracts protect the banks from the underlying credit risk being hedged. As Mae West noted: “An ounce of performance is worth pounds of promises.” Documentation and counterparty risk means that the market may not function as participants and regulators hope if actual defaults occur.

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or “basis” risk.

The CDS contract is triggered by a “credit event”, broadly default by the reference entity. The buyer of protection is not protected against “all” defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like “restructuring” are complex. There are different versions – R (restructuring); NR (no restructuring); MR (modified restructuring); MMR (modified modified restructuring). Different contracts use different versions.

“PAI” (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in case of defaults.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% - 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band ....

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities (“CMBS”). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an “orphaned CDS”.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work...

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection.

Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented....

For hedge funds, the CDS is marked-to-market daily and any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. In practice, banks may not be willing or able to close out positions where collateral isn’t posted.

ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. The problems at ACA are not unique.

A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis.

CDS contracts entail significant operational risks. Delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. Where collateral is used, there are additional challenges of the accuracy of mark-to-market of CDS and monitoring of collateral.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between US$33 billion and US$158 billion [Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy - BNP Paribas Corporate & Investment Banking]. This compares to the around US$110 billion that banks have written off to date. While it may be unlikely that the CDS market will fail entirely it is possible that losses on the hedges will add to the losses that the banks have already incurred.

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of Lloyds. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Defaults may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

The impact of a bankruptcy filing by Bear Stearns on the OTC Derivatives market, including the CDS, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the investment bank. Barclays Capital recently estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.

Over the last year, securitisation and the CDO (collateralised debt obligation) market have become dysfunctional. As the credit crisis deepens, the risk of actual defaults becomes real. Analysts expect the level of defaults to increase. The CDS market is about to be tested.

Guest Post: Did The Black Swan Fly Over Bubbleville?

Reader Richard Kline is providing a mini-series that was prompted by an anonymous reader who had observed that a complex systems theory view might raise doubts about regulatory policy. Financial overseers believe that liquidity is always and ever good, but that view may be naive:

Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn't make risk go away, but moves it more quickly from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.

Richard, in a guest post last week, posed a question he wanted to take further:

To what extent have nonlinear processes promoted the Securitization Bubble, precipitated its collapse, or prolonged the resulting instabilities in the financial system?

After a background discussion, he presented five issues:

Does innovation require untrammeled information flow across social/ economic event spaces?

Is the crisis in securitized debt the result of a ‘black swan’ event?

Was the creation of the Securitization Bubble the result of nonlinear processes in the financial markets?

Is a financial event-space optimized for propagation desirable?

If not, what structure or process parameters might improve process outcomes?

That post presented his response to the innovation question and prompted quite a few comments. Hopefully, this offering, on black swans, will elicit more reader discussion. Your comments very much appreciated.

From Richard Kline:

A black swan event, loosely described, is an occurrence that: 1) is structurally possible within a system, 2) is of very low probability within that system, but which 3) should it take place has a disproportionate impact upon the systemic order. An older name for such a systemic event is a 'blue sky catastrophe' (catastrophe is a technical term in dynamics), itself a specific form of bifurcation catastrophe where a system sharply and disproportionately changes its internal order following precipitating shift(s) in internal variables or order which can be quite small. Does the present financial crisis as a whole represent a low-probability nonlinear transformation of the US or the global financial system, or of major markets therein? In my view, no---or at least, not yet.

Yves here. I do have a wee definitional dispute. Taleb considered black swan events not merely to be low probability, but unimaginable. They blindside the incumbents, just as the collapse of the World Trade Center towers did. But this distinction does not affect the thrust of his argument.

Back to Kline:

It is important to consider this question closely despite the quick negative conclusion since many in and near to the financial community profess loudly that "No one could have known" that such massive losses from collateralized debt obligations were possible, or that credit spreads could widen and stay widened for months on end. The financial community does not use the black swan terminology, but the claim is the same: "Our crisis was not foreseeable." "The system is liquid, it's just in a stubborn panic." "We are the victims of fraud and a lack of transparency; wider remedies would be unhelpful."

From the other side of the financial industry's mouth with more brass than consistency, we also hear, "Financial innovations are sound, and they did not contribute to unanticipated market instabilities." We have 'an accident' where no one at the scene claims to be or know the driver. Bear in mind that the bubble in financial assets, particularly residential real estate in the US and some markets in Europe, and the collapse of that bubble should best be viewed as discrete processes with potentially distinct drivers. Both those processes embody some contributory if not primary nonlinear transformations. Even more, strictly linear and low dimensional occurrences can in combination easily produce sharply nonlinear and even chaotic outcomes. Nonetheless, on present examination neither the bubble nor its crash fit the black swan hypothesis. Many if not most of the component processes of both were linear, highly probable, and fully visible.

To consider just some contributors to the Securitization Bubble: In the period of negative real interest rates after 2001, mortgages increasingly came to be originated to borrowers at the bottom of the financial system whose capacity to pay depended upon the continuation for decades of historically very low interest rates. Similarly, hundreds of billions of dollars were lent for securitized junk bond debt speculation at the top of the financial system where the viability of that debt also depended upon the continuation of historically low interest rates. Both debt streams were extensively securitized. Concurrently with these entirely observable trajectories, bank-like speculative vehicles proliferated which borrowed, lent, and underwrote the quasi-insurance of credit default swaps to very large sums, again facilitated by historically low interest rates and by borrowing at the extreme short term via commercial paper offerings to capture the best rate spreads. No commercial bank was then permitted to operate with the severe leverage, lack of hard reserves, and term mismatches of these 'wildcat banks,' to resort to an historical term, since these practices, severally and jointly, have a strong association with financial failure. Wildcat quasi-banks speculated in securitized debt in very large volume; in many cases, their operating models depended upon the availability of such instruments. If, when, and as rates rose, large portions of these debts would turn sour. If these debts went sour, the value of the securitized loans as collateral would decline. If the value of the collateral declined, the terms for short term loan refinancing would shift higher in rates and requirements even if liquidity remained constant. These were linear relationships of high probability.

Judging in real time the onset of the turnaround for such trajectories is hard; however, the rise in the Fed Funds rate from 2006 marked a fair closing bell, and indeed many large financial buyers such as pension funds by then stood well back from purchasing such (in)securities. If markets were self-correcting, instability dampening systems, origination of low equity mortgages and high leverage buyout bonds would have tapered off from that point. Instead, the reverse happened. With rising interest rates, loan criteria _loosened_ and volume if anything rose.

At the same time, securitized debt underwriters shifted to ever shorter term commercial paper funding themselves for their pass-through conduits to maintain favorable interest rate spreads and thus stay level with their quasi-bank competitors, exposing themselves also to term mismatch potentials severe by historical norms. In the course of this bubble expansion, correlated asset price rises were ongoing in residential real estate, equities, commodities, and bonded debt, a highly negative indicator for the sustainability of price increases. Again, all of these trajectories were observable; all of them had high probability negative outcomes which would drive trend reversals; all of them had repeated historical validation for such outcomes; all of them were publicized as such by knowledgeable participants and observers.

By the autumn of 06, both residential real estate prices and residential mortgage failures had diverged so extremely from long-term trends that if these shifts were sustained the changes themselves would have represented a nonlinear systemic transformation. Instead, the observable linear relationships held: mortgage delinquencies rose and home prices flattened as interest rates rose, maintaining their historical correlations if at extreme values: not New and Different but More of the Same only more so.

Considered separately, the ongoing crisis in the financial system began in June 07 with the most mundane of events: a margin call on a smallish short-term debtor as their securitized collateral declined. That debtor failed to cover and publicly collapsed; a few smallish hedge funds similarly got squeezed out. When bids for their securitized collateral came in solidly below face, holders of securitized collateral lost face generally with their creditors: if "housing prices always rise," the debt on them was now declining. The worst managed volume purchasers of this debt in Europe promptly went insolvent, indicating both the risk and the illiquidity of mortgage backed securities. Commercial paper quotes for securitized debt holders came in a levels they could not pay, while over the counter offers for their securities came in below the outstanding debt against them. Banks and bank-like holders of large securitized debt positions massively sold liquid collateral to cover their short-term positions, precipitating extensive swings in multiple markets, provoking a full-blown liquidity squeeze. The transformation of the commercial paper market does denote a nonlinear transformation, and will be discussed next in this series. However, none of the inputs to that change were themselves nonlinear. Furthermore, even if short term debt availability had declined in a linear fashion, it would certainly have declined, coming to the same position over a few months so long as the market price of securitized debt continued to decline.

By November 07, new reporting requirements made the existing market price decline of debt securities more difficult to hide, forcing more of these assets onto the books of major financial firms. Concurrently, home price declines and unsold inventories both accelerated. None of these changes were markedly nonlinear; instead, they extended decline trends already locked in. By January, large commercial banks and primary dealers began pulling back from lending or guarantees wherever they could while frantically raising capital themselves, severely exacerbating financial system liquidity constraints. The primary driver of those choices, though, appears to be their own functional insolvency due to unstated losses in securitized debt holdings, perhaps exacerbated by mismatch losses in credit default swaps. A drop of 300 basis points in interest rates did not reinflate the mortgage, junk bond, or commercial paper markets since accelerating housing price declines at the bottom of the financial system and major unrealized losses at the top of the financial system served as ironbound negative indicators for loan risk. If the exact circumstances for the implosion of Bear Stearns in March remain opaque, it is clear that they faced a major run of customers, cascade of margin calls, and withdrawal of dealer counterparties: a very large if old-fashioned bank run performed by financiers rather than retail depositors. There has yet to be any mention of a precipitating major loss for BSC from a nonlinear event. All of these events, and likely more to come, are directly driven by linear price declines in massive quantities of securitized debt, trajectories which were largely locked in from the date of issuance for these instruments.

The surge and purge of the Securitization Bubble has not been a black swan event; it has been a cooked goose event. In that respect as in prior historical examples, the faces change but the fools remain the same. A salient hypothesis from this summary, to which I'll return, is that to the extent that nonlinear processes figured in these trajectories, they were in the making of the bubble more than in the baking of it. The 'black swan' metaphor fails 2), its low probability condition. In fact, we have not even seen 3), a real shift in systemic order in the financial system---yet.

Despite well-publicized failures of some exposed small and mid-size operators, there has been no default cascade to this point, either of short-term obligations of securitized debt holders or swap counterparties. Few banks or bank-like entities have failed outright, though only due to massive public lending. Over the counter securitized debt transactions can and do take place, though they have become rare. Liquidity is in the system for mundane commercial loans, though money is far more expensive. Mortgages are still issued, though far fewer and none at all for higher valuations; the volume declines are linear expressions, however. Local government revenues are declining, but service collapse, bond defaults, and bankruptcies are not widespread. Yet; not yet. And so long as price declines for securitized assets are not realized faster than asset holders acquire offsetting capital, such outright market failures may not happen at all. Those asset price decline trends?: they appear to be accelerating, and have a long way to run; a long way in relation to historical prices; a long way in relation to inventories; a long way in relation to solvency. We haven't seen truly non-linear changes in the financial system---yet, i.e. (sustained) turbulence, catastrophic order transformation (say of market volume, market participants, or currency), or chaos.

In my view, there has been a black swan event in the US financial system within the last ten years: the budget surplus for the Federal government in the few years through 2000, and I don't mean this facetiously. Sovereign pubic debt in the US is not intended to be retired overall but rolled over, since this debt, as the best quality available, highly liquid, and copious, is the fulcrum for all large-volume private financing. With the budget surplus, however, the potential for the contraction of outstanding Federal debt was real---even while it was an event that 'could not happen' in the financial system in the US functioned 'as designed.' Moreover and concurrently, external demand for US Treasury debt, especially from China if often indirectly, began rapid and large increases due to trade flows and their related policy responses. This external demand has proven to be somewhat insensitive to price, effectively making China the winning high bidder for Treasuries whenever it chooses to be, although this factor was not as evident eight years ago and more.

Thus an unheard of budget surplus together with major new Treasury buyers indicated that the asset basis for large-volume transactions in the US was going to contract sharply, putting pressure on top tier banks and bank-like entities to find the next best alternative, and fast. These were . . . securitized GSE instruments. Which as slightly less favorable assets carried slightly more charming rates. It was this experience which in many ways set the feet of large US financials on the slippery slope of asset backed security speculation. Thus an event structurally possible within the US financial system, but of very low probability (hadn't happened since your grandfather was younger than your children are now, and wasn't intended to happen at all), refocused major capital flows at the top of the system. With disastrous near term results as we now see. That the budget surplus appears to have been largely generated by capital gains thrown off by the dot.com equities bubble, and so not sustainable not to say illusory, is secondary since the effect of the surplus on the system as a whole was real at the time.

Did anyone at the time worry regarding 'a destabilization of the financial system' in consequence of the ephemeral budget surplus? People scratched their heads, and then applauded; no one saw 'an event that cannot happen' as indicative of a systemic problem---which it was beyond the summary above. This is what really happens when people see a black swan: nothing, as they have no context. This is another reason why markets heavily dependent upon the competence and reactivity of participants cannot reliably make stable adjustments to low probability events.

Further reading:

Christopher Zeeman. 1989. A new concept of stability. In B. Goodwin and P. Saunders, ed. Theoretical Biology.

Hyman Minsky. 1986. Stabilizing an Unstable Economy.

[Zeeman greatly developed the catastrophe concept, of which this paper is a fine distillation in a theoretical text itself splendidly rich. Minsky is a voice worth hearing.]

What Has Happened to Gillian Tett?

A year ago, I found Gillian Tett, then the Financial Times' capital markets editor, to be the single most useful financial reporter by a considerable margin. She gave insights into areas that were important but badly neglected elsewhere, such as CDOs, credit default swaps, SIVs, all well before they entered the mainstream lexicon.

She was promoted. While she may add value behind the scenes, her stories this year are a shadow of her former work. And that's being polite.

Consider her offering du jour, "How talking can help cut the risk of a lemming fall." Here's the set-up:

Imagine for a moment that you are a banker, who stumbles across a juicy new instrument called the "lemming" product that your sales team could sell to retail clients - for a fat profit......even though it has been rubber-stamped by your compliance department....investors will suffer big losses if stock markets fall more than 30 per cent.

....over 70 per cent of the audience [in a Securities and Investments Institute conference] voted to block the lemming deal in an anonymous poll, taken after the participants had discussed the issue with neighbours.

But then the organisers presented a chart which highlighted a more sobering point: when the SII has done these tests before, it has typically found that the proportion of bankers who block risky trades falls dramatically when participants do not discuss the issue with their neighbour first - even if they vote anonymously.

Tett uses this example to conclude that what investment banks need isn't better incentives, but (to use that horrid American term) more dialoguing:

....bankers should be forced to talk about their business with a wide pool of colleagues, including those outside their immediate silo, rather than just their bosses alone.

Rubbish. A conference is such an artificial setting that to generalize its findings to the day-to-day operations of a company is fantasy. People want to look good before their peers, and in a weird bit of self-deception, once someone takes a position publicly, they typically find it difficult to recant privately. And here, the tradeoff has been framed in uncharacteristically black and white terms: big profits versus big downside to clients in relatively low-odds situations. Would the response had been different if the question has included: "the odds of the market falling 30% in the next X year is Y"? Yes. Survey results are HIGHLY influenced by the wording of the question. So just imagine how susceptible real world situations are to subtle and shifting pressures.

Take the lemming. The response of a manager/department head in the real world no doubt will also be shaped by:

How tough standard disclosure language would be

What leadership in the lemming might do for league table rankings

How close your team is to being on track for its targets for the year

Whether your boss is satisfied with you these days

Whether your firm has had a major compliance/litigation problem in the last two years

Whether you sell to retail clients directly (ie, you own them) or primarily via other firms' salesforces

Whether other firms are selling lemmings actively. This is probably the biggest single consideration. There is far less perceived risk if others are already in the pool

Tett also argues that Goldman, an example of better practice, engages in just this sort of debate:

Institutions such as Goldman Sachs, for example, try to ensure that different business silos have ways of watching what each other does. They also invest heavily in creating a holistic risk management culture: Goldman Sachs' risk systems, for example, are run by Gerry Corrigan, the former New York Federal Reserve president, who makes a virtue out of sticking his nose into as many dark corners as po