"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Monday, April 26, 2010

Really great links - Greece - Greece II - Paul Krugman - Resolution Authority - Monetary policy and bubbles - Goldman

Nick Rowe - Greece - "It's difficult to know what will happen in the Eurozone. My own guess, for a worst-case scenario, is that we will see multiple Argentinas. No country will want to leave the Euro, but some might have no choice. The only way for a government to pay wages will be in scrip. That scrip will become a new national currency. They will rewrite the laws to make debts payable in the same national currencies."

Tyler Cowen - Questions that are rarely asked - "Was it predatory lending when they gave money to Greece?"

Paul Krugman - Ponzi and financial sector profits - "So I’d suggest that what we did between 1980 and 2008 was to replace a financial system in which profits were created by lack of competition with a system in which profits were created by misinformation and misperceptions — a giant, if mostly (not entirely) unintentional Ponzi scheme, which finally went bust."

Adam Levitin - Resolution Authority: What's Wrong With the Dodd Bill - "The Dodd bill gets things right on first principles: there needs to be some type of resolution authority, and it needs to provide the ability to impose haircuts on creditors. The bill accomplishes that much. But it goes way off the rails on a critical issue that has received virtually no discussion: how the resolution authorization process is supposed to work.
        There's been a good deal of ink spilled recently over how to regulate systemic risk, but little consideration of the institutional design of resolution authority. Who gets to decide to pull the plug on a troubled firm? And who gets to decide to provide support for other firms or sectors of the economy? "

Masaaki Shirakawa - Governor of the BoJ - Monetary policy and bubbles - Austro-Japanese economic theory - "There has already been considerable debate about the relationship between monetary policy and emergence of bubbles. One thing is clear: over-confidence is the core factor which breeds a bubble. In that sense, bubbles do not transpire from expectations of a continuation of low interest rates alone. This is, however, only a half of the truth. The other half is that bubbles do not materialize without expectations that low interest rates will continue. For me, the key question, which applies to many central banks including both the Bank of Japan and the Federal Reserve, is that, why we, as central banks, maintained interest rates at such a low level, in spite of the uneasiness we felt at that time toward the bubble-like symptoms."

Interfluidity - Goldman CDO - Hedging vs. speculation  - (H/T Broken Symmetry) - "As an investor, one always should ask oneself the question, “why would taking this position be more beneficial to me than to a counterparty willing to escape or oppose it?” Here are three answers: i) Personal situation: the asset is more valuable to me than to others (I need wheat in two months!); ii) speculative: I simply know better than my counterparty. iii) hedging: I suspect the average counterparty is overweight this exposure, and is willing to offer what would be a decent value to someone whose portfolio is uncorrelated with the exposure. Unless one assumes both efficient markets and homogenous investors, all three of these things are reasonable to think about, and I think successful investors do think about them routinely. If an investor does not believe herself to have special information about the “fundamental” value of a contract or commodity, she still may believe that hedging demand for a product is one-sided, and that would tilt in favor of taking the other side of that trade at the margin. Obviously, suspecting that wheat farmers need to hedge wouldn’t be sufficient motivation for buying August wheat contracts. But when choosing between a menu of imperfect investments, the existence of imbalanced hedging interest can be important information. With standardized products, that is something one can try to learn and understand.
        With a bespoke product, one cannot. With a bespoke product, there is generally an initiating party (Paulson for our CDO, perhaps an industrial firm looking to hedge an idiosyncratic risk). The counterparty to a bespoke contract (e.g. an investment bank) usually knows something about the initiator and can divine something about its motivation. The counterparty to a bespoke product should generally not be anonymous. If the counterparty remains anonymous, it should at least be identified that there is an identifiable initiating counterparty. Otherwise, there would be terrible scope for tailoring products based on precise information asymmetries that the non-initiating counterparty wouldn’t suspect.
        If Goldman could have met Paulson’s needs by stitching together positions in the CDS market without constructing a CDO, there would have been no issue: Those are standard markets, and participants understand that there is both speculative and hedging demand, and traders with more and less information. Traders make statistical inferences, for better and for worse.
        But Goldman met Paulson’s demand for a bespoke product by creating a new counterparty and pretending the new counterparty was the initiator of the trade, not the responding to external demand for a custom product. Not knowing who is the initiator and who is the respondent is seriously harmful: market-makers and traders pay great attention even in standardized markets to where trades fall in the bid/ask spread, and adjust pricing actively based on that information. Ordinarily, someone who needs a special product that cannot be synthesized (at convenient prices) from available markets has to reveal their need, allowing potential counterparties to evaluate the source (is this counterparty hedging an industrial risk, or do they know something). That information would crucially determine the pricing and willingness of a counterparty to transact.
        Goldman actively camouflaged who initiated and who was responding to Paulson’s demand for short positions in certain securities. It created a single bespoke counterparty that believed itself to be the initiator. Goldman hid from that counterparty information that it knew, and that generally any one party responding to some other party’s complex and specific demands would either learn as a matter of course or demand to be revealed. ABACUS investors thought they were in an ordinary CDO deal, initiated by longs in cooperation with a facilitating investment bank, buying an optimized portfolio in standard markets that included both speculative and hedging demand. That was not their situation at all. Their information was worse than the information an individual transactor would have purchasing a stock or in the RMBS CDS market (no specific knowledge but a decent probability distribution). And the stakes were much higher, because they were entering into a large transaction with one counterparty. If this had been a large transaction spread across many counterparties, their statistical inferences about the degree of spec/hedging interest and information asymmetry might have been accurate. In this case, they would have had to assume an almost worst case scenario to be accurate, but didn’t know that."

1 comment:

  1. Its very interesting and very informative and i really like your approach.


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