Twofish's Blog

October 25, 2008

More about failing gracefully

Filed under: finance — Tags: , — twofish @ 6:01 pm

I think that there is a huge misconception here about what happens when a company “fails.” When a company goes bankrupt, the first thing that happens is that you infuse the company with “debtor in possession” financing. If you don’t immediately infuse a failing company with emergency cash, then everything will fall apart quickly, and the creditors will end up with nothing.

Immediately after Lehman went bankrupt, it got an emergency loan of several billion dollars in cash to keep itself operating while people figured out what to do with it. People are willing to lend to bankrupt companies, because the bankruptcy laws insure that those loans will be repaid regardless of what the balance sheets look like. Also bankruptcy laws *encourage* these sorts of loans in precisely to prevent a bankruptcy from destroying suppliers, employees, and yes even creditors.

So yes, I agree with Ms. Schwartz that what we have is a solvency problem rather than a liquidity problem, and that the thing to do is to let the bad banks “fail.” The difference is that people don’t have an accurate idea of what a “corporate failure” looks like. The problem with using standard bankruptcy laws with financial institutions is that you not have a company that goes bankrupt, you have an entire system, so a lot of what has happened are ad hoc efforts to adapt the concepts of bankruptcy to the financial system, and one of those concepts is to deal with a bankruptcy by flooding the company with enough money to pay for its immediate cash requirements so that people will still do business with it, and so that you have time to figure out what to do with the rest of the company.

One bit of annoyance I have with people in academic economics is that they seem really out of touch with the day-to-day activities of how markets operate. If the solution to the problem is “let the banks fail” (and I think that it is), then the question should be “what are the standard procedures for dealing with corporate failure” and standard operating procedure is to put the company under the control of a government official (i.e. usually a bankruptcy judge) and flood the company with immediate emergency cash under the oversight of that government official. We have to change the play book somewhat but what is going on right now in the financial markets looks a lot like a bankruptcy proceeding.

The importance of failing gracefully

Filed under: china, finance — Tags: , , — twofish @ 5:13 pm

Also one reason I’m somewhat optimistic about the informal finance sector in China is looking at how well the informal finance sector in the United States (i.e. hedge funds) are doing.  Yes hedge funds are falling out of the sky left and right, but it’s not causing a financial crisis, now the way that they did ten years ago.

There are two reasons….

The reason for this is that hedge funds can do something that banks can’t, which is to shut their doors to redemptions.  When you go to a bank and demand your money, they have to give it back, but if you put your money in a hedge fund, there is a contract clause that limits the amount that people can redeem hedge funds.  Typically, what happens is that the clause says that only some percentage of people can redeem hedge funds on one quarter, and that if that quota is filled then you have to wait to the next quarter to get your cash.  So instead of having a fast train wreck, you have a slow motion train wreck, which is a good thing because it allows the markets to adjust.

The second reason is that hedge funds are not leveraged as much as they were a decade ago.  When LTCM fell, it was leveraged at 100:1.  Today no prime brokerage will extend that much credit, and the Federal Reserve will not let a prime broker extend that much credit.  The maximum leverage that a prime broker will allow a hedge fund is something like 10:1, and that was reduced to something like 3:1 in the current crisis.  This is important because if a hedge fund starts having problems, the first reaction is to “double up the bets” which means that when things finally collapse, it could take the entire financial system with it.  If you leverage is limited, then if you start having problems, then the bank calls you put and demands that you put up more capital.  This could lead to a “death spiral” in which the hedge fund has to fold, but in that situation it folds quietly without destroying the financial system.

Now if you look at the informal sectors in China and look at these two factors (ability to limit redemptions and leverage), they look more like hedge funds in 2008 than hedge funds in 1998.  In particular, because the informal sectors are quasi-legal or illegal, you can’t use them as checking accounts because if your a check written against a informal account bounces, you have no legal recourse.  This means that if you want your money, an informal money lender can do what banks can’t do.  Tell you to come back tomorrow.  Also, because the informal sectors are quasi-legal or illegal, this means that there are limits to the amount of leverage that they can have.  Now I’m sure that there are all sorts of complex and tricky methods that people us to get money out of the formal system into the informal.  But the important question is whether or not you can get the huge amounts of leverage that create a crisis that is big and fast, and my sense is that in a crisis, the mechanisms that people use to tunnel money from formal to informal sectors will fall apart, which causes things to fall apart before you have huge amounts of damage.

This also gets at two things that I *don’t* think are issues:

1) Transparency – Hedge funds make a good test case for financial theories because they are unregulated and non-transparent.  Transparency is usually a good thing, but in the case of a bank run, it can be quite a bad thing, because people see people losing money, and this generates a panic.

2) Monetary policy – My thinking is highly influenced by Hyman Minsky, but I think one point of Minsky is lost and that is that boom-bust cycles are *inherently* part of market economics, and that it results from the dynamics of how these systems operate.  Booms naturally create risk seeking activities that will fall apart when the boom turns into a bust.  I’m also more interested in looking at what is political possible.  Yes, the problem may be solved by having people be less greedy or by tightening credit, but it is hard to take away the punch bowl when the party is going, and solutions require that people behave in ways that they don’t want to are not solutions.

Academics often come up with solutions that are politically not workable, and when you come up with a policy that people just don’t want to do (restricting credit in boom times is one), the reaction tends to be to curse the politicians and then figure that people deserve what they get.  I don’t think this is a useful reaction, and if people want accept plan A, I think the thing to do is to think of Plan B, which they might accept.  If they don’t accept Plan C, then you go with Plan’s D, E, and F.  Plan F might not create a perfect utopia, but I don’t think that perfect utopias are possible with imperfect people, and trying to make people perfect causes more problems than it solves.

So my thinking involves less trying to tell people to be less greedy in the boom times, but rather thinking ahead to the time in which everything falls apart, and trying to structure things so that you reduce the amount of damage when you have a bust.  If Minsky is right, then things *will* fall apart every few years, and the goal is to make sure that when things fail, they fail gracefully.  This makes it much easier to reduce the craziness when times are good, because setting things so that things fail gracefully reduces the desire to keep the bubble pumped out, and to engage in increasingly desperate “doubling strategies”.

October 19, 2008

How to take over the world

Filed under: china, finance, wall street — Tags: , , — twofish @ 5:41 pm

black swan: The solution is so simple. Instead of having the Fed/Treasury insure the new senior debt of the nine banking institutions that sheltered the architects of our present worldwide solvency crisis, have them insure muni bonds.

Not so simple. If you insure municipal bonds, but don’t insure the banks, then you don’t have anyone to underwrite the issuance of the bonds. What typically happens when a municipality wants to float an municipal bond is that they go to a syndicate of investment banks that buy the bond, and then the bank takes the bond and sells them on the credit markets. If you insure the bonds, but the banks aren’t willing to underwrite them beause they have no cash, then it’s pretty useless, since you have no mechanism to sell the bonds.

black swan: I believe the Treasury is not talking about doing anything like this, because the Treasury is Goldman Sachs (Paulson, Kashkari, Wilson and Forst).

Precisely. They know the securities markets well enough to know that some things just won’t work. This is a big problem that I’m not sure how to deal with. Anyone that really understands the market is heavily involved in it and is going to have connections, left and right, and hence conflicts of interest. Anyone with no conflicts of interest probably doesn’t have the experience needed to do the job. Another problem is that if you need someone to do a job quickly, you find someone you know and trust, but this tends to squeeze out competent people that you don’t know, and the people who Paulson trusts are precisely the people that a lot of voters *don’t* trust.

I’m not that worried about Goldman-Sachs taking over the world, since if Goldman-Sachs starts acting out of line, the other big investment banks will start screaming. Of course, then there is the valid question of what you do when the big investment banks collectively act out of line.

black swan: There isn’t a modicum of evidence to suggest that any of the Treasury’s ‘fixes’ are done to benefit the US taxpayer.

We’ll see in a year. Goldman-Sachs is making one of those “bet the firm” bets that they are famous for. If three years from now, the economy is in great shape, and you point to the voter that Goldman-Sachs is in control of the Treasury Department. They may react with “Great!!! We need more people from Goldman-Sachs running the world. I want my kids to work for Goldman-Sachs. God bless Goldman-Sachs” If three years from now, the economy is in a depression, then Congress is going to hold lots of hearings on cronyism and people will be demanding human sacrifices.

The first case may sound odd, but there is precedent for something like this. At the start of the Great Depression, a small group of people figured out that they that could run the world by putting key people in charge of the economic infrastructure of the United States, and if did it competently that they would amass more power and wealth than anyone could dream of, and they could do it in a way that the general population would actively support their efforts. These people were in charge of running Harvard, Yale, Princeton, MIT, Stanford, University of Chicago, etc.

October 16, 2008

Recession versus depressions

Filed under: china, finance — Tags: , — twofish @ 3:14 am

Michael: His point was, since the current leadership is doing that, there will be no such credit contraction and economic depression. If only the dogma fit the facts.

We have to distinguish between a recession and a depression. The prevailing economic believe is that in 1929 as now a nasty economic contraction is inevitable. However, the choice is between a painful recession similar to what we saw in 1981-1983 and a decade long depression which we saw between 1939 and 1941 or 1972-1975. Bernanke’s belief is that between 1929 and 1932, things contracted so hard that it damaged the economy so that when things did hit bottom in 1932, there was no ability for the economy to recover until you had massive government spending associated with World War II. One thing that you do see around the workl is that when people end up losing their life savings whether through bank failure or hyperinflation, it scars them for the rest of their life, and it takes a generation to undo the damage.

If Bernanke is right then there *will* be a nasty credit contraction, but it will have worked its way through the system by 2012 rather than by 2022.

Michael: it didn’t stop thousands of banks from closing, and it didn’t stop the unfolding of the credit contraction.

There will be a credit contraction. However we will know whether we are looking at something bad or horrific if we see people lose their savings through bank failures which is what happened in 1930, and I don’t think this is likely, if for no other reason that we have FDIC.

The other big question that I’m think about is what happens if the stock market goes down and then stays down. It’s possible that the Dow will go to 5000 and stay their for a few years. If this happens then you have lots of people whose 401(k) is completely shot. You then have a very big problem of aging baby-boomers with no retirement savings counting on a government who owes lots of money to China to address it’s aging population problem.

Notes on US and Chinese monetary policy

Filed under: china, finance — Tags: , — twofish @ 12:59 am

The main method by which the Fed actually controls monetary policy is through repurchase agreements in the overnight lending market. The short term interest rates that get established through the federal funds rate then gets transmitted to the commercial paper and money markets that that has an immediate impact on the rate of business activity. Commercial bank interest rates really don’t have that huge of an impact on the rate of business activity and certainly not an immediate one. Most money flows in the United States go through the credit markets, with the commericial banks having somewhat of a passive role.

This is very different from how monetary policy works in China where there is no linkage between short term interest rates and commericial activities, and the method of controling the economy is through reserve requirements which impact how much the large banks can lend out to the big corporations. The current mechanism of trying to control the economy through reserve rates was developed late-2005/early-2006. The PBC raised interest rates. Nothing happened. They increased reserve requirements, things happened.

One consequence of this is that the Fed can control short term interest rates, but not long term interest rates, and between 2005-2006 the combination of the Fed trying to keep interest rates down combined with a war in Iraq resulted in a really, really steep yield curve, and this led to all sorts of silliness as people used short term borrowing to fund long term loans in things like real estate. The combination of near zero short term interest rates and 6% long term rates is what led to “teaser rates.”

However the game book has changed over the last month. One reason I think that both Paulson and Bernanke were alarmed at the short term credit markets freezing is that frozen short term credit markets means that the Fed and central banks no longer have any control over monetary policy, which is why the Fed and Treasury are basically forcing banks at gunpoint to lend.  The fear is that you will end up with a situation in which you set interest rates at zero, and then nothing happens.

The result of this is that I think that the tools that the Fed will be using to manage monetary policy six months from now, may be very, very different than they were six weeks ago. The only thing that I do know is that the financial world in August 2009 will be very, very different than in August 2008. What the differences are, I do not know.

The thing about finance textbooks is that they often have information that is years out of date, and they give the very false impression that everything has been worked out. One thing that is fascinating about the current episode is that you are watching people literally rewriting the textbooks day by day. Part of the reason I’m in a harsh mood against the pundits is that a lot of things that happen in finance are people making things up as they go along and figuring things out by trial and error. There are things that we know now that we didn’t know in early September, and policy makers are going to certainly do things right now that we will know to be stupid in six months or even in six days. I wouldn’t be surprised if at the end of next week the Dow is at 10,000 or if it at 6.000. I wouldn’t be surprised if at the end of next week, it turns out that everything that was announced thus far seem to be working perfectly. I also wouldn’t be surprised if there is some crisis tomorrow that causes everything to fall apart and we’d be tossing Plan C, for Plans D, E, and F.

Given the difficulty of what is being done, and the stakes, I think it is just a little rude to be screaming at the supposed incompetence of the fire fighters as they are trying to put out the fire.

October 15, 2008

What are the important questions in finance?

Filed under: china, finance — twofish @ 2:31 pm

If you ask enough questions and design an experiment well, you get answers. If enough people ask the right questions, you can make a huge amount of progress.

So what are the important questions right now:

1) How will current events affect currency values and flows?

2) How will current events affect balance of trade?

3) How will the Chinese economy react to current events?

4) More regulation seems to be a given, but what needs to be regulated?  How does it need to be regulated?  Who does the regulation, and who regulates the regulators?

As far as quantitative finance:

1) What are some of the fundamental assumptions that we were mistaken about? 

One of the assumptions I think is questionable is the whole idea that you can put a single price to any derivative instrument.  Putting a single price to an instrument implies the ability to see into the future since the price of the instrument depends on unknown and perhaps unknowable events.  Also how do you deal with the situation in which the tail wags the dog, and prices influence markets more than markets influence prices.

I think a lot of the way we look at derivative instruments incorporate some of the philosophical assumptions of neoclassical economics, and those assumptions I think have broken down.

How do you deal with illiquidity and feedback mechanisms?

The other thing that I think needs to be done is to rethink how we deal with disasters.  One industry that has learned a lot from disasters is the airline industries, and the fact that you can get into a plane and fly involves a large amount of social structures and experience.  One thing that you learn in the airline industry is that “blame and punish” really doesn’t work that well in disaster prevention.  Disasters are the result of complex social interactions, often involving people that do what seem to be reasonable things, and a “blame and punish” mentality, while feeling good, really doesn’t help in getting safer airplanes since everyone ends up blaming other people and trying to avoid blame, and nothing gets done to improve processes or understand really what happened.

October 9, 2008

Filed under: Uncategorized — twofish @ 2:45 am

I think we are in for some major shifts in quantitative finance. Since 1987, there have been two “games” 1) is to use valuation of liquid derivatives to price illiquid derivatives and 2) is to use time series techniques to find mispricings and take advantage of them.

I think both games are over. Project 1) has basically involved trying to get more and more sophisticated models of the volatility surface. The problem with this is that it fails when derivative markets become large enough so that illiquidity is a factor and you can’t simply expolate prices. Project 2) I think is over. As more and more people enter into the statistical artibitrage fields, the amount of leverage you need to create any return has increased, and I think we are at the point that people with money are no longer willing to provide capital to hedge funds to do these highly leveraged transactions.

What’s interesting about project 1) is that the data that has come from the markets since mid-September just make no sense using the old models. Once things settle down I suspect that a lot of the old models and games just won’t work.


The IMF looking silly

Filed under: finance — twofish @ 2:43 am

There’s something funny and sad about the IMF writing a report that talks about the necessity for “decisive policy action” three weeks into a major crisis. Right now anything that the IMF writes is pretty useless. What would have been useful is to teleport that report back in time six months. This is a really pompous quote

The time for piecemeal solutions is over. I therefore call on policymakers to urgently address the crisis at a national level with comprehensive measures to restore confidence in the financial sector. At the same time, national governments must closely coordinate these efforts to bring about a return to stability in the international financial system

Geeze. I call on the moon to rise and the sun to shine.

Chinese economy and the next few months

Filed under: china, finance — Tags: — twofish @ 2:34 am


When the credit cycle turns, suddenly all of the assets you thought you had disappear, where you suddenly have liabilities that you weren’t aware of. However, if you put all of the numbers in a spreadsheet and see how far off the assumptions have to be before there is a big problem, they have to be very far off.

One thing about the SOE’s is that because the government has equity stakes in the companies, it can force the companies to disgorge retained earnings if it really needs to. So along with “hidden liabilities” there are also “hidden assets.” However, some of the assets are certainly “fluff” but again, if you put in the numbers you would need for the assumed numbers to be very off in order to have a crisis.

Something interesting about the American system of corporate finance is that large companies in the US do not have large retained earnings that allow them to cushion shocks. The reason for this is that any corporation with large cash reserves is going to be the target of a corporate raid. As a result American companies rely on a system of “just in time financing” and debt financing from banks and the securities markets. The theory behind this is that it makes the companies more efficient and allows them to function with no capital reserves. This is true. However the downside of this is that the system requires there to be functioning capital markets and if you have a frozen capital market, then it’s like turning off the power.

My guess is that the United States will end up with a system in which you have some mega-banks that are essentially public utilities delivering cash in the way that the electric companies deliver power.

October 8, 2008

The word for the day – Minsky moment

Filed under: Uncategorized — twofish @ 8:51 am

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