Fun with lawyers for all the family

An interesting article in the FT on the standardisation of documentation for synthetic CDOs raises an interesting point. Whenever ISDA has standardised documentation before, the article claims, extra liquidity has resulted. Leaving aside the occasions when it took more than one stab to get the docs right -- the issues over restructuring and what a contingent obligation is exactly spring to mind -- it seems like that the FT is right on this occasion. So given how much the market makes on a new instrument, shouldn't the banks be falling over themselves to pay for more ISDA lawyers? It does at least appear that this is one case where everyone spending a pound brings most people much more than a pound back.

Pegged CDS spreads

I was reading Chris Patten's musings on Hong Kong, East and West,--it's not bad, but his unquestioning faith in free markets is a little naive,--when it occurred to me to wonder what a market with pegged CDS spreads would be like. Indulge me with this thought experiment. Patten points out quite rightly that one of the problems with China is a banking system rotting from the inside thanks to inappropriate lending at the wrong spread. This classic failure of managed economies typically causes a huge problems when the banking system needs to be recapitalised. OK. So how could this be avoided? Pass on some of the risk. But no one will buy these loans at anything like par given the spreads they were made at. But we know how to deal with an uncooperative market - fix the price. It worked in FX for many years - that was called Bretton Woods. So what would an economy look like when the government or its cronies dictated the 'fair' value CDS spread of local corporates? It might not be pretty, but it is an interesting question.

Trust me, I'm an economist

I've just seen an amusing programme on BBC2, 'Trust me, I'm an economist'. It applies, albeit in a rather trite way, ideas of game theory, strategy and incentive structures to 'real life' situations. And it isn't bad. Really. Considering. Given it is television.

The University of London - a really good idea gone horribly wrong

It seems as if the chances of the University of London breaking up are increasing. Imperial and UCL have been trying to escape for some time, with others not far behind. This is really a great shame, as the University of London is a good thing, and it would be a better one if it had some teeth.

First the logic. Land in London is expensive. Centralisation of function works in some cases. And large University departments often work better than smaller ones. So it makes sense for some functions,-the student union, the careers service, the library and so on,-to be provided centrally rather than by each college. The University provides these to the benefit of all.

Now for the more difficult bit. There are some genuinely world class departments at many Unversity of London institutions. Most of the science or engineering departments at Imperial, Asian languages at SOAS, theology and law at Kings, quite a bit of UCL for instance. There are also frankly pretty mediocre ones, and there is a lot of duplication. Is the University's reputation really enhanced, say, by physics at Kings, Royal Holloway or Birkbeck when it is done so well elsewhere? Perhaps, but the case is at least arguable. A University of London with teeth would be able to enforce quality control and would allocate resources where they could do the most good: it makes little sense for colleges to try to compete in subjects they are not world class in when they could spend the money in their best departments.

Of course, the colleges hate this idea. The idea of the University of London actually enforcing high quality standards seems to terrify them. They appear to prefer duplicating facilities and offering lower standard courses than cooperating with their colleagues a few miles down the road. Together, the colleges of the University of London could be a world class institution. Separately they are not nearly as strong. But pride and hubris seems to be pushing them apart.

Mathematical Finance as a Historical Subject

Reading papers outside your discipline is good, and I've just found a corker, The Big, Bad Wolf and the Rational Market: Portfolio Insurance, the 1987 Crash and the Performativity of Economics by Donald MacKenzie in the Sociology Department at Edinburgh. He makes several interesting points.

Firstly he suggests treating finance as (a) historically variable in its verisimilitude; (b) dependent for its verisimilitude on institutional and technological conditions; and (c) implicitly a historical project, incorporated into efforts to transform its object of study, the financial markets. No surprises so far, but rather nicely put. MacKenzie then introduces the term 'performative' for utterances that make themselves true, giving as examples the naming of a ship or the Black Scholes theory of option pricing. (Of course before Black Scholes, the warrant markets traded rather far from Black Scholes prices, a fact that cost Black, Scholes and Merton rather a lot of money. It was only once their theory became established that the markets came in line, modulo the smile.)

Then MacKenzie goes on to point out that the 1989 crash fits rather poorly within any of the standard Brownian motion based models of asset price dynamics, but it does mirror somewhat startlingly the initial falls of the Dow Crash of 1929.

Personally I think MacKenzie over emphasises the potential role of portfolio insurance in the Black Monday crash. He suggests that once markets were close to or beyond the protection bounds of CPPI strategies being executed by market participants, further falls were inevitable. While this is clearly true, it remains unclear if there was sufficient activity in this area to explain much of the Black Monday fall, at least compared with the activities of the large stock funds, investment managers (many of whom were aware of the comparison between the run up to Black Monday and the run up to the 1929 events before the fact), and indeed anyone else with a stop loss.

MacKenzie quotes Leland, one of the fathers of portfolio insurance, on the topic of information. Leland contents that if investors had known how much of the Black Monday selling was caused by programme selling, that is automatic selling under CPPI or options hedging, market participants would have been reassured and the fall would not have been so severe as 'judgement' investors would have been more willing to buy into the fall. This is an interesting claim: a devious experiment would be needed to test it, but the results would be fascinating.

Finally, MacKenzie comments on the market's performativity. To summarise a rather complex conclusion in a few sentences, he suggests that banks have an interest in making the markets as like the model as possible and that this process is dangerous in that it gives confidence in the stability of model applicability over time that may not be justified. It is almost as if we are saying 'the model works unless there are big jumps', then hedging so that big jumps are less likely but, if they happen, they will become bigger. Mathematical Finance is performative around the money, then, and antiperformative in the wings. Scarey.