February 9th, 2009, 4:35 pm
QuoteOriginally posted by: HOOKQuoteOriginally posted by: Traden4AlphaFiat currencies, fractional reserve banking, and most derivative contracts are quasi-stable. They are stable over some range of economic dynamics, but go horribly pear-shaped if pushed too far.That´s a very insightfull approach ! What do you think could make one derivative more stable than another ? Clearing houses? Feasiability to hedge ?Very good question..... Yes, clearinghouses do help by diffusing the counterparty risks, improving price discovery, increasing transparency on to the total state of the market, and providing a low-friction venue for price-stabilizing market-makers. But clearinghouses are not guarantor of stability (and can promote instability!).Hedging helps, but only if it can be strictly static (e.g., a "hedge-and-forget" strategy). Dynamic hedging depends far too much on the kindness of strangers and the pleasantries of well-functioning markets to provide liquidity and hedging instruments at a fair price.Another might be reserve regulations that record these instruments in terms worst-case value (e.g., liability value = the expectation of greatest of the likely payout and asset value = expectation of the least of the likely payoffs). Too many derivatives contain hidden leverage in the form of the span of outcomes relative to the nominal or "expected" value. Some of this might also be covered by the clearinghouse regulations, which would (we hope) have appropriate margin requirements. In contrast, I don't think that the Basel II-style asset categories work too well because it's too easy for high quality assets to suddenly become low quality assets and require an increase is reserves at the wrong time (i.e., the asset risk categories may be procyclical, not anticyclical).What fascinates me about the current crisis is that it represents the failure of a widely-used model of risk more than the failure of any given institution. If only one bank, even a behemoth, had over-leveraged and lent far too much money to uncreditworthy consumers, the system could have handled the problem. As a first approximation, if the market share of liabilities of the largest bank times one minus the worst-case recovery is smaller than the reserve ratios used by all other banks, then the financial system can survive the failure of the largest bank. Strictly speaking, none of the banks in the world was really "too big to fail." But, to the extent that so many banks overleveraged and held similar portfolios of toxic debt (e.g., large quantities of consumer debt instruments), then the failure of one bank becomes much more than a source of direct losses (i.e., unrecovered assets), it also becomes an indirect source of losses by repricing the assets of all the banks that hold similar portfolios. Thus the un-accounted correlation risks internal to consumer debt instruments were converted into un-accounted correlation risks in the larger banking system.That's why exchanges can actually increase instability. On the one hand, exchanges diffuse concentrated risks to reduce the probability that a counterparty failure begets trading parter failures. On the other hand, exchanges increase the correlation risk by allowing everyone to buy a piece of a toxic asset class. Clearly, exchanges aren't a prerequisite for the over-diffusion of risk -- that European banks took such large hits from American MBS if proof of that. But exchanges do increase the spread of instruments (especially instruments associated with a price bubble) by broadening access of capital to the freely exchanged instruments. Had MBS been actively traded on a public exchange, we would have seen even more money flowing into subprime mortgages, a delay to the peak valuation of housing, and an even deeper crash than the one we are experiencing now.The deeper lesson is that correlation risk cannot be avoided as long as we allow institutions to hold mutually correlated portfolios of assets. To the extent that most banks hold similar portfolios, then most banks will fail under the same conditions. (the same logic applies to hedge funds in which the forces liquidation of a "bad" HF causes trouble for all other "good" HF that hold similar portfolios)But the deepest lesson is that all attempts to stabilize a system tend to have two effects. First, attempting to stabilize the system does stabilize the system by expanding the range of scenarios under which the system remains controlled. Second, the experience of a stable system leads people to increase leverage, risk taking, and increases pressure to relax the stabilizing measures. People cannot help but interpret a period of stability to mean that we've had excessive conservatism and that it's OK to borrow a little more or push a little harder to get returns. Add L-2 norm risk models (e.g., our friend, the Normal distribution) and we create a system that shows increasingly modest risk with high probability and increasingly severe risk with low probability. That is, the pencil tip grows larger, but people compensate by getting/creating larger pencils.It's not clear to me how or even if we should try to control this phenomenon of boom and bust cycles. Ultimately, I'm ambivalent about bubbles (and crashes) due to their role in both creating beneficial new industries and in clearing flawed models, but that's a discussion for another thread.
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Traden4Alpha on February 8th, 2009, 11:00 pm, edited 1 time in total.