Reviewing the Shorts

David Warsh reviews three recent books on the role of credit default swaps in the financial crisis:

• Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe
• Gregory Zuckerman, The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
• Michael Lewis, The Big Short: Inside the Doomsday Machine

I enjoyed the first two. Tett tells the story of the rise of the credit default swap, and Zuckerman explains how John Paulson (among others) used them to profit by selling the housing bubble short. Michael Lewis tells the same story, less effectively, and ignores Paulson. I think this is so he can treat those who saw what was happening as weirdos. This may be because, as Warsh point out, Lewis sure considered them so in 2007. As Michael Osinski wrote in Business Week (hat tip to Warsh):

It wasn't until Jan. 31, 2007, that the index of subprime bonds suffered its first ever one-point drop. According to Lewis, that was the day "the market cracked." What Lewis fails to note is that the day prior, Lewis himself had filed a column for Bloomberg News from Davos mocking Nouriel Roubini's warning "that the risk of a crisis happening is rising." Such forecasts of doom came from "people with no talent for risk-taking gather[ed] to imagine what actual risk takers might do," Lewis wrote. The headline described them as "Wimps, Ninnies, and Pointless Skeptics." In The Big Short, Lewis recognizes he was wrong. The ninnies have inherited the earth.

Lewis's book is of course the best read. He is a great writer. But his book seems less like reporting than storytelling. He never questions or analyzes what his heroes tell him. And there ought to be some reward for depth.

I plan to write a longer post comparing Zuckerman and Lewis since they address the same subject but write different books. But for now, Warsh's review is very good.

Health Care Incentives

John Cassidy looks at the size of the subsidies and penalties that face individuals and firms under the Health Care plan. His analysis shows that

• The so-called “individual mandate” isn’t really a mandate at all. Under the new system, many young and healthy people will still have a strong incentive to go uninsured.
• Once the reforms are up and running, some employers will have a big incentive to end their group coverage plans and dump their employees onto the taxpayer-subsidized individual plans, greatly adding to their cost.

The penalties for individuals are not large enough to induce health people to buy insurance, and the subsidies for individuals dropped from group insurance are too high to not be taken up. This suggests that the estimated reduction in uninsured is overstated and that the subsidies that will be required under the plan are underestimated.

Tyler Cowan also discusses this issue.

Brooks on Economics

David Brooks had an article in the New York Times today on the future of economics. It is the usual stuff about how economics was too narrow but the financial crisis will make it better as economists become humanists:

Economics achieved coherence as a science by amputating most of human nature. Now economists are starting with those parts of emotional life that they can count and model (the activities that make them economists). But once they’re in this terrain, they’ll surely find that the processes that make up the inner life are not amenable to the methodologies of social science. The moral and social yearnings of fully realized human beings are not reducible to universal laws and cannot be studied like physics.

Once this is accepted, economics would again become a subsection of history and moral philosophy. It will be a powerful language for analyzing certain sorts of activity. Economists will be able to describe how some people acted in some specific contexts. They will be able to draw out some suggestive lessons to keep in mind while thinking about other people and other contexts — just as historians, psychologists and novelists do.

At the end of Act V, economics will be realistic, but it will be an art, not a science.

Greg Mankiw explains some of the flaws of the article.

I could nitpick this article forever, but one important point I think is that Brooks confuses what sells in the wider market for what economists will be doing. Thus, he writes:

One gets the sense, at least from the outside, that the intellectual energy is no longer with the economists who construct abstract and elaborate models. Instead, the field seems to be moving in a humanist direction. Many economists are now trying to absorb lessons learned by psychologists, neuroscientists and sociologists. They’re producing books with titles like “Animal Spirits,” “The Irrational Economist,” and “Identity Economics,” about subjects such as how social identities shape economic choices.

What sells in the wider audience, however, is not what economists are actually doing. It is a good market response to write a popular book saying economists are stupid, or whatever. But the professional work is getting more technical not less. Despite the impressions of Brooks or Skidelsky economists for the most part do not see the financial crisis as a repudiation of their efforts. So there is no reason to re-evaluate what economists do. I think that is how this is viewed internally. And that is what governs the dynamics of the profession.

Consumer Financial Protection Agency

The main reason why I have opposed the idea of a Consumer Financial Protection Agency is the fact that Elizabeth Warren would be chosen to head it. I thought my fear was paranoia, but the New York Times has an article today articulating just that premonition. So let's hope that somehow this idea can die.

Kinsley vs Krugman on Inflation

I enjoyed this debate between Kinsley and Krugman. I confess to the same puritanical views that Kinsley has regarding inflation.

Krugman and China

Paul Krugman has been calling for a surcharge on Chinese imports of 25% as a response to currency manipulation. He wants a tough policy because he believes they will not respond otherwise. Scott Sumner does a pretty nice job dealing with the hubris part of this argument. In a second column Krugman does a better job of explaining the economics:

Let me start with a proposition: the right way to think about China’s exchange rate is, initially, not to think about the exchange rate. Instead, you should focus on China’s currency intervention, in which the government buys foreign assets and sells domestic assets, on a massive scale.

Although people don’t always think of it this way, what the Chinese government is doing here is engaging in massive capital export – artificially creating a huge deficit in China’s capital account. It’s able to do this in part because capital controls inhibit offsetting private capital inflows; but the key point is that China has a de facto policy of forcing capital flows out of the country.

Now, bear in mind the two basic balance of payments accounting identities:

Capital account + Current account = 0

Current account = Domestic savings – Domestic investment

By creating an artificial capital account deficit, China is, as a matter of arithmetic necessity, creating an artificial current account surplus. And by doing that, it is exporting savings to the rest of the world.

This is a good way to think about the problem, but it does not necessarily support Krugman's policy preference. He argues that if China appreciated the yuan or if the US slapped a tariff on Chinese exports these would reduce the current account surplus of China. He starts from the macro balances but then comes back to the currency value being the exogenous driving force. He is reading his two equations from the top down. Why does it not work from the bottom up?

Suppose that China stopped purchasing foreign assets and let the yuan appreciate. Then we are to suppose that Chinese savings will necessarily fall. Presumably this arises because the movement in the exchange rate makes imports more expensive.

But why do we believe that the current account will adjust in this manner. Can't we read the CA equation the opposite way? If Chinese households and corporations want to save over 50% of GDP there will still be an excess of savings over investment (see this article for some evidence on the distribution of Chinese savings by type). So something else must give. What? Presumably the price level. Since net exports fall due to the currency intervention aggregate demand is lower. This puts downward pressure on the price level. This offsets the impact of the currency change on the real exchange rate. China is just as competitive as before.

For a currency surcharge or revaluation to reduce the Chinese current account surplus it has to change the savings/investment balance. It is not clear how that will happen until something changes the desires of Chinese corporations to hoard savings and Chinese households to save. There may be government policies that China can pursue to achieve this, and they would likely improve welfare (for example a retirement system), but it is not at all clear that they will be implemented in response to tough talk from US Congressman about the yuan.

More Naked CDS

According to Rajiv Sethi the prohibition of naked credit default swaps can be supported on the grounds of Diamond and Dybvig's financial instability model:

"In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic. What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation."

I don't understand this argument for (at least) two reasons. First, unlike bank runs there is no sequential service constraint with sovereign bonds. If people try to exit the price falls, which prevents runs. Bank runs happen because of the advantage to rush to the head of the line.

Second, and more important, Sethi seems to forget that with naked CDS the purchaser is out money, the seller is receiving income. It is negative carry for the buyer. Thus there is a bias already against shorting in this fashion. The naked CDS holders are putting their money where their mouth is. Hard to see why they would do this based on some expectation that others will also do it, thus raising the cost of their play. Most traders would want to keep quiet to buy the insurance at a lower cost, and hope that others do not follow.

See The Money Demand for more interesting critiques of the Sethy argument.

Naked CDS and Greece

Sam Jones has a nice column on the benefit of naked CDS and the Greek crisis. It is a critique of the argument of Munchau that:

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

Jones shows how hedge funds that were naked CDS are now likely to be buyers of Greek bonds. His argument is twofold:

Firstly, any naked CDS buying – as slated by Mr Münchau – occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks. (Banks, stuffed to the gills with sovereign debt thanks to the ECB, have)

Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe (as Mr Münchau notes, Greece seems content to do this all on its own anyway).

Secondly, and more importantly, however, hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.

In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.

And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.

What I don't understand is why his argument is not even stronger and simpler. Hedge funds buy naked CDS when prices are low speculating that a crisis may occur. When the crisis occurs and spreads rise, the hedge funds sell the swaps to those in dire need -- those who are lenders to Greece.

Indeed, isn't this just like any argument for short selling -- that it is providing more market information about what might happen? Suppose that enough hedge funds bought CDS on Greek debt years ago and that spreads rose significantly then. Lending to Greece would have been reduced and the extent of Greece's debt woes today would be smaller. Wouldn't more naked CDS have been better?

Right On

Felix Salmon had a nice post today about politicians and their nonsense regarding Greece and credit default swaps. Carolyn Maloney, Chair of Joint Economic Committee, is quoted in the FT:

Ms Maloney compared the use of credit default swaps in the Greek situation to the “activities that brought down American International Group”, referring to the US insurer that collapsed and was bailed out in September 2008. “These reports, if true, are a shocking echo of the financial crisis that faced the US in 2008 – whose reverberations are still being felt today, in the worst recession in decades.”

This is nonsense, as Salmon notes. AIG sold CDS and then could not cover claims, Greece is not selling any CDS, it is the subject of insurance. People are buying insurance against their default. The comparison is daft.

Salmon also points to the German financial watchdog which apparently is worried that German bailout funds will go to speculators, even though the speculators seem to be betting on a Greek default. It is crazy.

But as Salmon notes:

it’s all a big Kabuki, wherein anybody bashing banks in general, and Goldman Sachs in particular, gets automatic political brownie points. And there are no points at all, it seems, for basic financial literacy.