Harley knows some stuff. *
From Harley Bassman, The (accept no substitutes) Convexity Maven, May 23:
For a Government seeking to create good “Public Policy”, it is important to consider what is said, as well as what is unsaid. There is typically the dual goal of encouraging “good behavior” and discouraging “bad behavior” by employing carrots and sticks, both direct and implied.
While defining the line between good and bad actions can sometimes be difficult, such as when New York City effectively outlawed sugary “Big Gulp” drinks, other times the line is quite clear.
This is especially true when the Federal Reserve Bank (FED) offers policies or takes actions that create Moral Hazard.
Moral Hazard is defined as a situation in which one person makes the decision about how much risk to take while someone else bears the cost if things go badly. But I prefer a more general definition - a lack of incentives to guard against risk. Thus, I urge the FED to seriously consider the risks of Moral Hazard.
While the potential for Moral Hazard is easily identified, it is challenging to measure, ex post, if it has had an impact.
New York has a barrier beach that stretches from Brooklyn to the tip of Long Island; it starts as Jones Beach, submerges, and reappears as Fire Island, and after another dip finally rises as Dune Road in the Hamptons.
A December 1991 Nor’easter (hurricane) blasted a half mile hole through the dunes a few miles west of Westhampton Beach, taking 19 houses out to sea.
Via various legal maneuvers over a decade, the soon to be incorporated village of Westhampton Dunes eventually strong-armed the Government to spend $80mm for the Army Corps of Engineers to close the gap and rebuild the dunes.
Thus, a soggy ocean front lot that sold for $120,000 in 1996 resold in 2003 for $900,000. Presently, beachfront homes are offered at nearly $7,000,000.
The owners of these properties have surmised (perhaps correctly) that the Government will pay to restore their sandy property if damaged again. I will state that it is bad public policy to encourage building beachfront mansions in an area known for hurricanes without the owner absorbing the inherent risks.
On a grander scale is the current policy discussion about whether the Federal Government should cancel ~$400bn of Student Debt. Side-stepping issues of legality and fairness, the real problem is that future students may take on excessive debt by presuming loan forgiveness in the future.
I am not saying that government subsidized college loans are bad, but rather that policy makers be wary to not adversely skew the decision process.
Moral Hazard and the Great Financial Crisis
Let’s be clear, there were many bad actors who squired the GFC, including:1) Speculative home buyers (Flippers);2) Low-credit borrowers (Sub-prime);3) Lenders using ineffective underwriting and loan approval processes;4) Mortgage companies offering poorly designed loans (Negative amortizing);5) Wall Street banks deceptively packaging such loans (CDOs);6) Yield starved investment managers buying CDOs (mutual funds, banks);7) Government Agencies engaging in sub-prime loans (FNMA, FHLMC).But on equal footing with these various financial villains was the FED....
Although I sometimes poke gentle fun at Mr. Bassman for his proprietary product creation and packaging during his time at Mother Merrill—remember all those cutesy acronyms (OPOSSMS et al) in the '80's and '90's? That was him—although I poke fun at that, his knowledge of debt instruments and markets, particularly mortgage-related structured products (pre-2007), is unrivaled....
...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change)."Pish. Posh." is a technical term only used by market professionals for those situations where one has decided to go full Alinsky rule #5*
Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s....
*#5 Ridicule is man’s most potent weapon. It’s hard to counterattack ridicule, and it infuriates the opposition, which then reacts to your advantage...
The Convexity Maven is nothing if not a professional. Here is part of his mini-bio at MacroVoices:
Harley S. Bassman
Harley Bassman created, marketed and traded a wide variety of derivative and structured products during his twenty-six-year career at Merrill Lynch. In 1985 he created the OPOSSMS mortgage options product that facilitated risk transmission between MBS originators and financial institutions. In 1988, he assumed responsibility for trading and marketing IO/PO and other levered prepayment securities. Soon after this, he started purchasing RTC auctioned MBS Servicing rights and repackaged them for the securities market as BIGS - Beneficial Interests in GNMA Servicing. Later, he started a GNMA servicing conduit becoming one of the Top 20 originators in 1992. As managing and hedging prepayment risk became a priority focus for the financial markets, Mr. Bassman created PRESERV, Merrill's trademarked Prepayment Cap product. Merrill was a leader in this product category writing protection that covered the risk on tens of billions of notional mortgage servicing rights. Later, Mr. Bassman managed Merrill's initial venture into off-balance sheet mortgage trading.
In 1994, Mr. Bassman assumed responsibility for OTC bond options.
Within a year, Merrill was the leader in this product sector. A wide variety of products were offered including vanilla and complex options on MBS spreads and the Treasury yield curve.
To help clients more fully appreciate Volatility as a primary risk vector, he created the MOVE Index. Similar in form to the VIX Index, it is now the recognized standard measure of Interest Rate Volatility.
From 1995 to 2000 he focused on creating hedge strategies for MBS servicers and portfolio optimization techniques for Total Return and Index investors.
Mr. Bassman became the manager of North American MBS and Structured Finance trading in 2001. During his tenure, he created SURF, (Specialty Underwriting and Residential Finance), a self-contained Sub-Prime mortgage conduit. He supervised the issuance of Merrill’s first Sub-Prime securities. He also transitioned the structuring business to a new technology platform....
