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05/02/2010

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Michael F. Martin

What if we distinguish between positive and negative feedback speculation?

http://www.economics.harvard.edu/faculty/shleifer/files/positive_feedback.pdf

What's the marginal social benefit of positive feedback trading?

Jack

Man, I wish Becker had used some example other than oil to depict a functioning or efficient price setting market! Just five years before oil peaked, in high production cost Alaska, oil was profitable at $18-$20. Industry spokesmen themselves indicated that the $40 range would cover the costs of finding and developing new oil deposits. As most oil is not "new" that would point to an average price well below $40. Instead this "market" has set the supply-demand equilibrium in the $80 range for several years.

Absent severe shortages I can't think of any freely traded commodity that maintains a price of four or more times production costs. (Leaving out anomalies such as gold or diamonds)

I'm not at all hostile to traders and speculators and understand well the role they play in setting the price of farm and other commodities which then feeds directly back into emboldening growers to plant more or different crops in the spring.

In oil futures do we know that sovereign funds of OPEC nations or excess profits of Exxon, Mobil and BP are not pumping up futures? While a regular player might fold his hand or go short at these multiples of the fundamentals those helping to set their own prices could afford to take a chance that a few of their long contracts would be losers.

Then do we know whether the oil producer is taking the market signals to produce more? Here in Alaska they are clearly dithering and investing very little. Well, hard to know, but there are very very few things sold at wholesale for $80 with production costs of under $20.

But to housing:
"Applied to the financial crisis, if when housing prices were rising so rapidly, more speculators had been shorting the housing market, or shorted mortgage-backed securities whose value depended on what happened in the housing market, their actions would have reduced the sharp increase in housing prices, and reduced the subsequent steep fall in these prices. Therefore, it was the absence of sufficient short speculators when commodity and asset prices were rising sharply that helped widen the run up and eventual collapse in these prices."

..... Exactly right, but a very tough assignment. The rise of most stock prices are slowed by there being too few new buyers, or put another way, more sellers than buyers of a small percentage of the entire float that sets the price. Shorting is always a risky biz as the trader has to not only get the fundamentals and direction right but the timing as well.

(Ha! about ten years ago I saw that computer store -- with Comp in its name -- had no clue how to be a retailer, further prices of computers and accessories were falling so fast they'd be bound to see lower grosses and worse margins. What stopped me from shorting it was the market already knew and the stock price was falling. Just a few weeks later a Mexican billionaire bought the chain at a premium --- I'd have gotten hammered!)

........ Today the push is for "transparent" trading of these complex instruments. Ha! Get rid of the complexities of derivatives that allowed excessive risk taking, benefiting by fooling investors and incentives for shoddy (criminal?) underwriting and ratings and we're back to a simple bond market that would work just as Becker describes.

Too simplistic? or not raising enough capital? Does anyone think that hustling derivatives at 30 times assets is a healthy way of creating capital that doesn't exist?

QuizmasterAu

This is such a great item it should be mandatory reading for the whole world. It would be terrific if this item were used as a basis for a national competition for Econ. students. A good CME/ICE joint project?

Gordon Longhouse

Speculation is of limited utility but can cause or assist is causing considerable damage to markets.

Speculators take risks that other market participants refuse to take or, more to the point, put a price on risk. Hedgers are price takers and not price makers. In essence speculators set the price. This is useful.

Also useful is the willingness of speculators to look at both long and short sides of a trade. In the absence of short side speculators market would have an upwards bias which would make bubbles more bubbly and crashes hurt more.

Speculators do not provide liquidity. This is demonstrated during the GFC during which speculators deserted the market leaving liquidity provision to the much despised institutions of the government.

Speculators trade on information and will seek to take advantage of any information advantage that they can find. This is one reason why banks who service speculators (such as hedge funds) and who seek to speculate themselves (through proprietary trading) have an irresolvable conflict of interest.

The profits available from trading derivatives with less informed people, whether through embedded options or hidden leverage are huge.

This in my opinion is at the heart of the problem with speculation. People who are in fact speculating (such as fixed rate investors seeking higher rates of interest at little risk) ought to know that they are speculating. Hidden options and leverage needs to be identified in the products sold.

Bogus instruments designed to fool investors do not add to market efficiency, indeed they transfer risks to those least able to manage them, and so contribute to systematic market failure.

The issue is a legal one of being able to identify precisely which instruments should be permitted and which should not. Indeed is this a matter of the instrument or of identifying the market or of provision of information to the market?

sam vinson

Both observations buy Posner and Becker are fundamentally correct. Perhaps only growing up in an agricultural community and not living on a farm can enable an individual to appreciate the utility of speculation. By making prices more predictable, commodity speculation permits farmers to benefit by making it possible to understand when they can afford to buy a combine. The great social advantage of the recession that Posner persists in calling a depression is that it has caused the recognition that houses are commodities. That recognition will help millions of ordinary people recognize that spending money on a house must be compared to putting it into the stock market. If you drive around suburban America you cannot help but wonder whether America had over-invested in housing years ago. As an economy we might be comparatively better off with fewer, smaller houses. That is not a decision that government should make--although it has with various subsidies--but today after watching the housing price collapse, individual consumers are much more able to make these spending decisions objectively.

Liqing Pan

That's what I want to say! There are two types of speculation, positive and negative feedback speculation, and unfortunately, the positive speculation speculation has been empirically proved to be profitable, which is the reason why we see more and more institutional investors, who are powerful and skilled at smelling hidden instability factors in the financial market, taking such actions and cause more and more instability in the world.
We all know the East Asia Crisis around 1997: that crisis was very much worsen by hedge fund companies, i.e. institutional investors that barely have any moral bottom line.
And the problem here is: the government is weak at combating with these speculators because 1) the speculators are more smart-their team has more economists and PhD students than the government team; 2)they are much faster in action because they don't need to go through bureaucratic processes the government team goes through; 3) governments are less experienced because financial crisis is not some dish you have three times a day. But for professional speculators, its just their job to do it good.
Such speculator should be and can be regulated because of the noticeable high volume of purchase they make on market. When market is defect, government should be there to correct!

Bob

Thanks Michael, extremely interesting article. It practically says it all. Judging by this article, one can really hold the willful ignorance and selective blindness of American neoclasical economists, perpetually praising the financial sector for services it doesn't deliver, accountable for much of the U.S. and by extension the world's economic woes (which most Europeans do instinctively anyway). By comparison, the China Economic Review today has two articles regarding the Chinese response to their looming housing bubble. One claims that "measures to prevent a property bubble have seen the Shanghai Composite Index fall 15% in 2010", the other is about the increase in reserve requirement ratio. It makes me wonder how, if all these American Nobel-prize winning economists are indeed so smart, why the Chinese technocrats seem to be way ahead on practically every issue. My guess is that they prefer the messy real world over the beautiful theory.
I do agree on two points however, and that's that social anger shouldn't be directed solely at shorters, since they simply undo the price increases created by irrational speculators, and that speculators can indeed serve an economic purpose (the assymetric information argument). That said, the fact still remains that from the moment CDO's were created, all these geniuses should have been writing articles about the dangers of moral hazard instead of believing the market would sort it out.

csissoko

This article doesn't address the "casino-like" speculation that has been the topic of recent Congressional hearings. In these transactions there is always a speculator who makes money and a speculator who loses money. By Becker's logic there's no reason to believe that such transactions contribute to economic efficiency (because one of the speculators necessarily loses money -- and acts to push prices in the "wrong" direction).

I'm still waiting to hear a coherent logical defense of these products.

Jack

Some great comments! Sam sez: "If you drive around suburban America you cannot help but wonder whether America had over-invested in housing years ago. As an economy we might be comparatively better off with fewer, smaller houses. That is not a decision that government should make--......"

......... yes, the "old game" of home mortgage interest being deductible with cap gains being exempt only once in a life time over 55 seemed fairly stable and built in a retirement nest egg. Today, or at least yesterday, inflation and modest appreciation covered interest costs, and being allowed to take cap gains repeatedly on flops or the cash-back refi's created something of a "can't lose" "investment" for many. As Posner and others lament our savings and investment rate, dialing back some of the housing goodies (which ARE a huge government tax subsidy favoring high earners of higher tax liabilities) should divert more investment toward stocks, bonds and capital for small biz.

Gordon, exactly!
"Bogus instruments designed to fool investors do not add to market efficiency, indeed they transfer risks to those least able to manage them, and so contribute to systematic market failure.

The issue is a legal one of being able to identify precisely which instruments should be permitted and which should not. Indeed is this a matter of the instrument or of identifying the market or of provision of information to the market?"

........ While as csissoko points out true speculation (as opposed to investment) is typically a zero sum game of winners and losers, But in that process, as Sam points out in Agriculture, the "right" price is discovered and set. Trouble was, as everyone is seeing, there was no "market" with all the bucks being gleaned on the upside with us unwitting stockholders, taxpayers, and home buyers being the default bagholders on the wrong side of the trade.

Congress seems to be going very slowly, almost as if walking on eggshells in reforming this mess while China is apparently reigning theirs in and India simply didn't allow such complex instruments.

Can anyone here make a case for slice and dice derivatives? Essentially the mortgage biz is a bond market and we've always had higher risk premiums on 2nd loans, private mortgage insurance on the amounts borrowed over 80% and futures markets on bonds. My take is the whole derivative deal is a cloak to hide a massive Ponzi. No matter how it's chopped up you can't make capital out of nothing at 30 times assets.

Drew Saunders

Becker and Posner defend some idealized concept of speculation; but these esteemed writers miss the point, don't they? The problem is that LEVERAGE, the ubiquitous tool of speculators, is clearly capable of tearing up landscape. The "American people" aren't quite capable of putting their fingers on in, but it isn't speculators they are angry at; it is irresponsible use of leverage under limited liability. And it isn't the winners they (OK, we) are mad at; it is the fact that the ones who "lost" still made out like bandits. Defend the thieves at Bear Stearns, Lehman, and AIG, you two! Heck, why not Madoff?


N Mosley

Nobody ever seems to argue about the heart of a matter anymore.The central point. What is a market? any market.... Willing buyers and Willing sellers and the mechanism of price discovery. Period. I make a trade and win big and someone else loses. Now that's bad news to some. But now someone explain to me how it is more noble somehow If I LOSE and the other party involved enjoys big gains in any trade? I did not say there were no abuses,no insider trading,too opaque and exotic instruments,no due diligence on the part of investors or traders,overleveraging, etc.I am just saying that nobody is forced into taking on any financial risk that they do not want carry. Markets can and Do exist because you have willing buyers and sellers and transparent pricing. Don't like the prices..then you know what you have to do.. Don't you?

Jack

Mosley: Exactly. For example I rarely gamble at casinos or the horse track, so for the most part, other than the problems caused by compulsive gamblers becoming paupers and going on welfare, it matters little to me or the rest of society.

But! THE problem we're dealing with here is that of a HUGE cabal of sleazers having figured out a means of gambling for their own account and FORCING the rest of us to cover their losses.

If we could watch them lose everything they had right down to their wife's wedding ring, which IS the case for most small biz guys, we could fill football stadiums with spectators. Instead, we see notices of the "former" "banker" having closed on a $57 million flat overlooking Central Park. Cool eh?

Gordon Longhouse

One specific issue around speculation that I think needs more ventilation is the speculation on credit risk.

I see no utility to this form of speculation and a case can be made that it made the GFC worse than it would otherwise have been.

Institutions who are exposed to credit risk may have an interest in shifting some or all of that risk, but anyone who deals with such institutions are at an automatic information disadvantage as a lender will always be in a position to better assess and monitor the credit risks it takes on and sells than a third party without privity to the borrower.

Where persons without privity to the borrower offer "credit protection" and the borrower defaults, the loss is felt not only by the lender but by any who granted protection. The loss reverberates through the system especially if the seller of credit protection is itself a reference entity for other credit default swaps (e.g. AIG). If it is true that the total face value of credit default swaps exceeds the value of the borrowings of reference entities by five times, as has been reported, then this leveraging of debt default risk is a disaster waiting to happen.

Clearing trades through a central clearing house such as happens with exchange traded options and futures appears unlikely to resolve the problem of credit risk given the unique nature of credit default swaps.

Option and future positions gain or lose value as value is gained or lost on an underlying position such as commodity or share price. As value in a position is gained or lost the exchange requires traders to post collateral to cover losses which is paid to the gainers on the other side of the trade.

Most of the time value changes are smooth permitting the trader to manage their position and risk as market prices change. Though not always and when the market "gaps" as sometimes happens, it can quickly bring disaster to individual traders and the system.

The value of a CDS is not derived from the value of any given underlying loan. A CDS with a face value of say $100 million is either worth nothing, if the borrower is not in default, or worth $100 million if the borrower is in default.

Changes is value of traded debt of the reference entity may be an indication of the probability of default but the value of a CDS is not derived from the value of the traded debt of the borrower.

CDS is dangerous because it is not really a derivative.

The point is that changes in the value of a CDS are unlikely to move smoothly and price discovery at any given time is problematic which means that an exchange would be hard put to calculate the collateral required to manage the credit risk of its traders.

sam vinson

It may be true that few individuals speculated on the downside of the housing market, although many speculated on the upside--e.g. buying houses in Florida and Arizona with no doc mortgages. The market has educated them. Prices that rise can fall. Ergo, more intelligent speculators--as long as Congress does not deprive them of the instruments for downside speculation. The true risk is an inadequate capacity for downside speculation because then prices must fall precipitously when upside has been excessive. And it is true that the failure of our government to let Say's Law work has needlessly protracted this correction as in Japan. But no one ought expect politicians to act in economically pudent ways. They are subject to different influences--votes--except in one major way. If "special interests" are permitted reasonable access to government, the liklihood is that government will have a more balanced appreciation of speculation than if the populist ("kill the Kulaks")approach is essentially civil serviced as the only "legitimate" influence on Congress and the Exec Branch. And it is certainly worth noting that the anti-speculator infection is bipartisan whenever it matters.

Tito

You are assuming that speculators go against the flow of "commercial" players in the market, and that they buy low and sell high.

But it could very well be the opposite, with speculators engaging in a herd behavior that amplifies the boom-bust cycle, with a bunch of them making a killing while the music is on (and pocketing their 20% share in the upside) and losing everything (well, their investors' money) on the way down.

sam vinson

Tito, What I know is that in the middle of this decade housing speculators of virtually all types engaged in nearly pure hurd behaviour substantially exacerbating the bubble. What I assume is that people with money to spend learn, at least most do, after they have expended some of it stupidly. Consequently i expect more intelligent speculators because of this experience. Of course, government's effort to spread a transylvania tale that innocent investors were taken advantage of by scurrilous bankers may succeed in depriving some of those housing speculators of the benefit of their unfortunate experience. On the other hand, those who spend their time blaming others for their own decisions are likely to be unsuccessful generally.

David Kane

The authors are referring to traditional speculators who, as long as they do not dominate a market, provide needed services as described in this article.

But the problem in the commodity markets today are passive investors using commodity indexes and ETFs to buy and hold almost exclusively long commodity futures. These speculators remove liquidity by buying and holding for long periods of time (rolling them over every few months).

They do not make their decisions based on supply and demand fundamentals of commodities, but instead based on asset allocation decisions for their portfolios. Whether corn is $3/bushel or $5/bushel is irrelevant to them as they just want $X of commodities to "balance out" their portfolio.

These types of speculators have destroyed the usefulness of the commodity markets both for farmers and buyers to hedge and in terms of price discovery.

Because of this I think that commodity indexes and ETFs should be banned.

sam vinson

It is clear that speculators make decisions for the purpose of making money (thank God). That leads to them assessing many facts. For some in the grain markets, the weather report in grain producing areas; for others the "fact" they heard from Aunt Mary that nematodes must have developed a resistance to some poison. And for others, sophisticated demand and supply forecasts. That range of information is the value speculators bring to any market so that a real price can be discovered. All baning or regulating instruments of speculation will do is hide that information from the market and make price fluctuations more extreme. And David is absolutely right. Speculators by definition have only wanted to earn money throughout history. That's what distinguishes a speculator from a market participant (farmer, Alcoa, etc.) But the critical point for any speculator is that prices move--both up and down. And if they bet wrong on the direction they lose. Ergo, whether corn is $3 or $5 a bushel is critically important.

Dave Kane

Good points Sam. Clearly it's important whether corn is $3 or $5, but what I was referring to is how passive investors mess up commodity markets by making buying and selling decisions on things different than supply and demand of specific commodities. Traditional speculators go long and short, depending on whether they think prices will rise or fall. That type of speculator helps markets with liquidity and by helping to find the market price.

But in the last few years - especially since some AIG-funded studies indicated that commodities act contrary to other financial instruments and so were a good way to "balance out" a portfolio - pension funds, endowments, sovereign wealth funds, etc. started to put large sums of money into commodity indexes and ETFs. It was a small percentage of their individual portfolios, but cumulatively hundreds of billions of dollars were placed into the commodity markets through these financial tools that almost exclusively buy long contracts on a large number of different commodities and hold them for long periods of time, rolling them over before expiration date. These investments remove liquidity by holding for long periods and throw off the price discovery function by putting large amounts of money on one side of the bet.

These institutional investors don't look at the price of corn, oil, natural gas, wheat, soy, copper, etc., and calculate what they think each of them will do, but just want to buy $X of a commodity index to balance out their portfolio. That's where I came up with the idea that $3 or $5 corn doesn't matter to them. These types of investments have thrown the commodity markets completely off, with long term contango in some markets, and the overall destruction of the price discovery function.

Because of their investments, the markets are no longer useful to farmers and grain buyers, the people for whom commodity markets are designed to serve.

sam vinson

David, I would not argue about some large institutional investors making irrational decisions on speculative instruments. For example, some charitable and academic environments might be very driven by a need to try to cover the overhead costs of the charity or school when those costs are actually rising faster than the the rate of return on a reasonable portfolio. Nevertheless, most of these funds get pretty good advice. While I dont have any experience with them, I would think that if you want to be "in" copper, its projected price direction will generally drive you the most. It's easy to accept that there will be exceptions. For instance, the charity against fish farming may have a hard time being long on soybeans because its a component of what fish farmers feed salmon; the charity that believes global warming may insist on being short on coal because it believes its message is getting across. But if they bet heavily in that sort of way, they cease to exist--or at least become much smaller players. If we let these markets work they will either eliminate or educate. If we do not, anticipate the converse.

Dave Kane

Thanks Sam. The problem remains though, that when investors buy a commodity index, they are betting that the price is going to rise in a number of very different commodities - S&P GSCI has 24 commodities from all the commodity sectors. This is what throws the markets off. When they buy these indexes and hold them for months and years at a time, they are not acting like traditional speculators that are trying to guess the next day's prices. They sit on a long-only bet and hold it over a long period of time. By doing this they restrict liquidity instead of adding to it as traditional speculators, and they throw off the price discovery function of the futures market.

After interviewing a large number of commodity market participants and analysts, the Senate's permanent subcommittee on investigations stated, "These grain traders and analysts stated that the most significant factor contributing to the increasing basis and the lack of price convergence was the large presence of commodity index traders in the Chicago wheat futures market. Many traders stated that index traders had created an additional demand for futures contracts that was not related to or matched by any corresponding demand in the cash market, and that the futures prices had responded to this added demand by rising to a higher level than the prices in the cash market."

"In previous investigations conducted by the Subcommittee into the operation of the
commodity markets, there usually has been a range of views on the causes of particular price
movements. Typically, different traders with different market perspectives have had differing
views on the behavior of the market. In contrast, during this investigation, there has been a
striking unanimity of perspective. Virtually all of the traders and analysts contacted by the
Subcommittee stated that the large presence of commodity index traders in the Chicago market
was the primary factor contributing to the pricing problems in the wheat market."

Charities and schools will simply need to choose from the millions of other possible investment tools at their disposal. Commodities (the food we eat and the basis of everything that happens in the economy) are far too important to be allowed to be influenced by these types of investors.

sesli chat

Both observations buy Posner and Becker are fundamentally correct. Perhaps only growing up in an agricultural community and not living on a farm can enable an individual to appreciate the utility of speculation. By making prices more predictable, commodity speculation permits farmers to benefit by making it possible to understand when they can afford to buy a combine. The great social advantage of the recession that Posner persists in calling a depression is that it has caused the recognition that houses are commodities. That recognition will help millions of ordinary people recognize that spending money on a house must be compared to putting it into the stock market. If you drive around suburban America you cannot help but wonder whether America had over-invested in housing years ago. As an economy we might be comparatively better off with fewer, smaller houses. That is not a decision that government should make--although it has with various subsidies--but today after watching the housing price collapse, individual consumers are much more able to make these spending decisions objectively.

nfl jerseys

How dare people to take risks! Do not they know that can go wrong? And if not, why the government have to pick them up goes at the expense of taxpayers - so the old clich茅.

But the point is that these people invest their own capital, are not called investors . The new form of ridicule is thrown on these people, speculators . Whenever this word now the hope of those who really listen to http://www.epayebuy.com/nfl-team-color-jersey-cleveland-browns-17-edwards-p-236.html
the problem (Congress, radical environmental activists, animal rights lunatics, etc.) is that they are conditioned, with a great cry, a knot in the stomach and react on head to sign the agreement that the problem of blind oil prices is speculation.

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You are presenting a very interesting perspective on the events! I simply guess there is a "herd" behavior on the market that can explain all this. Great post!

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