Tag: finance

Margin Call

The best movie I have ever seen about financial markets is Margin Call.

Unlike anything else set on Wall Street1, the characters feel right. They’re all believable. What they do, and the way they relate to each other, is very realistic. They’re not caricatures, and they are all very different from each other, in realistic ways.

(The one possible exception — and this is important for reasons I will come to — is Jeremy Irons’ CEO. And I’m not so much saying he’s not realistic, as that I have no experience of that level of management at work, so I can’t tell. My other comparisons are from experience).

Great as the movie is — I highly recommend you see it — there’s one huge misunderstanding that nearly everyone has: they think the movie depicts what happened in the 2008 crash.

It has many of the points, but it is not at all what happened. But you can make a good argument that it’s what should have happened.

In real life, nobody panic-sold mortgage derivatives and caused a sudden crash in their prices. Rather, there was a severe sustained decline in their prices over months and months, with occasional bumps and false bottoms.

From the first investment funds based on mortgages going bankrupt, to Bear Stearns failing, was nearly a year. From Bear Stearns to Lehman was another six months. The whole thing happened in slow motion. Margin Call takes place in about 36 hours.

Throughout the whole period, banks were still making the same mortgages, and broker-dealers were still securitizing them and selling them. If a major trading house had panic-sold the derivatives and crashed the market at the beginning of that period, causing the whole crisis to happen sooner, it would have been very much smaller, and the damage would have been very much less.

The drama of the movie is the conflict between Jeremy Irons as the ruthless, heartless CEO who orders the bank to dump everything immediately (“It sure is a hell of a lot easier just to be first”), and head trader Kevin Spacey as the more human, complete man, torn by his relationships with his customers, and the effect of a crash on everyone else. Again, the characters and the acting are first rate.

But from my point of view, having experienced the real history from very close up, Irons is unambiguously the hero, and Spacey is unambiguously the villain. If the Jeremy Irons character had been real, he would quite likely have saved the world. In real life, any time a similar argument came up, the Spacey side must have come out the winner, and so the insanity went on, people continuing to buy and sell what at some level they knew or suspected was worthless, because they couldn’t imagine or couldn’t face bringing it to an end.

The fantasy didn’t end until people at one more remove — the shareholders of the banks and broker-dealers — panicked and dumped the stock. Bear and Lehman didn’t fail because they lost money, they failed because because their stock became worthless and without the confidence that they could raise capital by selling equity, nobody would give them any credit. They couldn’t roll over short-term loans, and died.

Background: I’ve written all this before, on Twitter and elsewhere, in the past. I’m dropping it here now so I have an anchor I can refer to. Incidentally, I’m anonymous, but as I’ve mentioned before, I was there. Any responsibility I bear for what happened is, I would claim, tiny, but then again, who’s wasn’t? It was a collective and structural failure, and I was part of it.

Honour Given and Taken

Not long ago, Fred Goodwin was a Knight, his successor Stephen Hester was in line for a £900K bonus, and Chris Huhne was a cabinet minister.

It would be neat in a literary way to show that these three withdrawn honours are part of the same thing, but it’s more interesting, and more true, to see how they’re all different.

Going in reverse chronogical order, Huhne is in some ways the most straightforward. He was in a position of trust, and he is accused of criminal dishonesty.

On more detailed reflection, oddities emerge. For one thing, while it would be nice to think that laws and policies are being made by people who are honest and trustworthy, the idea that any of his rivals or colleagues are honest enough to admit their mistakes or crimes is laughable.

For another thing, why is it the decision of the police to prosecute that triggers his resignation? The facts are not really any better known than they were before.

I suspect that what forced him out was the media deciding to claim that he must be forced out. That doesn’t necessarily indicate any particular animus to him on behalf of the media; a cabinet resignation is worth pushing for just for story value. It might be that earlier, there were reasons for the press not to try to do him in, but those are now gone.

I could suggest a couple of possible reasons: one is that the media seemed somewhat invested in the coalition, but is now more soured on it. (The 2010 story of David Laws tells against that theory somewhat, but he might have been more specifically unpopular to the media). Another theory might be that Huhne’s activity on climate change protected him, but that has mysteriously become less of a concern.

Ultimately, I don’t think we can know what’s really going on, and that’s why day-to-day party politics isn’t worth paying attention to.

On to Goodwin then. On the one hand, if Goodwin was rewarded for benefiting British Banking, it is fair to say that the any benefit he bestowed was more than undone. On the other, the whole process did not seem to have much to do with either justice or wise decision-making; rather it had all the appearance of a stampede.

Whatever knighthoods are for these days, it can’t be what they were originally for. It’s a bit murky. Interestingly, knighthoods would fit well into a formalist system, as a treatment of the coalition problems I just wrote about. It could serve as a formalisation of informal power: a recognition that the recipient has some power, is loyal to the sovereign, and is being rewarded for that loyalty. If that were the basis of honours, they would not be withdrawn for incompetence, or even for criminality, but only for disloyalty. It would mean that that person ought not be permitted to obtain any power again.

Finally Hester. Hester is CEO of a bank which is making modest profits in a difficult market. As such, he would normally expect a substantial bonus. The same stampede which took away his predecessor’s knighthood took that as well.

There are legitimate questions about the amount of money made by banks and their employees, which I am not going to address — anyone worth reading on the issue would be either more knowledgable or less personally interested than me.

The question of bonuses per se is a separate one, though. What it amounts to is that companies that award large bonuses (relative to salary) are run in a more formalist manner than most other corporations. In many organisations, valuable employees are rewarded with more responsibilities, or better job security. Arnold Kling recently raised the point that this can produce bad outcomes. These companies avoid that, giving responsibilies as tasks rather than rewards, and rewarding valuable employees more directly with cash. This is the appropriate response to the sort of issue that Arnold Kling raised, and which Aretae picked up on as a widely applicable example of bad governance.

The fact that this formalist measure to improve governance arouses such opposition (again, independently of the actual sums involved; Hester’s salary for 2011 was over a million pounds, and attracted little attention), says a lot about what is wrong with modern political culture.

So, three very different honours: a minor position in our corrupted and ineffective system of government, an anachronism that might once have been a formalist recoginition of power and reward for loyalty, and a straightforward, honest payment for value. All removed, for better or worse, in the same way, by an unthinking popular stampede, triggered by a media driven not primarily by ideology but by a need for drama.

99% chances

Another sensible article by John Kay, this time about financial models. He mentions the Allais Paradox, which relates to what I called folk probability.

I have a quibble though: Kay says “There are no 99 per cent probabilities in the real world”. Clearly, there are. That doesn’t mean, though, that you or I know what they are.

The real point is that at very low probabilities, the chances of your model being wrong dwarf the chances you’re predicting. If you model a probability as 20%, but there’s a 2% chance that your model’s significantly wrong, the true probability is somewhere in 20±2%. That’s useful to know. But if you model a probability as 0.2%, that doesn’t magically make your chance of having got the model wrong a hundred times smaller. What you really have is a probability of 0.2±2 %. It might as well be 1±2% or 0.000001±2% — the question of how sure you are about your model is far more important than whether the model says 1% or 0.1%

More comments on John Kay pieces: ICI rents climate, copyright

Peston on Deregulation

Robert Peston, who gets a bad press in some quarters, describes in some detail the “rampant deregulation” which we are told preceded the credit crunch:

As someone who has been a banking journalist at various times since the early 1980s I can speak with weary authority about the many years of intellectual toil invested by an elite financial priesthood of central bankers and regulators in devising complex rules on the capital that banks should hold.

These are known as the Basel Rules. And since the late 1980s, they have been the foundations of how banks operate: they determined how much banks could lend relative to their capital resources.

It’s generally a good post, about subordinated debt.

Ten-year-old mystery solved

Thanks to Michael Brush at MSN (and the Economist), we now know the answer to a question that has been outstanding since December 1998.

Greenspan reasons that because hardly anyone actually sees a guy’s undies, they’re the first thing men stop buying when the economy tightens. (He told this to National Public Radio’s Robert Krulwich years ago.)

By extension, pent-up demand means underwear sales should be among the early risers when growth returns and consumers feel confident enough to shrug off “frugal fatigue,” says Marshal Cohen, the chief industry analyst with NPD Group, which tracks consumer behavior.

So now we know:

1. Collect underpants
2. Examine their condition, and use the degree of wear as a leading indicator of the price of risky assets, guiding your investment decisions.
3. Profit!

Thank you.

Gordon Brown: Genius

Back when Gordon Brown looked like a competent politician, he held out against Britain joining the Euro. He said that, amongst other things, tests would have to be passed that:

Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?

If problems emerge is there sufficient flexibility to deal with them?

and he correctly determined that neither test was passed.

Current events prove him right. Britain, with its property-speculating populace and large international financial sector has been hit hard by the crash, and this has produced a large fall in Sterling, leading to the market pushing towards the structural changes that are needed.

Even the EU agrees:

One senior EU policymaker told the FT that, in his view, the UK was in breach of article 124.

Brian Lenihan, the Irish finance minister, in January directly accused the UK of running a policy of “competitive devaluation”, putting other countries under “immense pressure”.

Apart from the fact it’s not a “policy” – Gordon couldn’t prop the pound up if he wanted to, and a good thing too – it’s dead right. Britain is benefiting enormously from not being in the Euro, for exactly the reasons Gordon gave when he chose not to go into the Euro. He was right, and those that said Britain would be better off in the Euro were wrong, and even the EU itself now admits it (and is trying to nullify the benefit to Britain by other means).

Sovereign Debt

Rad Geek is overjoyed to see Ecuador default on its bonds.

He argues, entirely correctly, that there’s no moral case for a government to pay debts – it has no moral right to contract debts on behalf of the people.  Lenders who lend to governments are in the same boat as the contractors I was talking about the other day.  They’re doing business with a government, the name for which is “politics”.  They are therefore exposed to political risk.

He also points out the absurdity of the “debt forgiveness” movement.  Governments don’t have to pay any debts they don’t feel like paying, as Ecuador demonstrates.  Therefore if they pay, they want to pay.

Why would they want to pay?  Because they want to continue to participate in the system.  Bluntly, they want to be able to borrow more.

Felix Salmon has a somewhat different take on the situation.  By his account, we are not seeing a principled attempt to detach from the global financial system, rather an almost-random blundering by a corrupt government that doesn’t know what it’s doing.

Meanwhile, Greg Ip asks in the Washington Post whether the US is likely to default on its debt.  Would that be a victory for the people?  I’m not convinced that the Ecuadorean default will be any better for the people of Ecuador.

EconTalk

I prefer reading to listening, but the latest EconTalk is really good.  Russ Roberts and Steve Fazzari, with their very different views on macroeconomics, get right to the nub of the difficult questions about recessions and stimulus.

Arnold Kling's Sheriff

I’ve been thinking about Arnold Kling’s “Stern Sheriff” idea for regulatory management of financial crisis. In brief, he suggests that when there’s a rush for collateral from an endangered institution, regulators should immediately step in and “penalize liquidity preference” – i.e. tell everyone to wait.

What that really amounts to is declaring bankruptcy earlier. After all, if you are demanding payment which you are due, and someone is telling you you can’t have it, the debtor is officially not creditworthy.

Put that way, it seems a very good idea. After all, my layman’s understanding of insolvency is that a party is insolvent not when it fails to make a payment, but when it knows that it is not going to be able to make a payment, and that to take on new obligations while insolvent is not allowed. Of course, in real life, that is presumably wrapped up in a whole lot of very necessary, very complicated accountancy. But the principle is that bankruptcy happens not when the money runs out, but before the money runs out, so it can be shared out fairly without chaos and panic. And that’s all that Professor Kling is asking for.

It seems a good idea, but of course the next problem is that no real financial institution can pay all its debts on time without access to more borrowing. If I accept the stern sheriff, I’m likely to end up at the Moldbug position, that all maturity transformation is wrong, that a borrower that will not have cash on hand to pay every debt as it comes due is insolvent. I’ve argued against that view, largely on the basis that it’s too easy, and too profitable, to do secretly. If you stop financial institutions from doing it, the result will be that everybody else does it.

There is, to be fair, some room for action between a run on a borrower’s credit being possible and it actually happening. But it’s very small. And the earlier you are expected to step in and prevent withdrawals, the more incentive you create to withdraw (or call collateral, or whatever) even sooner, before the sheriff arrives, so that window gets even smaller.

The more of a “hair trigger” you put on bankruptcy, the easier it is for the creditors to expropriate the equity-holders at any time. That conflict of interest becomes much sharper and more problematic for maturity-transforming financial institutions than for other enterprises – perhaps those institutions should avoid having two tiers of financing in that way.

Hey! I just invented the investment-banking partnership and the mutual building society! Maybe I’m onto something…