Wednesday, April 21, 2010

GS and systemic instability: monetary theory.

One of the fallouts I expect from the ongoing GS vs the rest of the world saga, is a huge inquiry in the mechanisms of modern debt creation and a revival of modern monetary theory.

Naked CDS or the collapse of the quantum wave

In theory you can price a CDS by knowing the probability distribution of the underlying security. It can be a bell curve or standard distribution or it can be anything. The point is that we have historical data to generate a distribution, however sparse, and in retrospect incorrect. One of the academic criticisms to the current pricing techniques is that they assumed distribution curves that did not account for fat tails. A spot price accounts for the future rate of defaults, your premium has got to cover that and your profit.

But essentially you are still speculating about the future by assigning probabilities to differents "states". Paulson knew that the weight assigned to "meltdown" was too low, he could see it coming. The discounted weighted average of future cash flows can vary wildly based on your assumptions. The current "un-observed" cash flow in present value form reflects the average you put in. This lingo, though familiar to investors is mathematical in nature, captured in the formal framework of Banach and Hilbert spaces and differential geometry. It is also common place in quantum mechanics.

Quantum mechanics makes use of this framework in a very intuitive way. Essentially "reality", or the state a system finds itself in is a sum of possible states. This is not some wishy washy religious non-sense this is hardcore observed photon reality for example. While un-observed a system remains in 'super-position" or "coherence". For those familiar with the Schrodinger cat, now is the time to remember him, the cat is in "super-imposed dead/alive state" until observed, by you. The act of observation, triggers a wave collapse, where "reality" as *we* understand it is essential is essentially one classical wave. This *wave collapse* onto reality is triggered by observation and is a catastrophic, one-way event. This is decoherence.

The study of decoherence is a topic of quirky research and a frontier in modern physics.

Collateral positions on CDS track decoherence.

One of the assumptions that many frameworks do is that you can alway rebalance a collateral position fluidly and continuously. I will show how this assumption fails in the case of large naked CDS.

A CDS is a quantum mechanics state in that it is the sum of future possible worlds in cash flow form. We may model a 15% default rate in a bond. That means, for the payer, a model that says 15 are out in cash flow, on average. But "average" is not reality, in the event of default it is a 100 that needs to be raised, not 15. This is decoherence.... you may read 15 but the contract, when realized or triggered says 100. How do we manage the transition in real life? from 15 to 100? through the use of collateral requirements.

As the bond gets downgraded to default, the collateral requirements are raised so that by the time "one wave reality" hits, it is 100% of the cash needs that have been posted. In this way, the process of decoherence (collapsing from a superposition to a single position in wave space) is continuously observed and MANAGED in contract.

Naked CDS decoherence as a catastrophic monetary event
By catastrophic, we mean "out of equilibrium", "one-way" (serious entropy reduction), non-continuous event, as opposed to a smooth event that is always in equilibrium or semi-equilibrium. Violent phase changes for example are out of equilibrium. A tower falling. Some of these run-away processes exhibit feedback loops, that is one way to get non-linear and unstable.

I noted in the previous post that regular CDS's are transparent from a monetary standpoint. A regular CDS is transfer of existing debt and risk between parties. It is a zero debt creation operation. A naked CDS however amounts to net new money creation in the system, in the most liquid form: cash. Because it is a CDS and indexed on bonds, it can also get quite big.

So back to our collateral. AIG is on the hook with GS. GS demands collateral because the sub-prime is going to shit. ACA is on the hook in front of Paulson. In a declining market they got to come up with cash, lots of it. But the problem is this: the numbers are getting really big. Raising that kind of cash to cover your bonds means trashing the equity markets. You unwind, you barf...

We are reaching a classic fisher moment, when "the boat capsizes instead of righting itself". ACA has got to go in a down market and liquidate, thereby creating pricing pressure and more demands on its collateral side. It is a vicious loop. A fisher moment. The fisher moment in monetary theory is in collateral dynamics of naked CDS. The monetary framework captures the difference between CDS and naked CDS. The monetary levels and liquidity requirements cannot be ignored.

A liquidity drain
The first sympton is a SEVERE liquidity crisis. As someone said in August 2007 in Barron', "no quant modelled the evaporation of liquidity in their models". But liquidity did evaporate following a forced unwind in the public markets. We had gone from shadow bonds to very public equity problems. It was just the beginning. The authorities were right to treat this as a liquidity problem in the beginning. It quickly morphed into a solvency crisis, where "if observed" the whole financial system would appear bankrupt. Of course the discussion went onto NOT OBSERVING the losses. This was the accounting wars around FAS 157 or the "mark to market" practices in reporting numbers: why sell? hold on to it! the market will recover!. A liquidity drain did trigger a wave of defaults, just like in the old times. The shadow banking system was under severe stress. Wholesale monetary funds broke the buck.

It was decoherence of the housing bets, that triggered liquidity demands that proved far too heavy for the international financial system. Ban naked CDS!


Wayt said...

I agree: ban naked CDS - it serves no econ function. But leave everything else alone. Fraud is already illegal, but it sounds like ACA received all info needed - thus there was no fraud and GS will fight and win. See Blankfein in FT today. Unfortunately, the current proposed US reform legislation won't ban naked CDS but would screw up much else (example: angel investment rules for tech startups). Meanwhile Fannie and Freddie will cost us $500B and we will look the other way as they increase their dominance of (and distortion of) the US mortgage biz.

Frederic said...

I do agree with your analyse, but Naked CDS are not the only both mispriced and dangerous derivatives on earth.

By nature, and by destination, derivative product are supposed to hedge and/or expose to a given area of risk (credit, equity, beta sensitive, delta hedge, cruve shifts..) with :
- No liquidity requirement
- Non correlated collateral requirements

This mean that by essence, Derivatives are draining liquidity out of the market, since they represent a "near money".

Another major caracteristic of derivatives is that they actually are subject to derivation.

An option can trigger an option, a CDS can trigger a basket of default protection (nth to default). Otpions can trigger swap (double up). Options on CDS. Options on CDS index, that is. Beting on something that does exist with model that are higly arguable.

Pricing is still however the biggest correlation factor : it does not really matter if the model is good or bad; and nobody cared really about liquidity issue since CDS were mainly use to gain exposure on unavailable credit.

CDO were structured to bring liquidity through equity, with a strong leverage and collateralisation.

What I'd love to read from you would be an analyse of the consequences of excessive derivation.

As far as I'm concerned, excessive derivation is just the result of the current financial mindset : put the risk away, and make the weakest pay the bill.

Aside from these considerations, it is always a pleasure to read quality content on this subject.


Jonathan Shore said...

Your analogy of the paths in a wave function is correct. We call this the expectation (i.e. the sum of all outcomes (probability weighted).

I don't have a problem with speculation in the markets. Speculators do, generally add liquidity, as allows for a buyer / seller pair to exist.

The main problem with the banks is and was the use of leverage. Lehman Brothers (and Goldman for that matter) were leveraged up to 30-40x. Imagine what a 3% drop does to you (you are underwater).

The reason why firms like GS could use this sort of leverage was that as long as people believe you are good for the money, they will continue to extend credit, covering, your hopefully short-term underwater status.

The crisis of confidence started with Bear's fall meant that Lehman could no longer cover the huge negative swings in unrealized P&L (and more importantly collateral valuation) with more borrowing.

Goldman was in much better shape, but nevertheless could have gone down given their leverage.

Capital / Collateral requirements need to be strengthened significantly. Glass-Steagall needs to be reinstated as well. The investment banks amp'ed up leverage so as to compete with the much larger cash base of the retail banks.