BATS's aborted IPO on Friday, March 23, 2012, is an excellent example of the stupid side of computerized trading. While the precise course of events isn't entirely clear, BATS (short for Better Alternative Trading System) tried to initiate trading in its own stock around 10:45 a.m., at a price of $15.25 per share, or $0.75 per share below the IPO price of $16. Not a good sign when an IPO begins trading below the offering price. But that wasn't the really bad news. Rather, trading in BATS stock stopped moments later for technical reasons.
Around 10:48 a.m., BATS announced it was looking into "system issues" concerning stocks having symbols between A and BFZZZ. Nine minutes later (10:57 a.m.) Apple stock, which was trading in the high 590's, suddenly traded on BATS at $542.80 a share for a single 100 share transaction. This was a 9% drop from the previous price, even though there was no intervening news or other public event. Trading in Apple stock was halted. Five minutes later, it resumed back in the high 590's.
Around 11:07 a.m., BATS informed other exchanges that it was having problems and they need not send orders to it. Since competition for order flow is the essential dynamic between exchanges, this instruction was like making an unexpected pit stop in a NASCAR race.
At 11:14 a.m., BATS resumed trading in its own stock with a large trade at $15.25 per share. Within seconds, BATS shares were trading for pennies per share. Trading in BATS stock was halted again, and didn't resume. Near the end of the day, BATS announced that it was withdrawing its IPO.
In essence, we had flash crashes in Apple (which rebounded within minutes) and BATS (which cratered in the most embarrassing way on its IPO day). These morasses were apparently the result of computer glitches. Both were plain stupid, perfect examples of stupid is as stupid does. It's inconceivable that a human trader would have sold 100 shares of Apple at $542 on no news when the market was in the high 590's. There's no way a human trader would have sold BATS stock for pennies seconds after BATS traded at $15.25. That these trades happened is because a computer has no way to tell when it's doing something stupid. It can only follow the instructions in its program coding. And if the coding is deficient, the computer will blithely plunge forward however stupid the result.
Of course, human traders are eminently capable of stupidity, and are stupid more often than not. But humans trade much slower than computers. And few humans control as much order flow as computers at the large high-speed trading firms. So when a computer does something stupid, it can do it really fast and perhaps in really large quantities. No human is fast enough to stop the computerized stupidity before it happens. And no computer has been programmed to have the judgment and common sense to realize that it's about to do something really stupid.
Friday's morass didn't affect the larger market, which ended the day up. But it serves as a reminder that the baseline problem in computerized trading--how to prevent it from having unexpected and undesired consequences--is hardly any closer to solution than before the Flash Crash on May 6, 2010. Unless high speed trading firms can find a way to prevent stupid trades, their animal spirits will likely be curbed. And it's hard to argue against constraining them when they produce results as ridiculous as last Friday's.
Sunday, March 25, 2012
Friday, March 23, 2012
Are the European Central Bank and the Stock Market BFFs?
The suddenness of this week's stock market drop, coming after a meteoric rise this quarter, can't plausibly be attributed to the usual suspects. We are told that fears of slowing economic growth in China and a probable recession in Europe are the culprits. But those fears existed one, two, five and thirteen weeks ago. Why would the market drop now?
The 21st Century financial markets are all government, all the time. If you want an explanation for puzzling market activity, look at government activity. In the past three months, the European Central Bank has printed something like $1.3 trillion worth of Euros. Not that you'd get anyone at the ECB to admit it was printing money (an anathema punishable by torture on the rack in Europe). But the ECB would admit that it's been making a lot of three-year loans to European banks with interest set at 1%, while accepting as collateral all kinds of hinky paper (not necessarily excluding matchbook covers, burger wrappers and junk mail). The banks taking out these loans were facing potential credit crunches, so with the ECB making loans on terms that the private markets probably wouldn't extend, one needn't have a lot of imagination to conclude that the ECB has printed a lot of dinero in the past three months.
All that moola has to go somewhere. The borrowing banks deposited a lot of it back with the ECB, to boost their cash reserves against more handwringing over the European sovereign debt crisis. But one suspects that quite a bit of it may have gone across the pond into the U.S. financial markets, where stocks have been frothy because of improving economic data. And the fact that last year the U.S. Federal Reserve extended dollar-denominated credit lines to national central banks in a number of European nations would only make it easier to convert Euros into dollars that can be invested in U.S. stocks.
But recent signals from the ECB indicate that it won't be extending more of these three-year beauties. Since financial markets respond, first and foremost, to cash flows, the prospect of no more foreseeable money printing must be discouraging. All good things end eventually, and we know from recent financial history that no asset rises in value indefinitely. While money is fungible and definitively proving that the ECB's money print puffed up the U.S. markets isn't easy, the past twenty years demonstrate that the most reliable way to jack up stocks is for central banks to shovel money off their loading docks. And the same twenty years demonstrate that this isn't the path to lasting prosperity. So look both ways before diving into stocks.
The 21st Century financial markets are all government, all the time. If you want an explanation for puzzling market activity, look at government activity. In the past three months, the European Central Bank has printed something like $1.3 trillion worth of Euros. Not that you'd get anyone at the ECB to admit it was printing money (an anathema punishable by torture on the rack in Europe). But the ECB would admit that it's been making a lot of three-year loans to European banks with interest set at 1%, while accepting as collateral all kinds of hinky paper (not necessarily excluding matchbook covers, burger wrappers and junk mail). The banks taking out these loans were facing potential credit crunches, so with the ECB making loans on terms that the private markets probably wouldn't extend, one needn't have a lot of imagination to conclude that the ECB has printed a lot of dinero in the past three months.
All that moola has to go somewhere. The borrowing banks deposited a lot of it back with the ECB, to boost their cash reserves against more handwringing over the European sovereign debt crisis. But one suspects that quite a bit of it may have gone across the pond into the U.S. financial markets, where stocks have been frothy because of improving economic data. And the fact that last year the U.S. Federal Reserve extended dollar-denominated credit lines to national central banks in a number of European nations would only make it easier to convert Euros into dollars that can be invested in U.S. stocks.
But recent signals from the ECB indicate that it won't be extending more of these three-year beauties. Since financial markets respond, first and foremost, to cash flows, the prospect of no more foreseeable money printing must be discouraging. All good things end eventually, and we know from recent financial history that no asset rises in value indefinitely. While money is fungible and definitively proving that the ECB's money print puffed up the U.S. markets isn't easy, the past twenty years demonstrate that the most reliable way to jack up stocks is for central banks to shovel money off their loading docks. And the same twenty years demonstrate that this isn't the path to lasting prosperity. So look both ways before diving into stocks.
Friday, March 16, 2012
Mr. Smith Is Going To Washington
Greg Smith, formerly of Goldman Sachs, is surely going to Washington. In an Op Ed piece published in the March 14, 2012 edition of the New York Times (http://www.nytimes.com/2012/03/14/opinion/why-i-am-leaving-goldman-sachs.html), Mr. Smith lambasted his erstwhile employer for having a "toxic and destructive" environment in which making money for the firm mattered more than serving clients, who were sometimes reportedly called "muppets" by high-ranking Goldman executives.
Money managers who deal with GS may well find themselves having to assure clients that they're sophisticated folks who well understood that Goldman is out for itself. And to be sure, the heart of Mr. Smith's revelations isn't exactly news. The SEC's 2003 settlement with major underwriters about the way they deployed analysts to help promote stock offerings is an earlier example of how investment banks thought of themselves before they thought of clients. (See http://www.sec.gov/news/press/2003-54.htm.) Going back to the 1930s, the Pecora Investigation trawled the slimey side of Wall Street and revealed that a lot of bankers are scum. And a couple thousand years ago, Jesus had a run in with some money changers.
But the problem for Goldman and other big banks is that the average Joe and Joan on Main Street (perhaps a/k/a "muppets") aren't cynically avaricious and don't care for those who are. The same Joe and Joan may have money invested in mutual funds, 401(k) accounts and pension funds that one way or another deal with Goldman. And they'd want some comfort that they aren't one way or another being ripped off by GS.
Goldman announced today that it was reviewing its conflicts of interest rules. http://news.yahoo.com/goldman-review-rules-conflicts-interest-194824355.html. One doesn't need a vivid imagination to suspect that Mr. Smith's essay had something to do with this announcement (although a Delaware judge's glance of askance at Goldman's conduct in a corporate acquisition played a large role in instigating the review). Perhaps this announcement will do something to ameliorate Goldman's image as the world's most notorious vampire squid, but GS shouldn't hold its breath.
The financial press is having a rollicking good time with this story, while members of Congress have donned Kabuki costumes and enthusiastically proclaimed their shock at discovering that venal things may have occurred at Goldman. No doubt Congressional hearings are in the works. Mr. Smith will surely receive an offer to testify on the Hill, where he can expect to be asked to confirm under oath that diverse and sundry senior personnel at Goldman are depraved, hypocritical, rapacious, swinish, ravenous, and wolfish, even as they continue to beat their significant others early and often.
In the Internet Age, in which instant celebrity is the life's greatest achievement and mud-slinging controversy paves the way to its attainment, Greg Smith may have limited future prospects on Wall Street, but a damn good chance for a lucrative book contract with gratifyingly valuable movie rights. But let's remember why Mr. Smith is now the best known young financier in the world. It's because people are hurting. Millions are unemployed. Millions are underwater on their mortgages. Mucho millions still feel the sting of losses in their 401(k) accounts from the 2007-09 stock market collapse. And all because of a financial crisis spawned on Wall Street. Mr. Smith's missive resonates. People want someone to blame, and Goldman's very high level of, shall we say, self-regard and self-confidence makes it an easy target.
It's de rigueur public relations 101 that when you screw up, you program the teleprompter for a profuse, sincere and unqualified apology. Many public figures have survived and even prospered by following this script. Others--most recently Rush Limbaugh--have learned that half-measures aren't enough. The one description that is most typically associated with Goldman is smart. But smarts consist not only of knowing a lot about calculus, differential equations, linear and nonlinear regressions, and other mathematical knowledge that can be applied to securities trading and financial engineering. It also involves having the good judgment to understand that you exist in a larger world and need to accommodate the concerns of that larger world. Mr. Smith won't be the only witness invited to testify before Congress, and we will probably soon see how good Goldman's judgment really is.
Money managers who deal with GS may well find themselves having to assure clients that they're sophisticated folks who well understood that Goldman is out for itself. And to be sure, the heart of Mr. Smith's revelations isn't exactly news. The SEC's 2003 settlement with major underwriters about the way they deployed analysts to help promote stock offerings is an earlier example of how investment banks thought of themselves before they thought of clients. (See http://www.sec.gov/news/press/2003-54.htm.) Going back to the 1930s, the Pecora Investigation trawled the slimey side of Wall Street and revealed that a lot of bankers are scum. And a couple thousand years ago, Jesus had a run in with some money changers.
But the problem for Goldman and other big banks is that the average Joe and Joan on Main Street (perhaps a/k/a "muppets") aren't cynically avaricious and don't care for those who are. The same Joe and Joan may have money invested in mutual funds, 401(k) accounts and pension funds that one way or another deal with Goldman. And they'd want some comfort that they aren't one way or another being ripped off by GS.
Goldman announced today that it was reviewing its conflicts of interest rules. http://news.yahoo.com/goldman-review-rules-conflicts-interest-194824355.html. One doesn't need a vivid imagination to suspect that Mr. Smith's essay had something to do with this announcement (although a Delaware judge's glance of askance at Goldman's conduct in a corporate acquisition played a large role in instigating the review). Perhaps this announcement will do something to ameliorate Goldman's image as the world's most notorious vampire squid, but GS shouldn't hold its breath.
The financial press is having a rollicking good time with this story, while members of Congress have donned Kabuki costumes and enthusiastically proclaimed their shock at discovering that venal things may have occurred at Goldman. No doubt Congressional hearings are in the works. Mr. Smith will surely receive an offer to testify on the Hill, where he can expect to be asked to confirm under oath that diverse and sundry senior personnel at Goldman are depraved, hypocritical, rapacious, swinish, ravenous, and wolfish, even as they continue to beat their significant others early and often.
In the Internet Age, in which instant celebrity is the life's greatest achievement and mud-slinging controversy paves the way to its attainment, Greg Smith may have limited future prospects on Wall Street, but a damn good chance for a lucrative book contract with gratifyingly valuable movie rights. But let's remember why Mr. Smith is now the best known young financier in the world. It's because people are hurting. Millions are unemployed. Millions are underwater on their mortgages. Mucho millions still feel the sting of losses in their 401(k) accounts from the 2007-09 stock market collapse. And all because of a financial crisis spawned on Wall Street. Mr. Smith's missive resonates. People want someone to blame, and Goldman's very high level of, shall we say, self-regard and self-confidence makes it an easy target.
It's de rigueur public relations 101 that when you screw up, you program the teleprompter for a profuse, sincere and unqualified apology. Many public figures have survived and even prospered by following this script. Others--most recently Rush Limbaugh--have learned that half-measures aren't enough. The one description that is most typically associated with Goldman is smart. But smarts consist not only of knowing a lot about calculus, differential equations, linear and nonlinear regressions, and other mathematical knowledge that can be applied to securities trading and financial engineering. It also involves having the good judgment to understand that you exist in a larger world and need to accommodate the concerns of that larger world. Mr. Smith won't be the only witness invited to testify before Congress, and we will probably soon see how good Goldman's judgment really is.
Tuesday, March 13, 2012
A Democrat Southern Strategy
Today's Republican primaries in Alabama and Mississippi open the way for a Democratic southern strategy to win the Presidential election this fall. A clear majority of Republicans in the South don't like Mitt Romney. He's getting only about 30% or less of the vote in these two primaries. He got 26% of the vote in the Georgia Republican primary earlier this month. Yet he is best positioned to win the Republican nomination.
Assuming, as do many political mavens, that Romney is the GOP nominee, the Democrats have an opening to skim off critically important electoral votes in the South. Romney, for all his recent rhetoric, is hard to distinguish in terms of policy from Barack Obama. He won't inspire the hard line conservatives that form the core of the Republican South. They, the true believers, might have a hard time remembering polling hours, and many might have to pick up the dry cleaning before they vote. And perhaps tend to 20 or 30 other errands.
Democrats, by contrast, with their large and growing war chest, can win over moderates, blacks and the growing Hispanic population of the South. Obama will lose in most of the former Confederate states. But he has a chance in Virginia, Florida and, who knows, maybe North Carolina or another state that once flew the bonnie blue flag. With the economy improving, Obama could be competitive in the Midwest, especially because Republican governors of Wisconsin, Ohio and Indiana have been vitriolically anti-union.
Republicans have become terribly PC, not in a liberal sense but in a rabidly conservative sense. And just as the mindless liberal PC of the Democratic Party of two and three decades ago drove out moderates, the bug-eyed, drool-at-the-corner-of-the-mouth ideologues of the Republican Party are alienating folks that just want a decent living and a good education for their kids. The Democratic Party of FDR dominated the South during the 1930s. Barack Obama is no FDR, but expect him to be making a lot of campaign stops in Dixie.
Assuming, as do many political mavens, that Romney is the GOP nominee, the Democrats have an opening to skim off critically important electoral votes in the South. Romney, for all his recent rhetoric, is hard to distinguish in terms of policy from Barack Obama. He won't inspire the hard line conservatives that form the core of the Republican South. They, the true believers, might have a hard time remembering polling hours, and many might have to pick up the dry cleaning before they vote. And perhaps tend to 20 or 30 other errands.
Democrats, by contrast, with their large and growing war chest, can win over moderates, blacks and the growing Hispanic population of the South. Obama will lose in most of the former Confederate states. But he has a chance in Virginia, Florida and, who knows, maybe North Carolina or another state that once flew the bonnie blue flag. With the economy improving, Obama could be competitive in the Midwest, especially because Republican governors of Wisconsin, Ohio and Indiana have been vitriolically anti-union.
Republicans have become terribly PC, not in a liberal sense but in a rabidly conservative sense. And just as the mindless liberal PC of the Democratic Party of two and three decades ago drove out moderates, the bug-eyed, drool-at-the-corner-of-the-mouth ideologues of the Republican Party are alienating folks that just want a decent living and a good education for their kids. The Democratic Party of FDR dominated the South during the 1930s. Barack Obama is no FDR, but expect him to be making a lot of campaign stops in Dixie.
Wednesday, March 7, 2012
America's Political Dichotomy
America's most salient political dichotomy isn't Democratic vs. Republican, liberal vs. conservative, or Tea Partier vs. Occupier. It's that most Americans talk conservative but act liberal. They don't like Big Government. But don't mess with their Social Security and Medicare benefits. They see themselves as sturdy, self-sufficient individuals. But, when things go badly, they turn to unemployment comp, food stamps, and COBRA and HIPAA rights to health insurance. They don't like regulations limiting their investment options. But they love federal deposit insurance. And when the stock market plummets, they expect the government to do something.
This dichotomy explains much of the results of the Republican primaries. Many Republicans love the conservative talk coming from Santorum, Gingrich and Paul. Americans are dreamers (other countries don't dedicate themselves to the pursuit of happiness). And the idealistic talk of Santorum, Gingrich and Paul is appealing to many. But larger numbers of Republicans understand that the pragmatic, nuanced approach taken by Romney paves the way to the political middle, where general elections are won. Major right wing government shrinkers won't beat Barack Obama, who angles for the political middle by diligently working the angles of the dichotomy: instigate major reform of health insurance, but take out Osama bin Laden; block the Keystone Pipeline, but talk tough to Iran; target the 1%, but keep open the prison for terrorists at Guantanamo Bay.
Forty-five years ago, the Republican Party understood this dichotomy very well. Richard Nixon, a candidate with a lot less charisma than Mitt Romney (imagine that), beat cheerful Hubert Humphrey by talking tough about crime, the North Vietnamese, the Soviets, and the Chinese, while treading lightly on the benefits government provided to the citizenry. Nixon's 1968 victory initiated a 24-year period of Republican domination of the White House. It wasn't until 1992, when Bill Clinton triangulated the traditional Democratic platform in a major shift toward the middle, that the Democrats again became competitive for the White House.
Now, Republicans have become more and more entangled in the conservative talk part of the dichotomy, and less observant of the need to make voters feel comfortable with them. The dichotomy could easily continue to bifurcate Republican primary results all the way to the Republican Convention. If so, Obama's chances for re-election will increase all the more.
This dichotomy explains much of the results of the Republican primaries. Many Republicans love the conservative talk coming from Santorum, Gingrich and Paul. Americans are dreamers (other countries don't dedicate themselves to the pursuit of happiness). And the idealistic talk of Santorum, Gingrich and Paul is appealing to many. But larger numbers of Republicans understand that the pragmatic, nuanced approach taken by Romney paves the way to the political middle, where general elections are won. Major right wing government shrinkers won't beat Barack Obama, who angles for the political middle by diligently working the angles of the dichotomy: instigate major reform of health insurance, but take out Osama bin Laden; block the Keystone Pipeline, but talk tough to Iran; target the 1%, but keep open the prison for terrorists at Guantanamo Bay.
Forty-five years ago, the Republican Party understood this dichotomy very well. Richard Nixon, a candidate with a lot less charisma than Mitt Romney (imagine that), beat cheerful Hubert Humphrey by talking tough about crime, the North Vietnamese, the Soviets, and the Chinese, while treading lightly on the benefits government provided to the citizenry. Nixon's 1968 victory initiated a 24-year period of Republican domination of the White House. It wasn't until 1992, when Bill Clinton triangulated the traditional Democratic platform in a major shift toward the middle, that the Democrats again became competitive for the White House.
Now, Republicans have become more and more entangled in the conservative talk part of the dichotomy, and less observant of the need to make voters feel comfortable with them. The dichotomy could easily continue to bifurcate Republican primary results all the way to the Republican Convention. If so, Obama's chances for re-election will increase all the more.
Wednesday, February 29, 2012
Maybe the Retail Investor is Retiring
A persistent trend for the past three years is that retail investors have been bailing out of the stock market. Even now, with the market reaching new post-2008 highs, individual investors continue their exodus. Stock market pundits scold shrilly, pointing out that these wusses have missed out on the big rally of the past six months. The same wusses are deemed to be short-sighted for piling into bond funds at a time of historically low interest rates following a 30-year bond market rally. The pundits pronounce retail investors foolish, or worse.
But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.
The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.
But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.
The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.
Thursday, February 23, 2012
The Greek Debt Crisis: Another Failure of Derivatives
Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.
Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.
An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.
In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.
Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.
Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.
An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.
In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.
Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.
Monday, February 20, 2012
Distribution of Income and Wealth is the Issue
As much as many politicians--mostly on the right--try to deny it, today's politics are all about the distribution of wealth and income. Democrats, with President Obama at the forefront, have made financial inequality a crucial element of their 2012 platform. Republicans argue against new taxes, and for the long term reduction of taxes and the shrinkage of the federal deficit. That, too, affects the distribution of financial resources, mostly in directions unfavorable to middle class and modest income households. Long term cuts, to be effective, would have to come to a large degree from Medicare and Medicaid, which verge on insolvency in the relatively near future. Social Security benefits may well shrink over time, although the cuts aren't likely to be apocalyptic. The 1% won't have to trim their sails much if the Republicans have their way. Most of the rest of us will notice the increased costs we would bear.
The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.
In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?
In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).
Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.
In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.
There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.
The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.
In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?
In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).
Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.
In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.
There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.
Thursday, February 16, 2012
Rising Oil Prices: Has the Fed Been Too Clever By Half?
In eviscerating interest rates and quantitatively tranquillizing (we're way past easing), the Fed has sought to push investors into risk assets. Investors have responded. Stocks have risen sharply over the past six months. More disturbingly, oil and gasoline prices have bounced up, too.
The standard explanation for rising oil prices--demand from emerging markets like China and India--seems less plausible now that these economies are slowing down. The threat of Iran going off the deep end points toward higher prices. But Saudi Arabia's expressed intention to keep prices stable can't be taken lightly either.
However, the flood of liquidity that has come out of the Fed surely is a factor in rising petroleum prices, as all this cash has to find a home somewhere in the financial system. Rising oil prices create jobs in some parts of the country, but discourage consumers in all parts. While oil consumption won't fall much in the short term (because demand for gasoline is relatively inelastic, as economists would put it), consumption of clothes, food, vacations, and other things will suffer as gas bills snarf up the monthly budget. Recently improving economic statistics may reverse their trend.
The distribution of income enters the picture. Owners and sellers of risk assets benefit handsomely from the Fed's easing, while consumers (most of whom are middle class and hold little or no risk assets) are shortchanged. This matters in America, where consumption is 70% of the economy. One can see why QE 1, 2 and perhaps soon to be announced 3 haven't and won't boost economic growth that much. With the QEs, the Fed giveth, and it taketh away. The net gain to the economy is unclear.
The standard explanation for rising oil prices--demand from emerging markets like China and India--seems less plausible now that these economies are slowing down. The threat of Iran going off the deep end points toward higher prices. But Saudi Arabia's expressed intention to keep prices stable can't be taken lightly either.
However, the flood of liquidity that has come out of the Fed surely is a factor in rising petroleum prices, as all this cash has to find a home somewhere in the financial system. Rising oil prices create jobs in some parts of the country, but discourage consumers in all parts. While oil consumption won't fall much in the short term (because demand for gasoline is relatively inelastic, as economists would put it), consumption of clothes, food, vacations, and other things will suffer as gas bills snarf up the monthly budget. Recently improving economic statistics may reverse their trend.
The distribution of income enters the picture. Owners and sellers of risk assets benefit handsomely from the Fed's easing, while consumers (most of whom are middle class and hold little or no risk assets) are shortchanged. This matters in America, where consumption is 70% of the economy. One can see why QE 1, 2 and perhaps soon to be announced 3 haven't and won't boost economic growth that much. With the QEs, the Fed giveth, and it taketh away. The net gain to the economy is unclear.
Tuesday, February 7, 2012
Is the Fed Banking on a Crisis?
Scary things can happen when a central bank prepares for a crisis and it doesn't occur. In the late 1990s, there was a great deal of handwringing over the so-called Y2K problem. Numerous computer programs written in the 1960s and 1970s didn't originally accommodate dates in the twenty-first century, evidently because no one thought they would be in use for that long. But they were, and vast armies of computer programmers were deployed to modify programs written in ancient, almost forgotten computer tongues like Fortran and Cobol.
The Fed, alarmed at the possibility that bank and other computer systems might abruptly fail at 12:00 am, January 1, 2000, flooded the financial system with liquidity during 1999, to combat the risk of a credit crunch at the outset of the new century. This liquidity had to go somewhere, and a lot went into stocks. In the last quarter of 1999 and the first quarter of 2000, the S&P 500 rose about 12-13% (or 24-26% on an annualized basis), and the Nasdaq rose by two-thirds (or about 135% on an annualized basis). We know what happened next--the tech bubble burst and stocks have never, on an inflation adjusted basis, returned to their March and April 2000 heights.
There was no Y2K crisis, as it turned out. The armies of programmers carried the day, and the world rolled right into the twenty-first century as if there had been nothing to worry about.
But the Fed's flood of liquidity set the stage for the crisis that actually occurred: the collapse of the tech stock bubble. Although tech stocks were bubbling anyway, the Fed made things worse by lowering the price of cash, thereby effectively escalating the price of stocks. The Fed's bargain basement sale on liquidity in 1999 was to the stock market bubble like gasoline poured on a prairie fire.
Since last fall, the Fed has been sending double and even triple trailer trucks filled with liquidity from its loading dock 24/7. It's ruthlessly stamped out any positive interest rates on the short end of the yield curve, and thoroughly cowed the long end. Its apparent rationales for such actions include preparation for crises such as the sovereign debt mess across the pond, Iran's nuclear ambitions, and so on. Not surprisingly, stocks have risen over the past six months. Liquidity has to go somewhere. In late 1999 and early 2000, it went into stocks. During the past six months, we seem to see something similar.
If there really is a crisis today--like a credit crunch in Europe from Greece's default (the Greek default has effectively occurred; all that's happening now is the negotiation of the exact amounts of the losses to be borne by taxpayers, bondholders, etc.), a war between Israel, Iran and who knows who else, or the real estate bubble in China pops--the Fed will probably look wise and prudent for having engineered the biggest liquidity dump in central banking history.
But if the Europeans somehow muddle through (the stock market's current assumption), Iranian nuclear ambitions are somehow constrained without use of force (the stock market's current assumption) and the Chinese government manages a soft landing (the stock market's current assumption), then what will happen with stocks? Since late last summer, the DJIA has risen about 18% (or 36% on an annualized basis). The economy has been improving, but hardly enough to account for this kind of upswing.
Price inflation has been comparatively low (although more of a problem for those with modest incomes than the top 20%). But asset inflation is alive, well and snarling. If we avoid a major crisis this year, stocks may well soar. And perhaps soar some more. But then what? We have an all too recent and vivid history of government engineered asset bubbles ending badly. Whether you think history repeats itself or only rhymes, things are starting to look disturbingly familiar.
The Fed, alarmed at the possibility that bank and other computer systems might abruptly fail at 12:00 am, January 1, 2000, flooded the financial system with liquidity during 1999, to combat the risk of a credit crunch at the outset of the new century. This liquidity had to go somewhere, and a lot went into stocks. In the last quarter of 1999 and the first quarter of 2000, the S&P 500 rose about 12-13% (or 24-26% on an annualized basis), and the Nasdaq rose by two-thirds (or about 135% on an annualized basis). We know what happened next--the tech bubble burst and stocks have never, on an inflation adjusted basis, returned to their March and April 2000 heights.
There was no Y2K crisis, as it turned out. The armies of programmers carried the day, and the world rolled right into the twenty-first century as if there had been nothing to worry about.
But the Fed's flood of liquidity set the stage for the crisis that actually occurred: the collapse of the tech stock bubble. Although tech stocks were bubbling anyway, the Fed made things worse by lowering the price of cash, thereby effectively escalating the price of stocks. The Fed's bargain basement sale on liquidity in 1999 was to the stock market bubble like gasoline poured on a prairie fire.
Since last fall, the Fed has been sending double and even triple trailer trucks filled with liquidity from its loading dock 24/7. It's ruthlessly stamped out any positive interest rates on the short end of the yield curve, and thoroughly cowed the long end. Its apparent rationales for such actions include preparation for crises such as the sovereign debt mess across the pond, Iran's nuclear ambitions, and so on. Not surprisingly, stocks have risen over the past six months. Liquidity has to go somewhere. In late 1999 and early 2000, it went into stocks. During the past six months, we seem to see something similar.
If there really is a crisis today--like a credit crunch in Europe from Greece's default (the Greek default has effectively occurred; all that's happening now is the negotiation of the exact amounts of the losses to be borne by taxpayers, bondholders, etc.), a war between Israel, Iran and who knows who else, or the real estate bubble in China pops--the Fed will probably look wise and prudent for having engineered the biggest liquidity dump in central banking history.
But if the Europeans somehow muddle through (the stock market's current assumption), Iranian nuclear ambitions are somehow constrained without use of force (the stock market's current assumption) and the Chinese government manages a soft landing (the stock market's current assumption), then what will happen with stocks? Since late last summer, the DJIA has risen about 18% (or 36% on an annualized basis). The economy has been improving, but hardly enough to account for this kind of upswing.
Price inflation has been comparatively low (although more of a problem for those with modest incomes than the top 20%). But asset inflation is alive, well and snarling. If we avoid a major crisis this year, stocks may well soar. And perhaps soar some more. But then what? We have an all too recent and vivid history of government engineered asset bubbles ending badly. Whether you think history repeats itself or only rhymes, things are starting to look disturbingly familiar.
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