Paulson’s address at the Shanghai Futures Exchange March 2007:

China's third challenge is a banking system which, while making progress, is still transitioning to a modem, efficient, market-driven system with proper controls, management, and professional staff. Some risk-averse credit officers may still believe it is safer to lend to state-owned enterprises backed by what they see as implicit government guarantees, rather than to dynamic small, medium-sized, and private businesses.

The continued large role of non-market factors that influence both state-owned enterprises and private enterprises - including financial services companies - stifles the dynamism of economic decision-making and the strength of regulatory integrity. Increasing the pace of privatization of state-owned enterprises would be beneficial.

the reality of the situation is that an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention.

Short Selling and Market Efficiency

A few interesting findings about short selling:


1. There is evidence in short selling activity consistent with information leakage and front-running. (Do Short Sellers Front-Run Insider Sales? Khan and Lu, June 2008.)

2. Short selling restrictions tend to be effective against negative skewness at market level but not at individual stock levels. (Efficiency and the Bear: Short Sales anad Markets around the World, September 2004, Bris, Goetzmann and Zhu.)

3. Where short sales are possible, aggregate stock returns are less volatile and there is greater liquidity. When countries start to permit short-selling, aggregate stock price increases, implying a cost of capital. There is no evidence that short-sale restrictions affect either the level of skewness of returns or the probability of a market crash. (A Study of Market-Wide Short-Selling Restrictions Jan 2005, Caroenrook and Daouk.)

4. While short-sellers take larger positions in stocks with recent price declines than in stocks with recent price increases, when the analysis is conditional on accounting-based measures of fundamental value, the positions of short-sellers in stocks with price declines are concentrated in stocks that are overvalued relative to fundamentals. (Does short-selling amplify price declines or align stocks with their fundamental values? May 2008, Curtis and Fargher.)

5. Stocks with limited lending supply and high borrowing fees respond more slowly to market shocks. Second, short-sale constraints have a small impact on the distribution of weekly stock returns. Limited lending supply is associated with higher skewness, but not with fewer extreme negative returns. Third, stocks with limited lending supply and higher borrowing fees are associated with lower R2s on average. (Price Efficiency and Short Selling, January 2008. Saffi and Sigurdsson.)

Point 1 above is interesting. It implies that someone somewhere has asymmetric (superior) information and at least some of these are short sellers.
Points 3, 4, 5 all point to greater market efficiency where short selling is permitted.
Point 2 implies that short selling has some negative impact on market returns but not on efficient pricing at the stock level. Measures that slow the momentum of short selling may correct some of the negative skewness without taking away too much from the market efficiency. An uptick rule would likely widen bid offer spreads as well as encourage smaller but more frequent trades.

Economic Consequences of the Paulson Plan

In the US:

The consumer is quite broke. Unemployment is rising. Firms have no access to credit. And now the government is quite broke too. The cost of cleaning up the banking system will fall on the government first. A budget deficit would imply austerity and a severe limitation to government fiscal spend as well as possibly higher taxes down the road.

The Fed will have to cut rates or face deep recession. Normally this is highly inflationary but given that the BRICs are slowing down as well, inflation is likely not to be a problem.

The USD will come under pressure improving terms of trade and providing some relief to the economy in the form of export growth. This will be limited by the synchronized slow down in Europe and Asia.

The recovery will take multiple years depending on the approach taken. If the scale of the bailout is big enough and the time frame is short and decisive enough, this could take a further 2 years or so to work through.

Equity markets should begin to price this in earlier but no further than 1 year in advance. Credit markets may react more quickly.

This is the good case scenario.

Market Manipulation, Nationalized.

The Fed and Treasury are putting their heads together to find a solution. They need to figure out first what the problem is beyond the symptoms we see. It is, however, a first step. Managing expectations at a time like this is as important as material policy.

It looks like they propose a system wide solution since their ad hoc measures are not working and the fairness of their process or lack of it has been called into question. It doesn’t mean that ad hoc solutions won’t be found for Goldman Sachs and Morgan Stanley. It certainly buys them time for a more orderly solution.

On the subject of bailouts, the US cried foul when Malaysia established currency controls, when HK spent 15 billion USD (1997 prices, in a much smaller market than it is today), to fend of the speculators, when Malaysia’s Khazanah bailed out the banks by buying their assets.

Academic purity reacts to all this by pointing out that:

Singapore did nothing during the 1997 crisis but emerged from recession ahead of Malaysia.

Bailouts sew the seeds of the next crisis.

The Greenspan put which was responsible in great part for the current crisis is now replaced by the Paulson put.

The intentions of the current plan look highly domestically focused and internationally myopic.

The intentions of the current plan look highly market focused and economically myopic.

The reality is that:

-Singapore was a sound economy and Malaysia wasn’t. Malaysia emerged stronger than Thailand which took the IMF’s prescribed hard medicine.

-Bailouts sew the seeds of the next crisis if lessons aren’t learnt. Bailouts are necessary so that there is enough residual industry to face the next crisis.

-The Paulson put has higher theta and omicron compared to the Greenspan put.

-It is likely that any bailout plan will be negative for the USD which would be positive for terms of trade

-It is likely that any bailout plan will be inflationary.


On the subject of banning shortselling, it will have the effect of:

-Impairing market efficiency by limiting the feasible set, this is mostly an academic objection.

-Forcing investors to sell long positions to scale risk instead of hedging whenever they want to reduce market exposure. This will have practical consequences.

-Making it hard for option holders and writers to hedge positions. The uncertainty that the restrictions introduce to derivative markets is significant.

-Lowering liquidity in the markets at a time when market liquidity is an important factor in the crisis.


Some conjecture:

The creation of some agency to purchase distressed assets from financial institutions has to be paid for. It will have to be paid for by the government. The government will have to raise cash. They will have to issue debt. Who will buy this debt? They could just auction new debt and see what the free market thinks of US sovereign risk. Given that the faith of the US government in the free market is not all that strong these days, its likely that they will need a backstop. Foreign investors may not be willing to take USD risk. US investors whether healthier corporates or individuals through asset management companies may not be willing to take that risk either. The financial institutions in receipt of aid may be asked to be that backstop resulting in a de facto swap of US Treasuries for risky assets. System wide, this would only defer the liabilities, not crystallize them. It would, however, reflate the financial institutions, providing them income bearing risk free assets in exchange for toxic waste, without relying on external price discovery.