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January 23 2010

Play fullscreen
Social Banking - Verantwortung für sein Geld übernehmen
Noa Bank - Focus Money-Bericht

// It's a commercial from Noa Bank, which states more or less directly, what everyone could have asked himself, if he would have been honestly enough about the complacent cynism as the insane basis of our economy; only some did it - the commercial itself, I mean, how it visually done, is simply mainstream.
oanth muc 20100123
Reposted fromyum yum viareturn13 return13

January 21 2010

Obama Proposes Volcker-Style Financial Reform

It looks like the political winds have shifted away from Tim Geithner/Larry Summers and toward Paul Volcker/Elizabeth Warren:

Obama to Propose Limits on Risks Taken by Banks, by Jackie Calmes and Louis Uchitelle, NYTimes: President Obama on Thursday will publicly propose giving bank regulators the power to limit the size of the nation’s largest banks and the scope of their risk-taking activities...
The president, for the first time, will throw his weight behind an approach long championed by Paul A. Volcker... The proposal will put limits on bank size and prohibit commercial banks from trading for their own accounts — known as proprietary trading. ...
Mr. Volcker flew to Washington for the announcement on Thursday. His chief goal has been to prohibit proprietary trading of financial securities, including mortgage-backed securities, by commercial banks using deposits in their commercial banking sectors. ...[T]he concern is a new type of activity in which financial giants like Citigroup, Bank of America and JPMorgan Chase ... operate on two fronts. On the one hand, they are commercial banks, taking deposits, making standard loans and managing the nation’s payment system. On the other hand, they trade securities for their own accounts, a hugely profitable endeavor. This proprietary trading, mainly in risky mortgage-backed securities, precipitated the credit crisis in 2008 and the federal bailout.
Mr. Volcker ... has gradually lined up big-name support for restrictions on such trading. ... Under the new approach, commercial banks would no longer be allowed to engage in proprietary trading, using customers’ deposits and borrowed money to carry out these trades. ...

I want more details, these proposals don't exhaust the needed changes, and who knows what Congress will actually do -- I don't think we'll get anywhere near the amount of change we need when all is mostly said and little actually gets done -- but this is a move in the right direction. Too bad it didn't happen months ago.  [dual posted]

January 20 2010

Taxing Bailed-Out Financial Institutions

The administration's proposed bank tax can be considered an insurance payment that is paid after disaster strikes rather than the more usual case of collecting premiums ex-ante (as I talked about here). But what's the best way to structure this after the fact insurance premium? Diamond and Kashyup say that the answer is to base the tax on the difference between bank assets at the end of August 2008, and their level of capital today:

Return Our Investment, by Douglas Diamond and Anil Kashyup, Commentary, NY Times: Wall Street is considering legal action to prevent President Obama from imposing a new tax on bailed-out financial institutions. Because the law that created the Troubled Asset Relief Program compels the government to recoup the bailout money, it’s unlikely that banks will succeed... So rather than debate the constitutionality..., it is far more productive to design the best possible repayment plan.
The consequences of getting this right are huge: with a new tax, the administration aims to raise $90 billion over the next 10 years, which would do much to offset TARP’s estimated $117 billion losses. We therefore suggest taxing banks based on the difference between their assets at the end of August 2008 and their current level of capital. After all, the support these firms received was based on the size of assets before the financial panic began, not the size of those assets today.
With the bailout money, the government wound up insuring the bondholders and other creditors of the financial institutions. The tax we propose would allow the government to effectively collect insurance premiums now that should have been charged ahead of time. ...
Because our version of the tax would require each firm to pay a tax proportionate to the size of its bailout, it would fall hardest on the former investment banks whose very survival was in doubt before the government stepped in. These firms are now making eye-popping profits and are on a path to pay record bonuses, but more importantly they had the most borrowed money that wound up being unexpectedly insured. This is why they ought to pay more.
Even TARP recipients that have repaid the bailout funds benefited from the stability the government provided, so they too would have to pay some portion of the tax. But our formula would lower the tax for organizations that have raised capital after August 2008...
By focusing on each institution’s assets before the fall of Lehman Brothers almost brought down the system, our plan would make it impossible for banks to shrink their way out of the tax. ... Likewise, by focusing on the historical size of a bank, our plan would allow little room to engage in sham accounting transactions to sidestep the tax. ...
It is generally a bad idea to enact after-the-fact penalties. But giving away free insurance, as the government did during the bailout, is also bad. Our tax would merely ask financial institutions to finally pay for the insurance policy that kept them afloat.

If we are going to provide such insurance -- and there is an implicit guarantee that the insurance will be available whenever a shock to the banking system has the potential to create systemic trouble -- then (as I argue here), one part of the regulatory response to the crisis must be to limit the amount of risk that these firms can take on.

January 19 2010

Is It Time for Obama to "Pick a Fight with the Banks"?

I don't put much of the blame for the financial crisis on the bad incentives embedded in executive pay structures. But that doesn't meant that pay structures didn't contribute to the problem. And it certainly doesn't mean that executive pay is justified by productivity, or that there are no important market failures associated with the way executive pay is structured:

The CEO Pay Slice, by Lucian Bebchuk, Martijn Cremers, and Urs Peyer, Commentary, Project Syndicate: ...In our recent research, we studied the distribution of pay among top executives in publicly traded companies... Our analysis focused on the CEO “pay slice” – that is, the CEO’s share of the aggregate compensation such firms award to their top five executives.
We found that the pay slice of CEOs has been increasing over time. Not only has compensation of the top five executives been increasing, but CEOs have been capturing an increasing proportion of it. The average CEO’s pay slice is about 35%,... typically ... more than twice the average pay received by the other top four executives. Moreover, we found that the CEO’s pay slice is related to many aspects of firms’ performance and behavior.
To begin, firms with a higher CEO pay slice generate lower value for their investors..., such firms have lower market capitalization for a given book value. ... Moreover, firms with a high CEO pay slice are associated with lower profitability. ...
What makes firms with a higher CEO pay slice generate lower value for investors? We found that the CEO pay slice is associated with several dimensions of company behavior and performance that are commonly viewed as reflecting governance problems.
First, firms with a high CEO pay slice tend to make worse acquisition decisions. ... Second, such firms are more likely to reward their CEOs for “luck.” They are more likely to increase CEO compensation when the industry’s prospects improve for reasons unrelated to the CEO’s own performance... Financial economists view such luck-based compensation as a sign of governance problems.
Third, a higher CEO pay slice is associated with weaker accountability for poor performance. In firms with a high CEO pay slice, the probability of a CEO turnover after bad performance ... is lower. ... Finally, firms with a higher CEO pay slice are more likely to provide their CEO with option grants that turn out to be opportunistically timed. ...
What explains this emerging pattern? Some CEOs take an especially large slice ... because of their special abilities... But the ability of some CEOs to capture an especially high slice might reflect undue power and influence over the company’s decision-making. As long as the latter factor plays a significant role, the CEO pay slice partly reflects governance problems. ...
[O]ur evidence indicates that, on average, a high CEO pay slice may signal governance problems that might not otherwise be readily visible. Investors and corporate boards would thus do well to pay close attention not only to the compensation captured by the firms’ top executives, but also to how this compensation is divided among them.

Which opens the door to ask the question, is it time for Obama to pick a fight with the banks?:

Whatever happens today in Massachusetts, finding 60 votes in the Senate for meaningful financial regulatory reform is likely impossible. That means it is now high time to jettison the middle road, and go full bore against the banks. Given Obama's cautious approach so far in his administration, it is difficult to feel any confidence in such a prospect, but really, at this point one has to ask, what's he got to lose?

We've got a lot to lose if we don't get meaningful financial reform, so just as with health care, if what we can get through Congress actually improves conditions in financial markets, we need to take what we can get and hope to build upon it later. The question is how to construct a political strategy that will allow us to get as much done as possible. It may be that aggressively going after big banks can create public support for reform, support that would be difficult for politicians of either party to ignore. But there's also a chance that such a strategy will harden the resolve of those now opposed to reform making it harder to get anything done at all.

So a second question is whether the baseline level of reform we could get without an all out, "jettison the middle road" strategy is acceptable, If it is, I'd prefer to protect that and proceed cautiously. My loss function is asymmetric. Getting something, even if it isn't as much as we'd like, is much better than nothing at all.

But my sense is that right now the administration can't get enough support to do anything except fairly cosmetic changes. If that's the case, and I'm not completely sure that it is, but if so, then hammering the big banks relentlessly may be the only chance we have to create the coalition needed to implement more meaningful measures.

Leverage Cycles

[Warning: Wonkish] I've said several times recently that I favor limiting leverage as one of the responses to the financial crisis, but I haven't talked a lot about the theoretical underpinnings for this view. Fortunately, Rajiv Sethi describes one of the papers in this area that helped to convince me that limiting leverage cycles is important. I've also included a summary of another paper by Ana Fostel and John Geanakoplis on the same topic from an interview of Eric Maskin (The paper has several attractive features. It is a general equilibrium model, it has heterogeneous agents, incomplete markets, and asymmetric information, and it can generate endogenous leverage cycles that can lead to a collapse of the banking sector. But it is just one in a series of papers on the topic, with the most recent described next):

John Geanakoplos on the Leverage Cycle, by Rajiv Sethi: In a series of papers starting with Promises Promises in 1997, John Geanakoplos has been developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role. This work has attracted a fair amount of media attention since the onset of the financial crisis. While the public visibility will surely pass, I believe that the work itself is foundational, and will give rise to an important literature with implications for both theory and policy.
The latest paper in the sequence is The Leverage Cycle, to be published later this year in the NBER Macroeconomics Annual. Among the many insights contained there is the following: the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs.
This has some rather significant policy implications:
In the absence of intervention, leverage becomes too high in boom times, and too low in bad times. As a result, in boom times asset prices are too high, and in crisis times they are too low. This is the leverage cycle.

Leverage dramatically increased in the United States and globally from 1999 to 2006. A bank that in 2006 wanted to buy a AAA-rated mortgage security could borrow 98.4% of the purchase price, using the security as collateral, and pay only 1.6% in cash. The leverage was thus 100 to 1.6, or about 60 to 1. The average leverage in 2006 across all of the US$2.5 trillion of so-called ‘toxic’ mortgage securities was about 16 to 1, meaning that the buyers paid down only $150 billion and borrowed the other $2.35 trillion. Home buyers could get a mortgage leveraged 20 to 1, a 5% down payment. Security and house prices soared.
Today leverage has been drastically curtailed by nervous lenders wanting more collateral for every dollar loaned. Those toxic mortgage securities are now leveraged on average only about 1.2 to 1. Home buyers can now only leverage themselves 5 to 1 if they can get a government loan, and less if they need a private loan. De-leveraging is the main reason the prices of both securities and homes are still falling.
Geanakoplos concludes that the Fed should actively "manage system wide leverage, curtailing leverage in normal or ebullient times, and propping up leverage in anxious times." This seems consistent with Paul Volcker's views (as expressed in his 1978 Moskowitz lecture) and with Hyman Minsky's financial instability hypothesis. But it is inconsistent with the adoption of any monetary policy rule (such as the Taylor rule) that is responsive only to inflation and the output gap.
It is worth examining in some detail the theoretical analysis on which these conclusions rest. Start with a simple model with a single asset, two periods, and two future states in which the asset value will be either high or low. Beliefs about the relative likelihood of the two states vary across individuals. These belief differences are primitives of the model, and not based on differences in information (technically, individuals have heterogeneous priors). Suppose initially that there is no borrowing. Then the price of the asset will be such that those who wish to sell their holdings at that price collectively own precisely the amount that those who wish to buy can collectively afford. Specifically, the price will partition the public into two groups, with those more pessimistic about the future price selling to those who are more optimistic.
Now allow for borrowing, with the asset itself as collateral (as in mortgage contracts). Suppose, for the moment, that the amount of lending is constrained by the lowest possible future value of the collateral, so lenders are fully protected against loss. Even in this case, the asset price will be higher than it would be without borrowing: the most optimistic individuals will buy the asset on margin, while the remainder sell their holdings and lend money to the buyers. Already we see something interesting: despite the fact that there has been no change in beliefs about the future value of the asset, the price is higher when margin purchases can take place:
The lesson here is that the looser the collateral requirement, the higher will be the prices of assets... This has not been properly understood by economists. The conventional view is that the lower is the interest rate, then the higher will asset prices be, because their cash flows will be discounted less. But in the example I just described... fundamentals do not change, but because of a change in lending standards, asset prices rise. Clearly there is something wrong with conventional asset pricing formulas. The problem is that to compute fundamental value, one has to use probabilities. But whose probabilities?

The recent run up in asset prices has been attributed to irrational exuberance because conventional pricing formulas based on fundamental values failed to explain it. But the explanation I propose is that collateral requirements got looser and looser.
So far, the extent of leverage has been assumed to be fixed (either at zero or at the level at which the lender is certain to be repaid even in the worst-case outcome). But endogenous leverage is an important part of the story, and the extent of leverage must be determined jointly with the interest rate in the market for loans. To accomplish this, one has to recognize that loan contracts can differ independently along both dimensions:
It is not surprising that economists have had trouble modeling equilibrium haircuts or leverage. We have been taught that the only equilibrating variables are prices. It seems impossible that the demand equals supply equation for loans could determine two variables.

The key is to think of many loans, not one loan. Irving Fisher and then Ken Arrow taught us to index commodities by their location, or their time period, or by the state of nature, so that the same quality apple in different places or different periods might have different prices. So we must index each promise by its collateral...

Conceptually we must replace the notion of contracts as promises with the notion of contracts as ordered pairs of promises and collateral.
Even though the universe of possible contracts is large, only a small subset of these contracts will actually be traded in equilibrium. In the simple version of the model considered here, equilibrium leverage is uniquely determined (given the distribution of beliefs about future asset values).
To derive the amplifying mechanisms which give rise to the leverage cycle, the model must be extended to allow for three periods. In each period after the initial one the news can be good or bad, so there are now four possible paths through the tree of uncertainly. As before, suppose that at the end of the final period the asset price can be either high or low, and that it will be low only if bad news arrives in both periods. Short term borrowing (with repayment after one period) is possible, and the degree of leverage in each period is determined in equilibrium. It turns out that in the first period the equilibrium margin is just enough to protect lenders from loss even if the initial news is bad. The most optimistic individuals borrow and buy the asset, the remainder sell what they hold and lend.
Now suppose that the initial news is indeed bad. Geanakoplos shows that the asset price will fall dramatically, much more than changing expectations about its eventual value could possibly warrant. This happens for two reasons. First, the most optimistic individuals have been wiped out and can no longer afford to purchase the asset at any price. And second, the amount of equilibrium leverage itself falls sharply. There is less borrowing by less optimistic individuals resulting in a much lower price than would arise if those who had borrowed in the initial period had not lost their collateral.
There is much more in the paper than I have been able to describe, but these simple examples should suffice to illuminate some of the key ideas. As I said at the start of this post, I suspect that a lot of research over the next few years will build on these foundations. There is still a large gap between the rigorous and tightly focused analysis of Geanakoplos on the one hand, and the expansive but informal theories of Minsky on the other. An attempt to bridge this gap seems like it would be a worthwhile endeavor.

Here's a description of another paper on leverage cycles from Ana Fostel and John Geanakoplos (open link):

Economic theory and the financial crisis, Eric Maskin Interview: ...So tell me about your last pick, the Fostel and Geanakoplos article, Leverage Cycles and the Anxious Economy.

This article is again about leverage. The relevant point it makes is that, just as there’s a business cycle with booms and recessions, so there is a leverage cycle. And the two are intimately connected. So, in boom times, leverage tends to be high, and in fact may become too high. By too high I mean that it becomes too easy for banks or other financial institutions to be wiped out by relatively small declines in asset values. Now, high leverage is a calculated risk that an individual bank may be willing to take on. If I’m highly leveraged, I stand to profit greatly if my bet pays off, and so some probability of collapse may be tolerable. But the problem is that my collapse doesn’t stop with me. If I go down, then other banks could well go down too. The Fostel-Geanakoplos paper describes a mechanism by which that happens. In their model, some banks are especially optimistic about assets and so take on high leverage. If assets turn out to be worth less than they thought, they get wiped out. But now – with them gone – there is lower demand for assets, causing a further fall in their value, which then wipes out banks with somewhat lower leverage, and so we have the same kind of downward spiral as in the Kiyotaki-Moore paper. So, these papers are related. They both give explanations for how a relatively small piece of bad news can give rise to a big deterioration – in liquidity, lending, and production. In both cases, the remedy, once such a decline begins, is for the government to step in and provide liquidity. In Fostel-Geanakoplos, furthermore, the government can act beforehand to limit crises (downward spirals) by constraining leverage in the first place.

You do that by regulating?

Yes, you do that by regulating leverage or equivalently by limiting liquidity. If leverage is restricted, then the bank’s capital requirements are higher, and so it can’t lend as much. In other words, the bank’s liquidity – how much it can finance productive projects – is reduced. Another way of accomplishing the same thing is for the central bank to raise interest rates. So, monetary policy and leverage/capital requirements are closely linked. Unfortunately, in the time leading up to the current crisis, not only was leverage high, but interest rates were low, both of which encouraged overly risky behaviour.

The paper is dated 2008, which presumably means it was written before the crisis?

Yes, it was. In fact, Geanakoplos made much the same set of points in a sequence of earlier papers going back to the late 1990s.

So policymakers, especially people in Congress, need to read these papers.

Yes, or at least understand what’s in them. I think most of the pieces for understanding the current financial mess were in place well before the crisis occurred. If only they hadn’t been ignored. We’re not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them.

January 18 2010

A Technocratic Solution to Financial Instability?

Robert Shiller says financial engineering can fix the instability problems in financial markets:

Engineering Financial Stability, by Robert J. Shiller, Commentary, Project Syndicate: The severity of the global financial crisis ... has to do with a fundamental source of instability in the banking system, one that we can and must design out of existence. To do that, we must advance the state of our financial technology.
In a serious financial crisis, banks find that the declining market value of many of their assets leaves them short of capital. They cannot raise much more capital during the crisis, so, in order to restore capital adequacy, they stop making new loans and call in their outstanding loans, thereby throwing the entire economy – if not the entire global economy – into a tailspin.
This problem is rather technical in nature, as are its solutions. It is a sort of plumbing problem for the banking system... Many finance experts ... have been making proposals along the lines of “contingent capital.” The proposal by the Squam Lake Working Group ... seems particularly appealing. ... The group calls their version of contingent capital “regulatory hybrid securities.” The idea is simple: banks should be pressured to issue a new kind of debt that automatically converts into equity if the regulators determine that there is a systemic national financial crisis, and if the bank is simultaneously in violation of capital-adequacy covenants in the hybrid-security contract.
The regulatory hybrid securities would have all the advantages of debt in normal times. But in bad times, when it is important to keep banks lending, bank capital would automatically be increased by the debt-to-equity conversion. The regulatory hybrid securities are thus designed to deal with the very source of systemic instability that the current crisis highlighted.
The proposal also specifies a distinct role for the government in encouraging the issuance of regulatory hybrid securities, because banks would not issue them otherwise. Regulatory hybrid securities would raise the cost of capital to banks (because creditors would have to be compensated for the conversion feature), whereas the banks would rather rely on their “too big to fail” status and future government bailouts. Some kind of penalty or subsidy thus has to be applied to encourage banks to issue them. ...
Contingent capital, a device that grew from financial engineering, is a major new idea that might fix the problem of banking instability, thereby stabilizing the economy – just as devices invented by mechanical engineers help stabilize the paths of automobiles and airplanes. If a contingent-capital proposal is adopted, this could be the last major worldwide banking crisis – at least until some new source of instability emerges and sends financial technicians back to work to invent our way of it.

The last sentence highlights why we shouldn't put all of our regulatory eggs into one policy basket, a point I've made before in arguing for broad based solutions that limit the damage if a breakdown occurs. That is, while contingent capital might help, and maybe even fix existing problems, we should also be sure to implement measures that limit the damage and protect us if the financial sector implodes again despite the creative financial engineering and regulatory changes designed to prevent it.

January 17 2010

"Please Sir, May We Have Some Justice?"

Maxine Udall:

Please, sir, may we have some justice?, by Maxine Udall: We have just witnessed highly compensated investment bankers asserting that they are the clueless victims of an unforeseeable, unpreventable hundred year financial crisis (except when it happens every five to seven years).
Until last year, Maxine had always assumed that at least one reason for investment bankers' high compensation was that the market had chosen to reward them for competence and knowledge about high finance, things we lesser mortals couldn’t possibly grasp with our mundane, tiny little minds. Now we find out that they apparently hadn’t even grasped the basics... “The higher the returns, the higher the risk, and if the returns are high and sustained, you’re in a Ponzi scheme or a bubble. ...” ...
It seems so basic and no amount of clever math and models can really change it...: Higher returns means higher risk and if the returns are high and sustained, you’re in a Ponzi scheme or a bubble.
We and our elected representatives have a choice to make. We can continue to compensate clueless victims way beyond the value of their marginal product in any domain of productivity you care to name and we can continue to allow them to cluelessly manage financial institutions for their own short-term short-sighted gains until they plunge the rest of us into serfdom or we can change how they are compensated and maybe even who is compensated (as in throw the bums out) and we can change the rules by which they are allowed to "play" with our money.
The latter shouldn’t be rocket science were it not for the wealth and power bankers are able to exert in their own interest. If the political will is not there now to do this, for heaven’s sake, when will it be????
Oh, right...after a full-blown depression, like last time.
But even then, reform and regulation will not be enough. We need a new language about business and markets that is sensible and grounded in reality. In the last thirty years, both have been elevated to near religion, with financiers and CEOs as high priests.
Something has been lost in that transformation. When Adam Smith wrote about the value and advantages of commercial society, he saw all of society (and, of course, was comparing it to the vestigial remains of feudalism which set a very low, preliminary standard). He wrote about how even those at the bottom were made better off. He appeared to care about them. He worried that because of the drudgery of the work at the lower end of society, people in those roles would require additional inputs, like education, paid for by the larger society. He viewed the entire wealth of the nation including the distribution not only of wealth but of opportunity (admittedly within the confines of a rather rigid class structure). And he was quite critical of the ne’er-do-well rich and of businessmen who colluded to extract welfare from consumers in the form of higher prices.
Perhaps most importantly, Adam Smith appears to have understood the value of the moral side effects of commercial transactions: trust, sympathy for our fellow tradesmen and women, for our customers, for our neighbors, a sense of community and of the common good, all traded in the marketplace along with the money, goods, and services that change hands. He recognized the interdependencies that markets create and reinforce, interdependencies that bind us to common objectives and that lower the transaction costs of achieving them.
So you see it isn’t just about the money. ... It’s about the moral side effects of market transactions and exchange. Morally clueless investment bankers have trashed the fabric that binds us together as a nation. They have sent a message loud and clear that short-sighted, immoral cluelessness that serves only one’s own short-run self-interest is what is rewarded. That unearned wealth, power and prestige have more political and economic currency than the hard-earned trust, confidence, and lower profit margins of honest businessmen embedded in, committed to, and serving their customers and their communities. ...
Moral, socially responsible, honest (usually small) businessmen and women ... provide some of the moral glue that holds us together. Market forces in small, truly competitive, transparent markets (which financial markets most definitely are not) often reinforce the moral glue and sometimes even provide it by reining in the Mr. Potters and the Gyges of the world.
Mr. Potter testified last week, pockets bulging with cash earned on the backs of the people of Bedford Falls, that he is clueless and incompetent and that stuff happens. He harmed Main Street, both the people who shop there and the people who own businesses there. He harmed the backbone of our democratic society. We bailed him out. Isn’t it time we held him to account?
We can reduce the moral hazard we’ve created with a no-strings bailout, we can reduce the moral side-effects of the moral hazard, and we can help Main Street. Let’s start by using all the bonus money to extend the safety net for unemployed workers, please. Then let’s tax the finance sector’s inordinate Ponzi scheme profits and use the proceeds to build new infrastructure and to retool the US workforce for the 21st century. And for God’s sake, let's regulate Mr. Potter.  Let’s take a longer-term view of economic and societal well-being. Let’s make something good from this that will benefit our grandchildren.
Please, sir, may we have some justice?

Businesses will do whatever they can to give themselves an advantage over their customers and increase profits. How can we level the playing field? Adam Smith believed that competition was the best regulator of economic behavior. You can't trust government to intervene and protect people because the rich and powerful will bend government to satisfy their needs. We should rely upon competition instead, that's our best chance of making these markets work for everyone, not just one side of the transaction.

It's easy to make the case that the financial system does not satisfy or even closely approximate the conditions necessary for the textbook version of "pure competition," conditions that must be present if markets are going to maximize social welfare in the textbook fashion. For example, pure competition calls for free entry and free exit. Have we seen free exit among too big to fail firms? Pure competition calls for a large number of firms, none of which is big enough to influence market conditions on its own. Do those conditions exist? Pure competition requires that all parties in transactions be equally informed, but that certainly wasn't the case in these markets. The list of violations of the conditions for pure competition is a long one, too long to list here extensively, but there is little doubt that substantial departures from ideal conditions were present and pervasive in the financial industry.

There was a time when I would have called for us to reestablish competitive conditions in the financial industry as a means of fixing the problems that led to its breakdown. I still think that is an important part of the solution -- I think the consequences of departures from pure competition in these markets are larger than most people recognize -- and it is part of what is behind my calls to reduce banks to their minimum effective size. But is competition enough to fix the problems? If it is enough, can we actually achieve an adequate approximation of pure competition in this industry?

 I have lost my "faith" that competition alone is enough to regulate these markets (I find that sentence surprisingly hard to write and do not wish to assert it for all markets). Regulation, particularly regulation that reduces the impact on the broader economy if the financial industry implodes again (and it will) is essential. Perhaps the test that led to this conclusion was unfair since, as just noted, the conditions in financial markets were nowhere near competitive. If we could actually establish competitive conditions in these markets, maybe they'd be fine. It's hard to say because I don't think those conditions were present in financial markets, and I've come to doubt that they can ever be present.

Some people argue that these firms are natural monopolies (or that there's only room for a few fully efficient firms). I don't think they are, but if so, they should be heavily regulated just like any other natural monopoly. In any case, natural monopolies or not, over time these markets appear to tend toward concentration rather than competition, and inherent and important market failures do not appear to self-correct (e.g., to name just one, participants in these markets do not consider the externalities their failure would impose on the broader economy as they decide how much risk to take on, or, to say it another way, how much capital to hold in reserve).

If we could overcome these market imperfections, would competition be enough to maximize the safety of these markets? I don't know because an approximation of the textbook conditions for pure competition have never existed in this industry, and the structure of the industry works strongly against such conditions ever existing. If that's the case, if we are unsure that competition would be enough to fully protect us, and if we are unsure that we can get to those conditions and then maintain them in any case, then the important role that these markets play in our economy makes it essential that we insulate ourselves from the consequences of this happening again.

I don't think we can ever fully guarantee that we are safe from collapse in the financial industry (though we should do our best to prevent it), but we can reduce the consequences if and when the financial system does collapse again. That's why I've been emphasizing broad measures such as limiting leverage/increasing capital requirements/increasing margin requirements (which all amount to the same thing), measuring and limiting interconnectedness, etc., rather than trying to identify and fix specific problems. The individual problems are important and need to be addressed, that will reduce the likelihood of collapse so I don't mean to ignore them, but insulation from big shocks and widespread collapse comes mainly through the more broad-based measures.

January 16 2010

"FCIC Interviewing the Wrong People"

Calculated Risk:

"FCIC Interviewing the Wrong People", by Calculated Risk: Jillayne Schlicke writes: The Financial Crisis Inquiry Commission is Interviewing the Wrong People
If the Commission really does want to learn WHO knew what, when, then they’re interviewing the wrong people.

They need to interview the line workers. Mortgage loan processors, managers, escrow closers, underwriters from the banks, private mortgage insurance companies as well as wholesale lending, loan servicing default and loss mitigation workers and even consumers. Seasoned mortgage industry veterans who have proof in the form of saved memos or emails, that they informed senior management of the red flags, predatory lending, and the insane relaxation of underwriting guidelines that started to pop up as early as 2001 and 2002 yet were ignored or whose concerns were dismissed.

I think this is the key - instead of interviewing bank CEOs and top regulators, start with the field examiners and the "line workers" in the mortgage industry. And as Jillayne noted, talk to the consumers too.

Reposted by02mysoup-aa 02mysoup-aa

"Legal Scholars Debate the Financial Crisis"

This is from an email that said, "I thought these non-economists' views on the crisis might be of interest to you and your readers."

I *think* I understand this one: Mae Kuykendall on David A. Westbrook's Out of Crisis: Rethinking Our Financial Markets. I did have to stop and think for a moment when I hit sections such as this:

Westbrook directs us to a critical insight for this crisis: we are collectively enmeshed in a tragedy of language, using it to govern financial exchange in ways that are naïvely representational or, in the alternative, unrealistic about the power of a linguistic construct to constrain the world. Disclosure as a strategy, given to us by our savants of the last finance reset, assumes what the English professors tells us is really a childish idea: that language serves as a window to a real picture and, as such, is just a conveyance to us of what is there to be seen and understood. In Westbrook’s phrase, this idea about managing the problems investment presents makes language invisible. 
In our other principal strategy-- risk management-- language is asked to set up containers for large swaths of poorly described arrays of claims on something real. The tragedy is the contradiction. We believe, like children, in being told what our basket of claims contains, and we rely, like language engineers, on the idea that a big enough basket of abstractions—claims on too many things to try to understand with the faith of children looking through a picture window—is conceptually safe.

This helped. This too, e.g.:

Out of Crisis explores a more complex and interwoven approach to both diagnosis and reform. It conceives the relation between regulation and markets differently than prevailing talk. Markets do not arise or arrive bearing inevitable or immutable traits, rules or roles. They are instead products of particular features of social and political organization whose participants help to shape their attributes and functions.
If so, the theme modestly emerges, debate must not dwell upon simple trade offs between regulation versus markets. People must appreciate that markets are social and political products and that participants in effect choose what design features particular markets should offer.

January 15 2010

Will the Administration's Proposed Bank Tax Create Moral Hazard?

At MoneyWatch:

Will the Administration's Proposed Bank Tax Create a Moral Hazard Problem?, by Mark Thoma: I reconsider yesterday's contention that the bank tax won't affect bank behavior. Will it create moral hazard?

Paul Krugman: Bankers Without a Clue

The testimony of "clueless" bank executives before the Financial Crisis Inquiry Commission undermined the credibility of their arguments against financial reform:

Bankers Without a Clue, by Paul Krugman, Commentary, NY Times: The official Financial Crisis Inquiry Commission — the group that aims to hold a modern version of the Pecora hearings of the 1930s, whose investigations set the stage for New Deal bank regulation — began taking testimony on Wednesday. In its first panel, the commission grilled four major financial-industry honchos. What did we learn?
Well,... the bankers’ testimony showed a stunning failure, even now, to grasp the nature and extent of the current crisis. And that’s important: It tells us that as Congress and the administration try to reform the financial system, they should ignore advice coming from the supposed wise men of Wall Street, who have no wisdom to offer. ...
The U.S. economy is still grappling with the consequences of the worst financial crisis since the Great Depression; trillions of dollars of potential income have been lost; the lives of millions have been damaged, in some cases irreparably, by mass unemployment; millions more have seen their savings wiped out; hundreds of thousands, perhaps millions, will lose essential health care because of ... job losses and draconian cutbacks by cash-strapped state governments.
And this disaster was entirely self-inflicted. This isn’t like the stagflation of the 1970s, which had a lot to do with soaring oil prices, which were, in turn, the result of political instability in the Middle East. This time we’re in trouble entirely thanks to the dysfunctional nature of our own financial system. Everyone understands this — everyone, it seems, except the financiers themselves.
There were two moments in Wednesday’s hearing that stood out. One was when Jamie Dimon of JPMorgan Chase declared that a financial crisis is something that “happens every five to seven years. We shouldn’t be surprised.” In short, stuff happens, and that’s just part of life.
But the truth is that the United States managed to avoid major financial crises for half a century after the Pecora hearings were held and Congress enacted major banking reforms. It was only after we forgot those lessons, and dismantled effective regulation, that our financial system went back to being dangerously unstable. ...
Still, Mr. Dimon’s cluelessness paled beside that of Goldman Sachs’s Lloyd Blankfein, who compared the financial crisis to a hurricane nobody could have predicted. ... [T]his giant financial crisis was just a rare accident, a freak of nature, and we shouldn’t overreact.
But there was nothing accidental about the crisis. From the late 1970s on, the American financial system, freed by deregulation and a political climate in which greed was presumed to be good, spun ever further out of control. There were ... bonuses beyond the dreams of avarice ... for bankers who could generate big short-term profits. And the way to raise those profits was to pile up ever more debt, both by pushing loans on the public and by taking on ever-higher leverage...
Sooner or later, this runaway system was bound to crash. And if we don’t make fundamental changes, it will happen ... again.
Do the bankers really not understand what happened, or are they just talking their self-interest? No matter. As I said, the important thing looking forward is to stop listening to financiers about financial reform.
Wall Street executives will tell you that the financial-reform bill the House passed ... would cripple the economy with overregulation (it’s actually quite mild). They’ll insist that the tax on bank debt just proposed by the Obama administration is a crude concession to foolish populism. They’ll warn that action to ... rein in financial-industry compensation is destructive and unjustified.
But what do they know? The answer, as far as I can tell, is: not much.
Reposted by02mysoup-aa 02mysoup-aa

January 14 2010

The Financial Crisis Responsibility Fee

Calculated Risk summarizes today's proposal from the Obama administration for a "Financial Crisis Responsibility Fee" to recover the cost of the bailout of the financial system:

Proposed "Financial Crisis Responsibility Fee," by Calculated Risk: From Treasury:

Fact Sheet: Financial Crisis Responsibility Fee: Today, the President announced his intention to propose a Financial Crisis Responsibility Fee that would require the largest and most highly levered Wall Street firms to pay back taxpayers for the extraordinary assistance provided so that the TARP program does not add to the deficit. The fee the President is proposing would:
  • Require the Financial Sector to Pay Back For the Extraordinary Benefits Received: ...
  • Responsibility Fee Would Remain in Place for 10 Years or Longer if Necessary to Fully Pay Back TARP:
  • Raise Up to $117 Billion to Repay Projected Cost of TARP:
  • President Obama is Fulfilling His Commitment to Provide a Plan for Taxpayer Repayment Three Years Earlier Than Required: ...
  • Apply to the Largest and Most Highly Levered Firms: The fee the President is proposing would be levied on the debts of financial firms with more than $50 billion in consolidated assets ... Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions.
There is much more detail at the link. The proposed fee would be 15 bps of covered liabilities per year.
Free Exchange gives the motivation for the tax over and abovethe desire to recoup the money spent bailing the banks out:
The administration is clear in its desire that this function as an incentive for banks to get smaller and less leveraged:
The fee the President is proposing would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms. By levying a fee on the liabilities of the largest firms – excluding FDIC-assessed deposits and insurance policy reserves, as appropriate – the Financial Crisis Responsibility Fee will place its heaviest burden on the largest firms that have taken on the most debt. Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions.
What's mystifying, then, is that the fee will only apply until TARP has been repaid.

But how much impact will the tax actually have, i.e. is it substantial enough to serve as a deterrent? Will the levy be large enough to change the behavior of investment banks? FT Alphaville does some calculations:

A quick, very rough back-of-the-envelope calculation, has Goldman Sachs, for instance, paying a very conservative (i.e. assuming all of its deposits are FDIC insured, which is unlikely) 2008 figure of:
($884.55bn – $62.64bn – $27.64bn) * 0.0015 = $1.19bn.
Or, less than a tenth of the $10.93bn the bank spent on compensation and benefits that year.

Kevin Drum summarizes:

Ouch! That's hitting 'em where they hurt.

And if the Lucas critique type effects are stronger than anticipated (i.e. firms taking actions to avoid the tax), the tax burden will be even smaller.

What else might have been done? Progressive Fix has a list:

In the discussion of taxing banks and bankers, a couple of possibilities have been floated, some of which can reap short-term political points, others of which have the potential to promote progressive policies:
Bonus tax – One of the easiest – and politically most satisfying – would be a tax on excess bonuses. The British exercised this option on London bankers this past year. Bonuses in the City above a certain amount were taxed at a 50 percent rate. Banks responded by threatening to move offshore and – when that threat rang hollow – doubled the bonus pool they paid out to bankers. The end result was that the bankers whose decisions led in part to the crisis were financially unharmed, the British government raised a relative pittance in taxes, shareholders in City banks took a hit (as the bonus pools were increased at their expense), and the underlying fault lines in the British banking system remain unaddressed.
Transaction tax – The worst of the options would be a tax on transactions. As discussed before, this would merely pour sand in our financial system, breaking it and slowing economic recovery.
Excess profits tax – A more appealing option would be a tax on excess profits. A defining aspect of the financial bubble of the last decade was the fact that financial profits were 40 percent of overall corporate profits – more than double the slice financials made up of profits in the 1980s. A tax on these excess profits would rein that in. But while this could be useful, as Simon Johnson points out, it would be fairly easy to game, and end up being ineffective.
Tax on assets – A tax on bank assets above a certain amount addresses not just political sentiment that banks have made it through the crisis unscathed, but also the fact that banks are too big to fail. Encouraging banks to “right-size” themselves would make our economy safer from the systemic risk imposed by banks like Citigroup or Bank of America – which are debilitated but whose failure would be economically catastrophic.
Excess leverage tax – Taxing the leverage that financial institutions use to increase returns would allow us to avoid situations like that faced a year and a half ago when Lehman Brothers – leveraged over 30:1 – collapsed over the course of a weekend. It would make banks “safer” but would leave them still too big. In the event a bank were to fail, it would still be a systemic threat to our economy. This would be a more targeted version than an assets tax, but it would be harder to implement — definitions of leverage differ – and if not properly defined would leave hedge funds, insurance companies and other “non-bank financial institutions” untouched, leading to a crisis like that perpetuated by Long-Term Capital Management in 1998 or AIG last fall.

I'm not sure I agree with the conclusions on the transactions tax, particularly when applied to actions such as those described by Robert Solow:

Take an extreme example. I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move. Deep pockets in a large market can make a lot of money out of tiny advantages. (Of course, if you have any such advantage the temptation is irresistible to borrow a lot of money to enlarge your bets and your profits. Leverage is good for you, until it isn’t. It is not so good for the system.) A lot of high-class intellectual effort naturally goes into trying to invent ways to find those tiny advantages a few seconds before anyone else.
Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

But that aside, I would have preferred to recoup the bailout money and increase the safety of the system at the same time through a tax on assets (to get at the too big to fail problem) and a tax on leverage (to reduce the damage the big banks can cause if they do fail).

[More on the proposal: NY Times, Washington Post, Wall Street Journal, Bloomberg, Financial Times, Steve Benen, Ezra Klein, , Mathew Yglesias, Felix Salmon, Jon Chait, Dean Baker.]

January 13 2010

Reich: Why Obama Must Take on Wall Street

Robert Reich warns Democrats of the political consequences of failing to enact tough financial reform:

Why Obama must take on Wall Street, by Robert Reich, Commentary, Financial Times: It has been more than a year since all hell broke loose on Wall Street and, remarkably, almost nothing has been done to prevent all hell from breaking loose again. ... Bankers are still making wild bets, still devising new derivatives, still piling on debt. The big banks have access to money ... cheaply..., courtesy of the Fed, so bank profits are up and bonuses as generous as at the height of the boom. ... And, of course, American taxpayers are out some $120bn, while millions have lost their homes, jobs and savings.
All could be forgiven if the House and Senate ... were about to come down hard on the Street and if the Obama administration were pushing them to. But nothing of the sort is happening. ... The bill that has already emerged from the House is hardly encouraging. ...
What happened to all the tough talk from Congress and the White House early last year? Why is the financial reform agenda so small, and so late? Part of the answer is that the American public has moved on. A major tenet of US politics is that if politicians wait long enough, public attention wanders. With the financial crisis appearing to be over, the public is more concerned about jobs. ...
Yet if the president and Congress wanted to, they could help Americans understand the link between widespread job losses and the irresponsibility on Wall Street that plunged America into the Great Recession. They could make tough financial reform part of the answer to sustainable jobs growth over the long term.
True, financial regulation does not make a powerful bumper sticker. Few Americans know what the denizens of Wall Street do all day. Even fewer know or care about collateralized debt obligations or credit default swaps. To the extent Americans have been paying attention to the details of any public policy, it has been the healthcare reform bill. But that only begs the question of why financial reform has not been higher on the agenda of the president and Democratic leaders.
A larger explanation, I am afraid, is the grip Wall Street has over the American political process. The Street is where the money is and money buys campaign commercials on television. Wall Street firms and executives have been uniquely generous to both parties, emerging as one of the largest benefactors of the Democrats. Between November 2008 and November 2009, Wall Street doled out $42m to lawmakers, mostly to members of the House and Senate banking committees and House and Senate leaders. In the first three quarters of 2009, the industry spent $344m on lobbying – making the Street one of the major powerhouses in the nation’s capital.
Money is powerful. Talk is cheap. ... But the widening gulf between Wall Street and Main Street – a big bail-out for the former, unemployment checks for the latter; high profits and giant bonuses for the former, job and wage losses for the latter; buoyant expectations of the former, deep anxiety and cynicism by the latter; ever fancier estates for denizens of the former; mortgage foreclosures for the rest – is dangerous. Americans went ballistic early last summer when AIG executives got big bonuses after taxpayers had bailed them out. They will not be happy when Wall Street hands out billions in bonuses very soon. Angry populism lurks just beneath the surface of two-party politics in America. Just listen to Sarah Palin or her counterparts on American talk radio and yell television. Over the long term, the political stakes in reforming Wall Street are as high as the economic.

I think people understand the connection between what happened on Wall Street and job losses better than he implies (which bolsters his political argument).

Reposted by02mysoup-aa 02mysoup-aa

January 12 2010

Will We Get ''Sensible, Comprehensive Financial Reform"?

Alan Blinder is not very optimistic about the prospects for meaningful financial reform:

When Greed Is Not Good, by Alan S. Blinder, Commentary, WSJ: ...[W]hen the Treasury and Federal Reserve rushed in to contain the damage [from the financial crisis], taxpayers were forced to pay dearly for the mistakes and avarice of others. If you want to know why the public is enraged, that, in a nutshell, is why.
American democracy is alleged to respond to public opinion, and incumbents are quaking in their boots. Yet we stand here in January 2010 with virtually the same legal and regulatory system we had when the crisis struck in the summer of 2007, with only minor changes in Wall Street business practices... That's both amazing and scary. Without major financial reform, "it" can happen again. ...[H]istory shows that financial markets have a remarkable ability to forget the past and revert to their bad old ways. And we've made essentially no progress on lasting financial reform.
Perhaps reformers just need more patience. The Treasury made a fine set of proposals that the president's ... agenda left him little time to pursue—so far. The House of Representatives passed a pretty good financial reform bill late last year. And while there's been no action in the Senate as yet, at least they are talking about it. ...
But I'm worried. The financial services industry, once so frightened that it scurried under the government's protective skirts, is now rediscovering the virtues of laissez faire and the joys of mammoth pay checks. Wall Street has mounted ferocious lobbying campaigns against virtually every meaningful aspect of reform, and their efforts seem to be paying off. ...
My fear is that a once-in-a-lifetime opportunity to build a sturdier and safer financial system is slipping away. Let's remember what happened to health-care reform ... as it meandered toward 60 votes in the Senate. The world's greatest deliberative body turned into a bizarre bazaar in which senators took turns holding the bill hostage to their pet cause (or favorite state). With zero Republican support, every one of the 60 members of the Democratic caucus held an effective veto—and several used it.
If financial reform receives the same treatment, we are in deep trouble, both politically and substantively.
To begin with the politics, recent patterns make it all too easy to imagine a Senate bill being bent toward the will of Republicans—who want weaker regulation—but then garnering no Republican votes in the end. We've seen that movie before. If the sequel plays in Washington, passing a bill will again require the votes of every single Democrat plus the two independents. With veto power thus handed to each of 60 senators, the bidding war will not be pretty.
On substance,... health care at least benefited from broad agreement within the Democratic caucus on the core elements... The fiercest political fights were over peripheral issues like the public option ... and whether Nebraskans should pay like other Americans...
But financial regulatory reform is not like that. Every major element is contentious... What's worse, several components would benefit from international cooperation... This last point raises the degree of difficulty substantially. No one worried about international agreement while Congress was writing a health-care bill.
All and all, enacting sensible, comprehensive financial reform would be a tall order even if our politics were more civil and bipartisan than they are. To do so, at least a few senators—Republicans or Democrats—will have to temper their partisanship, moderate their parochial instincts, slam the door on the lobbyists, and do what is right for America. Figure the odds. Gordon Gekko already has.

I've been arguing that the longer that congress waits to move on financial reform, the less likely it is that reform will be meaningful and effective. For example, here's my response to "Don't Let the Cure Kill Capitalism," by Gary Becker and Kevin Murphy. They were worried that if we move too fast on regulatory reform, we will go overboard and undermine all the wonderful things that the financial sector has done for our economy: 

When the golden goose is too wild for its own good, you can clip its wings without killing it.
While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people like Kashyap and Mishkin arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that got us into this mess.

That was last March. Worries that moving on reform will undermine the stability of the financial sector have faded considerably, so even if you thought the stability argument was strong enough to overcome the arguments for moving forward back then (I didn't), that objection is now hard to defend.

Will the reform we get will be meaningful and effective? It's hard to have a lot of faith in Congress, I certainly agree with Blinder on that. But we have to do something, and the longer it takes to complete the reform process -- the more we give in to the interests of those seeking to delay reform and undermine the process -- the more likely it is that little will change.

January 09 2010

Bubble? What Bubble?

Paul Krugman:

Bubbleheads, by Paul Krugman: I was searching for unrelated material, but ran across this oldie but goodie from Jim Cramer:

As Toll Brothers (TOL - commentary - Cramer’s Take) cruises through $100, it’s time to hold the bubbleheads accountable. Who are the bubbleheads, in my book? Those are the people who have told you to bet against housing and to be worried about the speculative boom in homes.

Here’s where I am coming from. All day, I listen to and read people who say that housing’s got to roll over, that these companies can’t work, that it is just a matter of time. Then I look to see what’s been outperforming these stocks. Is it drugs? I don’t think so. Financials? Nah. Techs? Nope, not at all. Now I want to know when those who have warned us incessantly or told us it can’t last will get their comeuppance.

One question I’d like to answer, but haven’t had the time to research, is this: of those who condemn fiscal stimulus and demand that the Fed start raising rates now now now, how many denied that there was a housing bubble when it was actually inflating?

Here is Ellen McGrattan and Edward Prescott in 2000 telling everyone not to worry about a bubble in the stock market. They don't call them bubbleheads, but the message is clear:

...Is the current stock market value too high? Glassman and Hassett (1999) have argued that it is not. In fact, they have said that the market is undervalued by a factor of three. But others have expressed concern that the market is, indeed, overvalued. Federal Reserve Chairman Alan Greenspan (1996), for example, has suggested that the recent high value of the market may  reflect “irrational exuberance” among investors. Shiller (2000) has reiterated this concern and said that a 50 percent drop in the value is plausible. ...

Conclusions Some stock market analysts have argued that corporate equity is currently overvalued. But such an argument requires a point of reference: overvalued relative to what? In this study, we use as our reference point the predictions of the basic growth model that is the standard model used by macroeconomists today. We match up all the variables in our model with the U.S. national income and product account data. We find that corporate equity is not overvalued. ...

Following up on Krugman's question, I'd like to know how many of today's budget deficit hawks were selling the false supply-side promise that tax cuts would pay for themselves as an excuse to cut taxes and open up a bigger hole in the deficit.

January 08 2010

"Bubbles & Banks & Zero Lending Standard Loans"

Barry Ritholtz emails to say that he disagrees with Paul Krugman's about the importance of lack of regulation in the subprime market in explaining the crisis:

Bubbles & Banks & Zero Lending Standard Loans, by Barry Ritholtz: Paul Krugman has an interesting OpEd in today’s NYT, one that I mostly agree with.
However, I take exception to his perspective on a few issues, one of which might ultimately prove to be crucial to understanding the crisis and putting the correct financial reform measures in place. ... The ... disagreement is over the impact of sub-prime loans on the entire US Housing market, and whether lending standards can be adequately enforced. Had then Fed Chairman Alan Greenspan done his job properly, and prevented Zero Lending Standard loans from infecting the real estate market, we would have been looking at a very different housing situation — to the upside as well as to the down side.
Let’s look at the impact Sub-Prime had, then see what could have been done about it.
First, we need to consider that markets typically are in balance — there are a roughly equal number of buyers and sellers. ... What happens when you drop mortgage rates significantly? Monthly carrying costs become lower, and this attracts more marginal buyers (demand) — at least until prices rise to the point where the balance between buyers and sellers stabilizes prices once more.
Without the explosion of subprime, but with ultra low rates, we very likely would have seen a rise in housing prices, followed by a plateau. But it would not have been nearly as severe relative to historic price relationships (as an example, median income to median home price).
What the newfangled lend-to-securitize subprime model did, however, was to bring millions of previous non-buyers — people otherwise known as renters — into the housing market. On top of the rise in prices caused by 1% Fed Funds rates (~6% mortgages), this added an additional level of pricing destabilization to the Real Estate market.
This is evident in the charts I’ve shown again and again: Median income to median home price; cost of renting to ownership; Housing stock as a percentage of GDP — all of these showed a housing market several standard deviations above its historic pricing mean.
With that in your mind, consider how this sub-prime driven boom played into the securitization market, and eventually the Derivatives market (CDOs, CDSs, etc). Look at the 10 steps detailed here on Monday regarding the forming of the credit crisis.
The inevitable conclusion is that sub-prime was a major driver of not only the Housing boom and bust, but of the entire financial crisis and credit freeze, and the subsequent bailouts . . .
Could it have been prevented? Only if the Fed would have enforced traditional lending standards, i.e., the borrowers ability to service the mortgage. They should have regulated those non-bank lenders whose model was based not upon the borrowers ability to service these loans, but upon the lender’s ability to subsequently sell the loan off top securetizers on Wall Street.

So, the answer is yes, appropriate regulation could have prevented the entire mess . . .

But the loan originators would not have made the subprime loans without the confidence that the securitizers would take them off their hands. So even if regulation failed as a first line of defense, and it did, I still think you have to ask (and understand) why securitizers were so willing to take this paper from the loan originators. What went wrong in their assessment of the risks of buying the securitized loans? Here, failures of the ratings agencies and the mathematical models or risk assessment both played a role, as did the feeling that this time was different so prices would continue to rise. Confidence among some investors that even if there was a bubble, once things turned downward they could get out of the market before realizing big losses was also a factor.

The point is that there wasn't just one failure at work, there were multiple lines of defense, any one of which could have prevented the bubble or made its consequences much less severe, that broke down. As I've said before, when I look at these markets, I see regulatory failures, market failures, and other problems creating bad incentives at just about every stage in the process. Home buyers, real estate agents, appraisers, mortgage brokers, securitizers, ratings agencies, compensation packages of executives, lack of transparency, and so on and so on all broke down and allowed the housing/credit bubble to inflate. If any one of these groups had held the line and not gone along with everyone else, e.g. if appraisers had not reported bubble prices, if ratings agencies had priced risk correctly, etc., then the bubble either doesn't happen at all, or does much less damage when it pops.

The problems in these markets were systemic. Maybe we can target one area, e.g. the regulation of subprime loans, and insulate the system going forward. But my view is that broad based failures require broad based solutions. That's why rather than trying to fix each problem individually, I've advocated solutions such as limiting leverage ratios that will insulate the system from large breakdowns in the event that another bubble occurs. Yes, we should try to fix all the individual problems that we can, including regulatory failures at each stage of the home loan process. But we shouldn't rest after that since that may not be enough to prevent bubbles in the future. We also need to do the things necessary to make the system much less vulnerable to a crash when the next one occurs (and it will).

Paul Krugman: Bubbles and the Banks

What should be done to reform the financial system?:

Bubbles and the Banks, by Paul Krugman, Commentary, NY Times: Health care reform is almost (knock on wood) a done deal. Next up: fixing the financial system. ...
What should reformers try to accomplish? A lot of the public debate has been about protecting borrowers. Indeed, a new Consumer Financial Protection Agency ... is a very good idea. ...
But consumer protection, while it might have blocked many subprime loans, wouldn’t have prevented the sharply rising rate of delinquency on conventional, plain-vanilla mortgages. And it certainly wouldn’t have prevented the monstrous boom and bust in commercial real estate.
Reform, in other words, probably can’t prevent either bad loans or bubbles. But it can do a great deal to ensure that bubbles don’t collapse the financial system when they burst.
Bear in mind that the implosion of the 1990s stock bubble, while nasty — households took a $5 trillion hit — didn’t provoke a financial crisis. So what was different about the housing bubble...?
The short answer is that while the stock bubble ... risk was fairly widely diffused across the economy..., the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation’s banks. ... If they can’t function, the wheels of commerce ... grind to a halt.
Why did the bankers take on so much risk? ... By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem.
Of course, that conflict of interest is the reason we have bank regulation. But in the years before the crisis, the rules were relaxed — and, even more important, regulators failed to expand the rules to cover the growing “shadow” banking system...
The result was a financial industry that was hugely profitable as long as housing prices were going up — finance accounted for more than a third of total U.S. profits as the bubble was inflating — but was brought to the edge of collapse once the bubble burst. It took government aid on an immense scale ... to pull the industry back from the brink.
And here’s the thing: Since that aid came with few strings ... there’s every incentive for bankers to engage in a repeat performance. After all, it’s now clear that they’re living in a heads-they-win, tails-taxpayers-lose world.
The test for reform, then, is whether it reduces bankers’ incentives and ability to concentrate risk...
Transparency is part of the answer. Before the crisis, hardly anyone realized just how much risk the banks were taking on. More disclosure, especially with ... complex financial derivatives, would clearly help.
Beyond that, an important aspect of reform should be new rules limiting bank leverage. ... And reform really should take on the financial industry’s compensation practices. If Congress can’t legislate away the financial rewards for excessive risk-taking, it can at least ... tax them.
Let me conclude with a political note. The main reason for reform is to serve the nation. If we don’t get major financial reform now, we’re laying the foundations for the next crisis. But there are also political reasons to act.
For there’s a populist rage building in this country, and President Obama’s kid-gloves treatment of the bankers has put Democrats on the wrong side of this rage. If Congressional Democrats don’t take a tough line with the banks in the months ahead, they will pay a big price in November.

January 07 2010

Should He Stay or Should He Go?

Is Geithner "doomed"?:

Geithner’s Stained Past Leaves Future In Question, by Steven Russolillo: The latest revelation surrounding Tim Geithner has generated a spirited debate among your humble Market Talk editors: if and/or when will the Treasury Secretary get the boot?
Before we answer that question, here are the details. The NY Fed, when under Geithner’s leadership, reportedly told AIG to limit disclosures on CDS payments made to banks during the height of the financial crisis. Bloomberg has the scoop...
Bloggers have been all over this story, ripping Geithner for his cagey, often-times evasive maneuvering. ...
The Market Talk trio is a bit divided on this issue.
Shipman thinks Geither’s already fumbled enough times — from his pre-confirmation tax problems, to lame PPIP effort, poorly implemented mortgage mods plan and pusillanimous rationalization for paying 100 cents on the dollar to AIG’s CDS counterparties — to warrant dismissal, months ago. Now, he simply represents a growing liability for the Obama Administration.
Paul and I aren’t as extreme. Paul thinks Geithner isn’t likely to lose his job unless the recovery falters, in which case he’s an obvious fall guy. As long as the labor market starts generating positive job growth in the near future and there isn’t a significant stock market correction, there won’t be additional pressure on Obama to make a change. I also believe Geithner won’t get replaced anytime soon. Why would Obama risk creating public uncertainty by removing such a high-level official if the economy truly is on the road to recovery?

Readers? What say you? Is Geithner doomed? Speak freely in the comments section below.

I doubt that he's on his way out, but whether or not he should be is another question.

Interview with Raghuram Rajan

If you are unfamiliar with Raghuram Rajan, this is from the introduction to an interview of him conducted by Ron Feldman of the Minneapolis Fed:
In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., Raghuram Rajan presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the University of Chicago economist observed that financial innovation had delivered unquestioned benefits, but also had produced undeniable risks.
“It is possible these developments may create … a greater (albeit still small) probability of a catastrophic meltdown,” he told the assembled central bankers and academics. “If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions.”
It was a discordant note at a forum celebrating Alan Greenspan’s tenure as Fed chairman; many deemed his conclusions “misguided.” But history, of course, proved that Rajan’s analysis was dead on. ...

Here is a blunt assessment of the Jackson Hole episode.

Here are a few sections from the (much longer) interview:

... Doubts about Diminishing Risk
[Ron] Feldman: In a prominent Jackson Hole paper,2 you talked about some of the technologies of banking that people thought were going to distribute risk widely and therefore diversify it, making the financial system and financial institutions less risky. It was less clear to you that risk reduction was actually occurring. Could you talk about how you came to that view and how important you think that was in the current crisis?
[Raghuram] Rajan: One of the things I was asked to do was to look at the development of the financial sector, and I have great admiration for some of the things that have happened. There have been good things in the financial sector which have helped us. But to some extent there was a feeling that when you distribute risk, you’ve reduced the risk of the banking system.
My thought was, what business are the banks in? They’re not in the business of being plain-vanilla entities, because they can’t make any money that way. They are in the business of managing and warehousing risk. So if it becomes easier to lay off a certain kind of risk, the bank better be taking other kinds of risk if it wants to be profitable. And if the vanilla risk is going off your books, presumably the risks that you’re taking on are a little more complex, a little harder to manage.
That was the logic which led me to argue ... that distance-to-default measures didn’t look like they were coming down despite all this talk about securitization and shifting risk off bank books. That struck me as consistent with my view that maybe the risks that banks were taking on were more complicated. Whether they were excessive or not, I couldn’t tell.
Also, as I saw the mood, I became worried. Having studied past financial crises, I knew that it’s at the point when people say, “There’s no problem,” that in fact all the problems are building up. So that was just another indicator that we should be worried.
I should add that while I thought we could have a crisis, I never thought that we’d come to the current pass. However, I did argue that it could be a liquidity crisis..., and even though banks in the past had been the safe haven, they could be at the center of this problem.
So, one strand of my argument was based on the business of banks, but the second strand was to think about the incentive structure of the financial system and say that while we have moved to a compensation structure that penalized obvious risk, risk that you could see and measure, that may have made employees focus on risks that could not be measured. An example of that is “tail risk,” because you can’t measure it until it shows up, and it shows up very infrequently. So part of the reason I was worried was that people were taking more tail risk; an insurance company writing credit default swaps was just one example of that.
It didn’t require genius at that point to look around and say the insurance companies were writing these credit default swaps as if there was no chance on earth that they would ever be asked to pay up, so they were really taking on tail risk without any thought for the future. AIG should not have been such a surprise to the Fed.
Feldman: Ex post it was clear to everyone that the incentives were aligned so that firms were taking on risk that people didn’t understand, but at the time there was push-back to what you were saying. ...
Rajan: There were two reasons for the push-back. One was just the venue. This conference was almost a Festschrift [farewell tribute] to Greenspan, and it seemed to some—though it wasn’t intended as such—that I was raining on the parade. This was his farewell, and I was talking about problems that had arisen during his tenure.
But the bigger issue was the collective sense that the private sector could take care of itself, and if not, the Fed would be able to clean up. We had been through two downturns: the 1998 emerging market crisis and the 2000-2001 dot-com bust, and we had understood the tools that were required. In 1998, it was a short reduction in interest rates, not a dramatic one. In 2000-2001, it was a dramatic reduction. And these “successes” led to a feeling that “the Fed can take care of it.”
You know the argument: Typically, the private sector will have the right incentives. Why would they blow themselves up? Regulators aren’t that capable: They’re less well-paid and less informed than the private sector, so what can they do? And finally, if worse comes to worst, the Fed will pick up the pieces.
I think there are three things wrong with this argument, one for each of those elements. Private sector—yes, it can take care of itself, but its incentives may not be in the public interest; may not even be in the corporate interest if corporate governance is problematic. So the trader could fail the corporation, could also fail society. That’s one problem.
Second, the public sector has different incentives from the private sector, and that’s a strength of the public sector. When we’re talking about regulators, because they’re not motivated in the same way as the private sector, they can stand back and say, “Well, I don’t fully understand the risks you’re taking, but you are taking lots of risk—stop.” So I think we’ve made too little of the incentive structure of regulators which should be different, can be different, which gives them a role in this, rather than saying they’re incompetent and they can’t do it. I think they can.
But the third aspect was that I think we overestimated the ability of monetary policy to pull us out of a serious credit problem. The previous problems we had dealt with in the U.S. were not credit problems. They were standard, plain-vanilla recessions. The bank system was still active, so monetary policy wasn’t pushing on a string: The Fed brought down interest rates, and things did come back up.
When credit problems arose—and real estate was central to credit problems because of the real estate securities which ended up on bank balance sheets—then the banks were incapable of being part of the transmission process, and now monetary policy lost a lot of traction, so it wasn’t simply a matter of cutting interest rates and seeing everything come back.
Feldman: People might have thought after the banking crisis of the 1980s and early 1990s—which did not have the same macroeconomic effect as this crisis—that they could respond effectively.
Rajan: Exactly. I guess we didn’t see anything as big, as deep in the recent past. And there was a certain amount of hubris that we could deal with this.
Why was the Crisis so Severe?
Feldman: Why do you think this financial crisis was more severe? There are lots of potential explanations. Some observers point to the failure of credit rating agencies; others point to flawed incentives in compensation and to the creation of new financial products as examples. If you had to list the two or three things that you think really underlie why there was so much risk-taking, why more risk-taking than people thought, what’s the deep answer for that?
Rajan: You can go right to the meta-political level, but let me leave that aside for now. If you hone down on the banking sector itself, I think it was a situation where it was extremely competitive. Every bank was looking for the edge. And the typical place to find the edge is in places where there are implicit guarantees. ...

I think the most damaging statement the Fed could have made was the famous Greenspan doctrine: “We can’t stop the bubble on the way up, but we can pick up the pieces on the way down.” That to my mind made the situation completely asymmetric. It said: “Nobody is going to stop you as asset prices are being inflated. But a crash is going to affect all of you, so we’ll be in there. By no means go and do something foolish on your own, because we’re not going to help you then. But if you do something foolish collectively, the Fed will bail you out.”...

People were acting as if liquidity would be plentiful all the time. And my sense of what the Fed does, in part, by reducing interest rates considerably is help liquidity, and so there was a sense that, well, we can take all the liquidity risk we want, and it won’t be a problem. Of course, it turned out that not just interest rates mattered; the quantity of available liquidity or credit also mattered at this point. And that was the danger. ...

Corruption, Ideology, Hubris, or Incompetence?
Feldman: One thing you haven’t mentioned as a proximate cause is issues around “crony capitalism.” Some seem to argue that banks were allowed to grow large and complex because they were run by friends or colleagues of people who were in power. And for similar reasons, these firms got bailed out—because they had colleagues and friends in “high places.” Given that you’ve thought a lot about that in your own writing, given that you were at the IMF [International Monetary Fund] where you had the ability to look across countries where it is an issue, how important would you say crony capitalism is in the U.S. context in the current crisis?
Rajan: Let me put it this way. There is always some amount of regulatory capture. The people the regulators interact with are people they get to know. They see the world from their perspective, and, you know, they want to make sure they’re in their good books. And so it’s not surprising that across the world, you have a certain amount of the regulators acting in the interest of, and fighting for, the regulated.
Beyond that: Is there naked corruption, or less naked corruption? “If you do my work for me as a regulator, then you can come and join me as a senior official in my firm, and I’ll pay you back at that point.” I’m sure there were stray instances of that, but that to my mind, wouldn’t be the number one reason for this crisis.
I think I would put more weight on a sense of market infallibility which pervaded the economics profession, not just regulators. ... I think across the field of economics, we stopped worrying about the details in industrial countries because we said, by and large, things get taken care of. Yes, there is the occasional corporate fraud or misaligned incentives, but those are aberrations rather than a systemic problem. So I think this view, that you couldn’t have a large systemic problem, this was the problem.
Overlaid on this was the view that regulation was less and less important. We put excessive weight on the private sector getting it right on their own without understanding that the private sector can also break down—the board may not know what management is doing, management may not know what the traders are doing, so that process can break down. But even if everybody is working in the interests of the corporation, the corporation may not be acting in the interests of the system. We’ve seen all these things happen. So the regulatory system had a role to play, and it did not play that as much as it should have. ...
I’m positive that there were situations that we will discover in hindsight where excessive influence was used. There’s cronyism. In a crisis like this, it’s hard to escape it. But I’m less convinced that systematic cronyism was the reason for this. I think ideology was part of the reason we went wrong, as also was the hubris built up over decades of fairly strong growth and deregulation. ...
I guess I’m paraphrasing Churchill, but my tendency is not to attribute to malevolence what can be more easily attributed to incompetence. I think there are a fair number of situations where things didn’t work out as advertised.
Feldman: But you’re talking about more than incompetence, right? You’re talking about the incentive structures within firms that would lead people to act as if they were incompetent.
Rajan: I’d even go one step further and say you don’t have to offer an explanation that relies on evil people or corrupt people. The entire crisis can be explained in terms of people who were doing the right things for their own organizations. You can even argue that it was not that they were misdirected by their own distorted compensation structures; they thought they were doing the right thing for their organization. But when you added it all up, it didn’t add up to doing good for society. And that’s where we have the problems. ...
The Economics Profession
Feldman: We just talked about the economics profession and what has worked well or hasn’t worked well. There’s been a lot of discussion about saltwater and freshwater schools in economics recently.4 I think you have an interesting background to talk about that since you’re at the [freshwater] University of Chicago business school and you’ve done a lot of work about financial systems, but you got your Ph.D. at [saltwater] MIT. Do you have a view about what the economics profession didn’t do well? And what the economics profession ought to be focused on going forward?
Rajan: I have a take on this, yes. But first, one has to remember that the saltwater economists, so to speak, were crowing victory in 1969. You see quotes from Paul Samuelson and Bob Solow [at MIT] saying essentially that the business cycle is dead; we have learned how to deal with it. And we know what happened after that.
I think there is a problem with economics when it thinks it has solved all the traditional problems. That’s when economics slaps you in the face and says, “Not so fast!” The reason rational expectations in macroeconomics and efficient markets in finance are under attack now is not so much because people can tie specific failings to these theories but because they’re the dominant part of the economics or finance profession right now. So I think debate has gone a little off track, in the sense of saying, “You were responsible.”
Would any of the neo-Keynesians have done any better? There were many of them in the Clinton administration where some of this stuff built up. Would anybody pin all this on the Bush administration only? No, it’s a systemic problem. So, I think the debate about “economics is to blame.” well, yes, it is to blame to the extent that it didn’t pick up on some of what happened. But this crisis is problematic for all broad areas of macroeconomics or even of finance.
It is clear that there are many areas of economics that have studied the problems we saw in this crisis. For example, the banking and corporate finance guys have looked at agency problems, looked at banking crises, etc. The behavioral theorists have inefficient markets and irrational markets. So, again, the profession as a whole, I don’t think, deserves blame. It has been studying some of these things.
The central question is why certain areas of economics, particularly macroeconomics, abstracted from the plumbing, which turned out to be the problem here. My sense is that that abstraction was not unwarranted given the experience of the last 25 to 30 years. You didn’t have to look at the plumbing. You didn’t have to look at credit. Monetary economists thought credit growth was not an issue that they should be thinking about. Interest rates and inflation were basically what they should be focusing on. The details of exactly how the transmission took place were well established, and we thought they would not get interrupted. Well, we’ve discovered they can get interrupted.
The natural reaction is now to write models which have the details of the plumbing, and you see more of that happening. So I think what the macroeconomists did was not because they were in the pay of the financial sector or consultants of whatever [laughter], as some have said. But I think it was that that was a useful abstraction given what we knew, and it’s no longer an abstraction that we can ever undertake now. ...
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