Thursday, February 25, 2010

Repent! Repent! Before the Inferno Consumes You!

Original posted on the Streetwise Professor:

Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives. (Indeed, I think I’ll start referring to him as “Jeremiah.”) I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.” Lo and behold, what do I read in today’s FT:

US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.

I personally find it very disturbing that I can channel Gensler’s thinking.

The substance of the oped is more Gensler same-old, same-old. Clearing is again the deus ex machina of his sermon:

Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Uhm, just who backs that guarantee, Jeremiah? Could it be the very same derivatives dealers? Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?

Arguendo ad AIG makes its stock appearance (see the first quotation). George Stigler once wrote that data is not the plural of anecdote. What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data. What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed. First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were. Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing. Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.

Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis. He provides no evidence whatsoever–other than the tired AIG trope. This is a complete misreading of the history of the crisis. If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.

Gensler also makes some assertions that are categorically incorrect. For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.” It is, in fact, well known that excessive transparency can reduce liquidity. There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.

More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.

I could go on and on, but I’ll let it rest here for now.

If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights. He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire. (At least he spares us the apple story.) (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value. He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg. But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)

(And another parenthetical about the metaphor overload: is cancer “interconnected”? Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)

Perhaps this remarkable performance is actually good news. Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.

And that lack of success is not surprising. Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business. But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.

But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.

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