In times of crisis, what society most desires is an elegant, coherent theory of the crisis itself. That is, there must be a set of logically interconnected ideas that explains what happened before, what is happening now, and what will happen afterward. It would be nice if reality presented itself in such easy-to-understand terms. When it doesn't, as with the current emergency, we settle for a confused and hazy mythology that promises to explain our suffering.
Like many other mythologies, our new folk tale has developed organically, as the collective thinking of millions hashed together a cast of demons, sages, and saviors. Now we're on a financial witch hunt, looking for some black magic to destroy. Somehow, the derivatives market made the cast of demons in this mythology. And it seems that even some of the sharper tools in the box believe, in my opinion without any real theoretical basis, that the derivatives market has earned its place in that cast.
A Tall Order That Came Up Short
In a recent Financial Times article, George Soros explained his own theory of the crisis. While certainly less mythological than most others, it is still theoretically unsound and factually inaccurate in several respects. I happen to agree with many of his opinions on the Efficient Market Hypothesis and in a limited sense, what he calls "reflexivity," which holds that a market price is not only a reflection of fundamentals but can also affect fundamentals. But his opinion on derivatives is just plain wrong.
Soros begins his argument by explaining how the risks of shorting a stock differ from the risks of owning a stock. Although there are other ways to short stock, let's assume that we are talking about the method that involves borrowing stock, selling it, and then repurchasing the stock (hopefully at a lower price) and delivering it to the lender. Soros correctly points out that by shorting a stock, you leave yourself exposed to an effectively unlimited amount of risk, since the stock price could rise to arbitrarily high levels (back when those things used to happen), and you would be responsible for going out to the market, repurchasing it, and delivering it to the original lender, leaving you on the hook for the difference between the price you sold your borrowed shares at, and the price you have to pay for them now. He says that this means that ownership of stock and shorting a stock have "asymmetrical" risks. He then states that this asymmetry "serves to discourage the short selling of stocks." While that statement is a bit unclear and incomplete, I get what he's trying to say, and I can live with that.
He then incorrectly claims that shorting a bond through credit default swaps creates similar "asymmetrical" risks between buying protection and selling protection. He states that protection buyers have "unlimited profit potential" while protection sellers have "unlimited risks". That is categorically false. Those who read my blog often know that the maximum risk exposure of a protection seller is capped at the notional amount of the CDS, which also limits the maximum reward of the protection buyer. Without the jargon, this means that both sides agree to the amount of protection bought at the outset of the contract. The protection seller never has to pay more than that amount and the protection buyer will never receive more than that amount. Thus, both sides of a CDS have a cap to the amount of credit risk they are exposed to.
This pulls the cornerstone out of Soros' argument that CDSs over-incentivize buying protection. There may be other arguments to that effect, though I doubt it given the bilateral nature of the contracts and the rule of no free lunch. In any case, his is certainly not one of those arguments.
Betting On Failure
Soros then argues that both the shorting of stock and the buying of protection through CDSs contributed to a lack of confidence, by lowering the price of stocks and raising the cost of protection respectively, each of which accelerated the demise of several institutions. This argument is hard to prove or disprove, as it depends on knowing which occurred first: the lack of confidence or the shorting/protection buying. My instinct is that we may never know.
Moreover, the cyclical self-fulfilling dynamic that Soros is alluding to can be created without derivatives, shorting, or any of those fancy techniques: see e.g., bank runs. Whenever the dynamic running a market is a high level of demand for short term capital (which is what occurs during a liquidity crisis) coupled with the fear that you will be the last to exit a market, prices will plummet. This is because each participant has an incentive to maximize the short term value of its assets. And each participant knows that if it doesn't convert its assets to cash or other low risk short term assets, the collective selling of others will erode the value of any assets that it doesn't sell. So, even if a given participant doesn't want to sell and values its assets at a price that is higher than the current market price, it will sell anyway if it needs capital in the short term.
Note that this logic creates an exception to the EMH. That is, when there is insufficient short term capital, there isn't enough available cash to bring prices back up to efficient levels. This logic also explains the recent mad rush into short term Treasuries.
In short, even if Soros is correct that short selling and protection buying exacerbate self fulfilling market dynamics, which I doubt, they can occur anyway.
With respect I think Soros understands CDS's more than you do.
Of course you are correct that the notional value is the 'limit' of exposure for buyer and seller. But that doesn't take into account how these CDS's were actually implemented.
There are two big issues you are missing:
1. You don't need to own the underlying financial instrument to buy a CDS on it. So, unlike your house which you need to own to buy insurance on, with CDS's you can buy "default insurance" on all the houses in your city. This results in a multiplier effect has thousands of speculators rushing to buy CDS's (on things they don't actually own). All of these CDS's in turn creates negative pressure on the stock price....rinse, repeat, continue.
2. You can buy multiple CDS's contracts for the same issue. There is nothing stopping you from buying 5 or 10 CDS contracts for a particular issue. So yes, while the notional value is only for X the fact that I can buy 10, 20, or 100 issues creates a virtually unlimited up/downside.
Both of these things is why the current situation in the bond market. Which is, the total value of all corporate bonds is about $8T, yet there are a total of $45T in outstanding CDS's. Yes, that means that the average corporate issue has more people betting against it then it does of people that actually own the underlying issues.
Bstin,
1."This results in a multiplier effect has thousands of speculators rushing to buy CDS's (on things they don't actually own). All of these CDS's in turn creates negative pressure on the stock price....rinse, repeat, continue."
The multiplier effect refers to income, not derivatives. Secondly, in order to BUY protection, someone must SELL it to you. So, there is a limit to how much negative pressure you can exert on prices simply because you need to trade with someone that fundamentally disagrees with you. Finally, you don't own stock when you short it. Is that acceptable to you?
2. "You can buy multiple CDS's contracts for the same issue. There is nothing stopping you from buying 5 or 10 CDS contracts for a particular issue." False. There is something stopping you: the seller of protection. If demand for CDS protection increases, the price of protection will increase accordingly, making the protection less valuable. I suggest you read my other articles on the subject.
This is a solid piece about what was wrong with Soros' FT essay last week. Thanks.
You appear, however, to misrepresent the Efficient Markets Hypothesis (EMH) when you say you agree with Soros about his criticism of it.
In his FT essay Soros notes an asymmetry in the risk/reward ratio between being long or short equities. The asymmetry discourages short selling. He makes the old observation that long capital can be much more patient than short capital.
He extends this logic to connecting CDSs and shorting bonds; claims that no amount of arbitrage eliminates the asymmetries and therefore that this violates the EMH.
After lots of discussion he concludes: "The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime."
He makes a couple mistakes common to people who are hostile to the observation that liquid markets are informationally efficient. First, he doesn't appear to understand what the EMH says and doesn't bother to define it. Then he applies the EMH to markets that are illiquid or constrained in some way.
It seems that the CDS example is analogous to the mispricing of Palm and 3Com shares observed in behavioral finance literature during the '90s and held up as a violation of the EMH. Of course, the issue with Palm was the lack of liquidity and shares available for arbitrage. Once the shares appeared, the anomaly disappeared.
You note a similar lack of short-term capital that creates self-reinforcing spirals and "creates an exception to the EMH." None of that, however, has anything to do with the EMH.
All the EMH says is that in a liquid market in which arbitrage is readily available, information (read: investor expectations) is quickly incorporated into securities prices such that a trader is unable to implement a systematic (mechanical) strategy to achieve riskless profit.
That's all it says. Over 40 years of research hasn't dented that observation much. Yes, returns on some assets are predictable at long horizons. Ex ante, however, the length of those horizons are unpredictable, so it's a crap shoot whether investors can profit from this evidence.
Small-cap stocks earn higher premia than they should relative to large caps; high book-to-market (value) stocks earn more relative to low book-to-market (growth) stocks than they should. Momentumn factors exist. Again, ex ante, no evidence has ever been found that managers are able risklessly to profit from these observations. Where outperformance exists, it does so because of adherence to mechanical style, not because of stock picking. In fact, all the evidence in the most rigorous studies shows that fund managers systematically underperform risk-adjusted indices after costs and taxes by a lot (nearly 2%.)
The EMH is a hypothesis, not a theory. It can't be tested. However, it describes extremely accurately the way liquid markets works. That's the definition of an effective economic model.
Soros, in a long interview with the FT's editor two days after the essay you quote appeared, noted that he is "math phobic" and that's why his ideas about reflexivity haven't been accepted by finance academics. It's also probably the reason why he is oblivious to decades of research that demonstrate the validity of the EMH. He can't even be bothered to understand what the EMH is.
Bastian,
Great comment. Glad you like the article.
Note that I express qualified agreement with Soros' opinions on the EMH.
Also, the EMH claims to be informational-efficient in order to convince us that assets are priced efficiently. A rush into short term assets will deplete liquidity and distort prices. I don't see how you can disagree with that.
"The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks."
A typical stock can range in price from zero to infinity.
A typical (non-convertible) bond can range in price from zero to 100 (par) at maturity.
The asymmetry associated with stocks does not occur with bonds, so Soros is baffling on this point. That said, as bstin noted at 9:22, if you short an unlimited amount of something your risk can be unlimited.
Tom,
Sure, shorting an unlimited amount of something creates unlimited risks. What kind of comment is that for Soros is to make? How is that unique to CDSs. You can say the same thing about any asset.
Doesn't short selling make the price discovery process more efficient?
Even if short selling does pop a bubble, isn't it better to encourage bubble popping as early as possible in the bubble?
When you restrict short selling, does that create opportunities for regulatory arbitrage?
Steve,
Agreed on both fronts.