Archive for the ‘Politics’ Category

As the Volcker Plan limps through Washington and many are screaming bloody Armageddon, an idea has been floating through my head.  This is an idea that is sure to really rile up those on Wall Street, many readers of this blog, and followers on Twitter.  It is an idea that at the onset seems ridiculous but after pondering for some time has some merit.  This idea is nationalizing market-making in vanilla financial instruments.

Liquidity is to the flow of capital as as roads are to the flow of traffic.   Most would argue that both the flow of capital and the flow of traffic are both vital to economic well-being.  Yet unlike in transportation, in markets we largely leave our market infrastructure up to the private sector.  While provision of transportation infrastructure would not pass the public policy test of a pure public good, many would agree that is important and government has a inherent interest in making sure that traffic flows.   Why not leave this role up to the government in the capital markets?

Below are some reasons why this idea keeps banging through my head:

Additional Tools for Policy Makers

Over the past 20 years we have experience multiple liquidity crises where the Fed has had to step in and provide liquidity to financial institutions so that they could turn around and use that money to get the markets moving again – aka make markets.  The government is already somewhat on the hook as a “liquidity provider of last resort” to the markets, so why not do it all the time.

Think about the additional tools it would give policy makers.  Markets getting bubbly? Increase your spreads.  Capital not moving?  Decreae your spreads.  Too much debt being issued? Shift market making capital to equities.  Want to create the incentive for Alternative Energy companies? Make liquid markets in their debt and equity.  The private sector would never do this.  They make markets in wherever it is most profitable at the time.  Sometimes to aid other businesses that they are in and can get out of the game in a moments notice.

Steve Waldman at Interfluidity writes that Information is Stimulus:

A housing boom, any kind of boom, is attended by an increase in certainty. Information is stimulus, confusion is contraction. A bust occurs when the market is unsure of everything, when market participants perceive better risk-adjusted return in holding government securities (or supply-inelastic commodities) than in financing real investment. Sectoral shifts per se have no clear implication with respect to variables like employment and output. But “hangovers” do happen, because powerful booms are periods when market participants make consequential decisions with great swagger and confidence, and busts are when we learn that despite their certainty, they were wrong. They are left not only impoverished and burdened by debt, but bereft of confidence in their ability to evaluate new opportunities. The best way to avoid the hangover is not to err so terribly in the first place. Easier said than done, perhaps, but that’s no reason to cop out. We can build a better financial system, one in which degrees of certainty are attached and removed from economic propositions dexterously, rather than clinging like giddy leeches until a collapse.

Nationalizing market making gives policy makers a really interesting way to receive information from and inject information into the markets.   I take Waldman’s premise further and say that Capital flows towards information.  Under a lens of uncertainty, capital doesn’t flow, but if capital knows that there is a liquidity provider out there with an interest in allowing it to flow, it can flow more smoothly.  Nowhere can this seen better than the capital flow to arbitrage strategies, the “sure” thing.

Ability to Put Financial Innovation to Good Use

The last decade of financial innovation in the form of financial engineering should be used to improve market microstructure not allow a few rich people to profit.  Staying with the transportation metaphor, engineering breakthroughs such as bridges and roads weren’t built for a few rich people to benefit, but for society as a whole to improve.  These financial innovations should be applied in the same way.   We should take these brilliant minds, have them build robust, fair market making algorithms, and embed them in our market microstructure so that they benefit society as a whole.

Bid-Ask Spread is Already a Liquidity Tax

The market maker spread is essentially a tax on liquidity.  The market-maker provides liquidity and for doing so collects the spread.   On top of this brokers get their share in the market. In addition, many are throwing around the idea of a Tobin Tax on top of this.  Why not just simplify things and allow the government to simply collect the bid ask spread – a liquidity tax and in return be a stable liquidity provider.

While there are obviously concerns I have with such an idea, such as regulatory capture and inefficiency of the government to operate, the more I think about it, the more it makes sense.  I also know that this is something that would never go through in lifetime.  In any case, this has been something that I have been ruminating on for some time, not going any further in my own head, and wanted to share it with the blogosphere to see what they think.

Now, please, tear it shreds!

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Today I read a piece about how the US Postal Service is looking to cut costs as they stare at a potential cumulative $250 Billion shortfall in 2020.

From Reuters:

The U.S. Postal Service, faced with less mail and bigger shortfalls, plans to cut Saturday delivery and overtime, raise prices and trim its workforce by about 30,000, its chief financial officer, Joseph Corbett, said on Tuesday.

Because of e-mail and private delivery companies, traditional mail volume is expected to be down from last year by about 10 billion pieces in 2010 with first class mail expected to drop 37 percent by 2020, leaving the service with a cumulative shortfall that could hit $238 billion by 2020.

Faced with that shortfall, Corbett said the service was planning a moderate increase in stamp prices and pressing for a law to be changed that would allow it to drop Saturday delivery.

In today’s mailbox, out of 10 -12 pieces I received, only one was actually somewhat important.  I would figure most Americans have a similar experience.  While this article says that the problem is due to mail volume is dropping, I think the problem is completely the opposite.  There is WAY too much mail.

The US Postal Service is setting a price for mail at which the supply dramatically outweighs the demand.  This has led to the proliferation of Sharper Image catalogs and Super-Saver coupon packs.  It allows many companies to lay off some of their spamming marketing costs onto the post office.   The original intention of the post office wasn’t to give horny old men cheap thrills twice a month when the Victoria’s Secret catalog arrived, but to deliver important, relevant messages.  Even if I’m wrong, the internet is killing that intention too!

Since the postal service could essentially become a government subsidized spam factory, is this even a business we want to be in?   There must be a better and cheaper way to work alongside the private market to ensure that vitally important messages are promptly delivered to the citizens at a reasonable cost.

This week, the Obama Administration turned their attention away from healthcare and towards the banks, announcing the Volcker Plan.   While the official plan hasn’t yet been released, the blog and tweetosphere have been buzzing over the last few days.  The reactions have ranged from angry to confused.

I figured I would share a few of my thoughts:

  • It will be very difficult to define what prop trading is. Two great pieces that illustrate this point are Kid Dynamite and Bronte Capital.  That does not mean that it can’t be intelligently done, but it will be difficult (and unlikely).  This issue is not simple and those saying it is on either side are wrong.
  • This is political but the ends can still justify the means.  While this is obviously a political reaction. it doesn’t mean that it should be completely ignored and written off.  Let’s be honest here, EVERYTHING that comes out of Washington is political.  Many people who were criticizing Obama for not putting forth financial reform are now criticizing Obama because he did.  Yes, what he is proposing is not the solution, but criticize the idea not the man.  If there is one thing that both sides of the aisle can agree on is that there needs to be some financial reform of some sort.  The masses will be happy with something, so it should be in the interest of all incumbents to come together and pass something good.  I don’t agree with Obama on many issues, but still would like to see him pass some meaningful financial reform.  We must be constructive in how we approach this, not destructive.  Use this as a launching pad.
  • Just because prop trading didn’t cause the financial crisis doesn’t mean it can’t. A popular argument against the proposed reform is that it doesn’t address the causes of this crisis.  This is absolutely true.  This crisis wasn’t caused by prop trading (although it was a Bear Stearns internal hedge fund which helped to get the ball rolling).   This doesn’t mean that the next one can’t be.  Most would agree that reform shouldn’t seek to be solely punitive in nature nor should we engage in regulating in the rear-view mirror.   It doesn’t address specific causes of the last crisis, but does address a more general, timeless, and universal one – mixing opaque risks with customer deposits.
  • Just because something makes up a small percentage of a banks business or all bank business doesn’t mean it can’t present harmful risk into the system. In today’s WSJ Intelligent Investor Jason Zweig writes:

    But the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking, according to financial historian Eugene White of Rutgers University. Of the more than 7,500 banks in the U.S. in 1929, only 3% had significant securities operations. Nor did hawking investments make banks riskier for shareholders. From 1930 through 1933, nearly 2,000—or more than 26%—of federally chartered banks closed. But only about 7% of the banks that had a securities business
    went bust.

    Yes this is true, but the problem which caused the bank run in the 30’s was that some banks were holding the bag on worthless stocks.  This fear grew to speculation that ALL banks had this exposure.  If you remember this is similar to what happened with subprime.  Everybody was asking is this bank or that bank subprime.  Subprime loans were a small percentage of the total assets on the balance sheets but caused a disproportionate amount fear. Fear is a powerful emotion and if you look at the opacity surrounding some principal investments banks invest in, it isn’t hard to see this happening again.  It’s best to keep risks surrounding customer’s deposits as simple and transparent as possible. While this proposal isn’t as far-reaching as Glass-Steagall was, I don’t think the original law was completely unfounded.

  • This isn’t going to kill market-making as many people are claiming.  One of the biggest options market maker is Citadel.  Citadel is a hedge fund, not a bank.   There is no law in finance that says the same place I deposit my money has to be making markets in securities.   Market makers provide a valuable service to the market place – liquidity – and they get paid a spread to do so.  It also helps dealers underwrite and provide capital.  It is a business that is obviously viable on its own and existed before Graham-Leach-Bliley.  If prop trading is something that helps facilitate market making perhaps the whole enchilada should be separated.
  • Most large financial supermarkets failed, why argue against reality?  Citi and Bank of America (and Wachovia) should be a referendum on Graham-Leach-Bliley.  In the 1990’s, the bill was introduced in order to put the Citigroup merger through.  Citigroup has failed and is still on government life support.  There is nothing that has happened that convinces me that this is the model that works, so why fight to save it?  To those that scream “FREE MARKETS!”, the market has spoken and it said it doesn’t like these large financial institutions. Without government intervention they would already be dead by now.

Those are some of the ideas that have been bouncing around my head the last few days.   As I was writing this, The Epicurean Dealmaker shared an interesting FTAlphaville article that says how the proposal also helps crack down on some conflicts of interest on Wall Street and indirectly on pay, that is worth reflecting on as well.

I welcome comments, criticisms, and ideas.  I think those looking for reform have been given a gift here, as reform is now back on the agenda.  Instead of attacking the idea we in the blogosphare should be thinking more deeply, constructively criticizing, on it and improving it, because hopefully they are listening.

The other day it was announced that Obama was investigating starting a regulatory commission for financial products that would ensure that they were “safe” for consumers – basically a financial version of the FDA.

From WaPo:

The Obama administration is actively discussing the creation of a regulatory commission that would have broad authority to protect consumers who use financial products as varied as mortgages, credit cards and mutual funds, according to several sources familiar with the matter.

The proposed commission would be one of the administration’s most significant steps yet to overhaul the financial regulatory system. It would also be one of its first proposals to address causes of the financial crisis such as predatory mortgage lending.Plans for a new body remain fluid, but it could be granted broad powers to make sure the terms and marketing of a wide range of loans and other financial products are in the interests of ordinary consumers, sources said.

This is a bad idea, and I’ll tell you why.

Financial products are different than any other product.  They are not drugs.   They can’t be tested on small subgroups of people for safety.  There is only one test and that is the market at a given period of time.   Since rarely, if ever, do you see the same market twice, even a longstanding product can’t be ensured to be “safe” or “good” for consumers, and time only increases the chance that something crazy will happen.

Terms for financial products may seem good, and while at the onset some terms are definitely better than others, there are no terms that protect the consumer from market risk, moral hazard, and many of the other elements of markets that are timeless and not going anywhere any time soon.  Saying that the government can protect the consumer from this is naive and will almost always end up in disappointment.

Moreover, I believe there is a dangerous unintended consequences lurking here.  What happens when something goes wrong?  Now that the government has given this product its “seal of approval” surely it stands behind such a thing.   This is going to force the government’s hand towards bailing out the consumer of the product should a loss occur, or something go wrong.  Furthermore, like the FDIC, it allows the issuer of the product to hide behind the veil of the government regulatory board not its own desire to build a good, clean business and reputation.  This will almost certainly end badly – especially when Government and the financial companies are already kind of cozy.