Congestion pricing for security trades?
So the whole “banning shorts” thing was wearily predictable. The very politically-connected “good” investment banks had a little scare this week. Call it panic selling, call it a bear raid, whatever. Suddenly, it’s illegal to short financials. Go figure.
People like me are appalled. If it’s illegal to short in a “panic”, we ask, why isn’t it illegal to go long during obvious asset price bubbles? If you can tell a panic from a correction, then surely you can tell an asset bubble from a genuine boom, right Mr. Greenspan? Most people were perfectly aware of the housing and tech bubbles in real time. Only economists and idealists get confused.
Whatever. As I said, the whole dialog is tired, obvious, predictable.
But… Much as I’m an unapologetic short, I’m perfectly willing to concede that there’s such thing as irrational momentum selling, just as there is irrational momentum buying. Momentum buying is far more insidious and destructive in the long term, but both are bad. Banning short sales (or, in mirror image, restricting asset purchases to short covering) might help prevent momentum trades, but it’s a lousy way to address the problem. Decapitation is a perfectly effective cure for migraines, but that doesn’t make it good medicine.
Dean Baker frequently suggests a “Tobin tax” on securities trades, which, as reforms go, is not a terrible idea. What if we did put a small transaction tax on taking financial positions? Reduced liquidity means an increased commitment by investors to the underlying economics of their paper. That’s a good thing.
But what if we designed this tax so that, rather than being calculated as a constant fraction of transaction value, it was a function of both value and trading volume, so that it would be more expensive to trade when everyone else is also trading? Maybe it’d cost 0.02% of notional value to trade when daily transaction volume has been within 1 standard deviation of the trailing year’s mean, but the cost would increase as steeply rising function of any abnormal volume?
Such a tax would have lots of nice properties: First, it would be symmetrical, neutral between buyers and sellers. It would not harm transactors bringing new information into the market, since transaction volume would be normal while the information remains closely held. But it would bite transactors who react to widely known news or who pile on to price momentum. That is, “congestion taxing” wouldn’t much damage the information aggregation/price discovery of markets, but would tax the zero-to-negative sum rush into or out of positions once the information work is already done. “Me too” purchases would be expensive, and those that occur would be informative, because they would reflect conviction rather than copycatting. Low-conviction information cascades would be discouraged by a high cost of entry, rather than prevented outright by administrative fiat.
Is this a good idea? It’s Friday night, been a phukked up week, and I’m drinking right now (Kentucky Bourbon Ale, ya gotta try it), so maybe I’m slurring my thoughts. Just thought I’d toss this out into the world, and see where it lands.
Update: Jesse Eisinger has just published a nice column on the Tobin Tax in Portfolio.
- 22-Sept-2008, 9:45 p.m. EDT: Added link to Jesse Eisinger’s column.
Ouch!
This just makes it even more important to be first to sell if you smell a bank run coming on.
Before, you might sell if you thought there was a 0.1% chance of a bank run. You could be 10th in line, but you’d still be made whole.
But now, being 10th in line is even more expensive, so you’d better pull the trigger if you think there is a 0.01% chance! If you want twitchier markets, I think this the way to go.
Momentum selling is only a problem when you’re taking back short term deposits that prop up long term loans. There are easier ways to fix this problem — just stop using short term deposits to prop up long term loans.
-zanon
September 19th, 2008 at 8:17 pm PDT
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How about if we quit trying to come up with cute tweeks that involve unintended consequences and just let a perfectly good market function.
September 19th, 2008 at 8:32 pm PDT
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Some bloggers and others have argued today that the short selling ban is purely a political gesture, and has no effect on the chance that the banks will survive. It seems to me that the shorts’ plan could be to force down bank stock prices through the weight of their sell orders, with the aim of convincing providers of short term funds to the banks that the fundamentals are worse than they are. Don’t the big I-banks rely on short term funding to meet their obligations? And if lenders believe that stock market prices contain information about the fundamentals, might they not be more likely to pull their funding when stock prices fall dramatically? The only counter argument that I can think of (assuming that my assumptions are correct) is that the banks could always borrow from the fed under the arrangements made in recent months, which Steve seems to have an excellent understanding of. But then again I’m sure the Fed doesn’t want the banks to have to borrow for this reason.
Sorry this isn’t exactly on topic since your post is about the Tobin tax proposal. But I hope that Steve or some random commenter can set me straight on this so that I can get back to that reporter who keeps calling me and he can print it in the local paper and the local geriatric set can read it on Sunday and take it as the lord’s gospel. That and I’m on the tequilla tonight.
September 19th, 2008 at 9:28 pm PDT
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The preliminary version of the “plan” has been leaked out:
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I just read through the proposal. What happened to establishing an RTC-like entity to liquidate the assets? What happened to an RFC-like entity to recapitalize the banks? What happened to an HOLC-like entity to deal with the situation from the homeowner side?
All they are doing is handing Paulson a $700 billion check and telling him to buy mortgages and related securities over the next two years to prop up the market. This isn’t a solution. This is a transparent attempt to simply manipulate market prices upwards. What happens when the effect is only temporary and the markets fall off a cliff again? Raise the limit to a trillion, two trillion, let the Treasury start buying corporate bonds, equities, etc.? This is a joke, except it isn’t funny, it’s deadly serious.
September 20th, 2008 at 2:26 pm PDT
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Steve,
they change the rules of the game in the middle of the play (short sale bans, surprise rate cuts, etc). They go after alleged misbehaviour of some selected player (alleged rumor mongering by some shorts) and turn systematically the head the other way for their friends (continuous stocks pumping via rumors by the longs).
This has no semblance of a free market anymore. This is a Casinò and the House is cheating, in plain sight.
In one traders forum I follow, any speculation about future trasury and fed actions is done while repeating one sentence: “Think criminal!” They have become extremely more successful after they started thinking criminal.
Now I ask you, Steve. Will you advise anybody to invest at the man roulette of the Gran Casinò? Will you advise anybody to invest in the US stock market? Are Paulson and Bernanke kicking hard investors out of the US markets?
September 20th, 2008 at 7:13 pm PDT
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Zanon — This proposal does indeed create a race to sell first, but of the “congestion tax” is sufficiently steep in volume, creates little incentive for those in second or third place to carry through to the finish line. That’s a feature, not a bug. Investors would have every incentive to monitor there investments carefully, and to try to be near first out the door. But when they fail, they’d have to hold and take their losses. Those who bring new information to market get rewarded, those who don’t must bear the risk of the positions they have chosen to hold. Am I missing something?
toml — I should have made it clear, this was not a proposal intended for now, mid-crisis. It’d be a long-term tweak to the structure of securities markets. If you think, long term, the securities markets we have are sufficiently good, then, certainly, such tweaks are at best unnecessary and at worst harmful. I do actually think that short-term market dynamics interfere with the long term allocative efficience of securities markets, sometimes in material and harmful ways, thus I am open to reforms intended to blunt those dynamics, although wary of unintended consequences.
RTD — Pretty awful, huh. I like London Banker‘s take: “dictatorship”.
Alessandro — I try not to advise anyone on their investments, including on whether or not it’s worth playing. But I agree with your overall point: a market wherein bets are made or lost primarily as a consequence of whimsical policy choices ceases to have any claim to an economic purpose. A “good” market makes funds available to useful enterprises and withdraws funds from poor enterprises. A market that makes funds available to enterprices policymakers favor and withdraws funds from others only magnifies the hazards of “central planning”, especially since the whims the market rewards usually hardly even qualify as plans…
September 20th, 2008 at 7:49 pm PDT
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Ocho — I think it is precisely your reasoning that policymakers are using to justify the ban. The excellent knzn makes the same point.
The fact is that stock prices feed back through to enterprises by affecting the portfolio of real options available to them. So, stock price dynamics, whether manipulation or chaos, can affect the real value of a firm.
But… a firm has to be very vulnerable to begin with for a brief spikes down to affect its long-term prospects. Firms levered 30:1 should absolutely not have funded that with short-term loans that need to be rolled over constantly. Maturity mismatches are a risk financial firms should understand, and those who fail to manage maturity and liquidity risk should suffer. One can legitimately say that there are situations so extreme that firms ought not be expected to plan for them, and therefore social insurance kicks in without “moral hazard” (because we wouldn’t want firms being cautious about these risks). But, there’s that 30:1 number again. These vulnerable firms levered up for profit, levered far higher than was ever prudent, and lobbied hard to be permitted to take on that leverage. The same firms complaining now trade in large quantities on their own account, and I’d bet they’ve profited from sharp downward spikes on other firms themselves, whether intentionally provoked or not. Any firm has infinite value if it is permitted to weather temporary storms indefinitely: eventually a random walk will go high even if it starts from $40B underwater. I see no reason why reckless firms that made huge profits and payed out huge bonuses in “good times”, that understand and make use of short-term market dynamic plays more than anyone, should have the rules changed when their own recklessness makes them vulnerable to those same market dynamics. If Goldman were levered 5:1 (which still strikes me as far too high) rather than 20+:1 (where they are now), and if they had matched their financing sources to their liabilities, they’d have nothing to fear from shorts.
September 20th, 2008 at 8:02 pm PDT
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Steve, thanks for the reply. I agree that the financing strategies (maturity mismatches and massive leverage that you mention) used by the i-banks was absurd. I think that it can be explained by two factors 1) they could get away with it and 2) it isn’t good enough to get rich, or even to get very rich. You have to get very rich while still relatively young, and you have to get richer than your neighbors in the Hamptons. Contrast this with Buffet, who basically runs a large financial institution and holding company, and actually enjoys playing the game right as much or more than the rewards.
But now that we are where we are, I guess that we can’t let the “banking sector” collapse. I don’t know whether that means Morgan and Goldman had to be saved. Who could know, unless you’re Hank Paulson? I guess that we just have to trust him.
September 21st, 2008 at 10:40 am PDT
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there is no such thing as irrational buying per se. people buy assets for reasons beyond their underlying economics whether it be sentimental, status enhancing, political etc. There is nothing wrong with this. The problems only arise when the market is in disequilibrium and is not inherently preference based. There already is a market based mechanism for dealing with irrational risk. Its called the scarcity of capital. If scarce capital is drawn down on without new savings interest rates should raise thereby curbing risk or forcing the correct price. The scarcity of capital should not be manipulated by a central bank thereby damaging societies pricing mechanisms.
September 24th, 2008 at 10:24 am PDT
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