Finance Sector as Ultimate Risk Manager?
posted by Frank Pasquale
David A. Moss’s When All Else Fails: Government as the Ultimate Risk Manager should be a vital guide to our future. Moss describes programs ranging from social security to bankruptcy as backstops of support for all classes. As volatility in prices, employment levels, and wages climbs, we should be exploring new “automatic stabilizers” to guarantee every family a “social minimum.” Instead, we appear to be privatizing and financializing risk via opaque institutions whose only mandate is to increase their own profits.
Consider, for instance, this vignette from Louise Story’s excellent reporting on derivatives trading:
[B]anks in an elite group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market. . . Banks’ influence over this market, and over clearinghouses like the one this select group advises, has costly implications for businesses large and small, like Dan Singer’s home heating-oil company in Westchester County, north of New York City.
This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.
But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives. “At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.
As Story explains, if this arrangement prevailed in the housing market, “It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it.” Whatever Wall Street’s apologists say, the secrecy is indefensible. But perhaps the reliance of people like Mr. Singer on derivatives themselves is more troubling still.
Let’s step back a bit and think about what a derivative is. There is a dazzling world of financial transactions that come under that heading, but when we think of deals like Robson Oil’s, the following reflections from Brian Holmes are clarifying:
[A derivative] is a fungible contract, created by applying a mathematical formula to an underlying asset or commodity whose price is susceptible to fluctuation . . . . By assembling constellations of values that statistically tend to fluctuate in opposite directions, derivatives were supposed to mitigate the risks of globalization with the highest degree of efficiency. The idea was that that all risks, including collective ones, should be made into salable products, formatted for the market by private actors in search of a profit. . . .
Derivatives . . . have nothing directly to do with production; instead they are conceived to manage the environmental risks that weigh on the future of speculative activity. In this sense they are meta-commodities that govern the unfolding of the contemporary economic model. Their fascinating appearance acts to conceal the private deliberations that effectively shape the environment in which any productive or consumptive activity can take place.
Derivatives thus offer a tempting alternative to the messiness of politics. Rather than investing in sustainable energy, the US can allow everyone to hedge their own bets. Worry about peak oil? Buy some derivative that pays off big when it hits $200 a barrel. Think it’s all a big hoax? Then you can short the same instrument, or come up with some exotic variation on the short. Everyone gets to vote with dollars on some future. Worried about your home price? Robert Shiller seems to think that a “thick housing futures market” would help you diversify away that risk.
There are a few problems with such a future. Let’s forget, for now, the unfortunate fact that so many Americans are broke. Let’s not trouble with the divide between the median household (which has has net worth of under $100,000) and the top 1 percent of households’ mean wealth of over $15 million.* Let’s heroically assume that individuals can make all kinds of bets, er, investments, based on what they think the future holds. Could derivatives still serve as our ultimate risk manager?
Not really. Consider Mike Konczal’s fanciful take on the problem:
[W]hat do we call a product that pays out in times of high volatility, in times when an event out of the ordinary happens? One thing to call it is “insurance.” . . . There’s good reason we regulate insurance – it needs to pay out exactly at the moment when it is the least likely to get paid.
[There are limits to what insurers can promise. What] would you price a contract that paid $100 if the world turned into The Walking Dead, where cities were overrun with armies of zombies? The short answer is that you wouldn’t pay anything, since when you need to collect it the person on the other end is probably a zombie. This “who can credibly commit to backstopping bad events” goes towards a notion of the role the government can play in financial markets.
Of course, we did see a version of that disaster in 2008. Zombie banks walk among us to this day, propped up by lenient regulators, low interest rates, and dead ideas. Their employees will get about $143 billion in bonuses this year–more than the “$130 billion total budget gap for all 50 states,” according to SEIU. Perhaps in gratitude for the state’s generous subvention, Josef Ackermann (head of Deutsche Bank) said “I no longer believe in the market’s self-healing power” in 2008, admitting a role for government.
Yet this is the same Josef Ackermann who “pledged to seek 25 percent returns on capital before tax” after the crisis. As Simon Johnson argues, “In a world where safe assets barely earn a few percent, he can only achieve such returns through significant risk-taking.” Competitors will do the same, dancing while the music is playing. It’s hard to credibly promise protection to all the Robson Oils of the world, and to support seven to nine figure incomes. Risks have to be taken.
So we are in a curious situation: the very instruments designed to diversify away risk in one field end up exacerbating it in others. Back in November, 2007, one of the world’s best economic sociologists (Donald Mackenzie) was thinking about what he called the “end-of-the-world trade:”
The trade is the purchase of insurance against what would in effect be the failure of the modern capitalist system. It would take a cataclysm – around a third of the leading investment-grade corporations in Europe or half those in North America going bankrupt and defaulting on their debt – for the insurance to be paid out.
I asked one investment banker what might cause half of North America’s top corporations to default. No ordinary economic recession or natural disaster short of an asteroid strike could do it: no hurricane, for example, and not even “the big one,” a catastrophic earthquake devastating California. All he could think of was “a revolutionary Marxist government in Washington.”
The exchange both reveals a mindset common in New York and London, and confirms Mackenzie’s larger thesis about “performative theories” in finance. MacKenzie’s book An Engine, Not A Camera: How Financial Models Shape Markets describes how both finance theorists and traders’ views on “how the world works” end up promoting the very conditions they claim to merely reflect. The trader here locates the source of risk in the only institution that could credibly get the economy out of a severe rut, or (more importantly) avoid the rut in the first place.
MacKenzie’s trader’s nightmare scenario of a Marxist government is not nearly as plausible as the doomsday on the horizon of leading novelists, historians, environmentalists, and geologists. To take but the latest example of a flourishing genre, consider these ideas from Alfred McCoy:
Other developed nations are meeting [the threat of declining oil supply] aggressively by plunging into experimental programs to develop alternative energy sources. The United States has taken a different path, doing far too little to develop alternative sources while, in the last three decades, doubling its dependence on foreign oil imports. Between 1973 and 2007, oil imports have risen from 36 percent of energy consumed in the U.S. to 66 percent. . . .
[Given current trends in the dollar's value, one can imagine] OPEC oil ministers, meeting in Riyadh, demand[ing] future energy payments in a “basket” of Yen, Yuan, and Euros. That only hikes the cost of U.S. oil imports further. At the same moment, while signing a new series of long-term delivery contracts with China, the Saudis stabilize their own foreign exchange reserves by switching to the Yuan. . . .
The oil shock that follows hits the country like a hurricane, sending prices to startling heights, making travel a staggeringly expensive proposition, putting real wages (which had long been declining) into freefall, and rendering non-competitive whatever American exports remained.
Rather than engineering alternative sources of energy, we have focused on “financial engineering” of distributed risk management. But who really thinks we can arrange an “end of the oil era” trade to hedge against the situation McCoy is describing?
The ultimate irony is that ostensibly distributed risk management really isn’t that diversified at all. As Amar Bhide has demonstrated, the modern financial system is Hayek’s nightmare:
The financial system has been giving up . . . on the decentralization of judgment and responsibility. Case-by-case judgments by many, widely dispersed financiers with the necessary ‘local knowledge’ have been banished to the edges. . . . The core is now dominated by a small number of very large firms that have little direct contact with the ultimate real users or providers of finance. . . . [E]mployees of the organizations that produce research and ratings–and the traders whose aggregated opinions constitute the wisdom of crowds–usually don’t have much case-by-case local knowledge. They, too, often rely on [standard] statistical models, or just take cues from each other. (A Call for Judgment, 12)
Conservative thinkers like Russ Roberts and Nicole Gelinas have also observed just how far modern finance is from anything resembling a decentralized, “free market.” Louise Story’s “secetive banking elite” is not merely affecting derivatives trading, but core operations across the sector.
The finance industry’s long term efforts to take over government’s role in major risk management fail even on their own, free market terms. It’s time for radical rethink of the role of finance in the economy. The right is already well on its way toward “tight money” or even a gold standard as an answer to our current economic crisis. Progressives must realize how much is at stake if they fail to deliver an alternative narrative. Matt Stoller gets this, and offers the following insights:
Liberals should stop their love affair with conservative technocratic myths of monetary independence[,] move beyond [a] consumer-driven approach[,] and think about reform of the credit system, of the monetary order, as Elizabeth Warren [and Jane D'Arista have]. The link between the Federal Reserve and the ‘real economy’ is broken. When banks were the main conduit between the financial world and economic activity, translating savings into investment, the Fed could manipulate the economy by manipulating the banking sector. But now that shadow banks dominate our credit markets, and the Fed has allowed hot money to take over monetary policy, the Fed’s tools just don’t work. That’s why quantitative easing is foolish. We must dispatch with the ridiculous notion that pushing hundreds of billions of dollars into a broken banking system will have useful consequences.
Instead, let’s recognize that the Fed doesn’t fulfill either part of its mandate, and work towards a better and more plausible system of monetary stability. That’s not a longterm process, it’s a constant process. D’Arista argues that the Fed must connect itself to the shadow banking system and force credit to flow. This necessarily implies important changes in how the Fed interacts with financial services firms and entities. To give some idea of what this might look like, at least conceptually, Timothy Canova paints the portrait of a more democratic Federal Reserve financing the government debt during World War II. Cooperating with a phalanx of institutions, such as the Reconstruction Finance Corporation, and government boards that directed wartime rationing, the Fed was able to . . . dramatically equalize economic opportunity and wealth-building for the middle class.
Whatever one thinks of Stoller’s, Canova’s, and D’Arista’s views, we should be able to agree that high finance’s theories of risk management have led it to usurp roles that only government can play. We continue to bet on the privatization of risk at our peril.
*I derive that figure from Wolff’s update on trends in household wealth and Domhoff’s observation that “there has been an ‘astounding’ 36.1% drop in the wealth (marketable assets) of the median household since the peak of the housing bubble in 2007. By contrast, the wealth of the top 1% of households dropped by far less: just 11.1%.”
December 16, 2010 at 11:03 am
Posted in: Economic Analysis of Law, Financial Institutions, Politics, Securities, Securities Regulation, Uncategorized
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Responses (8)
A.J. Sutter - December 16, 2010 at 10:02 pm
It’s been a while since I looked at Moss’s book, but I think you may have missed an additional irony in your epic catalog of ironies. As I recall, Moss emphasizes that limited liability of shareholders is a gift to corporations from the government. Obviously, this further distorts the risk-taking behavior of private corporations.
Patrick S. O'Donnell - December 17, 2010 at 2:41 am
I haven’t read Moss’s book but with regard to the distortion of the “risk-taking behavior of private corporations,” we might mention the Price-Anderson Nuclear Industries Indemnity Act. As Cindy Folkers of the Nuclear Information and Resource Center explains,
“Through the Price-Anderson act, nuclear utilities can afford insurance that they could never obtain in real market circumstances. Moreover, Price-Anderson has a liability cap well below the compensation needed to cover most nuclear accident consequences. [….] If the nuclear industry is the safe, market viable and mature industry it claims to be, it can be held accountable for the real cost of doing business. If the public is to believe this ‘free market’ oratory then every nuclear power plant designer, supplier and operator should be required to internalize the insurance costs to the full extent of the risks and consequences associated with splitting the atom to create electricity. However, were Congress to lift the liability cap and require full insurance liability for as long as it takes to pay off an accident, utilities would likely abandon this technology for safer, cheaper, cleaner and renewable electricity generation.”
I think Ralph Nader was right to christen this an example of corporate welfare in which taxpayers would end up footing the bill in the case of a catastrophic accident. The Act “indemnifies Department of Energy and private contractors from nuclear incidents even in cases of gross negligence and willful misconduct (although criminal penalties would still apply).”
Patrick S. O'Donnell - December 17, 2010 at 2:58 am
It seems Moss might in fact discuss the Price-Anderson Act, as I saw it cited in the index by way of Amazon’s “look inside!” feature.
Frank Pasquale - December 17, 2010 at 8:25 am
Yes, the energy industries are a troubling example here; who can forget the cap on damages for oil spills!
As for corporate form, it might be another example where the “far left” and “far right” can agree: apparently some libertarians have rejected limited liability for corporations as a form of state interference with the “night-watchman state” rules of contract, tort, and criminal law.
Anonymous Coward - December 18, 2010 at 12:55 am
Your post made me realize a different problem with derivatives. Take your heating oil retailer’s customers as an example: If you can agree to pay $3/gallon for heating oil regardless of what it actually costs, knowing that it will probably end up costing around $3/gallon anyway, that’s a good bet. The largest volatility comes from how cold it is and thus how much demand there is for heating oil, so if the winter is warm then prices will be below $3/gallon while you’re paying $3/gallon, but you won’t be buying as much heating oil because it’s a warm winter. Moreover, you budgeted for $3/gallon anyway. Conversely, if it’s a cold winter, the price rises and you end up saving a lot of money because you’re paying below market rates on the large amount of heating oil you need over the cold winter. So it makes sense for customers to lock in their prices like this.
Now let’s say 75% of heating oil customers buy into this and agree to pay $3/gallon for the whole winter no matter what the market price is. Next we suppose there is a shortfall of heating oil. What happens absent a derivative market is that prices rise until demand falls to meet supply. So for example if there would be a 2.5% shortfall at $3/gallon then prices might rise to $3.10/gallon, if there would be a 10% shortfall prices might rise to $3.60/gallon, etc. People at the margin decide to lower the thermostat and use less heating oil rather than buying the exact same amount notwithstanding the higher price.
Now we add in derivatives. 75% of the consumers will no longer reduce consumption whatsoever in response to price increases because they pay a fixed price. What that means is that prices have to rise sufficiently to cause the remaining 25% of customers to reduce consumption by 100% of the shortfall. So if there would be a 2.5% shortfall you might see the price increase to $3.60 instead of $3.10 because you have to induce 25% of consumers to reduce consumption by 10% rather than inducing 100% of consumers to reduce consumption by 2.5%. And if there would be a 10% shortfall (or, catastrophically, a 26% shortfall), that could lead to very serious price volatility.
And it’s self-reinforcing. If, during the first cold winter, 50% of people have locked in prices, prices will perhaps rise to $3.25 rather than $3.10. But that will encourage more people to lock in the price, because the prospective price increase during a cold winter is greater ($0.25 rather than the historical $0.10), so the next winter you see e.g. 60% of customers locking in, which keeps ratcheting up as increasing price volatility induces more consumers to seek this “insurance” method.
And I imagine it’s clear that this doesn’t only apply to heating oil.
Anonymous Coward - December 18, 2010 at 1:40 am
“I haven’t read Moss’s book but with regard to the distortion of the “risk-taking behavior of private corporations,” we might mention the Price-Anderson Nuclear Industries Indemnity Act.”
I’m not sure this isn’t another market failure in the insurance market more than in the nuclear power though. The trouble is that we don’t have good data on the likelihood of a nuclear meltdown in a United States reactor because it has never happened. If a catastrophic event has not occurred even once over 50 years over 100 insureds, in theory the insurance should cost nothing: The expected value of a payout is zero. The problem is that it’s really zero plus up to the statistical margin of error, which with such a small sample size and large prospective payout is quite significant, and which the insurance company will want to somewhat overestimate so as to ensure a profit.
So what Price-Anderson is really doing is having the government step in and assume that the actual probability falls closer to the lower end of the margin of error than would a profit-seeking insurance company. (And then hedge their bet by limiting liability.)
(Incidentally, I should also point out that my hypothetical above would only work in practice if I had said something like ’75% of petroleum distillate customers’ instead of ’75% of heating oil customers’ since e.g. diesel fuel can generally be sold as heating oil. Which is why we don’t really see the described effects in the heating oil market: Most of the diesel market doesn’t lock in prices and the diesel market is much larger than the heating oil market, so the amount of volatility introduced by heating oil customers locking in isn’t enough to mean much.)
Ken Rhodes - December 20, 2010 at 8:46 am
“If a catastrophic event has not occurred even once over 50 years over 100 insureds, in theory the insurance should cost nothing: The expected value of a payout is zero. The problem is that it’s really zero plus up to the statistical margin of error,”
No no no no no, a thousand times no!
It has nothing to do with “margin of error.” The occurrences of rare events over time is represented by the Poisson distribution. The distribution of times between those events is the Exponential (literally, Negative Exponential) distribution.
The Exponential is a single-variable distribution, where the meant time between events (MTBE) is the inverse of the “arrival rate.” Consequently, the best we can say about a zero-event test is that there is a 50% chance that the true MTBE is equal or greater than the test time T.
Brian Holmes - January 23, 2012 at 1:13 pm
Thanks for this discussion, Frank. I read it when it was first published and found it extremely useful, by far the best critical extension of my ideas on derivatives as meta-commodities. The Moss book is a key reference. Today I just happened to discover a book published before the meltdown, in 2006, which comes to strikingly similar conclusions about derivatives:
“…we find it useful to draw a distinction between basic, or simple, commodities (wheat, iron, cars, etc.) and meta-commodities. The former, being historically prior and the products of labour, are ‘productive’ and correspond with our standard conception of a commodity. Meta-commodities come historically later, with the initial purpose of hedging the conditions of production and circulation of simple commodities. They absorb value discontinuities across time and space. As these meta-commodities have grown in importance, particularly since the 1980s, they have come to provide commensuration across time and space between diverse simple commodities as well as between different forms of money and finance.
“So the essential characteristic of derivatives as commodities is that they are products of circulation, not significantly of labour, and accordingly their value is defined in exchange and not in consumption. These meta-commodities are therefore always ‘capital’, for they never ‘leave’ a circuit of capital so as to be consumed. In that sense, they are more intensively capitalist commodities than simple commodities, for the latter are merely produced within capitalist relations, while meta-commodities are products of capitalist relations.”
“Capitalism with Derivatives: A Political Economy of Financial Derivatives, Capital and Class,” by D. Bryan and M. Rafferty (Palgrave Macmillan: Basingstoke and New York, 2006), p. 154.
The book looks excellent, an important contribution to the understanding of the financialized economy as a new layer on top of the productive or corporate capital that was dominant in the Keynesian-Fordist era. Since nothing has fundamentallly changed since 2008, it might still be a good read.
best, Brian Holmes
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