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Financial Economics, Deregulation and OTC Derivatives: Interview with Yves Smith of Naked Capitalism
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We ran an interview with our friend Yves Smith of Naked Capitalism today. She has done an excellent job of describing how the intellectual ghetto that was once financial economics has helped to destroy the world of investing and involuntarily turn us all into day traders. The full text follows below. -- Chris
Financial Economics, Deregulation and OTC Derivatives: Interview with Yves Smith of Naked Capitalism
The Institutional Risk Analyst
February 22, 2010
In this issue of The Institutional
Risk Analyst, we
feature a conversation with Yves Smith, the nom de plume of the
creator
of Naked Capitalism and one of the most savvy
and
respected members of the blogosphere. In professional life Yves is known
as
Susan Webber and is the founder of Aurora Advisors in New York. She is a
graduate of Harvard College and a Baker Scholar and Loeb Fellow graduate
of
Harvard Business School.
The IRA: Thanks you for taking the
time to speak with us today.
First tell us about your upcoming book.
Smith: The book is ECONNED: How
Unenlightened Self Interest
Undermined Democracy and Corrupted Capitalism and is out next week.
It is one of
the first books to explain the origins and mechanisms of the financial
crisis.
It takes a historical sweep, going back to the 1940s and 1950s, which
was when
the economic discipline made a deliberate effort to become more
"scientific"
which to them meant more mathematical. This methodological choice
favored
neoclassical economics and promoted the rise of financial economics
whose
fundamental flaws were incorrectly dismissed as inconsequential. These
faulty
ideas nevertheless became the basis of public policy, and led to
deregulation in
financial services, which in turn produced predation and looting.
ECONNED
exposes some particularly destructive trading strategies that played a
key role
in making the crisis much worse than it otherwise would have been, yet
have been
overlooked by regulators and the press.
The IRA: The economists wanted to
mimic the great minds in the
world of physics. They figured if the mathematicians could use quantum
theory to
solve problems of big physics, then why not use the same scientific
method to
address economic issues. The problem, of course, is that economics
involves
human behavior, so you cannot use mathematics to describe it. In the
February
25, 2010 issue of The New York Review of Books, Freeman Dyson,
Professor of Physics Emeritus at the Institute for Advanced Study in
Princeton,
wrote a wonderful profile of Paul Dirac, who along with Albert Einstein
was the
father of modern quantum theory. Dirac did not have Einstein's talent
for
publicity and self-promotion, so few people know of his crucial
contribution. Dyson described Dirac's views about the use of
mathematics
outside of the rational, verifiable world of science in areas such a
philosophy.
Economics falls into the same social science bucket as philosophy.
Dyson
writes: "Dirac took no part in these debates and considered them to be
meaningless. He said, as Galileo said three hundred years earlier, that
mathematics is the language of that nature speaks. When expressed in
mathematical equations, the laws of quantum mechanics are clear and
unambiguous.
Confusion arises from misguided attempts to translate the laws from
mathematics
to human language." One wonders what Dirac would say today about modern
economics.
Smith: Exactly. One of the problems
with financial economics is
that in order to make the mathematics tractable, economists assume
rationality
and consistency in human behavior. It is telling that economics is the
only
social science that makes these assumptions. Every other social science
assumes
human irrationality and inconsistency. A second problem is that
economists
prefer a proof-like stylization of their argument, and that further
constrains
how economists can model real-world behavior. Ironically, mathematicians
look
down on the way that economists use mathematics.
The IRA: Well they should. In the hard
sciences this type of
malfeasance and poor methodology choices get you bounced out of the
profession,
but in economics it is rewarded.
Smith: Yes. So when the economist
tries to present his argument
in a proof-like style, that methodological choice forces him to assume
stability. We all know that is a suspect assumption.
The IRA: So whether we are talking
about financial economics or
the use of statistical models to predict corporate default or
prepayments on
mortgage backed securities, the basic assumptions are all wrong and thus
the
final product is useless. This is, by the way, why we chose to embrace a
quarterly survey approach for our bank stress ratings that uses
fundamental
factors and not statistics. Only by testing each quarter using
consistent
criteria can you capture the changes in the entire banking industry and
individual bank business models.
Smith: Right. That illustrates one of
the difficulties of the
approaches the discipline prefers, that it makes it hard to integrate
qualitative information. "Hard" data that can be quantified easily is
preferred,
which produces drunk under the street light behavior, of framing
empirical
analysis around where economists can get clean data, rather than around
what
questions really are important to be answered, and then figuring out how
to get
insight with the information, both hard and soft, that is available.
The IRA: Correct, thus we have the
spectacle of efficient
market theory reliant upon equity market prices to predict default. This
brings
us to the luncheon discussion we had with Nouriel Roubini last week and
our
favorite topic, namely credit default swaps (CDS). We have always seen
CDS and
OTC derivatives in legal terms as an outgrowth of the market for
currencies and
interest rates. When OTC swaps were just about currencies and interest
rates or
even energy, there really was no problem because these contracts are
priced
against visible, liquid cash markets. But when the banks went into
credit
products, in our view at least, they went a bridge too far because there
is no
cash basis for the derivative. Instead the banks use models that were
developed
by financial economists in partnership with the large banks. Indeed, if
you
think of CDS as the creation of an ersatz, speculative market such as
trading
carbon credits, it fits very nicely with your description of the
speculative
nature of financial economics. What is your view of the evolution of
CDS?
Smith: People use the term "swap" for
CDS, but things like
credit contracts or carbon trading markets are at best prediction
markets. The
whole use of the term swap is a misnomer. There is a great fondness for
prediction markets, but they can and do perform badly. It really comes
down to
whether the people making the bets are making informed judgments. I'm
sure
you've heard your clients complain like mine that the marginal price of
these
instruments are being made by a 24 year old who knows nothing about the
underlying relationships. The CDS market is almost entirely divorced
from old
fashioned credit analysis and, indeed, the participants basically say
that if
CDS says X, why do I need to do credit analysis?
The IRA: Precisely. We see numerous
examples in the academic
literature where economists take CDS prices as biblical text and rely on
these
contracts to support research. The profession is effectively eating its
own
tail, but they don't seem to appreciate such distinctions. If you look
at the
Bloomberg or any of the other commercially available models to calculate
probability of default, the reality is that the users are simply pricing
off
volatility, not any thoughtful measure of default risk. At lunch last
week you
started to talk about Phibro-Salomon and the competitive issues which
drove the
evolution of CDS at the largest banks. Care to expand?
Smith: There was a very interesting
bit of industry evolution
which led to the creation of the swaps market. People forget history.
Back in
the 1960s, over 70% of securities industry revenue was from commissions
on
equities. Firms held very small inventories. Institutional investors
held longer
dated Treasury and corporate debt to manage the fixed liabilities in
their
portfolio. Because pension funds and life insurers matched assets
against
exposures, bonds did not trade very much in the secondary market. The
interest
rate environment was stable and people were fairly confident in their
ability to
forecast. In the newly volatile interest rate environment of the 1970s,
you
suddenly saw a shift to bond trading. This was also the period of
deregulation
of stock brokerage commissions, so you saw the safe businesses squeezed.
These
changes in the business environment drove an increase in trading of
instruments
and this forced dealers to increase their inventory to accommodate
trading and
began to put pressure on the old line partnerships. It meant they needed
bigger
balance sheets, hence more equity, when revenues were falling and risks
were
rising.
The IRA: Correct. We saw that working
at Bear, Stearns in the
1980s. They could not handle the huge leverage structure that rested on
top of
their capital position. Indeed, if you look at the banks that we cover
today in
the IRA Advisory Service, names such as Goldman Sachs (GS) and Deutsche
Bank
(DB) are heavily reliant on trading revenue. In the case of DB, the
bank's
primary business line is now cash and derivatives trading out of their
London
operation. So did deregulation cause the financial crisis of 2007? This
sounds
like yet another case in point where efficiency is not necessarily a
good thing.
When we deregulated Wall Street, did we force the banks to become more
speculative?
Smith: I don't think that anybody
thought through the
implications. Deregulation was seen as benign. All of the measures that
the SEC
took to wring more easy profits out of the industry were justified in
the name
of helping the little guy, the small investor. We went from trading
stocks on
eighths to decimalization. But while deregulation was justified as being
pro-consumer, the results do not bear this out. Look at the unintended
consequences. The average holding period for stocks has dropped
dramatically. It
used to be something like 22 months, now it is well below a year.
"Investors"
can no longer be considered to be investors anymore.
The IRA: No, they are speculators.
This is the Jim Cramer, CNBC
school of day trading as "investing." And this also goes to your point
about the
speculative nature of financial economics.
Smith: Exactly. Along with the changes
in the markets and the
behavior of individual investors, you had growing pressure on banks to
generate
profits and expand their balance sheets. Salomon Brothers responded by
selling
out to Phibro, a publicly traded commodities dealer, to gain access to
cheaper
capital in 1981. As the inflation-stoked commodities boom became a bust
almost
immediately after the deal closed, the old Salomon partners engineered a
bit of
a coup and came out on top. This was during the explosive period of
growth in
the mortgage-backed securities market, a very profitable business which
Salomon
pioneered. Salomon made more money in the mid 1980s than all of the
other major
firms combined. This freaked-out their competitors. Salomon was
aggressively
building out its platform internationally and this infrastructure
expansion also
put a lot of pressure on other firms. The economics of the traditional
partnerships with higher cost of capital could not accommodate these
demands. By
1986, all the full-line investment banks were public firms, with the
lone
exception was Goldman Sachs because they took an investment from
Sumitomo Bank.
The IRA: And of course you worked for
both firms during this
period.
Smith: Yes. The second wave of
pressure on investment banks
came with the rapid growth of the OTC derivatives in the early 1990s.
That
business favored commercial banks with bigger balance sheets and this
gave the
commercial banks the chance to get in on the ground floor. The
commercial banks
had been pecking away at getting into the old-style investment banking
business
during the 1980s and had not made much progress. OTC derivatives was a
market
where the commercial banks had an advantage. They could get into the
business
using quants trained in the world of financial economics, a lot of them
acquired
via acquisitions of teams or established firms. So, again, the
investment banks
were forced to bulk up even further and acquire more capital.
The IRA: This suggests one of our
favorite topics, which is
that efficiency is not always good. The founders of the United States
rejected
efficiency arguments and instead used mechanisms such as checks and
balances to
deliberately make our political system inefficient, but the financial
economists
took the nonsense of efficient market theory to its most extreme.
Smith: Correct. The policies that came
out of the Great
Depression, which policy makers thought about carefully, were successful
until
the environment changed radically. We had forty years of stability on
Wall
Street under the rules established in the 1930s. Commercial banks were
kept
stupid and comfortably profitable, but that approach depended on there
being
little volatility. The old rule of 3-6-3, gather deposits a 3%, lend a
6% and
the bank officer leaves as 3:00 in the afternoon was the model and it
worked
well.
The IRA: That is the description of a
community bank today.
They have a couple of funding choices and can perhaps go the Federal
Home Loan
Banks, but that's about it. But all banks are about to get to know the
old
boogie man of interest rate risk when the Fed ends its asset purchases
next
months. Our friend and mentor Martin Mayer likens the evolution of the
OTC
markets as a pre-1930s bucket shop model, a completely speculative
model. Do you
agree with that characterization?
Smith: That isn't too far off the
mark. The new behemoth
capital markets players really saw the role of traditional investment
and
commercial bankers eroded, so the new culture is a trading culture. The
concerns
on the investment banking side had acted as somewhat of a check on
behavior.
Branding and reputation matters to bankers, so you can't be seen to be
ripping
off your clients. Now with the trading side ascendant at most firms, the
attitude is that anything goes and all fair in love and war. This has
resulted
in a predatory posture by most firms toward their clients. If trading is
all
that matters and you are not concerned about traders and the sales desk
killing
the goose that laid the golden egg in terms of buy side clients, then
you end up
with situations like the one destroyed Bankers Trust. Proctor &
Gamble sued
them in a dispute over P&G's losses, and got access to taped
conversations
by BT's staff. The comments about clients became public and they
contained
incredibly damaging material, remarks like "We lure them into the dark
and fuck
them." That attitude has become common today. The only difference is
that people
in the industry today haven't been caught talking about it the way the
Bankers
Trust did.
The IRA: There was a little bit of
reporting on this in the New
York Times recently, talking about the difference between a sales person
and an
investment adviser. The former has no duty of care to the institutional
client
while the latter has an affirmative duty to follow rules on suitability
and
know-your-customer. Do you think that the SEC should revisit this issue
and
consider imposing a duty of care on all employees of banks and dealers?
Smith: Yes, because then you would
have grounds for private
lawsuits.
The IRA: Correct. Such a regime would
also imply an end to
FINRA arbitration to hide the bad acts so that investors could sue
dealer firms
for fraud and negligence when the duty of care was not performed. People
often
forget that there are many former employees of dealers who now work in
the hedge
fund community, including some very prominent names and owners of funds,
who
cannot be registered with FINRA because of previous transgressions.
Smith: Absolutely.
The IRA: What do we do to fix this
problem? Other than imposing
suitability and a duty of care by the employees of dealers, what else
would you
do to lessen the speculative character of the financial markets?
Smith: I would subject everything to
SEC disclosure standards.
One of my pet peeves is significant omissions in disclosure. For
example, one of
the things that the FDIC is pushing in its proposed changes for
securitization
rules is that the parties very clearly disclose their intent. Under the
current
rules, you cannot determine who intended to do what in a given
transaction.
Whoops! The underwriter of a securitization is using the vehicle to go
short?
Most investors would give a deal a lot more scrutiny if they knew that
to be the
case. Goldman's Abacus and Deutsche Bank's Start programs were each a
series of
synthetic CDOs that the firms used to put on real estate shorts. Most
people
think those deals did not pass the smell test; indeed, Bear Stearns
refused to
work with John Paulson when he wanted to create synthetic CDOs for the
same
purpose, to go short. But that sort of arrangement is kosher under the
current
rules. That's the sort of thing the FDIC wants to change. They would
require the
Paulsons, Goldmans and Deutsches to explain their true aims.
The IRA: Would you require that
holders of CDS be compelled to
deliver the underlying asset in order to receive payments on their
default
insurance? This would essentially take us back to the pre-Delphi world.
Smith: That would make a huge
difference. I do not understand a
world in which you can change the rules on existing contracts, as the
industry
did to preserve the CDS market when Delphi declared bankruptcy, on the
one hand,
but then rail about the sanctity of contracts on the other. All CDS
prior to
Delphi required that you present the bond to the protection seller, who
would
then pay you the face amount that he had guaranteed. Suddenly ISDA
discovers in
Delphi, the first real test of the CDS market, that the notional value
of the
contracts on Delphi greatly exceeds the face amount of outstanding
bonds. Rather
than risk the credibility of a product that was a big profit engine for
its
members, it modified the rules on the fly to allow for cash settlement.
And that
has allowed for a lot of destructive behavior, particularly the role
that
shorting subprime played in the crisis. It allowed the amount of
subprime
exposure to become much greater than that of the actual subprime market,
greatly
increasing the amount of damage done to financial institutions and costs
to
taxpayers.
The IRA: Well, this is the dirty
secret about Paul Volcker and
Gerry Corrigan. As regulators each of these men stood by and watched all
of
these developments in the banking industry and did nothing. Indeed, each
of them
encouraged these evil evolutions in order to boost the short-term
profitability
of the large banks but never understood or cared that on a risk-adjusted
basis
these returns were in fact negative.
Smith: One thing that has been
disappointing is that here we
are, approaching three years since the start of the crisis, and there
have been
no investigations of fraud on Wall Street. Lehman was clearly a fraud.
Hank
Paulson effectively says that in his new book, that Lehman had greatly
overvalued its assets in its SEC filings. Some argue that we should not
pursue
fraud claims with respect to Lehman because that would complicate the
bankruptcy. That is not a good enough reason because who knows where a
thorough
investigation would lead. The other part that I find disappointing is
that
people keep talking about banks, but don't differentiate between ones
those with
dealer operations and those without. None of the reform proposals on the
table
now, including the Volcker rule, deal with this distinction. Trading and
market-making operations pose very different sets of risks, both to the
institution itself and to the financial system than traditional banking,
and
therefore need to be addressed differently.
The IRA. We could not agree more.
Thanks Yves and good luck on
the book.
Questions? Comments? info@institutionalriskanalytics.com
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