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How to value toxic assets (part 6)

Via Tyler Cowen, I am reminded (again) that I should really be reading Steve Waldman more often.  Like, all the time.  After reading John Hempton’s piece that I highlighted last time, Waldman writes, as an afterthought:

There’s another way to generate price transparency and liquidity for all the alphabet soup assets buried on bank balance sheets that would require no government lending or taxpayer risk-taking at all. Take all the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100 par value claims, put all extant information about the securities on a website, give ’em a ticker symbol, and put ’em on an exchange. I know it’s out of fashion in a world ruined by hedge funds and 401-Ks and the unbearable orthodoxy of index investing. But I have a great deal of respect for that much maligned and nearly extinct species, the individual investor actively managing her own account. Individual investors screw up, but they are never too big to fail. When things go wrong, they take their lumps and move along. And despite everything the professionals tell you, a lot of smart and interested amateurs could build portfolios that match or beat the managers upon whose conflicted hands they have been persuaded to rely. Nothing generates a market price like a sea of independent minds making thousands of small trades, back and forth and back and forth.

I don’t really expect anybody to believe me, but I’ve been thinking something similar.

CDOs, CDOs-squared and all the rest are derrivatives that are traded over the counter; that is, they are traded entirely privately.  If bank B sells some to hedge fund Y, nobody else finds out any details of the trade or even that the trade took place.  The closest we come is that when bank B announces their quarterly accounts, we might realise that they off-loaded some assets.

On the more popularly known stock and bond markets, buyers publicly post their “bid” prices and sellers post their “ask” prices. When the prices meet, a trade occurs.[*1] Most details of the trade are then made public – the price(s), the volume, the particular details of the asset (ordinary shares in XXX, 2-year senior notes from XXX with an expiry of xx/xx/xxxx, etc) – everything except the identity of the buyer and seller. Those details then provide some information to everybody watching on how the buyer and seller value the asset. Other market players can then combine that with their own private valuations and update their own bid or ask prices accordingly. In short, the market aggregates information. [*2]

When assets are traded over the counter (OTC), each participant can only operate on their private valuation. There is no way for the market to aggregate information in that situation. Individual banks might still partially aggregate information by making a lot of trades with a lot of other institutions, since each time they trade they discover a bound on the valuation of the other party (an upper bound when you’re buying and the other party is selling, a lower bound when you’re selling and they’re buying).

To me, this is a huge failure of regulation. A market where information is not publicly and freely available is an inefficient market, and worse, one that expressly creates an incentive for market participants to confuse, conflate, bamboozle and then exploit the ignorant. Information is a true public good.

On that basis, here is my idea:

Introduce new regulation that every financial institution that wants to get support from the government must anonymously publish all details of every trade that they’re party to. The asset type, the quantity, the price, any time options on the deal, everything except the identity of the parties involved. Furthermore, the regulation would be retroactive for X months (say, two years, so that we get data that predates the crisis).  On top of that, the regulation would require that every future trade from everyone (whether they were receiving government assistance or not) would be subject to the same requirementes.  Then everything acts pretty much like the stock and bond markets.

The latest edition of The Economist has an article effectively questioning whether this is such a good idea.

[T]ransparency and liquidity are close relatives. One enemy of liquidity is “asymmetric information”. To illustrate this, look at a variation of the “Market for Lemons” identified by George Akerlof, a Nobel-prize-winning economist, in 1970. Suppose that a wine connoisseur and Joe Sixpack are haggling over the price of the 1998 Château Pétrus, which Joe recently inherited from his rich uncle. If Joe and the connoisseur only know that it is a red wine, they may strike a deal. They are equally uninformed. If vintage, region and grape are disclosed, Joe, fearing he will be taken for a ride, may refuse to sell. In financial markets, similarly, there are sophisticated and unsophisticated investors, and unless they have symmetrical information, liquidity can dry up. Unfortunately transparency may reduce liquidity. Symmetry, not the amount of information, matters.

I’m completely okay with this. Symmetric access to information and symmetric understanding of that information is the ideal. From the first paragraph and then the last paragraph :

… Not long ago the cheerleaders of opacity were the loudest. Without privacy, they argued, financial entrepreneurs would be unable to capture the full value of their trading strategies and other ingenious intellectual property. Forcing them to disclose information would impair their incentive to uncover and correct market inefficiencies, to the detriment of all …

Still, for all its difficulties, transparency is usually better than the alternative. The opaque innovations of the recent past, rather than eliminating market inefficiencies, unintentionally created systemic risks. The important point is that financial markets are not created equal: they may require different levels of disclosure. Liquidity in the stockmarket, for example, thrives on differences of opinion about the value of a firm; information fuels the debate. The money markets rely more on trust than transparency because transactions are so quick that there is little time to assess information. The problem with hedge funds is that a lack of information hinders outsiders’ ability to measure their contribution to systemic risk. A possible solution would be to impose delayed disclosure, which would allow the funds to profit from their strategies, provide data for experts to sift through, and allay fears about the legality of their activities. Transparency, like sunlight, needs to be looked at carefully.

This strikes me as being around the wrong way.  Money markets don’t rely on trust because their transactions are so fast; their transactions are so fast because they’re built on trust.  The scale of the crisis can be blamed, in no small measure, because of the breakdown in that trust.

I also do not buy the idea of opacity begetting market efficiency.  It makes no sense.  The only way that information disclosure can remove the incentive to “uncover and correct” inefficiencies in the market is if by making the information public you reduce the inefficiency.  I’m not suggesting that we force market participants to reveal what they discover before they get the chance to act on it.  I’m only suggesting that the details of their action should be public.

[*1] Okay, it’s not exactly like that, but it’s close enough.

[*2] Note that information aggregation does not necessarily imply that the Efficient Market Hypothesis (EMH), but the EMH requires information aggregation to work.

Other posts in this series:  1, 2, 3, 4, 5, [6].

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Whyte is wrong to think that Brown is wrong

Writing in Friday’s FT, Jamie Whyte argues that Gordon Brown is wrong to think that regulating bankers’ bonuses to stop the culture of short-term thinking will avoid future financial crises.  He writes:

[I]magine you are the manager of a lottery company. Your job is similar to a banker’s. You sell tickets (make loans) that have a certain probability of winning a prize (of defaulting). To ensure long-run profits, you must set a price for the tickets (charge a rate of interest) that is sufficient to pay out the lottery winnings (cover the cost of defaulting borrowers).

But suppose you were a greedy lottery company manager, concerned more with your own bonus than with your shareholders’ interests. Here is a trick you might play. Offer jackpots, ticket odds and ticket prices that in effect give your customers money. For example, offer $1 tickets with a one-in-5m chance of winning a $10m prize. A one-in-5m chance of winning $10m is worth $2 . So each ticket represents a gift of $1 to its purchaser.

With such an attractive “customer value proposition” you would leave your competitors for dead. And if you limited ticket sales to, say, 1m a year, the chances are no one would win the prize. In most years you will earn $1m in ticket sales and pay nothing in prizes. When someone finally wins the $10m prize, and your company collapses, that will be a problem for shareholders and creditors; you will probably have pocketed a few nice bonuses already.

To prevent such wickedness, Mr Brown may insist that lottery managers be paid bonuses on the basis of long-term profits: five years’, let us say. No problem: simply set the prize at $100m and the chance of winning at one in 50m. Then you will be unlucky if anyone wins in a five-year period, and you can be confident of walking away with a fat bonus.

This is why, even if Mr Brown were right that short-term bonus plans caused the financial crisis, his proposed remedy would not help. Whatever time frame he mandates, it will always be too short. For, like lottery managers, bank managers can manipulate the “risk profile” of the bank so that large losses, although inevitable in the long run, are unlikely during the mandated period.

I like Mr. Whyte’s analogy, but as far as I can see, there are three problems in his logic.  For the sake of some numbers to talk about, I’ll consider the idea of a five-year delay in high-end bankers having access to their bonuses.

First, he’s missing the fact that for his lottery company to offer a prize of $100 million, it’s going to need some backers with much deeper pockets than if his prize is only $10 million.  Whyte quite correctly points out that risk has been mispriced, but provided that it’s got some price, scaling up without a larger customer pool (the equivalent of increasing the leverage of your bank) must come with extra costs.  Even if the wholesale market is willing to stand behind you, one option is to increase the duration until the size needed to outflank it would require bank mergers that would run foul of competition law.

Second, a key feature long-term bonuses is that they accumulate.   If bonuses are awarded annually but placed into escrow for five years, then even if the bad event doesn’t happen until year 10, there will be five years of bonuses available for claw-back.  All the bankers are currently giving up one year of bonuses.  By putting bonuses to one side, we magnify the value at risk faced by the bankers themselves.

Third, we need to recognise that nobdy lives forever, and while one year might not be so long when measured against a career, five years is a serious block of time.  The reputational effects of any failure would be increased and, I hope, institutional memory would be improved.

As I say, I agree that a mispricing of risk lies at the heart of the credit crisis.  I simply disagree with Mr. Whyte on why it occured.  I’m not sure why he thinks it occured, but I think that part of the cause is the short-term nature of bank incentives.

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Яolcats

Via a mysterious blogger some describe as a grumpy, toothless old man, I bring you:  ?olcats (English translations of Eastern Bloc Lolcats).  It’s important that you click through to see the images, but here are a few captions to whet your appetite:

  • The men I’ve sent to death weigh heavily on my mind; but this burden is but a fist of straw compared to the strain of the republic.
  • Have strength, my little cabbage. By the mercy of NKVD Order No. 00447, we have been chosen for Resettlement. We will show the tin mines of Kolyma the true power of the proletariat.
  • Aaaaah… Pig iron, your musk is that of glorious industry …
  • Cease your protests, the deal is done!  You are to make a fine wife for uncouth American businessman!
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From tacit to (almost) explicit: inflation targetting at the Fed

From the latest press release of the US Federal Reserve Board:

The central tendency of FOMC participants’ longer-run projections, submitted for the Committee’s January 27-28 meeting, were:

  • 2.5 to 2.7 percent growth in real gross domestic output
  • 4.8 to 5.0 percent unemployment
  • 1.7 to 2.0 percent inflation, as measured by the price index for personal consumption expenditures (PCE).

Most participants judged that a longer-run PCE inflation rate of 2 percent would be consistent with the dual mandate; others indicated that 1-1/2 or 1-3/4 percent inflation would be appropriate.

Speaking earlier in the day, Fed Chairman Ben Bernanke observed:

These longer-term projections will inform the public of the Committee participants’ estimates of the rate of growth of output and the unemployment rate that appear to be sustainable in the long run in the United States, taking into account important influences such as the trend growth rates of productivity and the labor force, improvements in worker education and skills, the efficiency of the labor market at matching workers and jobs, government policies affecting technological development or the labor market, and other factors. The longer-term projections of inflation may be interpreted, in turn, as the rate of inflation that FOMC participants see as most consistent with the dual mandate given to it by the Congress–that is, the rate of inflation that promotes maximum sustainable employment while also delivering reasonable price stability.

(Hat tip: Calculated Risk)

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Deriving the New Keynesian Phillips Curve (NKPC) with Calvo pricing

The Phillips Curve is an empirical observation that inflation and unemployment seem to be inversely related; when one is high, the other tends to be low.  It was identified by William Phillips in a 1958 paper and very rapidly entered into economic theory, where it was thought of as a basic law of macroeconomics.  The 1970s produced two significant blows to the idea.  Theoretically, the Lucas critique convinced pretty much everyone that you could not make policy decisions based purely on historical data (i.e. without considering that people would adjust their expectations of the future when your policy was announced).  Empirically, the emergence of stagflation demonstrated that you could have both high inflation and high unemployment at the same time.

Modern Keynesian thought – on which the assumed efficacy of monetary policy rests – still proposes a short-run Phillips curve based on the idea that prices (or at least aggregate prices) are “sticky.”  The New Keynesian Phillips Curve (NKPC) generally looks like this:

\pi_{t}=\beta E_{t}\left[\pi_{t+1}\right]+\kappa y_{t}

Where y_{t} is the (natural) log deviation – that is, the percentage deviation – of output from its long-run, full-employment trend and \beta and \kappa are parameters.  Notice that (unlike the original Phillips curve), it is forward looking.  There are criticisms of the NKPC, but they are mostly about how it is derived rather than its existence.

What follows is a derivation of the standard New Keynesian Phillips Curve using Calvo pricing, based on notes from Kevin Sheedy‘s EC522 at LSE.  I’m putting it after this vile “more” tag because it’s quite long and of no interest to 99% of the planet.

Continue reading “Deriving the New Keynesian Phillips Curve (NKPC) with Calvo pricing”

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New feature: I’m now printer-friendly!

By popular demand (well, one person asked me), I’ve installed WP-Print – a WordPress plugin that will allow you, valued readers, to see a printer-friendly version of any post or page on this blog.

Every post and page now has a link at the top that takes you to the printer-friendly version of that post or page.  If you live-and-die by the URI bar, it’s the usual address with “/print/” at the end.

Let me know if you have any problems.