Unable to Clear The Derivative Deck

Peter Atwater writes (concerning the fears of a double dip recession):

Unfortunately, from my perspective there have been two very distinct recoveries.

The first one is a recovery in asset prices — which I attribute exclusively to the unprecedented level of liquidity provided by the Federal Reserve and the resulting “forced march” into risk. (i.e. people will tolerate 0% returns on their deposits for only so long before heading into something yielding more).

The second one is the recovery in consumer spending — which I attribute to high levels of fiscal policy spending by the government and the “reprioritization” of consumer debt paymentsaway from their monthly mortgage to something else.

Both note that both recoveries are manufactured. Meanwhile unemployment continues at near double digits; there remains enormous overcapacity of production and there is no wage inflation.

To me we have flooded an engine with no spark plugs.  And to me the spark plugs to a true recovery only arrive when you get true market clearing prices at the bottom. We got “panic” bottom prices, which reflected the confidence that “the government can save us once again.”                (my emphasis)

But how are you going to get market clearing prices at the bottom for the shadow banking derivative system?

John Robb:

In the case of the financial system, the simplified component of the bow-tie control system is money.  The regulatory system for these simplified components are markets (price discovery). Through this lens, what happened in the financial system is actually relatively simple.  The financial industry created a system called the shadow banking system (a notional value of $400 trillion ++), which is essentially a complex web of interconnected derivative contracts.  These contracts are, by and large, NOT regulated by market mechanisms (they “derive” their value from other things, including market prices).  Instead, they are customized and complex.  These derivatives created a set of interconnections that bypassed the financial system’s simple bow to directly connect inputs to outputs. This had the following results.

The consequences according to Robb?

• Since individual banks issued and participated in these derivatives, they became central to the system’s operation.  These banks are now, since they own a portion of the financial and economic system’s bow: “too big to fail.”
• The system became brittle to changes in inputs.  The shadow banking system doesn’t provide a way to price and “clear” these derivatives using a market mechanism.  Information typically discoverable by markets (fraud and bad assumptions) isn’t accomplished.  As a result, very small changes in sub-prime mortgage default rates (an input) rocketed through this system and was one of the factors that led to a systemic collapse.
• The banks that have a stake in the shadow banking system are parasitic.  Like cancer, they actively redirect financial resources away from useful pursuits (in the bow-tie) into a much larger shadow banking system over which they have exclusive control for their own benefit.  Worse, these connections are potentially fatal to the operation of the bow-tie system upon which we rely.  Efforts to defend this parasitism, from the subversion of control mechanisms (i.e. the rating agencies) and distortion of government operations (to prevent regulation that would limit or unwind these contracts) are inevitable.

Worth considering as financial reform looks to be next on the Obama administration’s plate (post health care) and The Treasury Secretary is not likely the guy to fix the problem.