"maybe we ought to have a two-tier financial system,"

From Justin Fox:

"Myron Scholes, intellectual godfather of the credit default swap, says blow 'em all up

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Myron Scholes, whose Black-Scholes option pricing model provided the intellectual underpinning for modern derivatives markets, thinks one particular derivatives market—that for credit default swaps—is due for a Red Adair style rescue. Or a Fred Adair style rescue.

Red Adair put out oil well fires by setting off gigantic explosions at the wellhead. "My belief is that the Fred Adair solution is to blow up or burn the OTC market in credit default swaps," Scholes said this morning. What that means, he elaborated, is that regulators should "try to close all contracts at mid-market prices" and then start up the market anew with clearer rules and shorter-duration contracts.

This was at a conference at New York University occasioned by a new collection of papers on how to fix the financial system, authored by a bunch of NYU Stern School faculty. Scholes kept saying Fred Adair. Sometimes he'd notice and correct himself, sometimes he wouldn't. The FT's John Gapper, who was on a panel with Scholes, finally speculated that this was because the government response to the financial crisis has been such an unwieldy mix of Fred Astaire (dancing around the problems) and Red Adair (doing something to fix them). Scholes did not disagree.

The blow-up-the-CDSes option is intriguing, and I'm going to check in with Scholes later to see if he wishes to elaborate. But for now, a few more notes from the panel, which was moderated by Paul Volcker and also featured NYU finance professor Matt Richardson:

Some would say Scholes is partly to blame for this whole mess, and Volcker dropped a couple of hints in that direction. Scholes didn't exactly accept responsibility, but neither did he give a blindered, Chicago-style defense. For one thing, he cited John Maynard Keynes—still a nonperson to many of Scholes's fellow Chicago Ph.Ds—arguing that we're currently stuck in a situation where the financial system needs to deleverage, but its current deleveraging is causing asset values to plummet, meaning that it's not succeeding in deleveraging at all (that is, debt is down, but so is the value of everybody's capital, so leverage ratios aren't declining). For another, he seemed to agree with one of the main criticisms of the Wall Street risk models that evolved in part from Black-Scholes—that they have some ability to capture the risks faced by one investor operating in a financial market that the investor is too small to influence, but aren't much good at capturing the risks faced by the entire market. "Risk aggregation is not linear," he said. "It's nonlinear." (This is what Chapter 13 of The Myth of the Rational Market is about. Doesn't that sound exciting?)

As the moderator, Volcker didn't say all that much. He did talk for a bit, though, about how "maybe we ought to have a two-tier financial system," with a heavily regulated "core part that I will for purposes of simplicity call commercial banking" and a less-regulated outer realm of hedge funds, proprietary trading desks, and such. Hmmm, said Gapper, that "reminds me of something I once heard of called the Glass-Steagall Act." This Glass-Steagall revivalism is happening all over. I'm even beginning to feel the spirit. But Gapper had an interesting question: "If you wanted to set up a new Glass-Steagall, where would you draw the line?"

Scholes finally got his free-market Chicago dander up over the possibility of synchronized global financial regulation—something that Volcker has been advocating as chairman of the Group of Thirty project on financial reform—sparking this entertaining exchange:

Scholes: If we internationalize everything, we end up with rules that stifle freedom and innovation. Mr. Sarkozy and others say our system has failed and we should adopt theirs. Do we want to become French?

Volcker: I'm not an acolyte of Mr. Sarkozy.

Gapper: Actually, the French banks are big derivatives users.

Volcker: The U.S. is no longer in a position to dictate to the rest of the world."

Me:

1. donthelibertariandemocrat Says:
   Friday, March 6, 2009 at 6:46 pm

   In my mind, the Glass repeal was a mistake, but not an obvious one at the time. Now it is. I'm going to bring up the S & L Crisis again. In that crisis, you had a kind of faux free market deregulation, that was built, paradoxically,upon government guarantees. This ended up being a bad brew.

   In this crisis, the Glass repeal and other faux free market deregulation, we now know, was built upon government guarantees. When these faux free market plans pass, there's a kind of implicit assumption that the businesses affected will live and die on their own without government intervention of any kind. That's what free market usually means to most people. Since there was no explicit policy about government guarantees or even insolvent large banks, many people assumed that taxpayers were shielded from any problems caused by this deregulation. We were wrong.

   If there are going to be government guarantees, then I believe that we should have narrow banking, which is guaranteed, and another financial sector which is not guaranteed, but supervised. The key to me is the extent of possible government involvement.

   My main point is that we should no longer accept ambiguity in these areas.

   Richardson also has a good essay on nationalisation, in which he said this:

   "In a recent conversation, Myron Scholes told me he was also in favour of nationalisation – as long as it lasts just 10 minutes."

Last year Myron Scholes predicted the credit crisis would be over on 7th March 2009.

From Knowing And Making:

"Myron Scholes - crisis to end in March

Last year Myron Scholes predicted the credit crisis would be over on 7th March 2009.

That's coming up this Saturday, so how's the prediction looking?

Well, AIG has lost $60bn and received a further capital injection; the US government has just converted a bunch of debt into 30-odd percent of Citigroup; Martin Wolf has written another article with some nasty-sounding predictions. We're running short of time to fix the system if Myron is to be proved right.

To be clear, this is not about the recession. I don't think we expect economic growth to start in the next four days. It's about fixing the problems in the financial system so that money can start flowing and the recovery can properly begin.

The debate in the US over nationalisation is growing louder. Unusually, the argument is getting simpler rather than more complicated: the losses are there, shareholders have been (as close as makes no difference) wiped out, so do the remaining losses go to creditors or taxpayers?

If no government action is taken, and banks go under, creditors will lose substantially (in the short term). The argument against this (made by Justin Fox at Time) is that if creditors take a loss, they will immediately stop lending to all financial institutions. This would be disastrous for economic efficiency and make the recession much worse. Another argument which he doesn't mention is that even the possibility of this happening will cause a series of bank runs as creditors try to take their money out. However, sufficient government guarantees have been given already to probably prevent this from happening in the short term.

On this argument, taxpayers need to take the hit. But there is at least one counterargument.

Lending is, in theory, based on the returns people expect in future and not those they have received in the past. Therefore, if bank creditors take a haircut in a way that is credibly not going to happen again in the future, their lending behaviour should - in theory - be unaffected.

For example, if this policy were instituted in the US, simultaneously with a constitutional amendment saying that it could never be done again, owners of wealth might have the confidence to keep lending. In theory. Note that the amendment would probably need to be backed up with substantial regulatory legislation to protect taxpayers from the unlimited future losses that might result from the moral hazard created.

Or if the system were credibly recapitalised and regulated in such a way that creditors felt a financial bubble could never happen again, it might work. In theory.

But in reality, creditors who have just lost 10% - or 40% - of their money are unlikely to trust in such promises. Even in the unlikely event that they behave with perfect rationality, it's probably rational to wait a while before reinvesting to protect yourself against legislative instability. And they're not likely to be rational; they're likely to, frankly, fly into a tantrum and start pulling their money out of all sorts of places.

If only there were a way for governments to invisibly reduce creditors' claims without openly confiscating their assets - and without destroying future confidence in property rights. A way for creditors and taxpayers to wink at each other; colluding in sharing the pain, without losing the faith in credit that has built our economic system. Game theory suggests that rational players can lose a round or two if they believe the game will be played enough times in the future to make it worthwhile to keep playing.

There is, of course, such a way - inflation. 10-15% inflation over the next three years would probably haircut creditors sufficiently to eliminate the banking system's deficits. A number of respectable people (Scott Sumner for example) are arguing for an official, pre-announced inflation target (or alternatively a 3 or 5-year target for nominal prices) which would presumably give the banks enough breathing room to sort themselves out within that timeframe.

In rational terms, this is no different than chopping off 3% off creditors' assets each year; but it's within the rules of the 'con game' that is the world monetary system and economy (and I use that term with affection). And thus, it won't have the same destructive effect on confidence.

Of course it is a bit unfair; it forces creditors everywhere to subsidise the creditors who lent to insolvent banks; and it will take some time to work. It creates its own moral hazard problems too. But maybe we have to be utilitarian, let the kids threaten their temper tantrum and give in because it's just easier.

If President Obama and the IMF could just announce it all by Friday, Myron Scholes will have been right and I'll buy him a bottle of champagne. Let me know if you want to claim it, Professor Scholes."

Me:

Don said...

A Fable:

There was an even called the S & L Crisis:

http://www.uwsa.com/issues/cfr/quicksandl.html

"The S&L crisis was caused by economic factors but was greatly exacerbated by five specific policy decisions:

* Lending requirements were loosened as described above.
* Deposit Insurance was raised from $40,000 to $100,000.
* Enforcement of the law by banking regulators was decreased.
* Politicians actively interfered in investigations of failing thrifts on behalf of specific S&L owners .
* Implementation of the solution was delayed until the industry itself couldn't possibly pay for it and taxpayers were stuck with the bill."

And then:

http://www.washingtonpost.com/wp-dyn/content/article/2008/11/24/AR2008112402593_pf.html

"Looser enforcement of banking laws would eventually allow Citi to expand into other forms of banking. And when regulations got in the way, Wriston, like Mitchell before him, found ways around them.

At the time, national banking regulations kept Citi out of the market for commercial paper -- a form of debt sold by companies to help meet short-term credit needs. Citi figured out that those restrictions applied only to multi-bank holding companies and set up Citicorp as a single-bank holding company, with Citibank as its subsidiary.

In the 1980s, Citi and other banks ran into trouble over loans made to developing countries in Latin America on the assumption that sovereign nations don't go bankrupt. Citi and other banks faced billions of dollars in potential losses when Mexico became insolvent in 1982. The government stepped in with the Brady Plan to help sell Latin American nations' debt and have the banks write off some of it.

Citi needed help again during the recession of the early 1990s. It accumulated $10 billion in bad loans, many related to leveraged buyouts or commercial real estate. Its stock price fell, and rumors of bankruptcy began to circulate. The Federal Reserve came to the rescue with several interest rate cuts.

To weather future crises better, Citi executives believed the company needed to become even larger and more diversified, a true one-stop financial services firm where consumers could go for checking, brokerage and insurance services."

And then:

http://www.gao.gov/archive/2000/gg00067r.pdf

11. Did the Federal Reserve’s intervention create new incentives
for other large financial institutions to take huge financial market
risks in the future?
Any type of intervention creates the potential for increased moral hazard;
however, the long-term implications of FRBNY’s involvement in the
recapitalization are unknown. Although the FRBNY stressed that its
actions were dictated by the state of worldwide financial markets at that
time, its actions raised concerns among some industry officials about
moral hazard. Some industry officials said that FRBNY’s involvement in
the rescue, however benign, would encourage large financial institutions to
assume more risk, in the belief that the Federal Reserve would intervene
on their behalf. According to FRBNY officials, it is unlikely LTCM’s
creditors would have been able to work together to avoid the rapid
liquidation of the Fund if FRBNY officials had not intervened. Thus,
FRBNY’s intervention probably affected the outcome in this case and, over
time, such actions could increase moral hazard and potentially undermine
the effectiveness of market discipline.
12. Did the Federal Reserve’s intervention in the rescue of LTCM
create unacceptable risks to the federal deposit insurance system
or expose American taxpayers to a threat of future hedge fund
bailouts?
Enclosure
Questions Concerning LTCM and Our Responses
Page 15 GAO/GGD-00-67R Questions Concerning LTCM and Our Responses
Although no federal dollars were involved in the recapitalization of LTCM,
the Federal Reserve’s involvement has raised concerns among some that
the “too big to fail” doctrine has been expanded to include hedge funds.
Federal Reserve officials have testified that its facilitation of the
recapitalization of LTCM was not an expansion of “too big to fail”13 and had
the private-sector recapitalization not come together, LTCM would have
been allowed to fail. However, if companies believe that the federal safety
net has been expanded, it may encourage more risky business practices.
Based on the LTCM experience, if problems surface during periods of
market turmoil, regulators may decide that some form of federal
intervention, albeit nonfinancial, may once again be necessary."

And then, in 2005, this was not posted on the internet:

http://www.msfinance.ch/pdfs/AnnelisLuescher.pdf

"It should by now have become clear that the Gauss one factor model is not the
right model to price CDOs and that we are in desperate need for a convincing
alternative. In this thesis, three promising models for pricing synthetic CDOs
were for the first time compared to each other and to the Gauss one factor
model. Further tests using current market data are necessary before we can
conclude on a superiority of any of the three models."

These are things which couldn't have happened, since they show that moral hazard matters, and that there simply wasn't enough data, under the best of circumstances, to rely on CDO risk models. These are such obvious, prudent points, that, in the real world, where people aren't idiots, the current crisis couldn't have occurred. And you surely couldn't have had a housing bubble, following on a tech bubble. That would have shown that bubbles can still occur. And people couldn't have loaned money to the riskiest borrowers at the top of a market, with loans that didn't cement in low rates.

This is all a fable. A counterfactual. Right? But I'm a Modal Realist, so, it did happen in some world, just not ours.

Remember, I'm a novelist. In fact, I write horror and satire. I'll let the reader decide which this fable qualifies as.

Don the libertarian Democrat

04 March 2009 16:18

"So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. "

Taleb again, in the FT with Pablo Triana:

"On March 13 1964, Catherine Genovese was murdered in the Queens borough of New York City. She was about to enter her apartment building at about 3am when she was stabbed and later raped by Winston Moseley. Moseley stole $50 from Genovese’s wallet and left her to die in the hallway.

Shocking as these details surely are, the lasting impact of the story may lie elsewhere. For plenty of people reportedly witnessed the attack, yet no one did much about it. Not one of the almost 40 neighbours who were said to have been aware of the incident left their apartments to go to Genovese’s rescue.

Not surprisingly, the Genovese case earned the interest of social psychologists, who developed the theory of the “bystander effect”. This claimed to show how the apathy of the masses can prevent the salvation of a victim. Psychologists concluded that, for a variety of reasons, the larger the number of observing bystanders, the lower the chances that the crime may be averted.

We have just witnessed a similar phenomenon in the financial markets. A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free society). There were plenty of bystanders. And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods)."

I'm with him completely. Remember Fraud, Negligence, Fiduciary Mismanagement, and Collusion? But who are the bystanders? Let's catch the actual culprits first.

"Let us start with the bystander. Almost everyone in risk management knew that quantitative methods – like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. LTCM was just one in hundreds of such episodes."

Okay. I agree.

"Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: “Lehman Brothers and Morgan Stanley use the model” or “it is on the CFA exam” or, the most potent argument, “modern finance and portfolio theory got Nobels”. Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible."

If they took part, then they're culprits, not bystanders.

"So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory – it is uniformly on the programme for next semester. An airline company would ground the aircraft and investigate after the crash – universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen."

Okay. Fine. But does anyone ever do time for these crimes, beyond a few token high profile cases?

"Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide be-hind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”

If they're not going to listen to you, I doubt that they'll listen to me. I'll give it a try anyway.