Too Big To Understand

One thing that has undergone hyperinflation in recent years is the length of financial regulations:

Too Big To Understand

The Dodd-Frank regulatory hyperinflation crowds out those who cannot afford teams of legal counsel, compliance officers, and expansive litigation. Dodd-Frank creates new overheads which are no challenge for large hedge funds and megabanks armed with Fed liquidity, but a massive challenge for startups and smaller players with more limited resources.

As BusinessWeek noted in October:

The law requires Hedge Funds to register with the Securities and Exchange Commission, supply reams of sensitive data on trading positions, carefully screen potential investors, and hire compliance officer after compliance officer.

So, is this expansion in volume likely to improve financial stability? No — the big banks are bigger and more interconnected than ever, which was precisely the problem before 2008, and they are still speculating and arbitraging with very fragile strategies that can incur massive losses as MF Global’s breakdown and more recently the London Whale episode proves.

Andy Haldane laid out the problem perfectly in his recent paper The Dog and the Frisbee:

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity.

Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans.

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the
frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity.

Big, messy legislation leaves legal loopholes that clever and highly-paid lawyers and (non-) compliance officers can cut through. Bigger and more extensive regulation can make a system less well-regulated. I propose that this is what the big banks will use Dodd-Frank to accomplish.

I predict that the regulatory hyperinflation will make the financial industry and the wider economy much more fragile.

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Can I Have a Bailout?

Am I about to get regulated?

From Zero Hedge:

SocGen’s Todd Martin, who is the bank’s Asia equity strategist, appeared on Bloomberg earlier today to discuss the Volcker Rule and prop trading, against which the anonymous blogosphere had some very “strong views” back in 2009. Sure enough, prop trading ended a few months later with the adoption of the Volcker Rule. Somehow, the topic of the Volcker rule shifted to the topic of whether or not Morgan Stanley is exposed to France, and its insolvent banks, and who is to blame: “For example one blog just a week ago, had a very, very strong view against Morgan Stanley. They quoted Sanford Bernstein who actually was telling people to buy the stock. And then they were quoting Gross Exposures not Net, and then concluding that Morgan Stanley had to go down and be dismembered [sic]. Now I have a serious problem with this. If I get regulated why isn’t this place regulated. It’s also very dangerous because they are using psudonames [sic] and we don’t know who they are. They could be the guy on the street. They could be a hedge fund dangling out information. It could be the head of a prop desk. Thing is it is supposed to be regulated. And they get their revenues from trading platforms on US soil. And I don’t think it’s fair. And I think the US should go and take a look and regulate the blogosphere. I think it’s really, really out of control.” In other words: it is all the blogosphere’s fault.

Of course, it is a simple fact that while the promise of bailout money hangs over markets, some traders and executives will take huge risks with other people’s money (shareholders, taxpayers, anyone with a loose chequebook). This agency problem creates huge fragility — especially in a system like modern international finance which is prone to the default cascade, where one bank failure can potentially bring the system down. And it is also true that Dexia — a bank that only recently passed the regulators’ stress tests with flying colours — just failed (ouch) and had to be bailed out.

The reality is that the only way to create a system based on responsible behaviour is to enforce the idea in capitalism that actions have consequences —  no bailouts for screw-ups, no free lunch, remove the money from politics, etc.

The real issue here, though, is just how “regulated” I might end up being.

From Wikipedia (surely this needs to be regulated, too?):

Censorship in Nazi Germany was implemented by the Minister of PropagandaJoseph Goebbels. All media — literaturemusicnewspapers, and public events — were censored. Attempts were also made to censor private communications, such as mail and even private conversation, with mixed results.

The aim of censorship under the Nazi regime was simple: to reinforce Nazi power and to suppress opposing viewpoints and information. Punishments ranged from banning of presentation and publishing of works to deportation, imprisonment, or even execution in a concentration camp.

Hitler outlined his theory of propaganda and censorship in Mein Kampf:

The chief function of propaganda is to convince the masses, whose slowness of understanding needs to be given time so they may absorb information; and only constant repetition will finally succeed in imprinting an idea on their mind.

Right — citizens need to have the right ideas imprinted on their minds.

Repeat after me:

The Euro is not failing.
The Euro is not failing.
The Euro is not failing.
The Euro is not failing.

Let’s try another one:

Goldman Sachs is doing God’s work.
Goldman Sachs is doing God’s work.
Goldman Sachs is doing God’s work.
Goldman Sachs is doing God’s work.

Feels good, doesn’t it?

More importantly, now that I am doing God’s work (by proxy), can I get a no-haircut bailout if I leverage myself 100:1 selling out of the money S&P calls and lose all my capital?

Is Leverage the Problem (Again)?

So the European Monetary Union is (slowly failing). Nations are reaching ever-closer to default, bringing about the prospect of shockwaves and turmoil throughout the region and the world. Why can’t nations just default? Well — they can. But policy-makers fear the consequences of blowing holes in the balance sheets of too-big-to-fail megabanks. Sovereign default would lead to the same problems as in 2008 — margin calls on banks’ highly leveraged positions, fire sales, a market crash, and the deaths (and potential bailouts) of many global financial institutions.

From Lawrence Kotlikoff:

Sovereign defaults are only the proximate cause of this euro-killing nightmare. The real culprit is bank leverage. If the lenders had no debt, sovereign defaults would reduce the value of their equity, but wouldn’t shut them down, thereby destroying the financial-intermediation system.

Non-leveraged banks are, effectively, mutual funds. If appropriately regulated, mutual funds don’t make promises they can’t keep and never go bankrupt. Yet they can readily handle all manner of financial intermediation as 10,000 of them in the U.S. make abundantly clear.

Countries get into trouble, just like households and firms. Similarly, nations should be permitted to default without threatening the global economy. Forcing the banks to operate with 100 percent equity by transforming them into mutual funds – - as I have advocated in my Purple Financial Plan – is the answer to Europe’s growing sovereign-debt crisis.

In a nutshell, the ECB tells the banks: “No more borrowing to buy risky assets, including sovereign debt, and forcing taxpayers to take the hit when things go south. You’re now limited to marketing mutual funds, including ones that hold nothing but cash and will constitute our new payment system.”

Now I don’t doubt that this is a very good idea that could potentially restore meritocracy — allowing good businesses to succeed and bad ones to fail. But would it solve the problems at the heart of the Eurozone?

In a word — no. As was noted at the Eurozone’s inception, the chasm opened up between a nation’s fiscal policy (as determined by a nation’s government), and its monetary policy (as determined by the ECB) necessarily leads to crisis, because monetary policy cannot be tailored to each economy’s individual needs. Kotlikoff’s suggestion would reduce systemic risk to the banking system (largely a good thing), but would merely postpone the choice that European policy makers will have to make — integration, or fracture.

Will China Bail Out the World?

With fear running high on global markets, particularly regarding sovereign debt in the Eurozone, many commentators are asking: will developing nations flush with cash (i.e. China) ride into town and save the day?

From Reuters:

Italian Economy Minister Giulio Tremonti said on Thursday that Asian investors are reluctant to buy Italian bonds because it sees they are not being bought by the European Central Bank.

Speaking at a news conference, Tremonti also said it would be desirable for the central bank to follow the lead of the Japanese and Swiss central banks in taking expansionary steps to tackly the euro zone’s crisis.

“I note that the Bank of Japan today launched quantitative easing and the Swiss cen bank cut rates to zero, we are waiting for decisions if possible, but desirable (from the ECB),” Tremonti said.

When you talk to Asia they say: “We don’t understand what Europe is,” he continued. “The second point is that they say ‘if your central bank doesn’t buy your bonds, why should we buy them”?

That is a fairly unqualified no. And why should they? As Amschel Mayer de Rothschild famously put it:

Buy when there is blood on the streets

And China are entitled to hang onto their money and let asset prices depreciate further to get more bang for their buck. But some signs suggest they will act. The more Europe and America deteriorate, the weaker the demand for Chinese goods.  And China’s massive FX holdings’ value is dependent on the system of international trade and the economies of various Western nations retaining functionality. Most importantly, the only remedies that Western governments have are money-printing, and (China’s worst nightmare) debt-forgiveness, neither of which the Chinese would like to see.

Of course, China stepping in to buy shoddy debt isn’t going to offer any  solutions to underlying problems. At best it will kick the can do the road awhile, as Europe muddles around and continues to fail to come to any kind of meaningful or coherent agreement on its future. So as as Europeans clutch furiously at (Chinese manufactured) straws, there is still only one bailout party in town: