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Let traders call the next bubble

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By Sebastian Mallaby
Friday, April 9, 2010

So here's a paradox to ponder: By now everyone has heard about traders who saw the housing crash coming -- and made millions betting on it. Yet most economists agree that central bankers won't prevent the next bubble from inflating. One group sides with Alan Greenspan, who argues that regulators can't know when a strong market has crossed into bubble territory. Another sides with Paul Krugman, who thinks that regulators can know -- but that they may choose to shirk their duty. Either way, what's up? Why can't regulators preempt bubbles if the hedge-fund crowd is smart enough to short them?

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The answer tells you something big about the financial reform brewing in Congress. There is a reason private traders beat public servants when it comes to anticipating crashes, and it points to the difference between a good reform package and a missed opportunity.

The reason boils down to conviction. Hedge-fund traders do not have to know that a bubble will pop in order to bet against it. They may not even need to feel that a crash is more than a 50-50 possibility. All they need to believe is that the odds of a crash are higher than others perceive them to be. The threshold for action is relatively low, so traders can act easily.

Take the example of John Paulson, whose hedge funds made $15 billion betting against the subprime bubble. When Paulson made his bets in 2006, the market consensus was that a nationally synchronized housing collapse was almost inconceivable. As a result, banks were willing to sell extremely cheap insurance on bundles of mortgages -- Paulson found he could pay $1.4 million for a contract that would pay him $100 million if the mortgage securities defaulted. With that overwhelmingly skewed payout, it made sense to bet against the mortgage bubble even if the odds of it popping were merely even. Paulson was like a roulette player who bets on red vs. black, but with a payout that more closely resembles the reward from betting correctly on a single number.

Now contrast Paulson's incentives with those of a central banker. As the Fed chairman in February 2000, Greenspan appeared before a Senate committee and explained why he was raising interest rates. Inflation had yet to pick up, but the powerful advance of technology stocks had fueled such strong growth that price pressure seemed likely. Of course, Greenspan could not know that he was right. But whereas Paulson had the prospect of that overwhelmingly skewed payout to compensate him for the risk of being wrong, Greenspan was greeted with a torrent of abuse. Then-Sen. Paul Sarbanes, Democrat of Maryland, charged that the Fed's preoccupation with runaway tech stocks harmed the job prospects of inner-city youths. Sen. Jim Bunning, Republican of Kentucky, railed that higher interest rates threatened the economy more than inflation. "I think people hear what you are saying and conclude that you believe that equities are overvalued," said then-Sen. Phil Gramm, the committee chairman. "I would bet that equity values, given what's going on, are not only not overvalued, but may still be undervalued."

Remember, this exchange took place in February 2000 -- one month before the tech bubble spectacularly imploded. If Greenspan was assailed for raising interest rates then, imagine the reaction if he had increased rates really aggressively around 2005, when the real estate bubble was a good deal less obvious than the tech bubble had been. Or imagine the reaction if Greenspan had unleashed a regulatory clampdown on home lending in the teeth of the consensus that rising homeownership was wonderful. Regulators cannot anticipate bubbles with certainty, as Greenspan rightly says. And they may not act even when bubbles seem probable, as Krugman contends, because the lack of certainty makes it difficult to face down angry members of Congress.

If regulators are unlikely to preempt the next bubble, where does that leave financial reformers in Congress? There are plenty of useful things they can do, but the hedge fund/central bank contrast points to one in particular. Reform should harness the energies of private traders, since their roulette-like incentives encourage them to call bubbles early. Big financial institutions should be required to issue special bonds that convert to equity in a crisis, and traders should drive the value of these bonds according to the odds that a crisis will materialize. In time, signals from these canary-in-the-coal-mine securities could inform regulatory decisions. When the markets telegraph a rising risk of crisis, regulators may restrain lending. Faced with angry senators, they could cite the message from the canaries.

A version of this idea made it into an early draft of the Senate reform bill. But now the Senate language, like the House bill, merely says that the concept should be explored. The final legislation should insist that it be implemented.

smallaby@cfr.org


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