Bankruptcy and the 'Counterparty' Myth

The latest fad words in business economics are “counterparty trading.” We are supposed to be worried that because there are many trading partners among financial firms—counterparty traders—the whole system could collapse if any one firm goes bankrupt.

One of Friedrich Hayek’s best works concerned information in society and the price system. Hayek showed that one of the greatest benefits of the price system was its role in spreading relevant information and eliminating the need for extraneous information. Hayek’s classic example was that if the price of tin went up, an actor didn’t need to know the reason why—there could be a strike affecting supply or an increase in demand—all he needed to know was to conserve more tin than he previously had. The price of tin connects disparate individuals and coordinates the activities of the innumerable people that are in the tin market.

All of these people in the tin market—all around the world—are nothing more than counterparty traders—to use the faddish term. If a supplier goes broke, it affects actors all over the world; similarly, if a consumer can’t deliver on a contract to buy tin, it affects those same actors all over the world.

Hayek showed that far from being alarmed by counterparty trading, it is something we should welcome. Counterparty trading is nothing more than the interconnectedness of the market which ties the various actors together and incorporates their decisions into the price of a product. This interconnectedness is not something to be feared, but rather embraced.

Hayek made another profound (and humbling) point in information theory. The point was that every individual knows more about his own situation than anyone else in the world; in this sense every individual is a worldwide expert in at least one respect. The importance of this observation can’t be overstated when it comes to central planning. Each individual knows his own likes and dislikes better than anyone else. These likes and dislikes are what constitute a person’s preferences.

A central planner would need to have communicated to him all of these preferences from individuals in the economy. An individual similarly knows his endowments—what he owns and doesn’t own—better than almost anyone in the world. Both an individual’s preferences and endowments would need to be communicated to a central planner, as opposed to a decentralized system allows individuals to use this information directly by purchasing and producing without approval of a central authority.

This second point about individuals’ store of knowledge is relevant to counterparty trading. A significant part of an individual’s economic situation is the viability of his trading partners. Before an individual or firm is extended credit, for instance, they usually must fill out credit applications, financial statements, sometimes tax returns, etc. Due diligence performed on a trading partner is not always perfect, but an individual or firm has every incentive to assess the credit of its trading partners accurately. If General Motors or Ford went bankrupt, their suppliers, as in their counterparty traders, might also go bankrupt, but those suppliers had every incentive to make the right decision about trading with General Motors.

The recent American Spectator article by John Berlau points out that the 2001 bankruptcy of Enron—the seventh largest public company in the United States—did not keep the economy from growing in 2002 and 2003. Berlau points out that Enron traded heavily in derivatives with counterparties such as Morgan Stanley and Citigroup that were heavily exposed to losses from Enron. Despite that, the economy kept growing.

Counterparty traders have every incentive to limit their exposure to those unable to perform, and did so to an extent when it came to Enron's implosion was not an economy breaker. There is no reason to think that the current financial situation is any different.

But let us suppose that the financial community’s counterparty losses were large enough to force a downturn in the growth of the economy. Should we then step in to save a firm and its counterparty traders from extinction? I would again answer no—no more than we should have stepped in to bail out Chrysler and those exposed to it.

It is sometimes suggested that the government actually made money on the Chrysler bailout and that this somehow justifies the government intervention. This argument misses the distinction between ex post and ex ante justification. Ex post, after the fact, we can say that the government was fortunate and made money. This does not justify the decision ex ante, or beforehand. Ex ante, no other private parties would lend the money to Chrysler on the terms set by the government and so the decision was not economically justified at the relevant point in time.

Similarly, the current proposed bailout will not be justified if the government ultimately makes money. Given that the last mortgage security package sold for only 22% of its face value, and that only 1 in 416 houses are in foreclosure nationwide, it would not surprise me if there was a profit on the government investment. But this would still not be a justification for the bailout.

If the mortgages are bought from the government by a private equity firm or a hedge fund, they'll not be subject to the same regulations that the current holders are. Indeed, the present requirement to mark securities to market value forces a public firm to write down the value of an existing performing mortgage portfolio merely because another firm had to sell its portfolio at a reduced price. If a new bidder such as a private equity firm—unhampered by the mark-to- market regulation—buys the mortgages, it will not be required to mark to market.

This same result of freeing a new buyer from mark-to-market regulation could also have been achieved by allowing these new bidders to have bid in a bankruptcy court for the mortgage securities. This would have been a much better way to free up the system and fix new prices for these securities, rather than having the government buy them ahead of an auction.