Tuesday, December 1, 2009

The wrong counterfactual

Here is an entirely speculative exploration of the inevitably if irritatingly termed GFC and in particular the role of derivatives. It draws little on empirical data for there are few of relevance, and depends instead upon logic built atop the kind of framework the late Fischer Black might have used as a point of departure.

That framework starts with the premise that the GFC was an equilibrium event – that is to say that whatever it was, it was not the idiosyncratic result of irrational behaviour driven by levels of greed and fear hitherto unobserved and peculiar to a certain class of rogue, thief or corrupt capitalist (who can be vanquished by regulatory fervour and adoption of some moral high ground).

It was, and we should let future events continue to be, business as usual.

I assert that the GFC and of greatest interest here, the entire of the  global derivative instrument portfolio deployed at the time the “crisis” struck, were standard rational responses – and here is the challenging hypothesis – which represented, in aggregate, more optimal responses by capital markets to then prevailing conditions than the responses implicit in the critics cries of despair, or indeed any other responses.

Second, Black’s (and others) standard requirement to accept that the world is not perfect. Rather, it is the best we have and thus we must accept and make the best of it. So both nirvana and greener fields fallacies are forbidden in the analysis.

Assume there were no derivative instruments. So no slicing and dicing of risk into credit default swaps. no collateralised debt obligations and no short selling instruments – or the kind of regulatory interventions now advocated, such that these markets were effectively closed down or were too expensive to operate at all.

What might have happened? We don’t know. We can speculate. A few obvious starters. With Clinton and his ilk advocating lending regardless of credit risk in the interests of “equity” or similar policy notions, demand would have been just as high as what was observed.  High demand for sub prime loans. Motown on full tilt borrowing.

Competition to meet demand, retain market share, even grow would surely have been as rife as that observed. Lenders then, keen to lend. With wider economic growth strong pressure would have been strong.

Likely response?  Carry on up the jungle. With the FDIC underwriting lending why on earth wouldn’t banks have kept lending into the feeding frenzy? Just like 1980s S&Ls.

True, we would not expect all banks to fall for this. They didn’t. They survived – maybe prospered.  Amongst 8,300 (see below) you would expect that. But…

Before the fall, when they wrote it on the wall, the FDIC had $60bn  (2007) to underwrite the moral hazard of the 8,300 FDIC guaranteed U.S. banks. A clear invitation to party…. and they would have. Just as they did in the S&L crisis of 1980s when derivatives weren’t even a blink in the Milken eye.

So imagine 8,300 banks all lending like crazy with only the FDIC as insurer – that is the counterfactual.  No risk transfer, easy credit, political encouragement and, to cap it, the idiotic Mae and Mac fiefdoms of shareholders fleecing taxpayers while management had the biggest time.

Writing  decades ago, Magellan guru Peter Lynch couldn’t understand why everyone wasn’t all over Fannie. No brainer transfer of direct to equity investors right out of the US treasury.

How good was that FDIC insurance? By August of 2009 with 64 banks in default the FDIC funds were down to $13bn from the $60bn reserve of a year previously. So, headed pretty much to DC for a top up.

That’s 0.8% only of the banks in default. In short, a tiny number in default. And so tiny because of the derivative market that transferred so much much risk away from the oh so rapidly heading for zero FDIC.

What did CDOs and like instruments do? They had already transferred the risk - away from governments and taxpayers – to people who were better placed to wear those risks.

Were these folks happy to lose? Of course not but they were better placed to wear it than taxpayers.

Exposure, worldwide, to CDOs was estimated variously by Reuters and Bloomberg to be around $US33 trillion in August of 2009. Reliable data? In precise terms likely not – the point here though is the sheer size of the risk spread and transferred relative to not spreading that risk.

The FDIC is lost in the rounding here. Not seriously in contention.

Even if the U.S. share was a small proportion of that and it had not been transferred then there would have been a serious bloodbath – more than enough to make Keynes's eyes water. Instead, worldwide creditors and investors shared, on a global scale – and some still have yet to share – the pain.

The message from economics is often “it could be worse, think of how well off you are compared with the alternative”. I’m suggesting that nothing has changed. The derivatives let people if not shuck off then at least share $33 trillion of pain.

When even one reform which seeks to kill derivatives can offer even a 10th of that benefit it might be worth waking up for.

The data can be out by magnitudes here but the Fischer Black idea – let’s imagine this is equilibrium, remains profound – and the guys from the government are simply not “the smartest guys in the room.”

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