Arbitrary conviscation is a good thing

OK, maybe that is a little provocative. But here's the reasoning. Any effective special resolution regime for banks has to intervene early. That means sometimes seizing banks (particularly too big to fail banks) which are well capitalised and liquid because the supervisor thinks that it is better for the system to act now than to wait. They need to have the power to do that.

How would such a regime work? Broadly the regulator would monitor signs of stress: capital ratios, ease and cost of funding, stress tests, loan performance and so on. The range of indicators should be broad, and over time more can be developed. If one or more of these gauges suggest a looming problem, or just because the regulator thinks it wise, the bank would be seized. Either it would be sold to a stronger, well capitalised peer or a good bank/bad bank split would be made, with shareholders ending up with a stake in the bad bank. (I prefer the latter as the former tends make big banks bigger, something I think is a bad thing.)

The result of this kind of power is events like the takeover of WaMu. Some people claim that this was unfair and unwarranted. (See here for John Hempton's take on the FDIC's action here. I don't know enough of the details to know if John's account is fair, but he certainly makes some interesting points.) But even if a seizure is arbitrary, I still think that the supervisor needs to have the power to do this kind of thing, and that that power should be exercised if there is a reasonable suspicion - no more - that the bank is in trouble.

Why? Well because if banks thought that this really was likely, they would take more care to stay safe. Conviscation is an effective moral hazard prevention mechanism. Providing that shareholders know that their rights can be voided by the regulator more or less whenever they like, they will demand that banks are run in a demonstrably prudent fashion. What's not to like about arbitrary conviscation?

Is it a bird? Is it a plane?

A frequent correspondant pointed me in the direction of the recent IATA air passenger and freight statistics. They give a useful counterpoint to the Baltic Dry Index. Freight first:
You can probably guess what Passenger looks like, given BA's results:

My guess is that the freight index is a more useful guide to global trade than Baltic dry, simply because it reacts faster, and is not as badly distorted by the lag of fresh capacity coming on line.

Tucking in

Bank of England’s Deputy Governor Paul Tucker gave a speech yesterday which FT alphaville picked up. He is surprised by something that doesn't shock me in the least:

...it would be good if regulators, internationally, required all banks regularly to turn over a meaningful share of their ’stock liquidity’ in the market on a reasonably regular basis. That would also help to put banks in a position to reap the benefits of the Bank’s Discount Window Facility, through which, as I have described, sound banks can borrow gilts. Frankly, it has been shocking over the past year or so to discover how many medium-sized banks and building societies did not hold government bonds or other very high quality assets; or, if they did, how many did not have a regular presence in the gilt repo market or even had no capacity to repo at all. Turning up in the core secured-funding markets for the first time for years is an absolute give away of distress. All that has to change.

Gilts trade well under Libor. The gilt repo market is sleepy and sometimes not particularly efficient. Is the Deputy Governor really that surprised that that smaller banks choose not to dabble in a market that will likely lose them money, and which has been something of an insider's club? I know the Bank believes that gilts are the cornerstone of the market, but from the late 90s to 2007 it was the Libor market, not the Gilt market, that was by far the most important source of interbank funding for most players. The only way that the Bank is going to change that is by getting FSA to require banks to buy gilts - which is exactly what they are doing.

Too big to succeed

As I write this, Manchester United are on the verge of their champion's league final with Barcelona. I'm cheering for Barca, but I have to admit that Man U are a success. They are one of Europe's great teams, for now at least.

Let's compare them with RBS. If Man U screw up - say Ronaldo goes to Real Madrid, they overpay for Tevez who then breaks a leg, and Rooney gets even fatter and loses it - then Man U's bond holders will probably suffer. Another team - the far more worthy Liverpool for instance - will win the Championship. There will be gnashing of teeth. But the fall of this particular champion won't cause much more than a surge in beer sales as fans drown their sorrows. The problems at RBS, on the other hand, left the UK tax payer with a lot of risk, cost them a lot of money and severely restricted the supply of credit to the UK economy, with hideous economic consequences. We simply could not afford to let RBS fail.

In other words, then, some firms' size is a problem for the economy, and some aren't. (Man U's size and spending power might be a problem for football, but that is a different story.) If you have firms whose size and market position makes them effectively too big to fail, then you already have a problem. Superivising them isn't the issue: stopping them getting that big is.

John Kay takes up the next part of the story in the FT. If large, systemic providers are inevitable, or at least if we have them at the moment, we need to ensure that their functions survive their failure, whatever the cost to shareholders and the restriction on companies' freedom of action.

There should be a clear distinction in public policy between the requirement for essential activities to survive and the continued existence of particular companies engaged in their provision. There are many services we cannot do without – the electricity grid and the water supply, the transport system and the telecommunications network. These activities are every bit as necessary to our personal and business lives as the banking sector and at least as interconnected. Even a brief hiatus in their supply is intolerable.

But the need to keep the water flowing does not establish a need to keep the water company in business. We do not mind if one chain of high street shops closes its doors, because there are many other places to buy our clothes and groceries. Other industries are different. We cannot contemplate keeping aircraft circling over London while the liquidator of Heathrow Airport Ltd finds the way to his office.

In all industries where there is or might be a dominant position in the supply of essential public services, there needs to be a special resolution regime. The key requirement is that assets that are needed for the continued provision of these services can be quickly separated from the organisations engaged in their supply. The businesses involved must be required to operate in such a way that such a separation is possible.

This implies of course that there is a big difference between the big boys and the rest. The state promises to intervene in their affairs and seize their assets far sooner than it would for a less important player. If this threat is credible, not only would it be good for the economy, it also might encourage firms not to get too large. Lots of small, competitive firms are good.

Update. 2-0. Thank you Barca. The look on Ronaldo's face is priceless.

Let's get all of those worries about inflation in perspective

Hat tip the Guardian data blog.

Update. Krugman's take is here. The one line summary: does the big inflation scare make any sense? Basically, no.

The real expenses scandal

I get the sense that if I ever met George Monbiot, I'd dislike him. He often comes over as ignorant and opinionated. He's angry a lot of the time too. But none of this makes him wrong. And in yesterday's Guardian he was spectacularly right about PFI.

PFI allows consortiums of banks, construction and service companies to build and run our public infrastructure. Though the government maintains that this offers better value than using public money, in reality the numbers behind all PFI projects are rigged. While the government retains much of the risk, the investors keep the profits, which often run to many times the value of the schemes.

The public liability incurred so far by the private finance initiative is £215bn...

One of the consistent features of PFI is that the projects are reverse-engineered to meet the demands of corporate investors. This, for example, is how the £30m public scheme to refurbish Coventry's two hospitals became a £410m private scheme to knock them both down and rebuild one of them – containing fewer beds and fewer doctors and nurses. The old scheme was too cheap to attract private money.

We should all be incensed by this. Yes, MP's expenses are scandalous and symptomatic of a wider dishonesty. But if you want a case of public money being used for private gain, PFI is the biggest, most glaring example. How Gordon Brown ever got a reputation for prudence after promulgating PFI is beyond me. We should not let our anger at his other failings to distract ourselves from the failings of this rotten, shameful system. PFI encapsulates the worst of free market dogmatism without any compensating controls. There is no price discovery and little competition. Instead we have a simple transfer of public funds to private companies. PFI brings crony capitalism to the heart of public procurement, and anyone who cares that their taxes are spent efficiently should be vehmently opposed to it.

The psychogeography of investment banking

I will ignore for a moment the fact that Epicurian Dealmaker does not make very accurate use of the term `psychogeography' (see Mind Invaders for a reasonable if amusingly partial introduction), and answer his question. First he quotes Tolstoy, the important part being

A Russian is self-assured just because he knows nothing and does not want to know anything, since he does not believe that anything can be known.

The question is then

Naturally, I exclude the Russians from my analysis, because I am completely unaware of anyone currently operating in the financial sector who will admit to knowing nothing, much less take pride in it.

Your thoughts?

My thoughts are that many of the MDs I have ever met in M&A fit Tolstoy's description admirably.

The flight to simplicity

Rick Bookstaber has an interesting if flawed post on the neue sachlickeit in derivatives:

Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products.

That would all be true if the list of standardised products stays short. But I am willing to bet quite a bit of money that more and more products will be exchange traded and cleared rather quickly. The sales people - who get paid more for exotic structures - will push hard for this. Soon range accruals and power inverse floaters will go through exactly the same infrastructure as plain vanilla swaps.

Where Bookstaber goes really wrong, though, is a mythologising of the early days of derivatives:

If someone writes a history of innovative products, it will start with the golden era, when options and other derivatives were introduced to help investors better meet their investment objectives, allowing them to mold returns or, in the parlance of academics, to span the space of the states of nature. Then, somewhere along the line... [things went bad].

Oh grow up. I mean, really. Derivatives were always about tax arb and regulatory arb and ratings agency arb and accounting arb/earnings smoothing. There never was a golden age when derivatives were used just to meet risk management needs, and where unicorns lay down with virgins after the market closed. Swaps grew because they allowed the derivatives desk to lend without the credit department finding out. Credit derivatives grew thanks to a massive regulatory arbitrage. It has always been a client facilitiation business, and what the client wanted, the client generally got (albeit at a price).

Pounds per pixel

I had cause recently to muse on the rather variable cost of a pixel. It's like this.

Pentax has a new digital camera out. It's called the K-7, it is apparently quite nice, and the body will cost roughly £1,200. It will produce images with 15 million pixels. This is fairly typical for a good quality digital SLR.

Now consider the large format camera I bought the other day. It cost £200, and it will take 5x4 film. Even a medium quality flat bed scanner can produce a three hundred million pixel scan from a 5x4 negative. Lenses for the LF camera are roughly the same price as high end digital lenses - a Rodenstock Apo Sironar S 150mm is comparable in price to the Pentax 31mm limited. So I am getting a pixel for 0.000067p, vs. 0.008p for the digital photographer, a factor of over 100 better.

Now of course digital is free once you have the camera, and large format isn't. But the £1,000 I have saved will buy quite a big pile of Fuji Velvia 5x4. Sometimes old technology is cheaper and better than new...

Rebuilding

There is a lot of comment around at the moment about how broken finance is: here, for instance, is a piece by Pablo Triana. And certainly there are many, many issues that we have no idea how to deal with in practice, including fat tails, autocorrelation, correlation smiles, and hidden systematic risks. These phenomena challenge option pricing models, CDO pricing, basket option pricing, ABS pricing and all sorts of quantitative risk management model.

But, but, but. There are some things that work. The huge push in the 1990s on the behaviour of the yield curve has at least left us with a good idea how to manage single currency swaps books. Vanilla puts and calls can mostly be hedged effectively. Credit derivatives - despite stident claims otherwise - have not caused the end of the world as we know it.

We need then to return to the things we do actually know, and to be very critical about what has worked well, what has worked acceptably, and what has turned out to be unhelpful. Saying the whole edifice of mathematical finance is rotten is just as counterproductive as saying that none of it is. For once, finance theorists need to be disinterested and critical observers of reality rather than cheerleaders (or hooligans). Let's see what we need to tear down and what is still standing now that the tumult is dying down.

Anish Does Brighton

A few shots of the Anish Kapoor installations at the Brighton Festival.

Data audialisation

Via Alea, ten years worth of stock price as an audio file. Isn't that nice? More details here.

Goat backed securities

And other goat derivatives. I'm not joking. The BBC is, though. (This link may not work if you are outside the UK - I'm not entirely sure, but my apologies if it doesn't.)

Homonym corner

Many years ago, my research work was in concurrency theory. Therefore it was a bit of a surprise to find the Guardian asking Is concurrency to blame for spread of HIV in Africa? Fortunately it turns out to be a different sort of concurrency. It was a nasty moment, though. Any donations of strong spirits will be gratefully received. Well, apart from the ghost of Hamlet's father.

Hoicked from the comments

In a comment on the non-classical cost benefit analysis post of a few days ago (a title, I think you will agree, of gigantic pretention), Dave said:

I agree with your conclusions: that uncertainty and moral hazard can make CBA unreliable and sometimes it is better to rely on qualitative objectives.

But I disagree with your applying these to systemic risk. Firstly, with systemic risk it is the "worst-case scenario" that is important. If regulators had used the great depression as the worst case scenario, they wouldn't have been far wrong.

Often, though, the worst case scenario can be hard to identify. The worst case scenario in much of finance for instance is that all claims are worthless and all liabilities come due immediately. We might as well all go home if that comes true, and barricade the doors. 'Plausible' worst cases have a nasty habit of turning out to be too optimistic: wasn't it David Viniar from Goldman who said that 2008 was much worse than the most pessimistic scenario they looked at?

Secondly, I can't see how systemic risk regulation would cause bankers to take greater risks. So, I don't see where moral hazard fits in.

Fair enough - bankers are not people riding bikes. (Quite literally, usually - Wall Street tends to view cycling to work as only marginally less strange than coming by elephant.) So probably bankers did not take more risk because they were regulated. Some of them did, however, take as much as they could subject to regulation, because that was the way to maximise returns to shareholders.

Thirdly, how do you take a "moral" position on systemic risk? I don't think this gets you very far.

Well, I think that the key idea of Anglo-Saxon capitalism - that the first and only duty of a firm is to its shareholders - is simply immoral. Of course, like any ethical judgement, you can disagree with that. But I also think, and I'd like to think that I can prove, that a system that has a wider burden of responsibilities, including a responsibility to the financial system, would be less likely to go into crisis, cost the taxpayer less over the cycle, and deliver slower but less volatile growth.

Finally, the main impact of systemic risk regulation would be to encourage smaller banking/trading institutions. I would think that this a good thing in itself. And I disagree with James Kwak that "countercylical measures in a boom dampen economic growth". Surely the opposite is true (in the long run).

Absolutely. We need a lot of small banks, not a small number of large ones. The hard part is how we get to there from here.

80/20 derivatives

In the FT, Aline van Duyn comments on the Geithner derivatives reforms:

In Mr Geithner’s vision, banks, investors and companies that use derivatives will have to register their activity. In this way, regulators will be able to see the whole picture of risk that has been built up in the financial system. These players in derivatives will all have to put some money aside in case their bets go sour. The amount of bets will therefore be limited. Large parts of the markets will be cleared centrally, which means that the default of a big bank at the centre of the market will not set off a daisy chain of defaults. Regulators will finally have specific jurisdiction over these financial instruments...

First, what is a “standardised” derivative? Is the cut-off size or simplicity?

That is relatively easy. Most banks' derivatives book - and certainly all the big players' books - are mostly vanilla. If you called 'standardised' a plain vanilla interest rate or cross currency swap, forwards, FRAs, caps and floors, plain vanilla swaptions into plain vanilla swaps, and plain vanilla options on single FX rates, equities, equity indices and commodities, (plus the already-DTCC cleared credit derivatives) you would have not just 80% of the industry, but probably more like 90%. Just centralising the clearing of these simple instruments would dramatically reduce counterparty risk and improve market transparency. If you added in basket options, asians and barriers, you would certainly have more than 95% of the industry.

Second, will plans to shift to centralised clearing include derivatives contracts that already exist, or just new ones? This is a vital issue: the risk in the financial system is largely the result of existing contracts. And, as the people still employed at AIG are realising, you cannot just throw these contracts into the river.

There is no reason not to novate old contracts into the new system. It will take time, but you can do it, especially for the inter-dealer business.

Third, who is subject to the regulations? Banks, certainly; large hedge funds, probably. What about smaller investors or companies such as airlines that use derivatives to hedge oil and currency positions?

Regulated banks and hedge funds, plus anyone else with more than a 1% market share, say, in a given market, or anyone the market regulator tells to use the system. The advantages to the banks of central clearing would be large enough that they will pressure big clients to move onto the system anyway.

Aline raises some reasonable objections, but in this case I do think that you can remove 80% of the risk for 20% of the effort.

The pain in Spain...

...as the FT says, will be felt mostly by the banksWhat is interesting about this is how vintage insensitive it is. In the US, there is a world of difference between the 2005s and the 2007s: in Spain, not so much.

Update. Downgrades loom for the Spanish banks as an interest diversion test is tripped on a Caja Madrid RMBS.

Sound words on defence spending

Lewis Page writes sharply and well on defence procurement. He's a sample:

defence manufacture brings us a measly billion or two in exports each year – and our arms industry requires the great bulk of the £15Bn defence materiel budget in spending to win us this rather paltry amount of trade.

Put that way, the claim that we need our massive - per capita larger than any other EU state - defence budget to support exports is clearly ridiculous. Does this spending provide credible independent capability? Page says no, and gives detailed examples:

the Prime Minister can fire his American-made Trident missiles without asking Washington frst. But he cannot expect his supposedly ‘Britsh’ or ‘European’ systems to keep operatng through a normal-length war if US support is cut of. No, seriously. The Eurofghter contains so much US equipment that American consent is required for us to export it to Saudi Arabia, for goodness’ sake. EADS tells us openly that “the A400M will beneft from use of American content”. The command system for the Nimrod is being made by Boeing. The Future Lynx uses American engines.

On a day when the shameful truth of defence procurment - that British soldiers are dying because we can't get them the kit they need - is once more emphasised, it is time to face the truth. Defence spending isn't just absurdly high in the UK: despite that, it does not give the ordinary soldier, sailor and flyer what they need and deserve.

If you want to subsidise exports, then support the most efficient exporters. They are not defence companies. If you want capable weapons systems, then buy the best ones that you can afford*. And if you want to send men out to fight, then you have a moral obligation to kit them out properly: that imperitive over-rides any possible national interest in a particular manufacturer or procurement process. We don't just need to cut defence spending: we need to spend smarter and more ethically.

*Subject of course to acceptable 'will they support it' risk. One might like to consider for a moment in this context whether the Sukhoi-30 is a better bet for the RAF than the Eurofighter...

Update. A correspondant with considerable knowledge of the defence industry points out that even when UK defence companies can meet a procurement objective, they are more expensive than their civil equivalents because they cannot meet the same timescales and margins. A combination of the shelter provided by captive defence spending and the overhead (both in cost and in putting off some staff) of security means that they simply are not lean and mean enough. If you want a van, go to Ford or Toyota or Renault - don't go to someone who makes tanks.

Non-classical Cost Benefit Analysis

Remember Schroedinger's cat? Poor moggy is trapped in a box with a radio active isotope. The isotope decays randomly. Let's say that there is half a chance of detecting a beta particle using a detector inside the box during some time interval. If the particle is detected, then poison gas is released and the cat dies. If not, it lives.

This setup is usually used to explain superposition of states: basically until you open the box, the cat is in the superposed state 'dead and alive'. You force it to be one or the other by observing it.

I want to use it to talk about something else, though - cost/benefit analysis. If you like cats, then you will want to save moggy. But there is a cost to opening the box early, a pound say. If you judge the worth of a cat as more than two pounds, then you'd spend the pound and guarantee that the cat is safe. In general, 'classical' cost benefit analysis says that if a bad event has cost x and probability p, then it is worth spending px to prevent the bad thing.

Concretely this is usually expressed with less likely events: a certain kind of brake failure on your car is a one in a million event, and the average cost of an accident if your brakes fail is ten thousand pounds, so it is only worth spending a penny to prevent the problem.

This classical cost benefit analysis makes two big assumptions. First it assumes that the bad events are independent and identically distributed. In many applications, this is not true: making the system safer sometimes encourages people to take more risk (and not fixing an obvious safety issue makes them more careful). There is good evidence for this from the development of ABS brakes, amongst other things: they didn't make cars nearly as much safer as the developers hoped, since drivers absorbed the safety margin by driving more aggressively.

In the cat experiment, you can think of this as moggy learning (perhaps by cat telepathy) that if it gets between the isotope and the detector, the particle is less likely to be detected, and hence it is more likely to live. This changes p from 1/2 to 1/3, say, and now your pound is only worth spending if you think a cat's life is worth three pounds.

The second major problem is that your estimate of the probability of failure for small p, is likely to be wrong. Your estimate of the cost, x, might be wrong too. As James Kwak says:

imagine that the government had considered the idea of systemic risk regulation five years ago. It would have cost money; it would have created new disclosure requirements for banks and possibly hedge funds; it would have required countercyclical measures in a boom that would dampen economic growth. Those are the costs of regulation. And how would anyone have estimated the benefits? No one would have estimated the scenario we face today – trillions of dollars of asset writedowns, 3.3% contraction in the U.S. economy and counting, even more severe damage elsewhere in the world economy. And as a result, the regulation would have died.

... it’s a mistake to think that all policies can be boiled down to cost-benefit calculations when one side of the equation is difficult or impossible to measure accurately, and the last thing we need today is more economics-based overconfidence.

In other words, cost benefit analysis is all very well if you can measure the costs, the benefits, and their probability distribution accurately. But if you can't, as in the costs of financial regulation vs. its benefits, then you shouldn't use spurious theory to try to justify the decision you wanted anyway. If you don't know the probability of the particle being detected, you simply have to fall back on an ethical judgement: killing cats is wrong.

Monoline death watch, day 1000

(The fate of the monolines was sealed by the risk they wrote in 2005-2007, so day 1000 is if anything conservative - it takes insurers a long time to die thanks to their accounting and the pay as you go nature of the claims against them.)

In a move so predictable it hardly raises a yawn, Bank of America, Citigroup, JPMorgan and 15 other large financial institutions filed suit on Wednesday against MBIA, claiming the bond insurer reduced its ability to pay policyholders by splitting its business in two.

It is difficult to think of how a monoline could split without generating lawsuits. If x of capital and y of investments support z of risk, and you split z into to pieces, how do you divide x and y? There is not widely agreed answer, so someone is going to think that the credit quality of the piece they end up with a claim against is lower that it should be - and they will sue. Moreover since there are clearly diversification benefits between risks, even if the split is entirely fair, the capital needed for the two pieces is larger than that for the original whole.

The lesson? Agree collateral upfront, based on your marks.

When you want to come bottom of the list

Bruce Krasting has an interesting story on sub-prime related litigation in Massachusetts:

Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages... In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today.

As Bruce says, this is not a big deal for Goldman -- but it might set a nasty precedent for those higher up the subprime ABS underwriting tables, notably BoA (labouring under both Countrywide and Merrill) and Citi. You can expect this story, like Enron-related litigation, to run and run.

Update. A different account of the case from Jonathan Weil at Bloomberg is here. His take is that Goldman paid greenmail to Mass, perhaps to avoid the disclosure associated with a full hearing. His article certainly makes interesting reading.

Trigger convertibles

This is an idea of Steve Randy Waldman's, and I like it.

The basic idea is that you have a deferrable CB. That is, a fixed rate bond which pays coupons, but where the issuer can defer the coupon without it being a default event. Many preference shares are like this, for instance.

The bond is also convertible into shares. Unlike a normal CB, though, the bond is convertible after deferral at a fixed discount to the then current stock price. Thus it is a trigger CB - the trigger being the deferral. (One could have other triggers too, such as quarterly net earnings being sufficiently negative, or Tier 1 capital ratios falling too far. You could also have conventional conversion features too.)

The attractive part, akin to contingent capital, is that the holder is incentivised to fund fresh equity issuance just when the issuer needs it. The issuer pays something for the option to raise equity, but not nearly as much as it would have to pay for real equity capital. If the issuer wants to be sure of the capital, conversion after the trigger is hit would be mandatory: if they thought that the discount was incentive enough, it would be optional, with a correspondingly lower coupon on the bond.

Who's right?

Krugman fears lost decade for US due to half-steps reports Reuters.

Elsewhere, George Soros leads growing chorus of 'green shoots' optimists.

I don't know who is right. I can't even make a good guess. But it is an interesting question. Opinions seem more divided now than at any time in the last six months - and divided opinions make for interesting markets.

Road deaths and other acceptable casualties

An article by David Mitchell from Sunday's Observer is so full of sense, and so nicely written that I want to quote quite of lot of it. It concerns the pathetic whingeing of the car lobby that they are sometimes caught breaking the law and even *gasp* punished for it (although not very much).

Apparently, the criminals who break the speed limit don't like the punishments they receive. Then again, the criminals who break the murder laws don't particularly like the punishments they receive either, but they don't form quite such a strident lobby...

The fact that many more people speed than murder does not make it any less a crime, even though it is a lesser crime. And the difference in the magnitude of the offences is reflected by the huge difference in their punishments. So that doesn't excuse the grumbling letters to Top Gear magazine either...

Almost everyone knows when they're speeding and almost everyone speeds. Maybe this massed recalcitrance means we should change the law, allow people to drive as fast as they like and accept a few thousand more road deaths? ...

Some drivers seem to have a gut feeling that racing around attached to a big internal combustion engine, going wherever they want, as quickly as they deem convenient, is some of sort of natural right or ancient British liberty. Well it's not. It may feel natural but so does smoking or an expensive boob job. It's recent, unnatural and unhealthy and the world would probably be a better place if no one had ever done it. Soon they may have to stop.

Then in today's paper, in a nice segue, we find:

Thousands of taxis, buses and council vehicles could be fitted with devices that prevent them from exceeding the speed limit.

Given that a driver's willingness to obey the law seems in inverse proportion to the cost of their car, I would suggest phasing in speed limiters immediately on all cars selling for more than £20,000. Sports cars, the worst offenders, would have to have speed limiters fitted at their MOTs. I am sure that this would do more to reduce road deaths than any amount of traffic calming or improvements in crumple zones. Add in genuine enforcement of the Highway Code by real policeman on the road, and we would have a revolution in road safety.

Student loans

Are student loans a good idea?

Certainly as they are implemented in the UK, they serve no one well. The level of tuition fees is set too low to fund Universities properly. (The under funding of higher education gives the lie to Blair's 'Education, Education, Education'. Schools might have done well under Labour, but Universities have not.) Yet they are set high enough to discourage some students from applying to University, particularly those who have a higher aversion to taking on debt or less experience at doing multi-year cost/benefit analysis - and that is primarily the children of the less well off.

In short, we have a classic Nu-Labour half a hard on situation (as in there is nothing worse than...) Either fees need to raised very substantially, so that at least Universities are not losing money on every undergraduate educated. Or England needs to follow Scotland in ending the experiment with loans, with a more-than-matching increase in government spending on Universities.

The quality of teaching in English higher education is falling; contact hours are declining; and equipment is often laughably bad. The only thing that will fix these issues is money. If we want as many students in University as we have at the moment, someone is going to have to spend more. And even if we don't, accepting that the Blairite push to higher numbers was overdone, then the spend per student needs to increase. If it doesn't, the English University system will keep getting worse.

Control theory and capital

The beginnings of control theory can be summarised as 'nail it in the right place'. Suppose there's a plank over a barrel. You can keep the plank level by putting a weight in just the right place, so that it balances.

The problem with this is that any perturbation will cause the plank to swing away from the level. A gust of wind might even do it: the equilibrium is unstable. Therefore control theory 101 would suggest that you move the weight dynamically to keep the plank balanced. If one end swings up, move the weight slightly that way until it swings back.

Over the years, a lot has been discovered about how to control unstable objects moving in unpredictable environments. Modern fighter aircrafts are in some ways a triumph of control theory: without the computers which control their flight surfaces, they would fall out of the sky. And what the computers do is determined by control theory.

One of the many reasons that the current regulatory capital regime is pants (not to put too fine a point on it) is that it is stuck with static control. That is, think of a number, and that's the amount of capital that you need. In reality, the regime needs to be dynamic: the anticyclical capital of earlier discussions is one piece of this puzzle. What struck me as I walking home from a lecture last night (one which touched in passing on control theory) is that we do not even have the right inputs to develop a control theory of bank capital. That is, we don't really know what the equivalent of the angle of the plank (or the speed, pitch, yaw and so on of the fighter) is. One can think of some things that it might make sense to monitor, like credit spreads or the availability of interbank liquidity, but so far as I am aware, there has been no systematic study which discusses the indicators of health of the banking system, let alone identifies how they respond to changes in regulation. That would be the basis of a serious control theory of banking.

On the curve

Bloomberg says Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings.

For that bet to come off, US banks have to earn lots of money.

What's the major determinant of bank earnings that Geithner can control? The shape of the curve. Banks make money if their short term cost of funds is lower than the longer term rates that the loans they make price from.

So... pay 1m USD Libor, receive constant maturity 3 year swaps. Trade of the month.

Scoring the SEC

The WSJ reminds us that despite the SEC's lamentable record, US regulatory reforms seems as far off as ever. How badly did they do? Here's my assessment.

• Supervisor of investment banks: 0/5. There are none left. That really does tell you all you need to know.
  
• Market supervisor: 2/5. Rule SHO didn't stop naked shorts, and the SEC's record dealing with market abuse and insider trading is not wonderful. Nevertheless, they have sometimes acted prudently in the equity markets in the past.
  
• Information gatherer: 4/5. Edgar is very useful, and Idea seems like it will be even better.
  
• Hedge fund regulator: 1/5. They could have found Madoff in 2002.

It seems to me, then, that the SEC is a great website with a deeply flawed supervisor bolted on the side. So why hasn't Geithner done anything?

Keep your enemies close?

The news that Obama has recently had a meeting with two of his fiercest critics, Krugman and Stiglitz, does him credit. I think there is more to it than the title of the post: it suggests maturity that Obama is willing to listen to different views. One can't imagine Gordon Brown, for instance, being so open minded. Leaders who encourage diversity of opinion are likely to end up better informed than ones that don't, and to make better decisions as a result. I'd like Krugman and Geithner to do a job swap, of course, but at least Krugman isn't crying unheeded in the wilderness.

Years and years - a riff continued

Charles Butler, looking at the same Jonathan Hopkin post I talked about earlier, comments:

We may find the right wing to be insufferably and unacceptably stupid since the time that the same Ronald Reagan took office, but the left has descended into the ethical black hole of defending only a restricted number of vested interests.

Would that he were wrong. But he's not. For me, one of the reasons that Thatcher got and kept power was that she challenged the entrenched interests that the left was in thrall to in the 1970s, notably the unions. (The unions of closed shops and entrenched employment rights for the few, that is.) If the general perception is that the Left is pandering to this kind of selfishness again, then it will be out of power in the UK for as long as it was in the Thatcher years.

The triumph of the system

Over the last few days I have cycled over sixty miles (for pleasure - business is not going that badly). Somewhere around mile 50, it occurred to me just how amazing public transport is. I can get further in an hour by train than I can cycle comfortably in a day under my own steam, and it costs me much less than I can earn in an hour. Imagine what getting around would be like without the kind of multiplication of effort that railways provide - if we all had to provide our own private infrastructure. The state really did do some things well, and even now, in these denuded times, those advantages have not entirely disappeared.

The failure of the left

Jonathan Hopkin makes a good point:

Almost as distressing as the collapse of the free market model of free-wheeling finance is the failure of the Left in the West to say anything very much about it.

So far so obvious, and so depressing. But Hopkin insightfully contrasts this failure to an earlier triumph.

Karl Polanyi's masterpiece 'The Great Transformation' interprets the rise of Nazism and Fascism as a response to the threats free markets posed to the livelihoods of the masses. Only after the catastrophe of war did Western governments discover a way of providing protection without foreign aggression or the scapegoating of ethnic minorities. 'Embedded liberalism' (as John Ruggie defined it) involved liberal trade between nations under stable exchange rates and capital controls, with welfare provision inside the nation state to insure workers against social risks. This model was a triumph, delivering growing living standards and social equality for the best part of half a century. But the moment it ran into trouble the assault began, and the various components of embedded liberalism have been steadily dismantled over the past couple of decades.

We need to put embedded liberalism back again

Now this is interesting. First is embedded liberalism the only solution? It seems rather overweaning to me to suggest that it is. But is it one solution? Well, it certainly worked before, if that is any guide. This kind of macro-political debate is exactly what we need: so why are parties of both the Right and Left so anxious to avoid it?

Setting budgets

I went to a big science talk this week. The details aren't particularly important, but the discussion of the budget process was. The speaker contrasted an earlier regime, where he had had a budget that was deliberately set lower than the expected cost of his projects, with an over-run expected, with the current system he had to operate under, whereby budgets were set higher, but he was not permitted to exceed the stated sum.

It made me wonder which resulted in the lowest expenditure for a given project, and what the risk implications of budgeting were. Clearly if you say 'don't spend more than $10M', then there is a huge temptation to spend $9.95M regardless of what it actually costs to get the job done. And if you say 'I think it will cost you more than $8M to get this done - see how much more' then some project managers will take perverse pride in trying to prove you wrong and do it for $7.9M. So I am rather inclined to recommend the deliberately low model of bidgeting. However, it is important in this setting that there isn't an incentive for cutting corners that should not be cut. Sometimes it really does cost $8.5M to do it right.

On transaction liquidity

Naked Capitalism has a typically engaging post on transaction liquidity.

One of the arguments apparently being made in Washington by those who oppose regulation of credit default swaps is that it would reduce liquidity and that of course would be a terrible thing.

Fair enough. A priori it is not clear if having transaction liquidity is a good or a bad thing.

One of the comments I have heard from debt market participants in the bubble era was that they were faced with a 'wall of liquidity", tons of money looking for places to park it. And some of that appeared to be the direct result of credit default swaps. CDS allowed banks in Europe to circumvent capital requirements, enabled investment banks to accelerate profits from deals into the current period by (in theory) defeasing risk, allowed banks to extend bigger loans than they would have otherwise by hedging some of the risk.

Let us look at these one by one.

• Capital. That was the regulator's fault and not the banks'. And it had little to do with liquidity. So yes, it was a bad thing, but it has nothing to do with either CDS per se or with transaction liquidity.
  
• Profits. There are arguments in both directions for fair value vs. accrual, but again this has nothing to do with either CDS or liquidity.
  
• Hedging. Here's the nub. A lower cost of capital is good for the economy when it is growing. But if it is created by over-leveraging the financial system, then clearly it is dangerous.

Let us turn back to NC:

Behavioral finance studies have found that even in simple bidding setting, participants create bubbles. Low transaction costs and the appearance of abundant liquidity supports short-term, momentum based trading strategies, with participants believing they can find the exits when they need to... Higher frictional costs lead investors to think twice about adding and exiting positions.

This is also a good point. Transaction liquidity supports the development of crowded trades, but often there is not enough to support their closing. I wonder if we should consider some form of frequency based regulation, whereby more frequent traders require more capital.

Personally, then, I think the case remains tantalisingly unproven. In traditional equity markets, abundant liquidity supports price discovery, permits speedy asset reallocation, and lowers everyone's cost of capital. But patchy liquidity, whereby there are periods of liquidity which can suddenly disappear, as in the ABS market and some other areas of credit, is deeply unhelpful. What we really need is more constant liquidity, so that liquidity assessment is possible for the life of a trade. Perhaps market maker requirements have a place here: obliging firms to provide liquidity in good times and bad - a feature of the equity but the credit markets - could help to even things out. And certainly if we are going to intervene to improve liquidity (as in the TALF), then we need to consider the possible negative effects of too much liquidity.

Monoline death watch, continued

Watching the monolines die is a bit like listening to Fidelio. Intellectually you know that it going to end, but there are times when it feels like it cannot happen fast enough. Now we seem to have moved past the Komm, Hoffnung of Act 1 - there is no hope - and the protagonists are in chains. Specifically Syncora (which used to be called SCA - the name swapping in monoline land is as bad as that in a Shakespearean comedy, and a lot less funny) has stopped paying claims. This is of course a default event for CDS written on it. The FT story is here.

Don't say he did not warn you

David Davis, writing in the FT, sets out Tory policy:

The first stages of an austerity regime, involving pay and recruitment freezes for the entire public sector, will be controversial and uncomfortable.

It is likely that this will be policy for the next government, and it scares me rigid.