Too Much to Think About

Today's Baseline Scenerio. Too much yet it must be read.

The Baseline Scenario
First Buy High; Then Sell Low
Posted: 19 May 2009 03:59 PM PDT
On Monday last week, Old National Bancorp bought back the warrants it had granted Treasury as part of its participation in TARP, after buying back its preferred stock on March 31. Today, the New York Times ran a story saying that Treasury only paid $1.2 million to buy back the warrants, while the warrants were almost certainly worth more.
The main authority cited by the Times was Linus Wilson, a finance professor at the University of Louisiana, Lafayette and a sometime commeter on this blog, so let’s go straight to the source.
Linus’s blog post is here (from May 14, I’m embarrassed to say) and his paper is here. Basically, he runs three different valuation models on the warrants (pages 14-16 in the paper), each with three different sets of assumptions. The assumptions have to do with volatility, dividend yield, and probability that half the warrants would be canceled.
Volatility matters because the value of an option depends on its volatility, and volatility has increased recently, so you will get a different estimate depending on the length of time you estimate volatility over.
Dividend yield matters because higher future dividends reduce the value of warrants (since when you exercise the warrant, you only get the share, not the share plus the dividends paid while you were holding the warrant), and again the dividend yield depends on whether you look at historical data or at current dividends.
Finally, the warrant terms include a provision that half the warrants will be canceled if the bank makes a qualifying stock offering before the end of 2009. So the assumptions include subjective estimates of the likelihood of the bank making such a stock offering.
You can look at the paper to see how Wilson came up with these assumptions. My guesses would be that the most likely assumptions are the volatility assumption of the middle valuation, the divided yield assumption of the high valuation, and the warrant cancellation probability assumption of the low valuation.
Wilson’s preferred model (page 14) produces the lowest estimates of warrant values – from $1.5 million to $6.9 million. Traditional Black-Scholes (page 16) produces estimates from $4.1 million to $8.5 million.
(For those wondering, warrants have a positive value even though the exercise price of the warrant exceeds the market value of the common share you get by exercising the warrant, because there is a significant chance – given the length of the warrants – that at some point the share price will exceed the exercise price.)
OK, so that’s the calculation. The question is, since Treasury undoubtedly has many smart economists who know all about derivative pricing, why did they end up getting only $1.2 million? That question is left as an exercise for the reader.
By James Kwak

Economics of Sick Days
Posted: 19 May 2009 08:31 AM PDT
Ezra Klein is one of those bloggers, like Matt Yglesias or Andrew Sullivan, that sometimes make me want to just give up. Yesterday he started a new blog at the Washington Post, and promptly put up fifteen posts on his first day – and not the one line variety, either. Today, he brings us this chart from the Center for Economic and Policy Research:

This is Klein’s explanation:
You’re seeing two things here. The light blue line measures paid sick days. This is what you use if you need to take three days off because you have a fever. The dark blue line is paid sick leave. This is what you use if you need to take three months off because you have cancer. Every other country on the list offers at least one. Most offer both. The United States is alone in guaranteeing neither.
Why does this matter? Because sick people without paid sick days go to work anyway, infecting others and increasing the virulence of epidemics. Or, when it comes to things like the common cold, they simply get more people sick, which sucks for them.
As a father whose daughter is in her first year of pre-school, I’m more sensitive to this phenomenon than when I was younger. I’ve gotten sick at least five times this year – which is about five times more than normal – and I try to avoid going to my classes when I’m sick to avoid infecting other people (even though I’m paying about $100 per hour for those classes).
So why don’t we require paid sick days here in the United States? Of course, there’s always an ideological argument – that’s government intrusion into the private sphere – but the argument you hear more often is that it imposes costs on businesses, particularly small businesses. Well, what’s wrong with that? A government mandate would affect all companies equally, so it shouldn’t make it any harder to compete in general. For small business owners, it would take away the unpleasant choice between minimizing costs and treating your employees right; the people hurt would be the ones who are willing to minimize costs on the backs of their employees, and the ones helped would be the ones who are not. (For the record, my company has paid sick days – but we’re in an industry that generally treats its employees well, so I’m not claiming any particular virtue.) Put another way, it takes away the competitive advantage of employers who do not treat their employees well. For anyone worried about American competitiveness overall, look back at that chart.
But then the higher costs of paid sick days would be passed on to consumers, just like a tax, which would reduce consumption and represent a drag on the economy, just like any other tax. Yes – but this is just a question of externalities. We already pay that tax, just in different forms. We pay it in the health care costs of treating the sick; we pay it in shortened lifespans of people who die (in extreme cases) from contagious illnesses; we pay it in reduced quality of life due to being sick; and we pay it in parents staying home from work (paid or unpaid) to take care of children too sick to go to school or day care.
The difference is that in a free market, when you let each company decide not to have paid sick days, that company only internalizes a fraction of these costs: the fraction associated with lower productivity of its own infected employees, and possibly with the premiums of its health care plan – but many of these companies don’t have health care plans anyway. So, like with all externalities, if the firm doesn’t face the full costs of its production, you get too much of the thing it produces – in this case, sickness.
By James Kwak

Insolvency And Consumer Protection (House Testimony Today)
Posted: 19 May 2009 03:13 AM PDT
Congressman Brad Miller has some interesting ideas about how to respond to the financial crisis; not exactly on the same page as Treasury. He’s called a hearing for this morning to talk about, in the first instance, how to assess insolvency in the banking system – and what to do about it (he chairs the Investigations and Oversight subcommittee of the House Committee on Science and Technology.) But my guess is that the conversation will cover considerably more ground, including his idea that we establish a Financial Products Safety Commission. (A full preview is now available at our joint venture with the Washington Post.)
The basic notion behind this commission is that consumers were taken advantage of by unscrupulous lenders. Of course, you could also say that consumers fooled themselves, but if that is pervasive and has systemic implications then we need to take it on. In his recent testimony before the Joint Economic Committee, Joe Stiglitz emphasized the need for more consumer protection, and this idea is also strongly advocated by Elizabeth Warren - against the odds, she continues to make some progress.
On the other hand, perhaps we already have enough consumer protection-type agencies? Would it be better to focus our efforts on overseeing and constraining the behavior of lenders and everyone else in the credit production and distribution chain? There’s plenty of education and information available about financial products (or not), but somehow that doesn’t get through to people when they need it. How should consumer protection be conceptualized, designed, and implemented in this space?
Over on The Hearing this morning, you can vote for or against the Financial Products Safety Commission – or send it back to Congress, the experts, and the lobbyists for more discussion. Any opinions written up in your comments there (or here) may be taken down and used to construct a more sensible national debate.
By Simon Johnson

Bankers Will Be Boys
Posted: 18 May 2009 07:06 PM PDT
Apparently, Anne Sibert has written an article at VoxEU describing three types of bad behavior committed by bankers that helped produce the crisis:
They committed cognitive errors involving biases towards their own prior beliefs; too many male bankers high on testosterone took too much risk, and a flawed compensation structure rewarded perceived short-term competency rather than long-run results.
I say “apparently” because I can’t get through to VoxEU despite trying three different browsers and two different computers (can’t ping it, either). But there’s a long summary over at naked capitalism.
Everything she says sounds right, although the classification of three behaviors is a little frustrating, because they fall into three different categories. Confirmation bias is just part of the human condition; I’m not sure what we can do about that, short of inventing Cylons (and we know where that leads). Testosterone is part of the male branch of the human condition; so the potential solution is to have more female bankers. And flawed compensation structures are completely human creations, so we can definitely do something about them.
Yves Smith hones in on that last point:
The “bad incentives” turn of phrase, while narrowly correct, does not put blame where blame was due. The industry’s leadership designed the compensation schemes; they were not visited upon them by a mysterious outside force.
I’m familiar with confirmation bias (I suffer from it myself, of course) and with flawed incentive structures, but I found the second point the most interesting. Here’s an interesting excerpt from Sibert:
In a fascinating and innovative study, Coates and Herbert (2008) advance the notion that steroid feedback loops may help explain why male bankers behave irrationally when caught up in bubbles. These authors took samples of testosterone levels of 17 male traders on a typical London trading floor (which had 260 traders, only four of whom were female). They found that testosterone was significantly higher on days when traders made more than their daily one-month average profit and that higher levels of testosterone also led to greater profitability – presumably because of greater confidence and risk taking. The authors hypothesise that if raised testosterone were to persist for several weeks the elevated appetite for risk taking might have important behavioural consequences and that there might be cognitive implications as well; testosterone, they say, has receptors throughout the areas of the brain that neuro-economic research has identified as contributing to irrational financial decisions.
Let’s say you could provide reasonably convincing evidence that you would get better long-term results by using a team that had an even balance of men and women. Could you get away with an affirmative action policy that instituted a quota for female traders? According to the Supreme Court’s extremely mushy and frustrating “intermediate scrutiny” standard for gender discrimination, you would have to show that the policy is “substantially related” to the achievement of “important governmental objectives.” (I assume that there’s enough of a state-action component here, since we’re dealing with major, federally-regulated financial institutions.) Reducing systemic risk sounds like an important objective to me.
Update: The link to VoxEU works now, and I fixed the name of the author of the article.
By James Kwak

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