Before I start tonight, a reminder, those that want to follow me on Twitter can do so here. I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog. I’m still working with it. Thanks to all of those that tweeted and retweeted, and those that are following me now.
One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro. If Greece defaulted, Greece would lose the low cost funding of the Euro. The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line. Tough love is the best policy; don’t bail others out if you care about the union as a whole.
On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge. If the speculator is undercapitalized, risks to the financial system rise.
This rule is pretty simple. There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank. In most cases with derivatives, the one that wants to reduce exposure relies on a speculator. There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.
The trouble occurs when the speculator can’t make good on his obligations. As with many speculators, he overcommits. He is short of funds because many trades are going against him at the same time. It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.
That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip. The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing. After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip. They were one of the main classes of marginal borrowers.
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Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu. There are trades that no one wants to take at any price that a seller could live with. There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer. Complexity is a minus. We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them. It is the price of creating safe securities.
No surprise: people pay a lot more for certainty, even if it is seeming certainty. We see it in corporate bond spreads. High quality borrowers borrow cheaply. Low quality borrowers pay up. So what else is new?
What is new is the low-ish spreads for going down in quality. This one could go either way; spreads are wide against history, but might be narrow against current difficulties. The rebound has been rather sharp.
Note: this is reposted because of a system glitch.
The problem is that that “seeming certainty” is deliberately manufactured by the bankers that designed the instruments, by ‘complexifying’ the instrument to the point where the buyer can’t understand the risks, and by deliberately misleading the buyers about the degree and kinds of risks inherent in the products. “Let the buyer beware” is all very well, but surely that’s different than deliberately selling defective merchandise. The bankers don’t seem to have any concern at all about the inevitable reputational damage they are doing to their companies by selling these defective products. Just more proof, if any was needed, that the bankers and managers do not have the long term interests of their companies at heart. They are carelessly destroying the massively valuable brand names and reputations for short term personal gains (aka, this years bonus).
“someone must speculate to a degree to allow you to hedge. If the speculator is undercapitalized, risks to the financial system rise.”
You are so right. The thing that leaves me just dumbfounded is that banks LEND MONEY TO HEDGE FUNDS. It is incomprehensible to me why banks are allowed by regulators to make such risky loans. The bank managers must know that the hedge fund is planning to leverage up with that money and speculate, not open some business. And the bank manager must also know, that if the speculation FAILS, the hedge fund will go bankrupt and the bank will lose their money.
This wouldn’t be any of my business, but they are making those loans with money guaranteed by the federal government, one way or another. Banks backed by the federal government shouldn’t be allowed to lend money to gamblers.
The best way, in my opinion to describe complexity and it’s effect on probability-adjusted returns is the law of conservation of energy and the laws of thermodynamics, because at the end, mathematically, this is all deeply rooted in the law of conservation of probability. Here’s a cutsey thing I wrote that I think you might find explains my point quite concisely:
http://blog.morallybankrupt.org/tagged/laws_of_financial_dynamics