Thursday, August 19, 2010

On Broken Trades and Bailouts

Back in 1980, Avraham Beja and Barry Goldman published a theoretical paper in the Journal of Finance that explored the manner in which the composition of trading strategies in an asset market affects the volatility of prices. Their main insight was that if the prevalence of momentum based strategies was too large relative to that of strategies based on fundamental analysis, then the dynamics of asset prices would be locally unstable: departures of prices from fundamentals would be amplified rather than corrected over time. More importantly, they argued that the relationship between the composition of strategies and market stability was discontinuous: there was a threshold (bifurcation) value of this population mixture that separated the stable from the unstable regime, and an imperceptible change in composition that took the market across the threshold could result in dramatic increases in volatility.
The Beja/Goldman analysis can be taken a step further: not only does market stability depend on the composition of trading strategies, but the profitability of different trading strategies, and hence changes in their relative population shares over time, depend very much on whether one is in a stable or an unstable regime. In a stable regime prices track fundamentals reasonably well, which makes it possible for technical strategies to extract information from incoming market data without going through the trouble and expense of fundamental research. Such strategies can therefore prosper and proliferate, provide that they remain sufficiently rare. But if they become too common, markets are destabilized, asset price bubbles can form, and the value of fundamental information rises. When a major correction arrives, it is the fundamental strategies that prosper, the composition of trading strategies is shifted accordingly, and market stability is restored for a time. This process of endogenous regime switching provides one possible interpretation of the empirical phenomenon known as volatility clustering.
From this perspective, it is critically important that technical trading strategies to be allowed to suffer losses when market instability arises. The cancellation of trades in almost 300 securities after the flash crash of May 6 did exactly the opposite, by providing an implicit subsidy to destabilizing strategies. The excuse that this was done to protect retail investors whose stop orders were executed as prices fell to insane levels is unconvincing. According to the SEC's own report on the crash, most trades against stub quotes of five cents or less were short sales, and there was also considerable upward instability, with prices rising well beyond the reach of ordinary retail investors. (Shares in Sotheby's, for instance, changed hands at ten million dollars per round lot.) The cancellation of trades was therefore a bailout of some funds (heavily reliant on algorithmic trading) at the expense of others, and this prevented a stabilizing shift in the market composition of trading strategies.
A similar argument could be made about the effects of the Troubled Asset Relief Program. It has recently been claimed, for instance by Alan Blinder and Mark Zandi, that TARP has been a "substantial success" because it averted a second Great Depression at a cost to taxpayers that is turning out to be much lower than originally feared:
The Troubled Asset Relief Program was controversial from its inception. Both the program’s $700 billion headline price tag and its goal of “bailing out” financial institutions—including some of the same institutions that triggered the panic in the first place—were hard for citizens and legislators to swallow. To this day, many believe the TARP was a costly failure. In fact, TARP has been a substantial success, helping to restore stability to the financial system and to end the freefall in  housing and auto markets. Its ultimate cost to taxpayers will be a small fraction of the headline $700 billion figure: A number below $100 billion seems more likely to us, with the bank bailout component probably turning a profit.
Yves Smith is unpersuaded by such figures, which she attributes to "back door, less visible bailouts, super cheap interest rates, [and] regulatory forbearance." But even if one were to take at face value the Blinder-Zandi estimates of the revenue consequences of TARP, there remain potentially harmful effects on the size composition of firms and the distribution of financial practices. The institutions that were bailed out made directional bets that either failed directly, or were with counterparties that would have failed in the absence of government support. Smaller institutions making such mistakes were allowed to go under, while larger ones were bailed out. Quite apart from the unfairness of this, the policy could be severely damaging to the stability of the system over the medium run.
This point was made a couple of months ago in a speech by Richard Fisher of the Dallas Fed (and expanded upon by Tyler Durden and Ashwin Parameswaran shortly thereafter):
Big banks that took on high risks and generated unsustainable losses received a public benefit... As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition...
The system has become slanted not only toward bigness but also high risk... Clearly, if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult. In this manner, high risk taking by big banks has been rewarded, and conservatism at smaller institutions has been penalized...

It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises.
Fisher goes on to argue for strict limits on the size of individual financial institutions relative to that of the industry. So does Nouriel Roubini:
Greed has to be controlled by fear of loss, which derives from knowledge that the reckless institutions and agents will not be bailed out. The systematic bailouts of the latest crisis – however necessary to avoid a global meltdown – worsened this moral-hazard problem. Not only were “too big to fail” financial institutions bailed out, but the distortion has become worse as these institutions have become – via financial-sector consolidation – even bigger. If an institution is too big to fail, it is too big and should be broken up.
But were the bailouts really necessary to avoid a global meltdown? Blinder and Zandi argue that the alternative would have been completely catastrophic:
The financial policy responses were especially important. In the scenario without them, but including the fiscal stimulus, the recession would only now be winding down, a full year after the downturn’s actual end... The differences between the baseline and the scenario based on no financial policy responses... represent our estimates of the combined effects of the various policy efforts to stabilize the financial system — and they are very large. By 2011, real GDP is almost $800 billion (6%) higher because of the policies, and the unemployment rate is almost 3 percentage points lower. By the second quarter of 2011 — when the difference between the baseline and this scenario is at its largest — the financial-rescue policies are credited with saving almost 5 million jobs.
Here the baseline is the set of policies actually pursued (including fiscal and financial policies) and it is being compared to the case of "no financial policy responses." However, as Yves Smith and Barry Ritholtz have pointed out, this is an absurd counterfactual. Barry argues that  the proper point of comparison ought to be what should have been done, which in his view is the following:
One by one, we should have put each insolvent bank into receivership, cleaned up the balance [sheet], sold off the bad debts for 15-50 cents on the dollar, fired the management, wiped out the shareholders, and spun out the proceeds, with the bondholders taking the haircut, and the taxpayers on the hook for precisely zero dollars. Citi, Bank of America, Wamu, Wachovia, Countrywide, Lehman, Merrill, Morgan, etc. all of them should have been handled this way.

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

And today, we would have a much healthier economy.
Whether or not one agrees with this assessment, Yves and Barry are surely correct in arguing that counterfactuals other than the hands-off policy ought to be considered before one accepts the emerging conventional wisdom that the authorities handled the crisis well.
What the broken trades trades of May 6 and the bailouts of 2008 have in common is that they were both impulsive decisions, designed to deal with immediate concerns, and executed with little regard for their long term consequences. As I said in an earlier post, these decisions were made under enormous pressure with little time for reflection, and mistakes made in such circumstances would ordinarily be forgivable. But to insist that the best available course of action was taken, and that any alternative would have had devastating economic costs, is neither credible nor wise.

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Update (8/20). The comments on this post by Andy Harless, David Merkel and Economics of Contempt are worth reading. Andy thinks that I am attacking a straw man and that the Ritholtz proposal was not even feasible, let alone optimal. David questions the use by Blinder and Zandi of a forecasting model to generate counterfactuals, given the appalling performance of such models in predicting the crisis in the first place. And here's Economics of Contempt:
"Smaller institutions making such mistakes were allowed to go under, while larger ones were bailed out."

I have to take issue with that statement. Yes, large banks were bailed out, but hundreds upon hundreds of small banks were bailed out too! Fully 836 financial institutions were bailed out using TARP money, the vast majority of which were small banks. While it's true that most of the bank failures have been small banks, there were large banks that were allowed to fail too -- e.g., Lehman, WaMu.

As for Barry Ritholtz's alternative scenario, there are too many basic factual errors to take it seriously. For one thing, receivership wasn't available to non-commercial banks. It was also legally impossible to separate AIGFP from AIG, since AIG had unconditionally guaranteed all of AIGFP's liabilities, and all their trades included cross-default provisions. A lot of the actions Barry proposes were literally impossible to do. It's simply not a credible list, and I'm surprised that you would fall for it.

Finally, I think it's unfair to say that the bailouts created bad precedents without also mentioning that we now have a resolution authority for non-bank financial institutions. How are decisions that were made without the availability of a resolution authority proper precedents for decisions that will be made with a resolution authority? You would never say that decisions made in pre-FDIC bank failures are proper precedents for post-FDIC bank failures, would you?
These are all good points. I probably should have been a bit more skeptical when discussing the Ritholtz scenario. I did not intend to endorse his proposal, only to suggest that we need to think through a broad range of counterfactuals in evaluating the response to the crisis. But of course these counterfactuals must be feasible given the tools available at the time, and his point about the resolution authority is well taken.

What bothered me most about Geithner's congressional testimony was his claim that "the government’s strategy regarding AIG was essential to our success in confronting the worst financial crisis in generations." That is, in averting an economic calamity, there was no alternative to the government making massive payouts on privately negotiated speculative bets. This is a bold claim with very serious consequences and ought not to be made lightly. In particular, the consequences of alternative scenarios has to be traced out with some seriousness.

18 comments:

  1. Does anyone insist that "the best available course of action" was taken, and that "any alternative" would have had devastating economic costs? I don't think I've heard anyone make that claim. The question is not, "Was the TARP the best possible response?" but "Was the TARP a good response?" Not that the Blinder-Zandi study is the definitive piece of evidence on that point, but it's something.

    As for Barry Ritholtz' idea, I don't think it was even feasible, let alone optimal. It would be easy if one could simply have declared those banks to be insolvent and put them into receivership, but they weren't clearly insolvent. It would have required some bureaucrat to say, "We think your bank is in shaky enough to be a danger to the system, so we're going to liquidate it." It might be nice if we had Barry Ritholtz as our benevolent dictator, but unfortunately we live in a constitutional democracy where there are limits on the government's authority.

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  2. Andy, take a look at Geithner's testimony on AIG:

    http://blogs.wsj.com/deals/2010/01/27/tim-geithners-prepared-testimony/tab/article/

    And that of Bernanke:

    http://www.federalreserve.gov/newsevents/testimony/bernanke20090324a.htm

    I don't know about you, but it sounds to me like they think the best available course of action was taken, or something close to it, and that anything short of an AIG bailout would have had catastrophic consequences. Perhaps you agree with this assessment. I don't.

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  3. Also, Andy, Barry is clearly talking about insolvent banks in his post, not just shaky banks that some bureaucrat deems to be insolvent. His proposal seems to me to require less of an expansion of government power than TARP did. But we're obviously reading this very differently.

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  4. "Smaller institutions making such mistakes were allowed to go under, while larger ones were bailed out."

    I have to take issue with that statement. Yes, large banks were bailed out, but hundreds upon hundreds of small banks were bailed out too! Fully 836 financial institutions were bailed out using TARP money, the vast majority of which were small banks. While it's true that most of the bank failures have been small banks, there were large banks that were allowed to fail too -- e.g., Lehman, WaMu.

    As for Barry Ritholtz's alternative scenario, there are too many basic factual errors to take it seriously. For one thing, receivership wasn't available to non-commercial banks. It was also legally impossible to separate AIGFP from AIG, since AIG had unconditionally guaranteed all of AIGFP's liabilities, and all their trades included cross-default provisions. A lot of the actions Barry proposes were literally impossible to do. It's simply not a credible list, and I'm surprised that you would fall for it.

    Finally, I think it's unfair to say that the bailouts created bad precedents without also mentioning that we now have a resolution authority for non-bank financial institutions. How are decisions that were made without the availability of a resolution authority proper precedents for decisions that will be made with a resolution authority? You would never say that decisions made in pre-FDIC bank failures are proper precedents for post-FDIC bank failures, would you?

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  5. My point regarding Blinder and Zandi is this: we don't know what the results would have been without the bailout. Macroeconomic modeling certainly did not forecast what happened, so why should it be able to tell us what would have happened in the absence of a bailout?

    Yes, things would have gotten worse in the short run without it, and allowing some big banks to fail would have made things edgy, but it would have been a big step in cleaning up the overindebtedness of the US economy. Failure is a major way of curing a debt bubble, forcing exchanges of debt-for-equity. Yes, prosperity would decrease for a time, but most of that prosperity was a debt-fueled illusion, so it would merely restore the economy to what is sustainable.

    Bailouts are just more of the "hair of the dog that bit us." They don't solve the problem driving our crisis: too much debt.

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  6. EC, thank you for your informative and helpful comment.

    I probably should have been a bit more skeptical when discussing the Ritholtz scenario. I did not intend to endorse his proposal, only to suggest that we need to think through a broad range of counterfactuals in evaluating the response to the crisis. But of course these counterfactuals must be feasible given the tools available at the time. Your point about the resolution authority is well taken.

    What bothered me about Geithner's congressional testimony on AIG was the suggestion that in order to avert an economic calamity it was necessary for the government to make good on large privately negotiated speculative bets. This is a bold claim with very serious consequences and ought not to be made lightly. In particular, the consequences of alternative scenarios has to be traced out with some seriousness.

    David, the Blinder-Zandi estimates are subject to model risk, but this would be true of any such exercise. My view is that it's better to have these estimates than not to have them, and to explore robustness using alternative models. But one can't just compare the chosen policy to business as usual - other kinds of aggressive policy responses - fiscal, monetary and financial - need to be explored. That's my main concern with their analysis. But you're right, there's lots of uncertainty surrounding these projections.

    Thanks to both of you (and Andy too) for commenting, I read your blogs regularly.

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  7. Fantastic post linking micro and macro. Thanks!

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  8. The Beja/Goldman analysis is certainly applicable to TARP. But it should be applied to the bondholders and shareholders of financial institutions, and not to the financial institutions themselves. Before the crisis, shareholders and especially bondholders of financial institutions were not doing anything resembling proper fundamental analysis, and TARP should have made them suffer. A massive dilution of shareholders and large bondholder haircuts should have sent the proper message.

    But we should not throw the baby with the bathwater. Operations of large financial institutions have huge value, for example, Lehman's broker is still functioning under the Barclays umbrella. Ritholtz's idea to sell-off all bad debts would destroy lots of economic value and is equivalent to selling foreclosed homes brick by brick.

    TARP with proper punishment for foolish investors would have preserved the current macro performance avoiding even sharper crisis that is favored by Ritholtz. Such modified TARP would properly incentivize shareholders and bondholders of large financial institutions. Large financial institutions would naturally shrink as diseconomies of scale would not be outweighed by TBTF benefits, but this should be a slow natural process that preserves good bits of large financial institutions.

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  9. Why couldn't the Treasury have pushed for emergency resolution authority when/instead of pushing for TARP?

    The excuse that resolution authority was not available then is pathetic, as it wasn't asked for. The assertion that resolution authority is available now is laughable, as political will is a critical element to that authority. Finally, the "resolution authority" granted in the Financial Bill is weak tea, as I don't believe it deals with cross border asset holders. How would the US Govt wind down Citi, for example? Write cheques to a bunch of Pakistanis?

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  10. 123, I broadly agree - my main purpose here was to shift the terms of the debate away from whether TARP was better than doing nothing, and to ask whether there were feasible alternatives that did not involve government payouts on speculative bets.

    Winterspeak, welcome - it's good to have your perspective represented here. I'm not really qualified to comment on the legal intricacies of what was possible at the time, or indeed on what is now possible. But I'm frustrated by the repeated claims by Fed and Treasury officials (Geithner, Bernanke, Dudley) that any failure to pay out fully on AIG's obligations, or to purchase assets at prices well above any reasonable estimate of their long term value, would have resulted in calamity. I think we are in agreement on this.

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  11. Rajiv - just a quick comment. The one part of Barry Ritholz's counterfactual that I wholeheartedly endorse is the suggestion that Bear Stearns should have been let go. The real problem was not that Lehman was allowed to fail, but that Bear Stearns was saved after which Lehman was allowed to fail - essentially creditors were lulled into a false sense of security which was shattered by the Lehman collapse. The Bear Stearns creditor bailout resulted in a dramatic fall in Lehman CDS spreads and despite a steady fall in Lehman's stock price, the CDS did not react violently until weeks before the eventual collapse in September (Lehman 5y CDS was below 300 right until September when it exploded to 800 or so).

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  12. Ashwin, thanks, this makes sense. And Barry seems to be arguing that Bear Stearns would have been bought by JPM even without government guarantees, given their exposure to Bear derivatives.

    The one counterfactual that I would really like to understand concerns AIG. Barry believes that AIG-FP could have been carved out for dissolution while the insurer continued to exist. Economics of Contempt argues that this would have been impossible. Which is it? Was there any alternative to making government payouts on AIG-FP obligations?

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  13. I'm no expert on insurance regulations but way I understood it is as follows: AIGFP was guaranteed by the holding company so AIG Inc would almost certainly have gone bankrupt on the back of AIGFP. But the insurance subsidiaries are mostly walled off and no state regulator would allow the holding company to access the insurer's assets in such a situation. What's more, the state has the authority to take over and run the insurance sub in the interests of the policyholder. And if this doesnt work, there's a deposit-insurance like scheme provided at the state level if the subsidiary turns out to be undercapitalised.

    Again this is just from secondary sources so could be wrong - a couple of relevant links from the period http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aqgbtQFLlxzM&refer=home
    http://biz.yahoo.com/wallstreet/080917/sb122159859013744663_id.html?.v=1

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  14. Thanks Ashwin, that's consistent with my recollection too. In Geithner's congressional testimony on AIG, he said the following:

    "Without assistance, the AIG parent holding company would have been forced to file for bankruptcy protection like Lehman Brothers, resulting in default on over $100 billion of debt, as well as trillions of dollars of derivatives. Such a filing would have caused insurance regulators in the United States and around the world to take over AIG’s insurance subsidiaries, potentially disrupting households’ and businesses’ access to basic insurance. And since many of the insurance products that AIG sold were a form of long-term savings, the seizure by local regulators of AIG’s insurance subsidiaries could have delayed Americans’ access to their savings, potentially triggering a run on other institutions."

    It seems to me that there were enough protections in place to prevent disruptions in access to insurance, or a run on insurance providers. If this is the case, then my feeling is that the parent holding company should have been forced into bankruptcy. Aside from vague arguments about contagion, I don't see much in Geithner's testimony to persuade me otherwise. Certainly the default on debt and derivatives positions is not obviously worse than an indirect bailout of those who severely underestimated counterparty risk.

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  15. Most of the institutions Barry Ritholtz lists were never legally insolvent. I guess he's arguing that they would have become legally insolvent, but who really knows? Even if he's right about that, the process of allowing them to become legally insolvent would not have been the short, sharp shock he seems to imagine. It could have been quite a drawn out process.

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  16. Andy, this is exactly what I've been trying to get my head around. The AIG failure would have set a lot of dominos tumbling, that's for sure. But what would have been the real resource cost, the impact on output and employment, if more traditional policy responses (fiscal, monetary and lender of last resort) had been used aggressively instead of bailouts? This is the proper counterfactual, which I don't think the Blinder-Zandi simulations address.

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  17. Rajiv:

    “Was there any alternative to making government payouts on AIG-FP obligations?”

    You might find this interesting:

    http://www.c-span.org/Watch/Media/2010/06/30/HP/R/34942/Financial+Crisis+Inquiry+Commission+Hearing+on+Derivatives.aspx

    It’s AIG’s Cassano et al in front of the commission.

    In particular, two sections totalling 5 minutes:

    1:25 to 1:28

    2:28 to 2:30

    It’s Cassano’s personal view (for what it’s worth) on what should have been done instead of 100 per cent taxpayer bailout.

    I found the entire video to be pretty interesting.

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  18. JKH, thanks... this is very interesting (though the idea of Cassano negotiating on behalf of taxpayers is a bit bizarre to me.) The sections you identified deal with how high the government payouts to counterparties should have been, rather than whether there should have been any such payouts at all. But I'll listen to the whole three hour long session as soon as I find time.

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