On Asymmetry, Reflexivity and Sovereign Default

One of the most rewarding aspects of blogging is that it gives me the opportunity learn from those who read and comment on the ideas expressed here. I have had the good fortune of being visited by a number of informed and thoughtful readers, whose remarks have often been of greater quality than the posts to which they were responding. Among those for whom I have developed the greatest respect is the anonymous author of Macroeconomic Resilience, who left a couple of very helpful comments in response to my recent post on credit default swaps.

MR pointed out that the idea of multiple self-fulfilling default probabilities plays a key role in George Soros' theory of reflexivity, and linked to an article in which Soros interpreted the Lehman bankruptcy in precisely these terms. In fact, it is a combination of reflexivity and a particular kind of risk/reward asymmetry that gives rise to what Soros calls self-validating bear raids:

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract...

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.

Soros' point about risk/reward asymmetry directly answers one objection to curtailing purchases of naked credit default swaps, namely that such contracts "provide identical leverage both to the optimistic and the pessimistic side of the transaction." Leverage may be considerable on both sides of the contract but this does not mean that market clearing prices reflect optimistic and pessimistic beliefs in equal measure, because the spreads at which sellers are willing to enter the contract must offer them adequate compensation for the significant downside risk that they face.

MR does not consider reflexivity to be a routine problem in credit markets, arguing that "only when the entity is in a state of low resilience that markets are sufficiently reflexive to push it over the edge." This is also David Merkel's view of the matter:

... if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.

But what causes a balance sheet to become weak? In the case of sovereign states, it could be widespread tax avoidance and excessive spending relative to revenues, as has been alleged in the case of Greece. But it could also be a significant decline in economic activity that reduces the tax base and triggers automatic stabilizers. This is how Paul Krugman interprets the experience of Spain, which had a budget surplus three years ago, but "is running huge deficits now [as] a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment."

Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. For this reason, Felix Salmon's claim that countries "have essentially no limit on how much they can tax or cut spending in order to make their debt repayments" cannot possibly be correct as a general principle. A government can change expenditure policies and tax rates, but has no direct control over realized revenues and outlays. As a result, raising tax rates or trimming expenditures (such as unemployment benefits) in the face of severe deficiencies in aggregate demand can worsen rather than improve its balance sheet position.

Under such circumstances, it is terribly important to determine whether the looming threat of default is simply one of several possible equilibrium paths. As Felix acknowledged in his response to my post, it is true in principle that "a company or country can find it easy to repay debt when spreads are low, thereby justifying the low spreads, while finding it hard to repay debt when spreads are high, justifying the high spreads." Default under these conditions would be terribly wasteful, and I can see no reason why attempts to avoid it should not be pursued vigorously.

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Update (3/11). Paul Krugman also seems to think that it's worth considering the possibility of multiple self-fulfilling default probabilities in the context of sovereign defaults (h/t Mark Thoma):

Markets are getting slightly more bullish on Greek debt — and Peter Boone and Simon Johnson are crying bubble. I’m not so sure, but I think their argument highlights something else: the possibility of multiple equilibria in sovereign solvency...

Suppose that Greece had as much credibility as Germany, and could borrow at a real interest rate of 2 percent. Then stabilizing the real value of its debt, even with a debt ratio of 150 percent, would require a primary surplus of only 3 percent of GDP. That’s certainly possible for some countries, although maybe not for Greece.

Boone and Johnson assume, however, that Greece would have to pay 10 percent nominal, say 8 percent real. Servicing that would require a primary surplus of 12 percent of GDP, probably impossible for almost anyone.

So this suggests that optimism or pessimism about future default can, to at least some degree, be a self-fulfilling prophecy. Not a new insight, I know, but it looks increasingly important for thinking about where we are now.

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Update (3/19). And here's Richard Portes arguing for the importance and empirical relevance of multiple self-fulfilling default probabilities, based on his work with Daniel Cohen (h/t Mark Thoma):

Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations, as Daniel Cohen and I have argued.