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The Week of Living Dangerously

September 21, 2008

We seem to have entered a new phase of the credit crisis. We spent a number of months learning just how much house prices would fall and which institutions had exposure to mortgage loans. Now, as credit problems cascade and liquidity remains scarce, events seem to have moved beyond mortgages. Now we are concerned, for example, about which firms are exposed to other firms via credit default swaps.

In this entry I will make some observations about a few of the extraordinary events of the last week, specifically about money market funds, short sales, and the need for centralized clearing of financial products.

Money Market Funds

Last Tuesday, the Reserve Primary Fund, a money market fund, “broke the buck”, telling investors that their $1 per share investment had become worth only $0.97. (The Reserve Primary Fund owned Lehman bonds, which they concluded were worthless after Lehman filed for bankruptcy.) A day later Putnam liquidated one of their institutional money market funds. Investors, concerned that more money funds would break the buck, headed for the exits.

This was a classic bank run: Investors feared that by not withdrawing they would be left owning a fund that had broken the buck, while if they withdrew immediately they might still receive a buck. The liquidations would probably prove a self-fulfilling prophecy, causing a drop in the price of assets money funds hold (who would have bought the assets being dumped by the money funds, such as bank CDs and commercial paper?). This drop would have caused funds to break the buck. The run would have had wider ramifications: Corporations have lots of short-term investments, so the decline in price of money market assets would likely have affected corporate balance sheets, causing losses for non-financial companies.

Only the federal government had the ability to stop a run, and it did so (one hopes) by announcing that it will insure money market funds.

Exactly what is the plan for insuring money market funds? The Treasury announcement is not packed with detail. Money market funds compete by offering high yields, but this requires taking risk, and government insurance for an activity always runs the risk of making the next crisis worse as the insured engage in riskier behavior. The funds compete with banks, who face stringent capital requirements and strict regulation. The bankers have already been complaining that insurance for money market funds is unfair to banks.  It will clearly be necessary to harmonize the different forms of insurance. If money fund insurance is to work, there will probably be restrictions on investable assets, monitoring of the money market funds, new account fees and a new agency required to do the job. Making this work will not be easy, and the federal government will have yet another potential future liability. The banking lobby will be hard at work to make insurance onerous.

Soon you will probably be able to choose between low yielding insured money market funds and higher yielding uninsured funds, and the higher-yielding funds will have the right to suspend withdrawals. Banks will have to somehow fit into this landscape.

(Update: The Treasury has announced that insurance will extend only to amounts held in money market funds as of Friday, Sept 19. So the guarantee is much more circumscribed than originally suggested. It would not surprise me to learn that over the weekend the banking industry requested that Treasury “provide clarity” along these lines.)

Short Sales

Of all the government actions this week, restricting short sales (all short sales of stocks of financial institutions, not just naked shorts) probably prompted the most eye-rolling among economists. (If you want to be reminded how short sales work, you can read here what I wrote about naked shorts.)  The SEC originally announced that option market makers would also be prohibited from shorting, but according to the Wall Street Journal, the SEC might back down, since option market makers are unwilling to make option markets when they cannot hedge the option positions by shorting stocks. Hmmm, seems like a loophole.

The interesting thing about a short-sale ban is that the obvious and intuitive conclusion—- that if you ban short sales you will prop up prices—- is most likely wrong. To see this, consider buying a stock on which short sales are permitted. Short sellers with information will have already shorted the stock and these negative beliefs about the firm will be impounded in the price. Investors who can go long or short will try to become informed about a company, since they know they can act on the good or bad information that they uncover. When short sales are permitted, you can trust the price.

If short sales are forbidden, investors with unfavorable information about the firm cannot express their information by trading. There is less incentive for investors to become informed about a company. Investors without information should not be willing to pay as high a price for the stock—- they will assume, correctly, that bearish opinions have been suppressed, and the price they will willingly pay for the stock will be reduced. So a short sale restriction may even lower the price by causing investors to discount high quality stocks.

The SEC’s focus on short sales reminds one of the adage that when your only tool is a hammer, every problem resembles a nail.

(Update: In the end, the SEC permitted market-makers to short as part of a “bona fide hedging activity.” (See the final order.) So investors can now buy puts, sell calls, and short futures, effectively shorting the stock by using a derivatives market-maker as a surrogate. So the order may make shorting more costly by requiring that it be indirect, but short-selling is not really forbidden.)

Central Counterparty Clearing

One of the most important issues has not yet received much attention in the press. Wall Street must move towards more use of a central clearinghouse for products such as credit default swaps. I expect that Wall Street firms will drag their feet on this issue, but they should be dragged along, even if kicking and screaming.

The term “clearinghouse” can mean a number of things (because a clearinghouse serves a number of functions), but Wall Street needs one that performs “central counterparty clearing.” Such a clearinghouse deals directly with the market participants who are clearinghouse members. When member institution A sells to member institution B, the trade is recorded, and the clearinghouse becomes the buyer against A and the seller against B: The clearinghouse stands in the middle.The primary credit exposure of A and B is to the clearinghouse. (Contrary to popular belief, the clearinghouse does not protect customers of either institution from defaults by that institution.) Clearinghouse members also agree to protect the clearinghouse against defaults. If A fails, other clearing members will provide funds to satisfy A’s obligations to other clearing members. Finally, a clearinghouse will typically require that all members post collateral (margin) for their positions to protect the clearinghouse against losses. In order for the clearinghouse to assess the value of member positions, there must be reliable prices for contracts handled by the clearinghouse. Derivatives exchanges such as the Chicago Board Options Exchange and the Chicago Mercantile Exchange operate in conjunction with this kind of clearinghouse.

How would a clearinghouse have helped in the current situation? It would not have prevented the initial round of losses from holdings of mortgage-backed obligations. But in the current phase of the crisis, losses from one firm cascade to others. A clearinghouse for credit default swaps would have provided information on the net exposure of major firms, market prices for swaps, and it would have required firms to post additional collateral as market conditions moved against them. AIG’s looming default would not have threatened the profitability of credit default swap positions at other banks, though it would have threatened the reserves of the clearinghouse. While AIG might have still gotten into trouble, its large credit default swap positions would have been apparent to regulators and to those at the clearinghouse monitoring member solvency. Ripple effects would likely have been contained.

This description of how things might have been helps explain why dealers (such as investment banks) do not want a clearinghouse for products that are currently traded over-the-counter (i.e, counterparty to counterparty).  Dealers are more profitable when products are bespoke, when prices are opaque and negotiated, and when the dealers set their own collateral requirements. In times of crisis, change seems inevitable. When things settle down and the industry lobbyists gain the ears of congress, change can become impossible.

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