George Soros, in today’s Financial Times, joins a long list of critics of the Paulson financial services reform plan, although even to dignify its bureaucratic legerdemain with the label “reform” is singularly misleading.
Soros departs from his peers in sketching out where he thinks regulators went wrong and offers two specific proposals, I am particularly keen about his idea of moving credit default swaps to an exhange; as I’ve discussed before, that is one of the cleanest and most sensible options available, and it would be viable in a large, active market like CDS.
From the Financial Times:
The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.
Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants’ biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.
Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.
The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.
The Bush administration has resisted using taxpayers’ money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers’ money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.
An exchange will not solve all the problems with CDS:
1) The ‘jump’ moves (from 50bp to 2000bp) in CDS doesn’t lend it self to daily variation margining.
2)The biggest problem which all dealers have known about since Day 1 is that there is no way to hedge a CDS.
The ‘theoretical hedge’– short a corporate bond go long a Treasury is both subject to squeezes and only works if the Tsy has rallied when the company goes into default.
The cousin of the CDS, the risk participation swap may also have played a role in the BSC fiasco. It appears that many dealers were selling protection on the interest rate swaps of BSC.
Agreed, plus I imagine some contracts won’t migrate well due to lack of trading in the underlying (ie, if a dealer wrote a CDS on a pretty customized index). But this at least would move the ball in the right direction.
“that would enable mortgage holders to be paid off at 85 per cent of the current appraised value”
So when housing prices fall 30% the government holds the bag for 15%? Where’s the logic in this?
Gosh everyone seems it’s just hunky dorry (sp?) for the government to spend trillions of dollars as if it were an afterthought. And there only reasoning is: it’s really bad out there, maybe this will help. Actually, if it’s so bad out there, maybe the conclusion is nothing will help, so we should just not waste money at this stage?
Because a few trillion dollars is starting to be real money.
“there only” => “their only”
I see that tallindian wrote most of what I wanted to write.
I will just add that it’s not so much large jumps in spreads as two defaults which would be causing headaches. Even a normal CDS is (despite all the models pretending otherwise) sort of a long second-to-default basket + short (real) vanilla CDS + a long call on the same (allowing costless termination of the short) on the writer of the CDS (i.e. order of the defaults matters).
BTW, you can hedge CDS, the problem isn’t so much the moves in treasuries (you can always hold cash instead of treasuries, and do an IR swap or something similar) as that it is VERY capital intensive. You loose all the advantages of derivative.
Mortgage approvals fall to near decade low as two more banks suspend lending
Mortgage approvals fell close to a decade low in February as the property market slumped and cash-strapped banks reined in lending, Bank of England figures showed yesterday.
The figures were revealed as two more banks took action after First Direct suspended lending on Tuesday. The Co-Operative Bank has withdrawn its two-year mortgage deals, while Lehman Brothers, the US investment bank, stopped lending at its two British mortgage businesses, South Pacific and Preferred, last night.
>> while Lehman Brothers, the US investment bank, stopped lending at its two British mortgage businesses, South Pacific and Preferred, last night.
Using cash subjects you to interest rate risk (if rates go down). You are short the corp and the overall level of rates fall. You lose on your short corp while the CDS hasn’t changed in value.
Switching to an swap leaves you with the same problem as the Treasury.
Every firm I was with always trotted out the ‘flight to quality’ == Treasuries will rally in the event of a default.
Not sure how you can market instruments that are worthless.
Then forgetting that proposed measures involve the government entering the private markets (further), all plans are just delaying tactics or else the house of cards all falls down.
Doesn’t leave much choice but to extend or put off a collapse using ingenious-hollow methods.
Oh well, the 3 years olds can worry about it when they grow up.
central exchange won’t happen anytime soon. that would require banks to mark all assets that are put on there to market which would mean instant insolvency
Would a CDS exchange also enable the possibility of collecting stamp duty taxation on each trade?
“You lose all the advantages of derivative.”
The problem: The CDS market, as played today, has very little real value ? An insurance policy that can’t pay off when the S**t hits the fan is not an insurance policy, it is a scam.
Just like a mortgage that can’t pay.
So being tax free and unregulated is the only argument for the entire CDS industry?
I have felt for a long time that an OTC market merely places the risk above the banking system.
An exchange is the only way to diversify, price and manage risk. It will also reduce “transaction” returns since one of the reasons for OTC contracts are the higher returns on creating them.
I would also recommend that all derivative contracts be ultimately exchange traded. A competitive capitalist system depends on pricing competition and transparency.
The financial institutions have forgotten that they are the medium through which the capitalist system operates and not the end itself.
The explosive development of OTC derivative markets since 2000 has corrupted the financial system that supports capitalism.
The TAMRIS Consultancy
By the way, this really is a great blogs.
I guess that if a derivatives trading exchange system were to be set up per GS proposal, a small derivatives trading tax (DTT) would not entirely kill off the market and while we are about it maybe open publishing on the net all trades (in real time or at least daily) with enough detail to see “who is up who” would cover the transparency request?
Too radical? Un peu trop?
“The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth”
“With sigle family home sales running at an annual rate of 600,000”
Try around 4.8 million.
Can you find the details for this “loan”? The following is general info on a loan, and it seems loans have terms, conditions, collateral, details of the transaction, thus do you have an opinion on the accounting or economics of this Bear/JPM loan?
The Chrysler Corporation Loan Guarantee Act of 1979 was signed into
law January 7, 1980, and established a loan guarantee board with the
authority to issue up to $1.5 billion in government loan guarantees for
the Chrysler Corp., a failing company, over the next three years. This
assured private creditors that the government would assume the losses if
Chrysler failed. The loans were to be repaid by the end of 1990(CQ
A number of strings were attached to the bill. To receive the loan
guarantees, Chrysler was required to:
· “Win concessions from the companyŐs workers, plus $500 million in new
credit from U.S. banks; $125 million in new loans from foreign banks and
other creditors; $250 million in aid from state and local governments;
$180 million in aid or credit from dealers and suppliers.
· Sell off $350 million of company assets or other equity.
· Develop an energy-saving plan.
· Issue $162.5 million of new common stock to its employees.
· Make another $100 million of new common stock available for sale to its
employees. Any worker purchase of such stock would count against the
required wage concessions.” (CQ Almanac 1979, P. 292).
Unlike the many terms and conditions included in the Chrysler
legislation, few terms and conditions are given to the airlines under S.
1450 in exchange for the loans and compensation. The act creates an Air
Transportation Stabilization Board “to review and decide on application
for federal credit instruments.” It goes on to say that “A federal credit
instrument shall be issued under section 101(a)(1) in such form and on
such terms and conditions and contain such covenants, representatives,
warranties, and requirements as the board determines appropriate,” (S.
1450). It seems that the board can determine certain conditions for the
loans, but these conditions are not spelled out in the legislation like it
was with Chrysler. By giving away $5 billion in compensation in addition
to not providing stricter guidelines to receive money, lawmakers are not
holding the airlines accountable for their actions.
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Lender of More Than Last Resort
Recalling Section 13(b) and the years when the Federal Reserve opened its discount window to businesse
Finally, in 1957, Fed Chairman William McChesney Martin exorcised most of the demons of Section 13(b) when he appeared before a subcommittee of the Senate Banking and Currency Committee to discuss the “problem of small business financing”:
… the Board would favor neither the financing of such institutions by the Federal Reserve by purchase of stock or otherwise, nor the exercise by the System of any proprietary functions.
… Basically, our concern stems from the belief that it is good government as well as good central banking for the Federal Reserve to devote itself primarily to objectives set for it by the Congress, namely, guiding monetary policy and credit policy so as to exert its influence toward maintaining the value of the dollar and fostering orderly economic growth.
One year later, legislation creating the Small Business Investment Company Act, subject to regulation by the relatively new Small Business Administration, officially repealed Section 13(b), thus ending what economist Anna J. Schwartz has termed “a sorry reflection on both Congress’s and the Fed’s understanding of the System’s essential monetary control function.”
“The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt.”
Notional amounts are next to meaningless. The market value of that $42.6 trillion in “notional” CDS contracts as of June 2007 was $721 billion. Credit exposure would be less than that.
I do think there is another shoe to drop there, but we’re talking about direct losses at worst along the lines of the MBS losses, in the hundreds of billions.
Updated: How to Keep your Investments Safe
I don’t want to add to the panic, but one thing that is getting little in the way of attention here is the question of whether investors should have investments in their name or street name. Many brokerage accounts are automatically opened as margin accounts, or with margin features, which means if a brokerage runs into trouble, you become just another creditor.
Granted, alls well that ends well if your broker (Bear Stearns) is acquired by another (JP Morgan), assuming the acquiring broker remains in good shape.
If you’re not willing to take that chance, one suggestion is to transfer your account to a custody-type account at a trust company or bank trust department
I find it difficult to disagree with your comments. However, the horse is already outside the barn and nowhere to be seen. Perhaps that is why the CFTC is objecting to being mixed in with this whole “faith based reorganization”. The idea of a futures and options market for CDSs has been floating around for years. Obstructionist to these ideas were those who would have benefited the most and who are now on their knees praying for a miracle. These obstructions were motivated by a fear of transparency.
Let me ask you, what has changed….?
Forming an exchange now, to deposit, clear, secure and guarantee delivery and execution of these synthetic instruments, would shine the light of day on the magnitude of the problem. Neither Hank nor Ben can afford this. You know this, George Soros knows this and I know this.
My best regards,
What is the end game in all of this? In the end, i suspect, a whole bunch of equity and money will evaporate. Deflation on a grand scale has just begun. At some point in the next ten years massive inflation will occur. Inflating the value of everything will be the only option. What about housing? Housing is the centerpiece of this ruse. It is not unrealistic to surmise that the american people would accept almost any changes in this country as long as they are able to keep their homes. The question then becomes…what are the terms?
Michael Greenberger was interviewed by Terry Gross earlier today (my time.)
Interesting history on Phil Gramm’s legislation to legalize what let UBS lose all that money. Interesting observations on Paulson’s irrelevant regulation reshuffle. Interesting claim that “we’d” be better off if “Las Vegas” ran things given the current rules…
Once upon a time, there was something called “The Peter Principle”….
I disagree that most contracts, including CDS’s can’t be traded on exchanges. For those of you working in the industry, I think you’re falling into the trap of fawning parents who think their kids are completely unique and totally unlike any of the rest of the kids in the neighborhood.
When stock options were first started, I’m sure there were people who said you couldn’t possibly trade them on an exchange, seeing as how you had so many different strike prices, expiration dates, etc. etc. I mean, you could have HUNDREDS of options on a single stock! No way. But it happened. True, you can’t buy a leap that strikes at 102.145 and expires on Sept. 13, 2010 or something like that, so you did lose some flexibility, but overall, the market functions well.
Similarly, while you would lose some flexibility in CDS contracts, that would be far outweighed by what you gain in fungibility and transparency.
Furthermore, why the heck should a regulator care about whether forcing these contracts onto an exchange makes it harder/easier to hedge, or makes the market more/less liquid? The purpose from the govt’s POV is to 1) standardize contracts so that they’re more easily regulated by the authorities and understood by investors 2) force daily mark-to-market valuations 3) provide fewer points of regulation (the exchange, the clearing house, and perhaps the market makers) to set standards such as margin requirements and capital reserves. That’s it. It’s up to the whiz kids to figure out how to make money off of it. And I’m sure they will.
I think you’re dead right. Wall Street will learn to live without customized contracts. Life will go on.
We need to get rid of this hidden OTC stuff as much as possible—there’s too much systemic risk created—as we should have all learned by now in vivid detail with Bear Stearns.
Starting from the end,liquidation will be the bottom line. But first we have to finish inflating to the point uselessness then deflation begins leading to that liquidation event.
Discussions sound like everything is fixable, it’s not.
Consideration also needs to be given to the fact that the Fed has expanded the pipeline on these “less than attractive” securities. I’m deeply concerned about the “Full faith and Credit” issues as they relate to the Treasury market. Where are Hugo Chavez, Mr. Ho and Mr. Putin, to name a few, going to be when we need them.
I have have some thoughts on this matter, however they have been labeled as blasphemous, and I have been advised severely to stick to my shoemaking and respect NOMA.
This exchange from this morning’s NY Times just about says it all. It gives a sense of just how devoid of reason, how internally contradictory the administration’s argument in favor of the $700 billion bailout is:
Representative Barney Frank, the chairman of the House Financial Services Committee, put forward the Democrats’ proposed changes to the administration’s plan. They would give the Treasury secretary the authority to set “appropriate standards” for compensation of senior executives whose companies sell troubled assets to the government.
Under a so-called claw-back provision, the secretary would have the power to force companies to recoup previous payments to executives of companies involved in the program. And Mr. Frank’s plan would give broad authority for the Government Accountability Office, an investigative arm of Congress, to audit and oversee the program.
But Mr. Paulson said that he was concerned that imposing limits on the compensation of executives could discourage companies from participating in the program.
“If we design it so it’s punitive and so institutions aren’t going to participate, this won’t work the way we need it to work,” Mr. Paulson said on “Fox News Sunday.” “Let’s talk about executive salaries. There have been excesses there. I agree with the American people. Pay should be for performance, not for failure.”
But he quickly added: “But we need this system to work, and so we — the reforms need to come afterwards.”
So let me get this straight. The only way the bankers will participate is if the US taxpayers give them a blank check with absolutely no strings attached. Otherwise, as Paulson says, they “aren’t going to participate.”
But, almost in the same breath, if the taxpayers don’t give the bankers everything they want, exactly on their terms, then there will be “economic calamity,” “meltdown,” and “cataclysm”.
Actually, this type of “reasoning” has a name. It’s called “Divine Right:”
“Divine sanction thus made the monarch right in reason, and not merely by might, his power was in every way legitimate.”
“At the same time, the theory imposed terms: the king must feel the deepest awe in the face of his responsibilities. If he governs badly, he will suffer. On the other hand, if he does govern badly, and the people suffer, it is because they have sinned and are being punished.”
Jacques Barzun, From Dawn to Decadence
It was with good reason that FDR dubbed the nation’s economic elite “royalists.”