1000 Alitalia in one shot: so' forti 'sti Amerikani .... (II)

'<h' . (('4') + 1) . '>'Back to Earth'</h' . (('4') + 1) . '>'

I ended the first part with a puzzle that seemed unsolvable. This was

just to make sure I could keep your attention, because things are not

nearly as bad as I made them appear; at least they are not nearly as

bad when financial markets function "properly" and "normally". Here's

why. As Filippo noted,

the notional amounts are seldom if ever paid: they are used only to

calculate the actual payments taking place between the two

counterparts. Consider the case of a simple interest rate swap on a

notional amount of $100 million. Neither party expects to ever have to

pay $100 million to the other; instead A will pay to B the difference

(0.7%, say) between the fixed and the floating rate in the reference

period, time $100 million, that is $700K, which is a lot less than the

notional. Also, many derivatives often expire without any payment or

only a few payments taking place, other are balanced by the issuing of

similar derivatives with the opposite sign, and so on. Further, for

derivatives traded in organized markets (e.g. futures)

on top of the fact that at settlement one must pay only the net loss

(receive the net gain), the organized exchanges ask for margin deposits

that are proportional to the open positions and force their closure

whenever those margins cannot be reasonably met. In other words, I

wanted to scare my readers a bit ... to drive home a point that Warren Buffet has repeated a number of times and to which everyone, including financial economists, have paid little attention.

The OTC derivatives market allows for the establishment of contractual

obligations between financial institutions that may be impossible to

satisfy, even in principle. In particular, OTC derivatives allow for

the creation of a "pyramid" of financial promises that cannot possibly

be satisfied because the amount to be paid, in certain states of the

world, is larger than the value of total world wealth in those same

states of the world. Call this point 1.

In models where individual portfolios are fully observable, beliefs

over future states of the world are common (or, at least, they have a

common support) and markets are dynamically complete, the situation

conjectured in point 1 is impossible. This is because either B, before

beginning to tango, will be able to correctly assess A's

creditworthiness in all future states of the world and make sure it

holds enough net real assets to back its promises to pay, or the rising

costs that A faces in financing its portfolio positions will force it

to diversify away its risk until the previous condition is in fact met,

i.e. A has enough real equities to pay for its derivative commitments

in case those come due and X (i.e. shit, for those that just tuned in)

happens. Because economic theorists studying financial markets almost

always assume these conditions to be satisfied, the fear that point 1

raises in the layman was not shared, until now, by financial economists.

Which begs the next question: along which dimensions did actual US

financial markets violate the assumptions above? How about "all, and

then some"? While I believe that "some" is the key, let me go through

"all" first.

'<h' . (('4') + 1) . '>' '</h' . (('4') + 1) . '>'

'<h' . (('4') + 1) . '>'Earth is, indeed, different from the standard model'</h' . (('4') + 1) . '>'

We teach that financial markets serve two purposes. They allow society

to transfer resources from those who did the saving to those that would

like to do the investing, which is good. We also teach that financial

markets arrange transactions shifting the bearing of risks from those

who do not want them to those who want them, in exchange for a fee. The

latter function is considered of the utmost importance by financial

economists, who spend a large amount of time showing how risk-bearing

is reduced as financial markets become more "complete" - i.e. more

independent securities are created; derivatives have been shown to be

able to play a key role in this beneficial process - and economic

allocations more efficient, in the sense of Pareto. An important caveat

here is that we assume that there are two kinds of risks: the

individual or diversifiable one (I gain, you lose) and the aggregate or

undiversifiable one (we lose, or gain, together). While financial

markets are magically capable of "dissolving" the first kind of risk,

they cannot do the same for the second. The second is just shifted from

one person to another in exchange for a fee, but the grand total

remains constant independently of how many fancy securities there are

out there. Let's keep this in mind.

We never teach that financial markets can be used to take bets, but

this is what the second function implies. If A transfers some aggregate

risk to B, then A may believe to be safer because B is now bearing its

burden. But this is not really true unless B is capable, and willing,

to cover the risk by means of actual equities, should the downside

event take place. Hence, as before in point 1, risk-shifting is bounded

by the total amount of resources available at any given point in time

and, specifically, is bounded by the amount of actual equities the

seller of insurance owns relative to the insurance it promised through

derivative contracts. If you think of it this way, the whole thing

becomes quite obvious, no? That's why, traditionally, we (i.e. the

regulators and independent overseers that are supposed to act on behalf

of citizens) make sure that insurance companies own lots of big and

fancy buildings, good land, safe stock, oil fields, and so on ...

pretty much like AIG did, right? Let us keep also this in mind.

Now, let me go back to my old example of A, B, C, etc. and make it a

bit closer to what we are talking about. In the updated story B is a

bank, holding a mortgage of $100 on a house with a market value of

$111. B may have purchased that mortgage from someone else, which

originated that mortgage by assessing incorrectly the risk that the

borrower may default ... or which may have made a small - and for sure

unintentional - mistake when typing in the income of the borrower in

the loan application form (say, $70 instead of $50, which makes a big

difference for the implied probability of defaulting ...). This does

not matter at this point: clearly LOTS of things like these happened

in the US mortgage market between 2000 and 2006, but our focus here is

on the continuation. Hence, B values the mortgage at $100 on the asset

side of its books, posting $100 in own capital on the other side, and

nothing else. The banker running B feels there is a 50% probability

that the borrower will default, in which case, via the foreclosure

process, it would end up receiving only $50. B does not like to hold

this risk, as it means that its net capital is really only $75 (i.e.

$100 - 50x0.5), while the shareholders will approve the banker's hefty

bonus of $15 only if net capital is at least $90. Hence B goes to A and

buys insurance, say in the form of a CDS,

promising to pay $90 no matter what in exchange for the proceedings

from the mortgage. You may ask if A is stupid or something, and the

short answer is "no". Clearly, something is happening here that is

creating a profit, for B, of $15 out of thin air: the mortgage has an

expected value of $75, so why should A promise B $90 for sure? There

are various explanations for this, all of which I believe apply to the

US 2000-2008. Here they are:

1. A assigns only a probability of 20% to the default event. People

make random mistakes, we assume, so there are equally as many As assigning a probability of 80% to the default event. But

these two groups do not cancel out because the first will

sell insurance whereas the second will do nothing. Think of this kind

of As as comprising all the "dumb/unlucky guys" that are always around

financial markets but become particularly frequent when the market is

bully.

2. B intentionally packages the mortgage in some "vehicle" that is

confusing enough to lead A to believe it is better than it is. Indeed,

this is

what private information means, in this world! Think of these As as

those guys that said "oops, we did not know what we had purchased",

like UBS or SG.

3. A's own capital is only $4, which it will not mind losing should the

default occur: 10/2 -4/2 = 3, which means a positive expected profits.

Assume A is an investment bank, or an insurer, and pick your name among

the now famous ones.

4. A is "betting" by taking up risk that cannot be diversified because

it goes always the same way. For example, it may be purchasing very many

of these mortgages (at a price of $90) by borrowing on the

money market or issuing bonds. A (or should I call it F&F?) pays very low interest rates because markets perceive the Federal Government is backing A's liabilities.

5. The interbank market is flooded with liquidity at a very low nominal

rate, say 1.5%. A cannot find any liquid security paying a decent

return, while these deals on mortgages are liquid and seem to be paying

a hefty return as long as the borrowers do not default. Call A

Countriwide.

6. There is another character, called A', from which A plans to buy

insurance against the risk of losing $40 in case of default. The

character called A' satisfies one or more of the characteristics 1.-5.

and charges $8 for this.

7. Repeat 6. as many times as you please, because the OTC derivatives

market, which is neither regulated nor centrally organized, allows you

to do so. All you need is that S&P, Moodys and friends keep saying

you are a great credit. You pay their fees, so chances are they will.

Let me take home my second point.

Actual financial markets are much more imperfect than our

theoretical models, whose crucial assumptions are often violated. This

is well known, and things have always been like this, hence per se this

is not big deal. What the existence of an unregulated OTC derivatives

market plagued by private information allows is to leverage these

common "frictions" dozens of time, creating, under the appropriate

circumstances, a snowball that is, indeed quite big. Call this point 2.

'<h' . (('4') + 1) . '>' '</h' . (('4') + 1) . '>'

'<h' . (('4') + 1) . '>'All assumptions are violated, and then some'</h' . (('4') + 1) . '>'

Let me conclude for today with the "some" that, in my opinion, happens

to be the crucial one. That is: if point 3, coming next, had not been

true the fact that points 1 and 2 were would have created some

problems, but not the disaster we are apparently facing. It would have

been, in other words, business as usual on Wall Street.

The key thing is that the probability of default on nominal loans with

variable rates (and mortgages are nominal loans with, in recent years,

very variable rates) is endogenous. It depends, first and foremost, on

the nominal interest rate applied to the loan, which, in turn, depends

on the nominal interest rate clearing the short term interbank markets

that, in turn, is controlled by the Federal Funds rate. When those

rates are low the rates on mortgages are low and liquidity is abundant:

very many mortgages are issued and, if one has reasons to believe that

the short term rates will stay low for quite a while, it is reasonable

to expect the default rates will remain low. When those nominal rates

increase, and nominal incomes do not increase likewise, the probability

of default on those mortgages increases. This is what happened in the US during the 2001-2007 period due to the Federal Reserve "countercyclical" monetary policy.

Now, this is pretty normal and if those mortgages were held by the

banks that had issued them and the latter had not yet "taken profits"

on those mortgages, they would have set aside capital reserves to cover those

losses. This is what is currently happening in Spain that has also seen

a gigantic (in fact, proportionally much bigger than the US one) real

estate boom (1997-2006) followed by a bust in the last two years. In

Spain default rates on mortgages have tripled and interest rates have increased but, because (a) most

mortgages are held by the banks that issued them, and neither (b) have

been heavily securitized through derivatives nor, (c) have the "nominal

profits" on those derivatives been cashed-in (either in the form of

dividends or gigantic bonuses to the investment bankers) the financial

system is very far from coming apart. In fact, it posted record profits

even during the first semester of 2008, which I find rather surprising.

In other words, for reasons that should by now be clear, the "nominal

profits from derivatives issuing and trading" were not "taken" but set

aside till the end of the life of the underlying mortgages. The

opposite happened in the US.

What happened in the US, then? Simple: a derivative is a contract that

involves a sequence of payments over a period of time. If you make real

profits or not from a given derivative contract can be decided only

once the derivative expires and the whole sequence of implied payments

has been settled. But the current functioning of the OTC derivative

market allows something different to happen. Using our simple example,

here's the story. A mortgage is issued that, at current nominal rates,

has a low probability of default. Insuring it is cheap and, by

securitizing it, profits can be taken right away as the financing of

the security is obtained at low nominal rates, insurance is cheap and

the mortgage is off our hands in three days. This is quite fine, if the

probability of default on that mortgage does not change due to altered (by the Fed's actions) conditions in the borrowing and

lending markets. Should conditions remain constant, those initial

profits would correspond to actual profits also at expiration. But in

the meanwhile interest rates increase and default rates raise

accordingly. This means that the derivative security linked to the

underlying mortgage is actually loosing value and its prices should

drop. But you have it in the book for 100 and writing it down to 80

is a problem, so for a while you borrow on the money market to finance

the payments that, for example, the CDS you signed on forces you to.

The opacity of the OTC markets allows you to do so, maybe by entering in

even more derivative contracts. This goes on as long as you appear to be

credit worthy to the counterparts, which is not forever. In the

meanwhile pseudo profits are made, dividends are paid (these are

peanuts) and bonuses are also paid to you (these are not peanuts). From

the point of view of the theory this is money that should "stay in" (in

the form of capital reserves of the investment bank or the insurer underwriting

the CDS) to cover (via its capitalization at risk-adjusted market

rates) for possible future losses. But this is not what happened: the

capital reserves to cover future losses did not "stay in", they went

out to the mansion in the Hamptons. Call this point 3.

When shit hits the fan, oops X happens, you have no capital reserves, hence you

are not credit worthy, hence no one lend to you and you are maybe

insolvent and certainly illiquid. Hence you go the way of Bear Sterns

or Lehman Brothers ...

To quote, with a small [alteration], Robert Solow:

 

[...] the hedge-fund operators [read: investment bankers] and

others [fill in the name of your preferred banker] may earn perfectly

enormous incomes. (Margaret Blair of the Brookings Institution was one

of the first to point this out.) If they are clever enough, and they

are, they can arrange their compensation packages so that they batten

on profits and are shielded from losses.

 

This is because, in the actual financial environment of USA 2001-2008,

(pseudo) profits from derivatives came earlier - when interest rates

were low, hence expected default rates were low - and (very real)

losses came later - when interest rates increased, hence actual default

rates also did - and had to be absorbed by the little capital left in

the firm, which was not enough. The actual capital reserves had been

taken out by calling them "profits". This is point 3 again, only shortened.

Because it is late, I hope it is now clear why it took the convergence

of all three contingencies, summarized as points 1, 2 and 3, for this

disaster to happen. Any two of them without the third would have not, I

believe, caused the big mess we are currently into.

In this sense this

is an "exceptional event", and it needs not imply the "end of capitalism". But, in an another sense, it is and was a

perfectly predictable event: various people wiser than myself (e.g. Mr.

Warren Buffett) had pretty much predicted it a few years back. We, the academic economists, were blind to the facts and did not see it happening because we assumed the deviations of reality from our "standard model" to be quantitatively small. We were mostly wrong, and a few wiser people were right. More than anything, though, I believe we did not see that the particular nature of derivative contracts (their being "zero sum games, if no one cheats") together with the private information that plagues the OTC derivative markets allowed for gigantic (pseudo) profits-taking of funds that were, according to the theory and should have been in fact, capital reserves that had to be "left in the firm" to serve until the life of the derivative contract. But derivative contracts, these misterious zero net supply securities, allow for redistributing wealth from B to A at points in time that preceed their expiration, and redistributing to oneself very large sums of money (in a perfectly "legal" way) is a temptation no one can easily resist. Investment bankers may not be wizards, as they often portray themselves, but they are certainly humans.

Quite

correctly bygones are bygones and, in the unlikely event this

analysis will be found convincing, it still does not tell us what to do

NOW given the current circumstances. In particular, should we go the way that

Bernanke and Paulson are pushing us to go? Is there another and better

way? I am not sure, but I believe a narrow but clear other way can be

found on the basis of this analysis and similar ones developed by other. To the issue of "WHAT TO DO NOW" I hope to turn soon in the third part of these thoughts.