Monday, April 06, 2009

Make A New World

For the second month in a row, the US nonfarm payroll figure came out bang in line with expectations, missing the consensus forecast by just 3k (after missing by 1k the previous month and 1k in January.) Macro Man isn't naturally prone to wearing tin-foil hats; if he were, he could only conclude that the Street's newfound forecasting prowess is the result of government manipulation of the numbers.

In any event, the data brought to mind a comment from last summer, when the US government first announced a support package for the Agencies. "When I picked up my newspaper yesterday, I thought I woke up in France,'' quipped Jim Bunning last July, before excoriating the Federales in a Senate hearing.

Well, Senator, many Americans would gladly wake up in France these days. The US unemployment rate is now above France's for the first time since the early stages of the Reagan revolution, despite (or is that because?) US workers toiling for a Gallic 33.2 hours per week. At least the French get good health care, decent grub and an unshaken faith in their own superiority. No wonder Sarko would shout the death of Anglo-Saxon capitalism from a soapbox, if only he could climb up that high.
It seems clear that we are living and trading in historic times, an epoch that will be seen by future generations much as our own regards the Great Depression. Putting on his long-term forecasting hat, Macro Man can see a scenario where regulation and government control of various aspects of economic activity endure for a decade or two, until eventually a backlash emerges and a new Reagan or Thatcher emerge fifty or sixty years after the originals.

Regardless, the people in power today have the opportunity (or, depending on your perspective, excuse) and the will to make a new world. Now, the thing about modern media (both mainstream and alternative) is that are ten guys offering criticism and lobbing barbs from the cheap seats for every guy offering a prescriptive suggestion. It is, after all, easier to tear down than to build up, and regular readers will know that Macro Man has not been averse to hurling shells from the peanut gallery.

Today, however, he wishes to offer a few small suggestions as to how he would make a new financial world. The list is by no means meant to be comprehensive. nor indeed is every item on the list replete with detail. Still, you gotta start somewhere:

* Change the regulation and/or incentive structure of the ratings agencies. One of the fundamental flaws in the current (or is that prior) economic system is that the ratings agencies were paid by the sellers, rather than the buyers, of bonds and structured credit. They were therefore incentivized to help those sellers game the models to win the most favourable ratings. If, however, they were compensated by the buyers of bonds and structured credit, they should be incentivized to, you know, get things right.

* Migrate the CDS market to exchanges with position limits and heavy margining. This has obviously been suggested elsewhere, but bears repeating. In its worst form, the CDS market has a) added untold leverage into the system, and b) represented little more than Mr. Smith buying fire insurance on the houses of Mr. Jones and Mr. Wesson. If a fire (whether natural or via arson) consumes the entire street, the neighbourhood as a whole loses out, but Mr. Smith is quids in. What sort of incentive structure does this give Smith, and what is the impact on society at large?

* Grant loans and mortgages held on balance sheet more favourable tax treatment than those sold off to a secruity factory. One of the primary problems behind the subprime fiasco is that mortgage lenders had little to no incentive to critically assess the quality of borrowers, since they had no intention of holding the loans themselves. If, however, more loans were held on balance sheet, rather than nested in the A tranche of some steaming turd of a CDO-squared, lenders would exercise a bit more responsibility in the allocation of credit moving forwards. And if there's one thing that the new world could use, it's a little more responsibility.

* Re-institute some sort of Glass-Steagall split between commercial and investment banking. In the modern era of Goldman Sachs, bank holding company, the pendulum has obviously swung pretty far in the other direction. And in all honesty, Macro Man hasn't been through the fine detail of what this would entail with enough rigour to provide a checklist of costs and benefits. What he does know, however, is that the creation of financial leviathans that make both loans and securities hasn't done much other than create firms that are too big big to live and too big to die. Rather a sticky situation, that. In any event, splitting investment banks off feeds through into the next suggestion:

* Create tax incentives for investment banks to function as partnerships rather than as publicly listed companies. One could argue that this is all John Gutfreund's fault. Back in the days when investment banks were run as partnerships, the amount of leverage that they could take was constrained by the amount of capital in the firm. Moreover, because partnerships risk their own money, rather than that of some anonymous shareholder, they have every incentive to act within the bounds of reason; if they don't make money, they don't get paid without reducing the capital of the firm. By taking Salomon public in the 80's, Gutfreund helped usher in the era of the firm-wide "Acapulco trade": swing for the fences on Friday and jet out to Acapulco. If the trade works, come back on Monday and collect the plaudits and start mentally spending your bonus. If it doesn't, stay in Mexico and let someone else clean up the mess.

If there is one tenet that Macro Man would like to see introduced into the financial system, it is that more actors should be incentivized to act as if they are in partnerships managing their own capital.

* Scrap the dollar if you want, but get ready to pay. China and Russia have been particularly vocal about the desirability (if not the need) for an alternative to the US dollar as a global reserve currency. Evidently they are tired of paying the toll for the "exorbitant privilige", which in practice has kept the US dollar artificially strong and led to a cessation of some monetary policy sovereignty (the bond conundrum.)

Reserve currencies are, of course, a matter of choice. No one is forcing China and Russia to hold as many dollars as they are, both in terms of gross levels of reserves and in terms of currency allocation within their reserve holdings. If they want to IMF to create and maintain a new "store of value" unit based on the SDR, fine. Run with it. But a store of value unit is an incredibly, er, valuable resource, which should not come free. Currently, China, Russia, and other reserve managers are paying the cost of low US nominal yields and a burgeoning supply of bonds for using the dollar as their primary store of value. Perhaps a new system could have a transaction tax on SDR purchases above a given threshold to discourage over-accumulation of FX reserves. At the very least, a new system should include a heavy does of oversight of the reserve accumulation policies of large current account surplus nations, with both carrots and sticks included in the policy arsenal.

So there's a starting point for discussion. Readers are encouraged to submit their own suggestions and/or critiques in the comments section.


EJ said...


What about nixing the "non recourse" housing loans in the US ?...going fwd, surely banks don't need to be implicitly granting free put options on the property mkt any more...


Macro Man said...

A move to recourse mortgages would be hugely deflationary to the existing housing stock, which isn't exactly what's needed. And the spectre of banks going after the financial assets of of mortgage holders isn't a particularly pleasant one. Perhaps maintaining non-recourse status for primary residences is the way to go...

Anonymous said...

You say that many are lobbing barbs from cheap seats. But they have every right to do so since the basic problem is not, and has not, been resolved, namely the proper pricing of toxic waste in banks. They are being allowed to get away with it. The Administration is clearly still in thrall to Wall Street and those bred in that NY culture, e.g. Geithner.
Do what Hussman says: make bank bondholders take a haircut - regardless of what PIMCO and their ilk want. It is the only way for banks to write down the bad stuff. Take a simple bank balance sheet of liabilities and assets, as Hussman says, it's obvious what needs to be done. The equity counts for nothing: its trivial against the needed write-downs.

Anonymous said...

My idea would be not to force everyone into exchanges (which will just create another boom - in clearing) but to restrict CDSes to what they were intended to be: insurance - i.e. it never pays out more than actual damages incurred, and impossible to claim "double insurance" by taking the same insurance with multiple insurers.

Anonymous said...

how about just banning CDS or, better yet, a global ban on any derivative trading?

of course that would leave us exposed to people going underweight or shorting underlying bonds but perhaps we can outlaw this too. and while we are at it, let's ban selling bonds in primaries - nobody can price credit risk these days anywy. Lets go back to good old bilateral lending where companies take out loans from the remaining banks.. all two of them.

Richy Rich said...

Or go completely the other way.

Set up a new renegade state that is free of all regulations and relies solely on basic contract law. The ultimate "caveat emptor" environment. Do what you like but by god you got to understand the risks yourself and not blame someone else if you lose. It would be a "Mad Max" financial centre. Risks but also rewards. But remember .. "Break a deal , face the wheel" ..

Employers would naturally tend to employ along the lines you suggest.
Tax haven status would attract enormous funds and talent.
Guaranteed bank secrecy- There's plenty of demand and rapidly diminishing supply!
Open for business for all those $ trillions of "grey" funds that regs are trying to segregate out.
Real return for real risk - complete opposite of the environment govns are currently trying to create of No risk No loss.
If ratings agencies were going to be used at all in these environments they'd find out pretty quick that they had better be right , or some gentlemen in leather coats may turn up at their homes.

Of course you'd have to find somewhere suitable, undeveloped, isolated, right time zone..
Eritrea cant be that expensive ..
And you can hire your own defence forces from the neighbours pretty cheap ..
Just a thought….

Mind you .. Without regulations how would anyone ever make money? The city has always relied on the creating the machinery for regulatory arbitrage to pay the bills. What's the point of a "binary-tax-derivative-balancesheet-triple-salco" if there isn't tax law or come to think of it .. Balance sheets.

And while we are at it scrap balance sheet accounting completely.
. Balance sheet this balance sheet that, that’s what's caused all this. Go back to profit and loss accounting. Its real money that counts.

Here endeth the rant ..

Richy Rich

Anonymous said...

Deincentivise Banks' Cross Debt Holdings

In this crisis there were two vectors of contagion that lead to bail outs of financials: the counterparty derivative exposures (which you have dealt with in the clearing house + collateralisation proposition), and the fact that a lot of bank debt is held by, er, other banks.

If we increased the risk weighting on bank debt in banks' capital calculations significantly it would reduce the incentives for Bank A to own Bank B debt. Thus when the next crisis inevitably comes along it will be easier to let Bank B go down in flames and for the bond holders to pick up the tab - as is supposed to happen.


Anonymous said...

There is no difference in incentives between a naked CDS and shorting a stock.

Preventing shorting or naked CDSs is an effective way of laying the ground for new bubbles. How are markets supposed to be any close to effective if only bidding on the upside is easy? Will the correction come sooner with or without these instruments?


Anonymous said...

from the very cheap seats: I would like to see 3 world curriencies: European,Asian,and the dollar.

With 3, coordinated manipulation would be harder.

Macro Man said...

Johan, no difference in incentives, perhaps, but very different in execution, given the margin requirements, borrowing costs, etc on stock shorting. A CDS is, at its heart, an insurance contract without the limiting traits that characterize other insurance contracts (ie, u have to own the asset being insured, you can only claim on one policy per item, etc.)

Banning all derivatives is a terrible idea; despite the bad name that they have garnered via the most exotic wing of the species, derivatives play a valuable role in allowing business and individuals to hedge risk.

As it is currently constructed

Anonymous said...

Come on, MM, surely you know that derivatives are bad, mkay?


dblwyo said...

MM - very nicely done. Especially in contrast to the headlines on the G-20 emphasizing the conflicts rather than the amazing levels of convergence and collaboration.

You might be encouraged to note that all those are included in Geithner's strategic thinking and the plan btw (the best way to pick that up is with the C-Span video which is complete of his WSJ Dealmaker interview).

To your list I'd add changing the internal incentives in financial companies to balance accountability with authority - if you can risk it you can share in the upside AND downside - in both the short- and long-runs. That's also in TimmyG's thinking as well.

Finally to be truly off the wall how about requiring performance bonds or insurance which would create market-like incentives for financial institutions to police their own houses ? My own feeble attempts at wrestling with some of these issues are here (part 4 of a 4-parter btw):

Overall very nicely done. A 9 on Dancing with the Markets !

Anonymous said...

Steaming turd? Macro man has been living in the UK too long. What's next, watching cricket?

leif_81 said...

I think number one on your wishlist (manage money like it's YOUR money) is the key. But since you can't take the loss if it's NOT your money, those that invest and those that earn fees. It seems an irreconcilably conflicted system.

Macro Man said...

Mrs. Macro's sister is married to a professional cricketer. I'm all over it, baby!

MugPunter said...

MM - Rather than looking at CDS as an insurance contract, try considering it as a bond option.

We have no problems with the options market on futures and equities because we have clear, homogenous collateral requirements to prevent outsized positions and risk. If we were to apply the same to CDS, it would solve the AIG style issues trhough attrition if nothing else as excess collateral made the positive basis trades unprofitable beyond a certain level.

The problem in the CDS market has never been the buyers - its been the sellers who faced a different collateral and accounting environment from the rest of the market which enabled them to amass huge positions in the expectation that AAA stuff would never go into default.

Note that Big Warren in his latest letter to Berkshire investors specifically cited the absence of initial collateral as the reason he sold a bunch of IG CDS... now that he might be required to post collateral up front like the rest of us mere mortals he won't have it.

Also - spot on about the ratings agencies. In my view the delegation of risk management to them (enabled and encouraged by the existing regulatory regime - yes we had one, contrary to the belief of most lefty pundits) is one of the biggest foundations of the current bubble. A misplaced belief that we were close enough to predicting future certainty so we could infinitely DCF our future and rack up the debt now at our kids' expense.

Anonymous said...

Glass-Steagall was an obvious one, think we'll get CDS CCP rather than exchange so banks can maintain control and opacity. I like the on B/S loan incentives and LLP tax breaks - think this is the key, legal framework provides incentive structure. Don't really see how you can avoid contagion. Good discussion to start. Not sure G20 was such an unbridled success as Mr S would have it.
Cheers, JL

Skeptical Smith said...

Today it lacks humor&creativity. CDS is a bet, and thats it, like any swap it can bring the status of a hedge, in this case an insurance. You can and, I guess, shoud try to dwindle risks, but all you can get is hope. In the next turn they will come with another way to leverage. About the agencies one can say that the problem lies they are paid by the borrower, but lets go to facts: everyone knows it, so theres no excuse, the rules were clear, anyone who buys a security with the rating X knows exactly which incentives the agency had.

Macro Man said...

Mugpunter, I think we mostly agree, but I would point out that unlike a par put, a CDS only pays out by maturity under a specific circumstance, e.g. a default event, rather than the market price of the underlying trading lower. Regardless, I think we agree that limiting position sizing would be a useful exercise.

Skeptical, everyone may have known the ratings agencies were useless, and yet here we are anyways. Seems to me that something oughta change...

Nemo said...

Modernize anti-trust law (or maybe just banking regulations) to explicitly recognize that "too big to fail" is too big to exist. Identify firms whose failure would pose a systemic risk, and then smash them into little bitty pieces.

More briefly: Obama should emulate Teddy, not Franklin.

Anonymous said...

Great suggestions. I like the new criteria for antitrust - "too big to fail"! I think we cannot have incentives paid and based on one year's worth of performance. That doesn't aline the interests of the shareholders with those of the management. Either that or base board of directors compensation on 10 year stock price and let them figure out how to incentivise the CEO's.

prophets said...

I would like to see a much stronger, very proactive WTO. This way, protectionism can be avoided by cutting off the need for asinine domestic legislation.

Eventually major issues like carbon taxes will need to be adopted on a global basis to prevent cost of manufacturing disparities from favoring one territory over another.

I find it hard to understand how the US, Europe, Australia and others will accept these economic burdens while China and others thumb their nose at it. Something will have to give.

Manc Trader said...

Good post MM.
My suggestions are:
1) Go with Hussman
2) Scrap corporate taxes and adjust the personal income taxes to make up the numbers. Company managements should have to fight tooth and nail to get shareholders to allow them to retain cash. I know the cost of raising capial goes up and the investment banks get fees. In my book that is a good thing as it will allow them to go back to some of their core functions.

3) Ideally get rid of the home mortgage interest deduction. Creates too many distortions and ultimately is self defeating as home price rise to accommodate the
4) Make any necessary one time transfers to make the initial adjustement socially acceptable.
5) some of marcros suggestions such as partnerships vs corps for investment banks, rating agency overhaul etc. etc.

Anonymous said...

We should keep in mind that while the rating agencies are a joke, the investment firms/CDO managers that purchased these securities also paid de facto rating agencies (i.e. credit analysts) who presumably had the incentives you are talking about. Yet we are still in this mess.

Turn banks into utility companies using a strong form of Glass-Steagall and get rid of the rating agencies all together. Capital ratios cannot rely upon ratings in this world.

anarchistas said...

A couple of facts from OCC’s Quarterly Report on Bank Trading and Derivatives Activities. Fourth Quarter 2008:

The notional value of derivatives held by U.S. commercial banks increased $24.5 trillion in the fourth quarter, or 14%, to $200.4 trillion.

Derivatives activity in the U.S. banking system is dominated by a small group of large financial institutions. Five large commercial banks represent 96% of the total industry notional amount and 81% of industry net current credit exposure.

Total credit exposure of five biggest players is (page 25) $1.357 trillion.

Total credit exposure to capital ratios:
J.P.Morgan Chase - 382
Bank of America - 179
Citibank - 278
Goldman Sachs - 1056
HSBC - 550

Total credit exposure is defined as the credit equivalent amount from derivative contracts or the sum of netted current credit exposure and PFE. The total credit exposure to capital ratio is calculated using risk based capital (tier one plus tier two capital).

The credit risk in a derivative contract is a function of a number of variables, such as whether
counterparties exchange notional principal, the volatility of the underlying market factors (interest rate, currency, commodity, equity or corporate reference entity), the maturity and liquidity of contracts, and the creditworthiness of the counterparties (page 3).

All five are too big to fail now. To my best knowledge, there isn't any risk management techniques to manage such leverage ratios, except government backing.

So I would reformulate the second MM's suggestion to "Government restrain itself from participation in Ponzi games".

anarchistas said...

As to reserve currencies, there is nothing to add to Michael Pettis scepticism.

"Cassandra" said...

MM - as a kid, I used to go to Connie Mack staudium and watch Jim Bunning. Now, even the republican's are distancing themselves from from his all-too-frequent Wild Pitches. It is doubtful he'll be re-elected...