Leverage-induced systemic risk under Basle II and other credit risk policies

We use a simple agent based model of value investors in financial markets to test three credit regulation policies. The first is the unregulated case, which only imposes limits on maximum leverage. The second is Basle II and the third is a hypothetical alternative in which banks perfectly hedge all of their leverage-induced risk with options. When compared to the unregulated case both Basle II and the perfect hedge policy reduce the risk of default when leverage is low but increase it when leverage is high. This is because both regulation policies increase the amount of synchronized buying and selling needed to achieve deleveraging, which can destabilize the market. None of these policies are optimal for everyone: Risk neutral investors prefer the unregulated case with low maximum leverage, banks prefer the perfect hedge policy, and fund managers prefer the unregulated case with high maximum leverage. No one prefers Basle II.Comment: 27 pages, 8 figure

The Hazards of Propping Up: Bubbles and Chaos

In the current environment of financial distress, many governments are likely to soon become major holders of financial assets, but the policy debate focuses only on the likelihood and extent of short-term market stabilization. This paper shows that government intervention and propping up are likely to lead to long-term bubbles and even wildly chaotic behavior. The discontinuities occur when the committed capital reaches a critical amount that depends on just two parameters: the market impact of trading and the target exposure percentage

Could short selling make financial markets tumble?

It is suggested to consider long term trends of financial markets as a growth phenomenon. The question that is asked is what conditions are needed for a long term sustainable growth or contraction in a financial market? The paper discuss the role of traditional market players of long only mutual funds versus hedge funds which take both short and long positions. It will be argued that financial markets since their very origin and only till very recently, have been in a state of ``broken symmetry'' which favored long term growth instead of contraction. The reason for this ``broken symmetry'' into a long term ``bull phase'' is the historical almost complete dominance by long only players in financial markets. Dangers connected to short trading are illustrated by the appearence of long term bearish trends seen in analytical results and by simulation results of an agent based market model. Recent short trade data of the Nasdaq Composite index show an increase in the short activity prior to or at the same time as dips in the market, and reveal an steadily increase in the short trading activity, reaching levels never seen before.Comment: Revtex, 7 pages, 7 figure

Regrets, learning and wisdom

This contribution discusses in what respect Econophysics may be able to contribute to the rebuilding of economics theory. It focuses on aggregation, individual vs collective learning and functional wisdom of the crowds.Comment: 9 pages, 1 figure. Opinion paper submitted to European Physical Journal - Special Topics "Can economics be a physical science?

Carried Interest: Can They Effectively Be Taxed?

During the April 2008 Democratic Debate, former Senator Obama with former Senator Clinton almost referred to the subject matter of this article verbatim at page three of the transcript. ( We saw an article today which showed that the top 50 hedge fund managers made $29 billion last year--$29 billion for 50 individuals. And part of what has happened is that those who are able to work the stock market and amass huge fortunes on capital gains are paying a lower tax rate than their secretaries. That\u27s not fair. ) (http://abcnews.go.com/Politics/DemocraticDebate/story?id= 46702 71&page= 1). As stated by both candidates, the budget is going to be a major source of contention, and revenue raisers, such as the proposed legislation under Internal Revenue Code (I.R.C.) § 710, will be a hot button item. It was estimated by a Congressional committee that the fund managers would save $30 billion in taxes over the next ten years if the rules did not change. As promised, on page 122 of President Obama \u27s 2009 budget is the proposal to tax carried interest as ordinary income. It is suggested that this change will raise$2.7 billion in tax revenue in 2011. The initial public offering (IPO) of Blackstone Group stock caused a public and political backlash when an IPO memorandum showed how much built-up gain existed in Alternative Investment Vehicles ( AIVs ). These offerings spurred public interest in the quantitative net worth of the owners of the funds, like Stephen A. Schwarzman, a cofounder of Blackstone, and the tax rates paid by these owner individuals. Congress also began to focus on the tax loopholes allowing these owner-individuals to monetize their carried interest at a significantly reduced tax. This surge in public interest combined with political needs for offsets to eliminate the alternative minimum tax led several influential lawmakers to seek passage of tax legislation that would reduce the tax incentives currently in place. These tax incentives primarily benefited managers of AIVs. The legislation was introduced most predominately in HR. 2834, which sought to add I.R.C. § 710 to the Code, changing the treatment of distributions to the service partners from capital gain rates to ordinary income rates. Thus, the bill contains provisions that seek to completely reverse over thirty years of jurisprudence with a shotgun approach in attempting to solve what is deemed an injustice by some. This article addresses the social equity arguments and the tax and economic theories to solve the perceived problem. Will the managers, if subjected to higher taxes, attempt to maximize the value for the investors? If one believes that there are enough people who want to be rich, then there is no reason to further incentivize the fund managers by taxing the fruit of their labor at reduced rates. There will always be ambitious and smart people who would be more than happy to step in and do these services even at higher tax rates. Further, it has been argued that a lower tax rate will not be sufficient to change the behavior of this category of individuals. One would have to demonstrate that fund managers would have to either reduce their current work efforts, if the rates were raised, or that this class of individuals is more sensitive to tax incentives than other professions. The article then concludes with a thorough discussion of the current law and the proposed changes to solve the social inequity. The article discusses the proposed H.R. 2834 and whether the proposed tax legislation will ultimately be successful in raising revenues as Congress intends. The article concludes with a thorough discussion of the current law and the proposed changes. Under the proposed legislation, the result would be to tax the general partner at ordinary income rates. This would mirror the treatment of nonqualified stock options. The carried interest would still retain the deferral characteristic but would be taxed when they are redeemed by the fund managers at ordinary income rates. However, it is argued that this approach would lead to tax planning such as the utilization of loans

Hedge funds and investor protection regulation

A recent Securities and Exchange Commission (SEC) ruling requiring hedge fund advisers to register with the SEC aims to foster conduct and compliance to better protect hedge fund investors. This article focuses on investor protection regulation, considering its goals and likely costs and benefits. After reviewing some alternative regulatory approaches, the author examines the current U.S. regulatory structure for hedge funds, which has, perhaps unwittingly, separated hedge fund investors into two distinct classes -- retail and wholesale -- defined by wealth levels. ; The SEC's recent ruling reflects its concern about the growing "retailization" of hedge funds -- the increasing ability of less qualified (retail) investors to access hedge fund investments -- as general wealth levels rise and as more affordable investments, such as funds of hedge funds (FoFs), proliferate. In addition, institutional investors have increased their investments in hedge funds, exposing even more individual investors, at least indirectly, to a type of risk they may be unfamiliar with. ; The author believes that the costs of increased regulatory protection for hedge fund investors will ultimately prove to outweigh the benefits, and he argues that hedge fund investment strategies be made more, not less, accessible to a broader array of retail investors. In particular, he recommends that the SEC consider authorizing FoFs under a regulatory structure that better enables hedge funds to pursue absolute-return strategies so that retail investors can benefit from them.Hedge funds