pondělí 6. června 2011

The need for smarter CDS

The financial crisis was blamed on two new instruments – collateralized debt obligations (CDO) and credit default swaps (CDS). More recently, the naked CDS were banned in response to Greece woes. In the first instance, the blame was partly warranted, since CDS with no collateral postings and no central clearing place (CDS dealt over-the-counter), allowed some financial institutions to take larger risk on their balance sheets than would be otherwise possible. In the second case, it is now clear that banning of short selling was an empty gesture with no real (positive) effect. But in a way, CDS played their role in Greece crisis, even though exactly opposite than their critics claim – they are guilty of omission, not commission. It is now clear, that Greece crisis was created long before it became apparent, in the pre-2008 years, when the country was allowed to borrow far more than it can handle.
The point is that CDS and especially naked CDS are perfect instrument for speculation. This is because the fact that they often do not require collateral postings and allow speculation where it was not before possible, since there were no securities to sell short. It is more than abundantly clear from Michael Lewis great book “The Big Short”, that CDS at one hand allowed some institutions to take more exposure than they would be (and should had been) able to do otherwise, but on the other allowed the few who were brave and farsighted enough to speculate against the subprime madness.
Indeed what was the problem before the crisis was that there was not enough speculation against the bubble. The number and purchasing power of speculators was not large enough, even after enhancement provided by CDS. This applies to Greece case as well, because if there was enough speculators exposing the clear truth, that Greece is heading towards default, during the 2000s, Greece would not be able to indebt itself to its current degree.
But can anyone blame them? Look at the current situation, when authorities want to avoid credit situation (i.e. official default) by any means. One of the reasons of course is that it would trigger payments on CDS. While this behaviour is perfectly rational from the damage-containment perspective, it comes at huge price into the future. No speculator sane enough will bet that any country will go bankrupt, knowing that there will authorities doing everything possible to avoid paying him. In economic language, this clearly points towards something we know very well in respect to monetary policy – time inconsistency. No matter what they say before, government officials will bail out their peers, because at the given moment it’s the right thing to do. That is, it is the right thing if we take in respect only current period.
If we extend this analysis to past, speculators were probably right to lend to Greece whatever its situation was, believing that default will not happen. (Of course, those holding the bonds and selling them were hit, but so far no owner of CDS was paid). What is then to be done? I propose (without any knowledge of the peculiarities associated) new generation of smart CDS. CDS, which would take into account the possibility of government-led bailout and would be payable even in such case. This would improve markets in the Arrow-Debreu sense by allowing speculators to avoid the risk being denied profit due to government action. Furthermore, it would directly price the advantage accruing to too-big-to-fail institutions and countries, setting platform for aligning incentives.  

neděle 5. června 2011

Where would 1998 Paul Krugman stand on current debate?

Just finished reading Krugman's take on Japan's slump. It is very interesting article in respect to our curent situation, but one thing striked me as really odd, given what Paul Krugman articulates now. When he discusses the possible fiscal answer to the problems of Japan, he stresses that "how much stimulus is needed, for how long - and whether the consequences of the stimulus for governemnt debt are acceptable" has to be considered. Now, this is perfectly acceptable position. Only that Krugman nowadays advocates continuous fiscal stimulus and ridicules those, who talk about the danger to US fiscal position and reaction of bond markets. The first attitude, after considering pros and cons, can still pass his original analysis. It is the second attitude, which is questionable. Not that USA would face imminent danger of debt markets pullout, Krugman is probably right that it does not. But he should know best of all, that the sudden reversions in market perceptions of sovereing debts can be, indeed, sudden. One could argue, that Japan shows, that the levels of governmen debt can go to much higher levels without any concerns (indeed, japanese government debt realative to GDP was roughly similar to current position of USA) . But Japan is definately in different position. Most important, it runs continuously current account surpluses, so the governemnt debt is financed by home savings. These savings are in a way trapped in the country and thus have no other choice than to be invested in japanese bonds. America is in exactly oposite position, since it depends on China's central bank (and others) for its financing. This means, that it is effectively vulnarable to changes of position of one big player. Arguing, that it is unlikely to happen, especially to America due to its central position in financial architecture, is variant of argument, that financial crises happen only in emerging countries. Guess what: they don't.

pondělí 30. května 2011

IMF, EU and ECB and Greek default - need for TARP?

Reading today once again about ECB's oposition to any kind of Greek deault in FT, one analogy from Lorenzo Smaghi strucked me - the one to Lehman Brothers and fairytale-like illusion that something like orderly default could exist. From my point of view we are having the pre-Lehman script replayed, but I take from it different conclusion. Ex-post, Fed was critized that in the period between Bear and Lehman it did not push banks toward recapitalizing. This, combined with the view that there will be another Bear-like solution, meant that neither Lehman acted to safe itself, nor the market participants were not prepared for something like this.

The theory of banking panics developed in past three decades tells us, that  the problem is asymmetry of information. From this point of view the unknown amount and location of exposures to Lehman's demise were the key driver for the banking run in shadow banking sector (i.e. run on repo, CP etc.). If we compare it to our situation in Europe, we have the advantage of the fact, that we saved Greece once so we can decide when and if its going to fail. Therefore, before any such event would happen, we could device a recapitalization program undertaken by US governemnt under the auspicies of TARP. Thus in the event of default, market participants would know where the losses are located (due to stress tests, which would need to be published in their detail - I am not so sure how this is possible from legal point) and would also be assured that governments stand behind the weakest banks, or even better that governemnt already provided capital to this banks. Therefore there would be very little scope for market participants to go into havoc as in the post Lehman period, when neither the location of losses, nor the safety of institutions, could be taken for granted. The only risk of course would come from the possibility that markets would not trust assesment of the banks by governments. 

This approach leaves out the biggest problem, and I think that all the talk about impossibility of organized default from ECB is result of this: the question of Greek banks. The default of Greek governemnt would mean that they are bancrupt, no doubt. In that event, ECB would either have to pull the plug on them, as it threatens, or greatly compromise its credibility by accepting the Greek bonds as collateral even after a rating event. And no doubt that they want to avoid this second possibility at any cost. However, there could be also another solution - that Greek banks' liabilities would be slashed. This would necessary include hit on ECB (which is provides great amount of funds to them), any remaining senior creditors, but crucially also depositors, depending on the size of losses from default of Greek government. With this a recapitalization would be possible.

Final possibility is that I am wrong, and the situation is much worse. Maybe ECB knows something more, maybe the losses from Greek default would be greatly concentrated, in a such way, that recapitaliztion of these institutions would be very, very costly creating further problems for ECB in terms of short term financing of these institutions. But the default of Greece would also have one very important advantege, which is not spoken about lately - that there would be less incentive for moral hazard behaivour by institutions in the future. With the real possibility, that country can default on its debts, betting and thus preventing country to run its debts to astronomic height would become more profitable. Right now we are punishing those, who were right in saying that Greek will be bankrupt. Lets see what the future brings.