Thursday, November 17, 2011

The Bond Market Rules

Do capital markets serve us or vice versa? This recent Barron's article by Thomas Donlan provides an unequivocal point of view when it comes to the bond market:

Knock, Knock: Open the gates of Rome to the market

"Unrecognized as saviors, the bond vigilantes are demanding the keys to the Eternal City. If the Italian people are very lucky and very wise, they will allow themselves to be ruled by the bond market."

Reminds me of what James Carville once said:

"I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody." - James Carville (Wall Street Journal, February 1993)

Consider that Carville said the above well before the vast world of what is essentially unregulated insurance, the credit default swap (CDS), came into prominence.

The world CDS is, in effect, an immense casino where you can bet against someone's debt (profit from default) without being required to have an insurable interest.

Now, consider that the insurable interest doctrine is a fundamental concept in insurance that came about long ago for some very good reasons learned the hard way. It originated in English statutes. The intention of these statutes was to...

"...remove insurance contracts from the environment of gambling and the misconduct commonly associated with one having the ability to profit from another's loss." - From the Origin Of The Insurable Interest Doctrine

It's, in part, about eliminating the ability to buy insurance on another's property. Basically, the aim is to remove any incentives a speculator may have to destroy or reduce the value of another person or entity's assets.

Well, the CDS market pretty much circumvents this doctrine.

The excerpt below is from a paper that compares an 18th century speculator to a 21st century hedge fund manager.

The 18th century speculator buys insurance on a British cargo ship.

The 21st century hedge fund manager buys credit default swaps.

Insurance and Credit Default Swaps: Should Like Things Be Treated Alike?

"Compare the following hypotheticals:

An 18th century speculator buys insurance on a British cargo ship in which he has no interest. The speculator then sends a message to his cousin in Paris, asking the cousin to inform the French fleet of the ship's schedule. A French frigate uses the information to sink the British vessel. The speculator collects on his insurance contract. To mitigate this danger, the insured interest doctrine was created to keep the speculator from profiting on his insurance contract.

A 21st century hedge fund manager buys millions of dollars in CDSs that will pay off only if company (x) declares bankruptcy. The hedge fund manager then organizes the short-term purchase of creditor voting rights as the embattled company (x) attempts to borrow money to avert Chapter 11. The hedge fund votes against allowing further borrowing and company (x) is forced to declare bankruptcy.

The CDS bet pays off and the hedge fund manager finds herself with a substantial return. In terms of the moral hazard to be averted, the second hypothetical is no different from the first as both create new risk through contract."

Later in the paper...

"...CDS traders and their attorneys have worked hard to distinguish their new financial product from insurance to avoid stringent regulatory insurance regimes."

Someone that buys a CDS, yet doesn't own the underlying debt, has an interest in things going badly. More from the paper:

"...CDS contracts, in [Professor Frank] Partnoy's words, might create incentives to destroy value by allowing profit to be born from loss."

Might? Nicely understated. Sometimes things in combination form their own reality. Maybe a few misleading statements get made or rumors get spread. More buyers come along and the price of the CDS goes up in value (the CDS markets are not the most liquid). That move in price is taken as an indicator of credit stress and creates a headline.

This stuff feeds on itself.

With enough force, emotion, money, and clever use of the media it can, in fact, do real damage. There's certainly no shortage of powerful media tools available these days.

Does it feed on itself to the point where a bank run of sorts is precipitated? Maybe not, but who knows?

More than occasional misconduct seems inevitable without, among many other things*, of course, something like an insurable interest requirement in place.

From a historical perspective, England provided leadership when it comes to the insurable interest doctrine. The doctrine came about in the 1700s under George II and III after seeing the kinds of bad behavior that results without it. They had learned the hard way from vast experience that lack of such a doctrine creates moral hazard. A system that allows someone buy insurance on another's property generally serves the world poorly.

It's a doctrine that has served civilization quite well I might add for a very long time.

"The English Statutes of George II and George III form the fundamental principles of the insurable interest doctrine by requiring owners of property and life insurance to have an 'interest' in the subject matter of those contracts." - From the Origin Of The Insurable Interest Doctrine

The arguments against treating CDS as insurance seem to deliberately ignore the inevitable creation of moral hazard. The disregard for the purpose of things like insured interest is disappointing but not surprising. It would be baffling if it weren't fairly clear that plenty with more than a little influence have a vested interest in the status quo.

No doubt these contracts serve some individuals or organizations very well but as constructed now it's potentially at great cost to the rest. Many will argue, especially true believers that markets always know best, things like CDS and bond vigilantes play a vital role in forcing the target governments, banks, and businesses to get their house in order. That can be a potential very real plus. The problem is that view ignores the other sharp side of what is a two-edged sword. Without more safeguards and a more proper balance, the current system as designed can make, if abused, a serious problem into an emergency with costly consequences.

Considering the immense size and potential destructiveness of the CDS market in its current form, I think it is more than fair to say that it, along with some other aspects of increases to system complexity and interconnectedness, needs to be reigned in to some extent. From this paper by James Rickards:

"Despite obvious advantages in terms of global capital mobility facilitating productivity and the utilization of labor on an unprecedented scale, there are hidden dangers and second-order costs embedded in the sheer scale and complexity of the system. These costs have begun to be realized in the financial crisis that began in late 2007 and have continued until this writing and will continue beyond."

There are very real structural problems related to too much global leverage.

There's no question.

Yet, the size, complexity, and interconnectedness of the existing financial system can also add instability that turns real and serious economic problems unexpectedly and unpredictably into even bigger ones.

It seems to me that the advent and existence of the CDS market, among other financial "innovations", can convert what are merely serious problems (that historically would otherwise likely be solved over time even if done in a messy and slow fashion) into crisis or worse because of the sheer scale, complexity, and interconnectedness now involved.

Financial weapons of mass destruction, indeed.


Related post:
Sinking Seaworthy Ships

* Among those other things less leverage is a good place to start. Also, more limitations on the use of derivatives (which is, of course, a huge source of hidden leverage and hard to measure risk) or at least a clearinghouse of some kind for transparency (increasingly banks are clearing credit and interest rate derivatives through central counterparties). The list of safeguards and limits that seem needed to assure system stability goes on. The risks associated with the scale, complexity, and interconnectedness of the financial system are clearly not well enough understood. I'm guessing, in time, we'll learn much more has to be done to protect the system against the risk of instability and catastrophic collapse. A system this complex ultimately, when under stress, cannot be expected to behave predictably in any meaningful way. Limits and safeguards that protect the system (not the participants) seem inevitable. The question seems to be whether they'll be done proactively or not.
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