(c) 2010 F. Bruce Abel
This posting by James Kwak (skip over the Simon Johnson piece for the moment), is a must, must read.
The Baseline Scenario
--------------------------------------------------------------------------------
Greek Bailout, Lehman Deceit, And Tim Geithner
Posted: 13 Apr 2010 04:53 AM PDT
By Simon Johnson
We live in an age of unprecedented bailouts. The Greek package of support from the eurozone this weekend marks a high tide for the principle that complete, unconditional, and fundamentally dangerous protection must be extended to creditors whenever something “big” gets into trouble.
The Greek bailout appears on the scene just as the US Treasury is busy attempting to trumpet the success of TARP – and, by implication, the idea that massive banks should be saved through capital injections and other emergency measures. Officials come close to echoing what the Lex column of the Financial Times already argued, with some arrogance, in fall 2009: the financial crisis wasn’t so bad – no depression resulted and bonuses stayed high, so why do we need to change anything at all?
But think more closely about the Greek situation and draw some comparisons with what we continue to learn about how Lehman Brothers operated (e.g., in today’s New York Times).
The sharp decline in market confidence last week – marked by the jump in Greek yields – scared the main European banks, and also showed there could be a real run on Greek banks; other Europeans are trying to stop it all from getting out of hand. But there is no new program that would bring order to Greece’s troubled public finances.
It’s money for nothing – with no change in the incentive and belief system that brought Greece to this point, very much like the way big banks were saved in the US last year.
If anything, incentives are worse after these bailouts – Greece and other weaker European countries on the one hand, and big US banks on the other hand, know now for sure that in their respective contexts they are too big to fail.
This is “moral hazard” – put simply, it is clear a country/big bank can get a package of support if needed, and this gives less incentive to be careful. Fiscal management for countries will not improve; and risk management for banks will remain prone to weakening when asset prices rise.
If a country hits a problem, the incentive is to wait and see if things get better – perhaps the world economy will improve and Greece can grow out of its difficulties. If such delay means that the problems actually worsen, Greece can just ask Germany for a bigger bailout.
Similarly, if a too-big-to-fail bank hits trouble, the incentive is to hide problems, hoping that financial conditions will improve. Essentially the management finds ways to “prop up” the bank; on modern Wall Street this is done with undisclosed accounting manipulation (in some other countries, it is done with cash). If this means the ultimate collapse is that much more damaging, it’s not the bank executives’ problem any way – their downside is limited, if it exists at all.
The Greeks will now:
Lobby for a large multi-year program from the IMF. They’ll want a path for fiscal policy that is easy in the first year and then gets tougher.
When they reach the tough stage, can’t deliver on the budget, and are about to default, the Greek government will call for another rapid agreement under pressure – with future promises of reform. The eurozone will again accept because it feels the spillovers otherwise would be too negative.
The Greek hope is that the global economy recovers enough to get out, but more realistically, they will start revealing a set of negative “surprises” that mean they miss targets. If the surprises add to the feeling of crisis and further potential bad consequences, that just helps to get a bailout.
The Greek authorities will add a ground game against the European Central Bank, saying things like: “the ECB is too tight, so we need more funds”. We’ll see how that divides the eurozone.
In their space, big US banks will continue to load up on risk as the cycle turns – while hiding that fact. Serious problems will never be revealed in good time – and the authorities will again have good reason (from their perspective) to agree to the hiding of issues until they get out of control, just as the Federal Reserve did for Lehman Brothers. Moral hazard not only ruins incentives, it also massively distorts the available and disclosed information.
As for Mr. Geithner, head of the New York Fed in 2008 and Secretary of the Treasury in 2009: Those who cannot remember the bailout are condemned to repeat it.
The Cover-Up
Posted: 12 Apr 2010 06:59 PM PDT
By James Kwak
Wall Street is engaged in a cover-up. Not a criminal cover-up, but an intellectual cover-up.
The key issue is whether the financial crisis was the product of conscious, intentional behavior — or whether it was an unforeseen and unforeseeable natural disaster. We’ve previously described the “banana peel” theory of the financial crisis — the idea it was the result of a complicated series of unfortunate mistakes, a giant accident. This past week, a parade of financial sector luminaries appeared before the Financial Crisis Inquiry Commission. Their mantra: “No one saw this coming.” The goal is to convince all of us that the crisis was a natural disaster — a “hundred-year flood,” to use Tim Geithner’s metaphor.
I find this incredibly frustrating. First of all, plenty of people saw the crisis coming. In late 2009, people like Nouriel Roubini and Peter Schiff were all over the airwaves for having predicted the crisis. Since then, there have been multiple books written about people who not only predicted the crisis but bet on it, making hundreds of millions or billions of dollars for themselves. Second, Simon and I just wrote a book arguing that the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself. Since, probabilistically speaking, most people will not read the book, it’s fortunate that Ira Glass has stepped in to help fill the gap.
This past weekend’s episode of This American Life includes a long story on a particular trade put on Magnetar (ProPublica story here), http://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going a hedge fund that I first read about in Yves Smith’s ECONned. The main point of the story is to show how one group of people not only anticipated the collapse, and not only bet on it, but in doing so prolonged the bubble and made the ultimate collapse even worse. But it also raises some key issues about Wall Street and its behavior over the past decade.
This will require a brief description of what exactly Magnetar was doing. (If you know already, you can skip the next two paragraphs.) It’s now a cliche that a CDO is a set of securities that “slices and dices” a different set of securities. But it’s slightly more complicated than that. First there is a pile of mortgage-backed securities (or other bond-like securities) that are collected by an investment bank. The CDO itself is a new legal entity (a company) that buys these MBS from the bank; that’s the asset side of its balance sheet. Its liability side, like that of any company, includes debt and equity. There’s a small amount of equity bought by one investor and a lot of debt, issued in tranches that get paid off in a specific order, bought by other investors. The investment bank not only sells MBS to the CDO, but it also places the CDO’s bonds with other investors. Whoever buys the equity is like the “shareholder” of this company. There is also a CDO manager, whose job is to run the CDO — deciding which MBS it buys in the first place, and then (theoretically) selling MBS that go bad and replacing them by buying new ones. The CDO itself is like an investment fund, and the CDO manager is like the fund manager.
According to the story, in 2006, when the subprime-backed CDO market was starting to slow down, Magnetar started buying the equity layer — the riskiest part — of new CDOs. Since they were buying the equity, they were the CDOs’ sponsor, and they pressured the CDO managers to put especially risky MBS into the CDOs — making them more likely to fail. Then Magnetar bought credit default swaps on the debt issued by the CDOs. If the CDOs collapsed, as many did, their equity would become worthless, but their credit default swaps on the debt would repay them many, many times over.
The key is that Magnetar was exploiting the flaws in Wall Street’s process for manufacturing CDOs. Because the banks made up-front fees for creating CDOs, the actual human beings making the decisions did not particularly care if the CDOs collapsed — they just wanted Magnetar’s money to make the CDOs possible. (No one to buy the highly risky equity, no CDO.) Because the ratings agencies’ models did not particularly discriminate between the contents that went into the CDOs (see pages 169-71 of The Big Short, for example), Magnetar and the banks could stuff them with the most toxic inputs possible to make them more likely to fail.
Now, one question you should be asking yourself is, how is this even arithmetically possible? How is it possible that a CDO can have so little equity that you can buy credit default swaps on the debt at a low enough price to make a killing when the thing collapses? You would think that: (a) in order to sell the bonds at all, there would have to be more equity to protect the debt; and (b) the credit default swaps would have been expensive enough to eat up the profits on the deal. Remember, this is 2006, when several hedge funds were shorting CDOs and many investment banks were looking for protection for their CDO portfolios.
The answer is that nothing was being priced efficiently. The CDO debt was being priced according to the rating agencies’ models, which weren’t even looking at sufficiently detailed data. And the credit default swaps were underpriced because they allowed banks to create new synthetic CDOs, which were another source of profits. So here’s the first lesson: the idea that markets result in efficient prices was, in this case, hogwash.
By taking advantage of these inefficiencies, Magnetar made the Wall Street banks look like chumps. This American Life talks about one deal where Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.
But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers’ pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)
So who’s to blame? The first instinct is to get mad at Magnetar. But this overlooks a Wall Street maxim cited by TAL: you can’t blame the predator for eating the prey. Magnetar was out to make money for its limited partners; if it had bet wrong and lost money, no one would have bailed it out. Although I probably wouldn’t have behaved the same way under the circumstances, I have no problem with Magnetar.
I do have a problem with the Wall Street bankers in this story, however. Because losing $880 million of your own company’s money to make a quick buck for yourself is either incompetent or just wrong. And allowing Magnetar to create CDOs that are as toxic as possible — and then actively selling their debt to investors (that’s where the banks differ from Magnetar, in my opinion) — is either incompetent or just wrong. But even so, I don’t think the frontline bankers are ultimately at fault. Maybe they were simply incompetent. Or maybe, they were knowingly exploiting the system to maximize their earnings — only in this case the system they were exploiting was their own banks’ screwed-up compensation policies, risk management “systems,” and ethical guidelines.
In which case the real blame belongs to those who created that system and made it possible. And that would be the bank executives who failed at managing compensation, risk, or ethics, endangering or killing their companies in the process. And that would be the regulators and politicians who allowed these no-money down no-doc negative-amortization loans to be made in the first place; who allowed investment banks to sell whatever they wanted to investors, with no requirements or duties whatsoever; who allowed banks to outsource their capital requirements to rating agencies, giving them an incentive to hold mis-rated securities; who declined to regulate the credit default swaps that Magnetar used to amass its short positions; who allowed banks like Citigroup and JPMorgan Chase to get into this game with federally insured money; and who failed at monitoring the safety and soundness of the banks playing the game.
The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them — only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident.
Showing posts with label james kwak. Show all posts
Showing posts with label james kwak. Show all posts
Wednesday, April 14, 2010
Thursday, July 16, 2009
Baseline Scenerio
The Baseline Scenario
· CIT Down
· The AEI Versus the Real World
· Is It Possible to Detect Bubbles?
CIT Down
Posted: 16 Jul 2009 03:46 AM PDT
At the end of the day, CIT had nothing. Their asset quality was poor, their systemic risk implications seemed limited, Sheila Bair dug in her heels, and Jeffrey Peek (CEO) didn’t have sufficiently strong connections to get her overruled.
CIT had friends, but not enough - and maybe this tells us something about the shifting political sands. The Financial Services Roundtable (top financial CEOs) came out in force, the House Committee on Small Business reportedly made worried noises, and Barney Frank sounded supportive. But the American Bankers Association (the broader mass of bankers) publicly stood on the sidelines and Senate Banking – and prominent senators – seemed otherwise engaged.
CIT’s small and mid-size customers are important to the recovery. But the reckoning is that this business can be easily sold to someone else – after all, this is exactly what bankruptcy can get right in the U.S.
So the question became: is CIT too big – on its liabilities side – to fail? And if $80bn financial firms are now “too big to fail”, what does that imply for other potential bailout conversations and for our fiscal future?
In the final analysis, CIT wasn’t even big enough to meet Secretary Geithner face-to-face – he’s still out of the country.
The bottom line: we need fewer $800bn firms and more $80bn firms. If Goldman Sachs were broken into 10 independent pieces, we could all sleep much more soundly.
By Simon Johnson
(More in my NYT.com column this morning – what are the implications of CIT’s failure for overall levels of capital in the banking system? This will run shortly.)
The AEI Versus the Real World
Posted: 15 Jul 2009 08:14 PM PDT
Peter Wallison of the American Enterprise Institute accuses the Consumer Financial Protection Agency of being a liberal plot to restrict good financial products to sophisticated elites. Mike at Rortybomb does a point-by-point takedown complete with actual data, so I can stick to the high level (not to be confused with the high road).
Wallison’s op-ed reads like a caricature of conservative ideology – all supposed moral principle and no real-world implications. His argument is basically that by imposing restrictions on complex products (Option ARM mortgages) that are not imposed on plain vanilla products (30-year fixed-rate mortgages), the CFPA is limiting choice for the poor and unsophisticated and preserving choice for the rich and sophisticated; since according to conservative ideology choice is always good in principle, the CFPA is discriminatory.
Where do we start?
First, this is exactly the way consumer protection is supposed to work. If you go to a convenience store, or wherever you can still buy cigarettes, you can buy lots of things that don’t have warning labels. The cigarettes have warning labels.
Wallison dismisses warning labels with a non-argument: “If the issue is whether the consumer understood the risks of the more complex product, strong warning labels or written ‘opt-ins’ simply raise the same question and will not be a defense for the provider.” Warning labels and written opt-ins are used all over the economy; every time you sign a piece of paper saying that you understand the risks of something and you agree not to hold the provider liable, you are opting in. It is true that these do not always hold up in court, but that’s a fact-specific question. In general, they certainly do protect service providers, although Wallison asserts the contrary.
Second, this is exactly the way securities regulation works today. The Securities Act of 1933 creates exemptions for securities that are only sold to “sophisticated” investors. This is how hedge funds escape most regulation; they only allow sophisticated investors in. The CFPA is extending this principle to a class of financial instruments that, in 1933, no one thought could be complex enough to be limited to sophisticated investors.
Third, the CFPA is simply broadening the concept of fiduciary responsibility, which already exists for various categories of service providers, such as lawyers, CPAs, and some investment advisors. Someone with a fiduciary responsibility has to put the interests of his client first. In a financial context, this would mean that you can’t put a client into a financial product that does not serve his interests. The purpose of the CFPA is similar: you can’t sell a product to someone without first making sure the he understands what you are selling him. Now, this is not exactly the same thing as a fiduciary responsibility; it’s actually considerably weaker. The point is that the idea that you should not treat your customers in ways that harm them is hardly liberal or elitist.
Fourth, Wallison asserts, without example or argument, that the more complex products are better.
So who will be able to get those more complex products and services? Not ordinary Americans, whose lack of financial sophistication will make the risks of selling to them too great for most providers. The more complex products, the ones that are better tailored to the needs of the particular consumer, will be offered only to the more sophisticated and better educated — in other words, to the nation’s elites.
“Better tailored to the needs of the particular consumer?” We’re talking about exploding mortgages and reverse convertibles here. Speaking as someone who could pass any test of sophistication, my personal opinion is that the CFPA regime would actually benefit the “unsophisticated,” because the “more complex products” are just higher-margin ways for banks to relieve rich people of their money. It’s a good thing that most people are not allowed to pay hedge funds 2-and-20 for the privilege of not being able to take their money out whenever they want. But that’s another topic.
Fifth, Wallison asserts that this is “not because the products or services are inherently dangerous, like drugs or explosives,” and hence need consumer protection. This completely ignores the biggest news story of the last two years (OK, maybe the second-biggest story after the election of an African-American president). We have millions of foreclosures – that’s people losing houses who either (a) would not be losing their houses if they had been given traditional mortgages that they would have qualified for or (b) would have been better off renting and not losing down payments, closing costs, refinance costs, and their credit ratings. Those foreclosures have negative externalities for their neighborhoods, including lower property values and higher crime. (Mike already nailed this in his now-famous “degenerate crackhead” example in this post.) And we have the biggest recession since the 1930s. How are complex financial products not inherently dangerous?
Sixth, what’s the alternative? The only one that Wallison mentions is disclosure.
Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure all consumers — of whatever level of sophistication — could make rational decisions about the products and services they are offered. No more. . . .
Apparently, adequate disclosure will not be the answer to the provider’s dilemma. As outlined in the white paper, no amount of disclosure can adequately protect consumers against complexity.
Note that Wallison is clever enough to avoid saying that disclosure works – because it obviously doesn’t. But still he leaves it floating out there as his only alternative to the CFPA. So let’s avoid the clever rhetoric. Disclosure doesn’t work. If it did, we wouldn’t be where we are today. We tried it; now we need to try something else. And Wallison doesn’t suggest anything.
What ties these six points together? Let’s see, we have:
1. ignoring the fact that warning labels and opt-ins are already used routinely in the economy;
2. ignoring the fact that the “sophisticated investor” concept is already used in the financial industry itself;
3. ignoring the fact that fiduciary duty, which is more restrictive than the CFPA approach, is already used for various classes of professionals;
4. ignoring the very real possibility that complex financial products are not actually good for you;
5. ignoring the fact that the financial products in question have just caused enormous harm to millions of people; and
6. ignoring the fact that his implied alternative, disclosure, has resoundingly failed.
The genius of the modern conservative movement (not the traditional conservatism of Edmund Burke, for which I have a great deal of respect) has been its understanding that to win in politics, the facts of the real world – the “judicious study of discernible reality,” if you will – only slow you down. Wallison does the movement proud.
By James Kwak
Is It Possible to Detect Bubbles?
Posted: 15 Jul 2009 07:00 PM PDT
On the one hand, it seems obvious; didn’t we all know there was a housing bubble back in 2006? On the other hand, if it’s that easy, why aren’t we all as rich as John Paulson?
A while back I suggested that the Fed could spot a housing bubble by treating housing prices the same way if treats the prices that make up the CPI. If there is high inflation in the core CPI, you don’t stop and ask if there is a fundamental reason for higher inflation; you tighten monetary policy (raise interest rates). The Fed could do the same thing for housing prices, since housing is an asset that people need to consume. But that’s probably a simplistic view.
Leigh Caldwell thinks that behavioral approaches may be able to separate out irrational overvaluation from changes in fundamental values. I believe his argument is that you can measure the degree of irrational overvaluation for certain types of assets, and you can extrapolate from there to see if there is a bubble:
Outside of the laboratory, precise knowledge of the returns of some assets does become available at times, and it would be possible to measure investors’ behaviour with regard to those assets. If investors, in aggregate, become overconfident about returns it will be possible to spot this from certain types of price change.
This makes logical sense to me, but it’s pretty vague. Caldwell’s VoxEU post goes a bit further:
I propose that regulators develop a small set of measures of irrationality that can be calculated and published at least monthly. These might include measures related to expected personal income, job security and asset values; measures of expectations about the performance of the economy as a whole; and measures of hyperbolic discount rates and other specific observable cognitive biases.
In essence, I think, the idea is that instead of trying to figure out whether a given financial asset is overvalued, we create an index of consumer expectations and cognitive biases and use that to tell us if we are in a bubble. If people are wildly optimistic, as reflected both in what they say and in how they act, then asset prices are probably also irrationally high.
There may be something here, but I worry that you still have to have something to compare your expectations index to. We already have indexes of consumer confidence – which, granted, are not quite what Caldwell is talking about – and I don’t think they have been much good as bubble-spotting devices. Maybe if you graphed consumer confidence against average economic forecasters you might see something – but most likely those forecasters are just as prone to irrational exuberance as the ordinary person. Really what we want is a reliable indicator of irrational exuberance that will be the same in every bubble; but how you would find such a thing, and how you would be sure that it would work in the next bubble, is beyond me.
By James Kwak
· CIT Down
· The AEI Versus the Real World
· Is It Possible to Detect Bubbles?
CIT Down
Posted: 16 Jul 2009 03:46 AM PDT
At the end of the day, CIT had nothing. Their asset quality was poor, their systemic risk implications seemed limited, Sheila Bair dug in her heels, and Jeffrey Peek (CEO) didn’t have sufficiently strong connections to get her overruled.
CIT had friends, but not enough - and maybe this tells us something about the shifting political sands. The Financial Services Roundtable (top financial CEOs) came out in force, the House Committee on Small Business reportedly made worried noises, and Barney Frank sounded supportive. But the American Bankers Association (the broader mass of bankers) publicly stood on the sidelines and Senate Banking – and prominent senators – seemed otherwise engaged.
CIT’s small and mid-size customers are important to the recovery. But the reckoning is that this business can be easily sold to someone else – after all, this is exactly what bankruptcy can get right in the U.S.
So the question became: is CIT too big – on its liabilities side – to fail? And if $80bn financial firms are now “too big to fail”, what does that imply for other potential bailout conversations and for our fiscal future?
In the final analysis, CIT wasn’t even big enough to meet Secretary Geithner face-to-face – he’s still out of the country.
The bottom line: we need fewer $800bn firms and more $80bn firms. If Goldman Sachs were broken into 10 independent pieces, we could all sleep much more soundly.
By Simon Johnson
(More in my NYT.com column this morning – what are the implications of CIT’s failure for overall levels of capital in the banking system? This will run shortly.)
The AEI Versus the Real World
Posted: 15 Jul 2009 08:14 PM PDT
Peter Wallison of the American Enterprise Institute accuses the Consumer Financial Protection Agency of being a liberal plot to restrict good financial products to sophisticated elites. Mike at Rortybomb does a point-by-point takedown complete with actual data, so I can stick to the high level (not to be confused with the high road).
Wallison’s op-ed reads like a caricature of conservative ideology – all supposed moral principle and no real-world implications. His argument is basically that by imposing restrictions on complex products (Option ARM mortgages) that are not imposed on plain vanilla products (30-year fixed-rate mortgages), the CFPA is limiting choice for the poor and unsophisticated and preserving choice for the rich and sophisticated; since according to conservative ideology choice is always good in principle, the CFPA is discriminatory.
Where do we start?
First, this is exactly the way consumer protection is supposed to work. If you go to a convenience store, or wherever you can still buy cigarettes, you can buy lots of things that don’t have warning labels. The cigarettes have warning labels.
Wallison dismisses warning labels with a non-argument: “If the issue is whether the consumer understood the risks of the more complex product, strong warning labels or written ‘opt-ins’ simply raise the same question and will not be a defense for the provider.” Warning labels and written opt-ins are used all over the economy; every time you sign a piece of paper saying that you understand the risks of something and you agree not to hold the provider liable, you are opting in. It is true that these do not always hold up in court, but that’s a fact-specific question. In general, they certainly do protect service providers, although Wallison asserts the contrary.
Second, this is exactly the way securities regulation works today. The Securities Act of 1933 creates exemptions for securities that are only sold to “sophisticated” investors. This is how hedge funds escape most regulation; they only allow sophisticated investors in. The CFPA is extending this principle to a class of financial instruments that, in 1933, no one thought could be complex enough to be limited to sophisticated investors.
Third, the CFPA is simply broadening the concept of fiduciary responsibility, which already exists for various categories of service providers, such as lawyers, CPAs, and some investment advisors. Someone with a fiduciary responsibility has to put the interests of his client first. In a financial context, this would mean that you can’t put a client into a financial product that does not serve his interests. The purpose of the CFPA is similar: you can’t sell a product to someone without first making sure the he understands what you are selling him. Now, this is not exactly the same thing as a fiduciary responsibility; it’s actually considerably weaker. The point is that the idea that you should not treat your customers in ways that harm them is hardly liberal or elitist.
Fourth, Wallison asserts, without example or argument, that the more complex products are better.
So who will be able to get those more complex products and services? Not ordinary Americans, whose lack of financial sophistication will make the risks of selling to them too great for most providers. The more complex products, the ones that are better tailored to the needs of the particular consumer, will be offered only to the more sophisticated and better educated — in other words, to the nation’s elites.
“Better tailored to the needs of the particular consumer?” We’re talking about exploding mortgages and reverse convertibles here. Speaking as someone who could pass any test of sophistication, my personal opinion is that the CFPA regime would actually benefit the “unsophisticated,” because the “more complex products” are just higher-margin ways for banks to relieve rich people of their money. It’s a good thing that most people are not allowed to pay hedge funds 2-and-20 for the privilege of not being able to take their money out whenever they want. But that’s another topic.
Fifth, Wallison asserts that this is “not because the products or services are inherently dangerous, like drugs or explosives,” and hence need consumer protection. This completely ignores the biggest news story of the last two years (OK, maybe the second-biggest story after the election of an African-American president). We have millions of foreclosures – that’s people losing houses who either (a) would not be losing their houses if they had been given traditional mortgages that they would have qualified for or (b) would have been better off renting and not losing down payments, closing costs, refinance costs, and their credit ratings. Those foreclosures have negative externalities for their neighborhoods, including lower property values and higher crime. (Mike already nailed this in his now-famous “degenerate crackhead” example in this post.) And we have the biggest recession since the 1930s. How are complex financial products not inherently dangerous?
Sixth, what’s the alternative? The only one that Wallison mentions is disclosure.
Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure all consumers — of whatever level of sophistication — could make rational decisions about the products and services they are offered. No more. . . .
Apparently, adequate disclosure will not be the answer to the provider’s dilemma. As outlined in the white paper, no amount of disclosure can adequately protect consumers against complexity.
Note that Wallison is clever enough to avoid saying that disclosure works – because it obviously doesn’t. But still he leaves it floating out there as his only alternative to the CFPA. So let’s avoid the clever rhetoric. Disclosure doesn’t work. If it did, we wouldn’t be where we are today. We tried it; now we need to try something else. And Wallison doesn’t suggest anything.
What ties these six points together? Let’s see, we have:
1. ignoring the fact that warning labels and opt-ins are already used routinely in the economy;
2. ignoring the fact that the “sophisticated investor” concept is already used in the financial industry itself;
3. ignoring the fact that fiduciary duty, which is more restrictive than the CFPA approach, is already used for various classes of professionals;
4. ignoring the very real possibility that complex financial products are not actually good for you;
5. ignoring the fact that the financial products in question have just caused enormous harm to millions of people; and
6. ignoring the fact that his implied alternative, disclosure, has resoundingly failed.
The genius of the modern conservative movement (not the traditional conservatism of Edmund Burke, for which I have a great deal of respect) has been its understanding that to win in politics, the facts of the real world – the “judicious study of discernible reality,” if you will – only slow you down. Wallison does the movement proud.
By James Kwak
Is It Possible to Detect Bubbles?
Posted: 15 Jul 2009 07:00 PM PDT
On the one hand, it seems obvious; didn’t we all know there was a housing bubble back in 2006? On the other hand, if it’s that easy, why aren’t we all as rich as John Paulson?
A while back I suggested that the Fed could spot a housing bubble by treating housing prices the same way if treats the prices that make up the CPI. If there is high inflation in the core CPI, you don’t stop and ask if there is a fundamental reason for higher inflation; you tighten monetary policy (raise interest rates). The Fed could do the same thing for housing prices, since housing is an asset that people need to consume. But that’s probably a simplistic view.
Leigh Caldwell thinks that behavioral approaches may be able to separate out irrational overvaluation from changes in fundamental values. I believe his argument is that you can measure the degree of irrational overvaluation for certain types of assets, and you can extrapolate from there to see if there is a bubble:
Outside of the laboratory, precise knowledge of the returns of some assets does become available at times, and it would be possible to measure investors’ behaviour with regard to those assets. If investors, in aggregate, become overconfident about returns it will be possible to spot this from certain types of price change.
This makes logical sense to me, but it’s pretty vague. Caldwell’s VoxEU post goes a bit further:
I propose that regulators develop a small set of measures of irrationality that can be calculated and published at least monthly. These might include measures related to expected personal income, job security and asset values; measures of expectations about the performance of the economy as a whole; and measures of hyperbolic discount rates and other specific observable cognitive biases.
In essence, I think, the idea is that instead of trying to figure out whether a given financial asset is overvalued, we create an index of consumer expectations and cognitive biases and use that to tell us if we are in a bubble. If people are wildly optimistic, as reflected both in what they say and in how they act, then asset prices are probably also irrationally high.
There may be something here, but I worry that you still have to have something to compare your expectations index to. We already have indexes of consumer confidence – which, granted, are not quite what Caldwell is talking about – and I don’t think they have been much good as bubble-spotting devices. Maybe if you graphed consumer confidence against average economic forecasters you might see something – but most likely those forecasters are just as prone to irrational exuberance as the ordinary person. Really what we want is a reliable indicator of irrational exuberance that will be the same in every bubble; but how you would find such a thing, and how you would be sure that it would work in the next bubble, is beyond me.
By James Kwak
Wednesday, July 1, 2009
Baseline Scenario
The Baseline Scenario
The Two Sides of the Balance Sheet
Benefits of Size?
The Cost of Life
The Two Sides of the Balance Sheet
Posted: 30 Jun 2009 02:30 PM PDT
Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”
This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)
The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. However, there are two alternative approaches to doing this. One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even if the banks have to sell them for a little less cash than their current balance sheet value, this would have the salutary effect of reducing vulnerability, since cash does not lose value (at least not in an accounting sense). Alternatively, you could achieve the same effect by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer.
The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.
One key to the financial crisis has been nervousness about toxic assets on bank balance sheets. It’s nice that people aren’t so nervous anymore. But as Raghuram Rajan said to Klein, “if we reenter the downturn, and the banks begin to look shakier – we’ll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system.”
By James Kwak
Benefits of Size?
Posted: 29 Jun 2009 09:13 PM PDT
Felix Salmon points out that Bank of America can now charge customers overdraft fees ten times a day (up from five). (Read the original Washington Post article if you want to be aggravated.) Well, I can do one better.
I recently had to track down some past bank records. Local banks? No problem, no fee. At Bank of America, however, they insisted on charging me $5 per page – even though they were breaking a state law forbidding them from charging a fee. (All I’ll say is that they weren’t allowed to charge a fee because of the characteristics of the person I was getting the records for and the purpose for which he needed the records.) I pointed out to the drone at the bank that she was breaking the law, but she insisted she couldn’t do anything about it and we would have to sue them to get the money back. And I believe her; the problem is almost certainly that requests go from the local branch to some central processing center, and there is no way for the local branch to tell the central processing center not to deduct the fee from your account.
Now perhaps this central processing center setup reduces costs for Bank of America. But do they charge lower mortgage rates? No. Do they offer higher savings rates? No. Are they too big to fail? Absolutely. Do things have to be this way?
By James Kwak
The Cost of Life
Posted: 29 Jun 2009 08:59 PM PDT
Mark Thoma links to a medical paper that brings up the issue that few people want to talk about: at what point is the cost of medical care to extend life not justified? Like Thoma, I don’t have a great answer, except to point out that in a world of scarce resources, the answer cannot be that any effort to extend life by any small amount is always a good idea. (And as David Leonhardt explained, our health care system is certainly constrained by scarce resources, whether we like it or not.)
I just have one observation and one recommendation.
The observation is that our political and legal systems already put price tags on life routinely. If you die on the job, the workers’ compensation system calculates how much your life was worth; if you are killed as a result of someone else’s negligence, the tort system does the same. In either case, the calculation is primarily based on your expected earnings for the rest of the life; in other words, young high-earners are worth more than old poor people. And for virtually everyone, the number you end up with is much less than the value implied by the cancer treatment discussed in the paper Thoma cites.
I’m no fan of that system. I’m just surprised that as a society we can be so brutal and inegalitarian in one sphere and so touchy in another (health care, where the thought that any life-extending treatment might be too expensive is probably considered morally abhorrent by most people).
The recommendation is that if you are interested in this issue, you should listen to Dr. Robert Martensen on Fresh Air. Martensen is not only a doctor and a bioethicist, but at the time of the interview I believe (my memory might be failing me) he was dealing with the imminent death of one of his parents, and the medical choices involved.
By James Kwak
The Two Sides of the Balance Sheet
Benefits of Size?
The Cost of Life
The Two Sides of the Balance Sheet
Posted: 30 Jun 2009 02:30 PM PDT
Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: “If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital.”
This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.)
The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. However, there are two alternative approaches to doing this. One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even if the banks have to sell them for a little less cash than their current balance sheet value, this would have the salutary effect of reducing vulnerability, since cash does not lose value (at least not in an accounting sense). Alternatively, you could achieve the same effect by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer.
The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.
One key to the financial crisis has been nervousness about toxic assets on bank balance sheets. It’s nice that people aren’t so nervous anymore. But as Raghuram Rajan said to Klein, “if we reenter the downturn, and the banks begin to look shakier – we’ll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system.”
By James Kwak
Benefits of Size?
Posted: 29 Jun 2009 09:13 PM PDT
Felix Salmon points out that Bank of America can now charge customers overdraft fees ten times a day (up from five). (Read the original Washington Post article if you want to be aggravated.) Well, I can do one better.
I recently had to track down some past bank records. Local banks? No problem, no fee. At Bank of America, however, they insisted on charging me $5 per page – even though they were breaking a state law forbidding them from charging a fee. (All I’ll say is that they weren’t allowed to charge a fee because of the characteristics of the person I was getting the records for and the purpose for which he needed the records.) I pointed out to the drone at the bank that she was breaking the law, but she insisted she couldn’t do anything about it and we would have to sue them to get the money back. And I believe her; the problem is almost certainly that requests go from the local branch to some central processing center, and there is no way for the local branch to tell the central processing center not to deduct the fee from your account.
Now perhaps this central processing center setup reduces costs for Bank of America. But do they charge lower mortgage rates? No. Do they offer higher savings rates? No. Are they too big to fail? Absolutely. Do things have to be this way?
By James Kwak
The Cost of Life
Posted: 29 Jun 2009 08:59 PM PDT
Mark Thoma links to a medical paper that brings up the issue that few people want to talk about: at what point is the cost of medical care to extend life not justified? Like Thoma, I don’t have a great answer, except to point out that in a world of scarce resources, the answer cannot be that any effort to extend life by any small amount is always a good idea. (And as David Leonhardt explained, our health care system is certainly constrained by scarce resources, whether we like it or not.)
I just have one observation and one recommendation.
The observation is that our political and legal systems already put price tags on life routinely. If you die on the job, the workers’ compensation system calculates how much your life was worth; if you are killed as a result of someone else’s negligence, the tort system does the same. In either case, the calculation is primarily based on your expected earnings for the rest of the life; in other words, young high-earners are worth more than old poor people. And for virtually everyone, the number you end up with is much less than the value implied by the cancer treatment discussed in the paper Thoma cites.
I’m no fan of that system. I’m just surprised that as a society we can be so brutal and inegalitarian in one sphere and so touchy in another (health care, where the thought that any life-extending treatment might be too expensive is probably considered morally abhorrent by most people).
The recommendation is that if you are interested in this issue, you should listen to Dr. Robert Martensen on Fresh Air. Martensen is not only a doctor and a bioethicist, but at the time of the interview I believe (my memory might be failing me) he was dealing with the imminent death of one of his parents, and the medical choices involved.
By James Kwak
Tuesday, June 30, 2009
Baseline Scenario
The Baseline Scenario
No Way Out: Treasury And The Price Of TARP Warrants
Debating the Public Plan
The Paradox of Strategic Defaults
No Way Out: Treasury And The Price Of TARP Warrants
Posted: 29 Jun 2009 03:58 AM PDT
Buried in the late wire news on Friday – and therefore barely registering in the newspapers over the weekend – Treasury announced the rules for pricing its option to buy shares in banks that participated in TARP.
The Treasury Department said the banks will make the first offer for the warrants. Treasury will then decide to sell at that price or make a counteroffer. If the government and a bank cannot agree on a fair price for the warrants, the two sides will have the right to use private appraisers.
This is a mistake.
The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.
In Treasury’s scheme, there is significant risk of implicit gift exchange with banks - good jobs/political support/other favors down the road – or even explicit corruption. For sure, there will be accusations that someone at Treasury was too close to this or that bidder. Why would Treasury’s leadership want to be involved in price setting in this fashion?
Treasury apparently sees corruption as an issue about personalities (i.e., WE aren’t ever corrupt) rather than about institutional structure. For example, if you create an arrangement that easily permits corruption, such as through nontransparent decision making or negotiation around warrant pricing, you set up incentives to be corrupt. Either existing people change their behavior, or new people will seek appointment in order to participate in corruption.
This is also a point, by the way, that Treasury has been making for years through its representatives at the International Monetary Fund – including during the Clinton Administration, when the same people were running U.S. economic policy as now. It’s a good point and never easy for countries-with-potential-corruption to hear. It applies as much to the United States as to anywhere else.
Treasury will argue the disposal of warrants is a one-off event, but this is not a plausible line: it is part of a much longer series of nontransparent decisions over finance. The attitude that “we can be nontransparent because we will never be corrupt” creates reputational risk for both Treasury and participating banks. If extraordinary support for the financial sector lasts several years, we will likely have at least one time-consuming and damaging investigation into all the details of these settlements.
In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes.
There is obviously unappealing midterm election risk in this pricing scheme and making a correction now – before major banks have participated – would be relatively straightforward.
(Primer on option pricing, applied to warrants; background on how we got here)
By Simon Johnson
Debating the Public Plan
Posted: 28 Jun 2009 08:01 PM PDT
Greg Mankiw weighs in directly (as opposed to beating around the bush) on the public plan. Here’s the summary:
Recall a basic lesson of economics: A market participant with a dominant position can influence prices in a way that a small, competitive player cannot. . . .
If the government has a dominant role in buying the services of doctors and other health care providers, it can force prices down. Once the government is virtually the only game in town, health care providers will have little choice but to take whatever they can get. . . .
To be sure, squeezing suppliers would have unpleasant side effects. Over time, society would end up with fewer doctors and other health care workers. The reduced quantity of services would somehow need to be rationed among competing demands. Such rationing is unlikely to work well. . . .
A competitive system of private insurers, lightly regulated to ensure that the market works well, would offer Americans the best health care at the best prices.
Whenever someone uses the phrase “basic lesson of economics” when discussing the U.S. health care system, you should be suspicious. As Paul Krugman says, “the standard competitive market model just doesn’t work for health care: adverse selection and moral hazard are so central to the enterprise that nobody, nobody expects free-market principles to be enough.”
I earlier tried to make this point in more detail: “lightly regulated” private health insurance is a fantasy, because the whole point of a for-profit insurer is to charge premiums that expect the expected payout under the policy; as a result, no sick person would be able to afford insurance. You don’t need adverse selection or moral hazard to explain this: if I know someone has an expensive form of cancer, I’m going to charge him $100,000 for health insurance, and he won’t be able to pay. The free market for health care is one in which sick people die, and smart people who ignore that point are being less than honest. (Or maybe they are hiding behind the phrase “lightly regulated” – if they consider the prohibition of medical underwriting “light regulation.”)
And if dominant market participants are the problem, then we already have that problem. Check out page 6 of this report (hat tip Krugman). In the median state in the U.S., the top two insurers have a combined market share of 69%.
Finally, it’s clear that the current system isn’t working – we have both 50 million uninsured people (plus many millions more who are not sufficiently insured against a major medical problem), and we have rising health care costs that will destroy the federal budget over the next several decades. So when Mankiw says we need “a competitive system of private insurers, lightly regulated to ensure that the market works well,” what is he saying? That we need less regulation than we have now? Or is he just talking about abstract principles?
By James Kwak
The Paradox of Strategic Defaults
Posted: 28 Jun 2009 07:00 PM PDT
Real Time Economics and Calculated Risk both discuss new research by Paola Sapienza, Luigi Zingales, and Luigi Guiso on homeowners defaulting on mortgages even though they have the money to pay them. According to their research, 17% of households would default when their negative equity reaches 50% of the house’s value. The argument is that public policy has not sufficiently addressed this problem, focusing instead on homeowners who cannot afford their mortgages.
Let’s make this a little more concrete. Let’s say you bought a house with zero money down for $300,000 in early 2006. A few years later, the house is now worth $200,000, so your negative equity is 50% of the market value. Yet only 17% of people in your situation would walk away from the house. The other 83% would continue to pay the mortgage, essentially throwing money away. Apparently people value the transaction costs of moving and the damage to their credit ratings at $100,000 (I think my numbers are approximately on the right scale – if anything they are probably low) – even after the fact that you can live in a house for free for several months before being evicted.
Or people are not as rational as economists would assume.
By James Kwak
No Way Out: Treasury And The Price Of TARP Warrants
Debating the Public Plan
The Paradox of Strategic Defaults
No Way Out: Treasury And The Price Of TARP Warrants
Posted: 29 Jun 2009 03:58 AM PDT
Buried in the late wire news on Friday – and therefore barely registering in the newspapers over the weekend – Treasury announced the rules for pricing its option to buy shares in banks that participated in TARP.
The Treasury Department said the banks will make the first offer for the warrants. Treasury will then decide to sell at that price or make a counteroffer. If the government and a bank cannot agree on a fair price for the warrants, the two sides will have the right to use private appraisers.
This is a mistake.
The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.
In Treasury’s scheme, there is significant risk of implicit gift exchange with banks - good jobs/political support/other favors down the road – or even explicit corruption. For sure, there will be accusations that someone at Treasury was too close to this or that bidder. Why would Treasury’s leadership want to be involved in price setting in this fashion?
Treasury apparently sees corruption as an issue about personalities (i.e., WE aren’t ever corrupt) rather than about institutional structure. For example, if you create an arrangement that easily permits corruption, such as through nontransparent decision making or negotiation around warrant pricing, you set up incentives to be corrupt. Either existing people change their behavior, or new people will seek appointment in order to participate in corruption.
This is also a point, by the way, that Treasury has been making for years through its representatives at the International Monetary Fund – including during the Clinton Administration, when the same people were running U.S. economic policy as now. It’s a good point and never easy for countries-with-potential-corruption to hear. It applies as much to the United States as to anywhere else.
Treasury will argue the disposal of warrants is a one-off event, but this is not a plausible line: it is part of a much longer series of nontransparent decisions over finance. The attitude that “we can be nontransparent because we will never be corrupt” creates reputational risk for both Treasury and participating banks. If extraordinary support for the financial sector lasts several years, we will likely have at least one time-consuming and damaging investigation into all the details of these settlements.
In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes.
There is obviously unappealing midterm election risk in this pricing scheme and making a correction now – before major banks have participated – would be relatively straightforward.
(Primer on option pricing, applied to warrants; background on how we got here)
By Simon Johnson
Debating the Public Plan
Posted: 28 Jun 2009 08:01 PM PDT
Greg Mankiw weighs in directly (as opposed to beating around the bush) on the public plan. Here’s the summary:
Recall a basic lesson of economics: A market participant with a dominant position can influence prices in a way that a small, competitive player cannot. . . .
If the government has a dominant role in buying the services of doctors and other health care providers, it can force prices down. Once the government is virtually the only game in town, health care providers will have little choice but to take whatever they can get. . . .
To be sure, squeezing suppliers would have unpleasant side effects. Over time, society would end up with fewer doctors and other health care workers. The reduced quantity of services would somehow need to be rationed among competing demands. Such rationing is unlikely to work well. . . .
A competitive system of private insurers, lightly regulated to ensure that the market works well, would offer Americans the best health care at the best prices.
Whenever someone uses the phrase “basic lesson of economics” when discussing the U.S. health care system, you should be suspicious. As Paul Krugman says, “the standard competitive market model just doesn’t work for health care: adverse selection and moral hazard are so central to the enterprise that nobody, nobody expects free-market principles to be enough.”
I earlier tried to make this point in more detail: “lightly regulated” private health insurance is a fantasy, because the whole point of a for-profit insurer is to charge premiums that expect the expected payout under the policy; as a result, no sick person would be able to afford insurance. You don’t need adverse selection or moral hazard to explain this: if I know someone has an expensive form of cancer, I’m going to charge him $100,000 for health insurance, and he won’t be able to pay. The free market for health care is one in which sick people die, and smart people who ignore that point are being less than honest. (Or maybe they are hiding behind the phrase “lightly regulated” – if they consider the prohibition of medical underwriting “light regulation.”)
And if dominant market participants are the problem, then we already have that problem. Check out page 6 of this report (hat tip Krugman). In the median state in the U.S., the top two insurers have a combined market share of 69%.
Finally, it’s clear that the current system isn’t working – we have both 50 million uninsured people (plus many millions more who are not sufficiently insured against a major medical problem), and we have rising health care costs that will destroy the federal budget over the next several decades. So when Mankiw says we need “a competitive system of private insurers, lightly regulated to ensure that the market works well,” what is he saying? That we need less regulation than we have now? Or is he just talking about abstract principles?
By James Kwak
The Paradox of Strategic Defaults
Posted: 28 Jun 2009 07:00 PM PDT
Real Time Economics and Calculated Risk both discuss new research by Paola Sapienza, Luigi Zingales, and Luigi Guiso on homeowners defaulting on mortgages even though they have the money to pay them. According to their research, 17% of households would default when their negative equity reaches 50% of the house’s value. The argument is that public policy has not sufficiently addressed this problem, focusing instead on homeowners who cannot afford their mortgages.
Let’s make this a little more concrete. Let’s say you bought a house with zero money down for $300,000 in early 2006. A few years later, the house is now worth $200,000, so your negative equity is 50% of the market value. Yet only 17% of people in your situation would walk away from the house. The other 83% would continue to pay the mortgage, essentially throwing money away. Apparently people value the transaction costs of moving and the damage to their credit ratings at $100,000 (I think my numbers are approximately on the right scale – if anything they are probably low) – even after the fact that you can live in a house for free for several months before being evicted.
Or people are not as rational as economists would assume.
By James Kwak
Sunday, June 21, 2009
Baseline Scenario -- The McAllen, Texas Problem in Health Care
This was discussed in a recent New Yorker article on health care comparisons within two different towns in Texas.
The Baseline Scenario
The McAllen Problem
Posted: 21 Jun 2009 05:00 AM PDT
What is the lesson of McAllen, Texas, the focus of Atul Gawande’s celebrated article (discussed here and here)? This is my attempt at an answer:
Currently, our health care system has high-cost and low-cost areas; the high-cost areas have no better outcomes than the low-cost areas. So theoretically we can solve our health care cost problem by making the high-cost areas behave like the low-cost areas.
However, the market incentives go in the other direction; the economically rational thing for providers (doctors, hospitals, etc.) to do is to run up procedures and thereby costs. It would be better if providers focused more on patient outcomes or organized themselves into accountable care organizations, as Gawande prefers; but there is no economic reason for them to do so. People are not magically going to become more altruistic overnight. Even shame has only a temporary effect on behavior. Here’s Gail Wilensky from a Health Affairs roundtable:
It’s only by being able to offer compelling evidence that it’s the physician that is the outlier relative to his or her peers, that the patients really aren’t different, and in fact they are not having better outcomes, that you are able to pull back physician behavior — although there seems to be a high recidivism rate.
(Emphasis added.)
In some ways McAllen isn’t the aberration; according to the old Chicago economics department, everywhere should be like McAllen.
Remember all the people who said that you can’t blame mortgage brokers and investment bankers for being greedy, because that’s how a capitalist economy works? Well, you could make the same defense for the McAllen doctors. We long ago stopped expecting lawyers and accountants to behave contrary to their economic interests; now we simply expect them to conform to the law and to certain professional codes of conduct, and otherwise make as much money as possible. Why should we expect anything different from doctors?
In a capitalist economy, the thing that is supposed to keep prices in check is the buyers. If someone offers me a product that costs more than it is worth to me, then I won’t buy it. But we can’t count on patients to play this role in health care, because there is no way to make patients internalize all of the costs of their care; they simply don’t have the money. Furthermore, most people don’t understand the health production function (the relationship between treatments and outcomes), so they don’t have the ability to select treatments that provide benefits that are worth their costs. (And, in many cases, it’s not obvious even to professionals that a treatment isn’t worth the cost; it’s only obvious when you look at the data in aggregate.)
What about payers (health insurers?) A “market” solution would be to change the reimbursement rates for different procedures – increase payment for things that doctors should do more of and reduce payment for things that doctors should do less of. Theoretically, payers should be doing this already. However, in the current situation, a private payer who tried to reduce the rates for popular, expensive procedures would find itself unable to attract providers. The only payer with any real negotiating power is Medicare. The private payers have little ability to control costs. Or, if they have the ability, they aren’t exercising it.
In short, prices will only go up. As a result, the cost of health insurance goes up, and the market finally kicks in in the crudest possible form: people who can’t afford it become uninsured. At some point, if we have enough uninsured people, the health care industry will hit a point where it cannot increase revenues anymore, because it has fewer and fewer paying customers.
The proposed public health insurance plan would have the power to negotiate lower rates with providers. That’s why some providers don’t like it. That’s also why private payers don’t like it; they would be at a cost disadvantage to the public plan. (They can live with Medicare because Medicare leaves them the entire under-65 market.) Maybe that’s unfair. But the current situation isn’t working.
By James Kwak
The Baseline Scenario
The McAllen Problem
Posted: 21 Jun 2009 05:00 AM PDT
What is the lesson of McAllen, Texas, the focus of Atul Gawande’s celebrated article (discussed here and here)? This is my attempt at an answer:
Currently, our health care system has high-cost and low-cost areas; the high-cost areas have no better outcomes than the low-cost areas. So theoretically we can solve our health care cost problem by making the high-cost areas behave like the low-cost areas.
However, the market incentives go in the other direction; the economically rational thing for providers (doctors, hospitals, etc.) to do is to run up procedures and thereby costs. It would be better if providers focused more on patient outcomes or organized themselves into accountable care organizations, as Gawande prefers; but there is no economic reason for them to do so. People are not magically going to become more altruistic overnight. Even shame has only a temporary effect on behavior. Here’s Gail Wilensky from a Health Affairs roundtable:
It’s only by being able to offer compelling evidence that it’s the physician that is the outlier relative to his or her peers, that the patients really aren’t different, and in fact they are not having better outcomes, that you are able to pull back physician behavior — although there seems to be a high recidivism rate.
(Emphasis added.)
In some ways McAllen isn’t the aberration; according to the old Chicago economics department, everywhere should be like McAllen.
Remember all the people who said that you can’t blame mortgage brokers and investment bankers for being greedy, because that’s how a capitalist economy works? Well, you could make the same defense for the McAllen doctors. We long ago stopped expecting lawyers and accountants to behave contrary to their economic interests; now we simply expect them to conform to the law and to certain professional codes of conduct, and otherwise make as much money as possible. Why should we expect anything different from doctors?
In a capitalist economy, the thing that is supposed to keep prices in check is the buyers. If someone offers me a product that costs more than it is worth to me, then I won’t buy it. But we can’t count on patients to play this role in health care, because there is no way to make patients internalize all of the costs of their care; they simply don’t have the money. Furthermore, most people don’t understand the health production function (the relationship between treatments and outcomes), so they don’t have the ability to select treatments that provide benefits that are worth their costs. (And, in many cases, it’s not obvious even to professionals that a treatment isn’t worth the cost; it’s only obvious when you look at the data in aggregate.)
What about payers (health insurers?) A “market” solution would be to change the reimbursement rates for different procedures – increase payment for things that doctors should do more of and reduce payment for things that doctors should do less of. Theoretically, payers should be doing this already. However, in the current situation, a private payer who tried to reduce the rates for popular, expensive procedures would find itself unable to attract providers. The only payer with any real negotiating power is Medicare. The private payers have little ability to control costs. Or, if they have the ability, they aren’t exercising it.
In short, prices will only go up. As a result, the cost of health insurance goes up, and the market finally kicks in in the crudest possible form: people who can’t afford it become uninsured. At some point, if we have enough uninsured people, the health care industry will hit a point where it cannot increase revenues anymore, because it has fewer and fewer paying customers.
The proposed public health insurance plan would have the power to negotiate lower rates with providers. That’s why some providers don’t like it. That’s also why private payers don’t like it; they would be at a cost disadvantage to the public plan. (They can live with Medicare because Medicare leaves them the entire under-65 market.) Maybe that’s unfair. But the current situation isn’t working.
By James Kwak
Tuesday, June 16, 2009
Baseline Scenerio
Am in Canada and was out of touch for a couple of days. May be again as more vacationers come up to choke up the bandwidth.
The Baseline Scenario
Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals
How to Sell Toxic Waste
You Don’t Get a Vote!
Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals
Posted: 15 Jun 2009 05:17 AM PDT
Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.
The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.
Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.
Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator.
Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors.
Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.”
Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.
And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compenstion within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.
There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.
Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.
By Simon Johnson
How to Sell Toxic Waste
Posted: 15 Jun 2009 05:00 AM PDT
One point I’ve made a couple of times is that complex structured financial products are sold, not bought. If you want to see how they are sold, check out Zero Hedge’s post on the lawsuit brought by those same Wisconsin school districts that were the subject of the Planet Money/New York Times feature back in November. The second attachment is the Stifel Nicolaus PowerPoint presentation used to sell those school districts a levered bet on a AA- tranche of a synthetic CDO.
It really takes you back to 2006, doesn’t it?
By James Kwak
You Don’t Get a Vote!
Posted: 14 Jun 2009 09:48 PM PDT
Barack Obama came to office as the conciliator, the bipartisanizer, the anti-Bush. But this is going too far.
The administration’s style has been to float policy proposals in public, listen to the responses (from other politicians, from the private sector, and from the blogs that Obama does not read), and adjust accordingly. When it comes to the financial regulation proposal that Tim Geithner is scheduled to deliver on Thursday, there may be little left after all the adjusting.
We heard last week that the initial plans to consolidate regulatory agencies have been scrapped, with the exception of closing the hapless Office of Thrift Supervision. Now The New York Times has a story that is ostensibly about the feud between John Dugan, the Comptroller of the Currency (and regulator of many large national banks), and Sheila Bair, head of the FDIC, but is also about the compromises that have dictated the administration’s regulatory plan.
The Treasury secretary, Timothy F. Geithner, the main author of the administration’s plan, in recent weeks has refereed among the competing views of Ms. Bair, Mr. Dugan and Ben S. Bernanke, the Federal Reserve chairman. . . .
With the administration and crucial lawmakers rejecting a single agency, the four officials have often disagreed on just how to streamline and strengthen regulation. Some points of contention include views on which agencies should play central roles in overseeing financial companies whose troubles could pose problems for the overall system, and whether to create a new agency to protect consumers from abusive mortgages or credit cards.
Officials say the latest version of the plan, in large part, is a compromise of various viewpoints.
I don’t want to get into the merits of these issues here. But when you are reforming the regulatory structure of an industry where the existing regulators got it horribly, embarrassingly, catastrophically, world-historically wrong, the last thing you want to do is strike a compromise between the positions of the existing regulators. Members of Congress get votes, and they already have enough ties to the banking industry to worry about; letting the regulators, who don’t have votes, shape the deal makes it more likely that the final result will be watered down into nothingness. Which, of course, is exactly what the industry wants:
Most of the banking industry couldn’t be happier with the current system. Bank executives and lobbyists say that the system, while flawed, enables regulators to tailor rules for a variety of financial institutions.
I know that it’s not as simple as saying that regulators don’t have votes, because they certainly have allies that do have votes, and they have allies who give money to the people who have votes. But the underlying problem is that somehow the Obama Administration managed to back itself into a corner where it had no one but the existing regulators to turn to. Geithner, Bernanke, Dugan, and Bair were all manning the ship when it hit an iceberg, and only Bair can claim that she arrived late enough not to share in the blame. (Bernanke, though he became chairman of the Fed only in 2006, was on the board of governors from 2002 and then was head of the Council of Economic Advisors.)
Shouldn’t someone with an independent perspective have been charged with this task? Paul Volcker, whom we heard so much about during the transition? Warren Buffett, whose name Obama liked to use on the campaign trail? Austan Goolsbee? Christina Romer? What happened to the best and the brightest?
All I can think is that Obama basically doesn’t think that financial regulation is that important. Or he thinks that the existing system is close enough. Or he figured that Congress would have the final word, anyway.
Or maybe Larry Summers will pull a rabbit out of his hat since, according to the Times, he is in charge anyway. While I have criticized his anti-regulatory positions of a decade ago, by his reputation – brilliant, strong-willed, etc. – I would expect more from him than from the bank regulators who helped bring us the crisis.
By James Kwak
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The Baseline Scenario
Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals
How to Sell Toxic Waste
You Don’t Get a Vote!
Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals
Posted: 15 Jun 2009 05:17 AM PDT
Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.
The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.
Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.
Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator.
Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors.
Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.”
Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.
And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compenstion within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.
There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.
Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.
By Simon Johnson
How to Sell Toxic Waste
Posted: 15 Jun 2009 05:00 AM PDT
One point I’ve made a couple of times is that complex structured financial products are sold, not bought. If you want to see how they are sold, check out Zero Hedge’s post on the lawsuit brought by those same Wisconsin school districts that were the subject of the Planet Money/New York Times feature back in November. The second attachment is the Stifel Nicolaus PowerPoint presentation used to sell those school districts a levered bet on a AA- tranche of a synthetic CDO.
It really takes you back to 2006, doesn’t it?
By James Kwak
You Don’t Get a Vote!
Posted: 14 Jun 2009 09:48 PM PDT
Barack Obama came to office as the conciliator, the bipartisanizer, the anti-Bush. But this is going too far.
The administration’s style has been to float policy proposals in public, listen to the responses (from other politicians, from the private sector, and from the blogs that Obama does not read), and adjust accordingly. When it comes to the financial regulation proposal that Tim Geithner is scheduled to deliver on Thursday, there may be little left after all the adjusting.
We heard last week that the initial plans to consolidate regulatory agencies have been scrapped, with the exception of closing the hapless Office of Thrift Supervision. Now The New York Times has a story that is ostensibly about the feud between John Dugan, the Comptroller of the Currency (and regulator of many large national banks), and Sheila Bair, head of the FDIC, but is also about the compromises that have dictated the administration’s regulatory plan.
The Treasury secretary, Timothy F. Geithner, the main author of the administration’s plan, in recent weeks has refereed among the competing views of Ms. Bair, Mr. Dugan and Ben S. Bernanke, the Federal Reserve chairman. . . .
With the administration and crucial lawmakers rejecting a single agency, the four officials have often disagreed on just how to streamline and strengthen regulation. Some points of contention include views on which agencies should play central roles in overseeing financial companies whose troubles could pose problems for the overall system, and whether to create a new agency to protect consumers from abusive mortgages or credit cards.
Officials say the latest version of the plan, in large part, is a compromise of various viewpoints.
I don’t want to get into the merits of these issues here. But when you are reforming the regulatory structure of an industry where the existing regulators got it horribly, embarrassingly, catastrophically, world-historically wrong, the last thing you want to do is strike a compromise between the positions of the existing regulators. Members of Congress get votes, and they already have enough ties to the banking industry to worry about; letting the regulators, who don’t have votes, shape the deal makes it more likely that the final result will be watered down into nothingness. Which, of course, is exactly what the industry wants:
Most of the banking industry couldn’t be happier with the current system. Bank executives and lobbyists say that the system, while flawed, enables regulators to tailor rules for a variety of financial institutions.
I know that it’s not as simple as saying that regulators don’t have votes, because they certainly have allies that do have votes, and they have allies who give money to the people who have votes. But the underlying problem is that somehow the Obama Administration managed to back itself into a corner where it had no one but the existing regulators to turn to. Geithner, Bernanke, Dugan, and Bair were all manning the ship when it hit an iceberg, and only Bair can claim that she arrived late enough not to share in the blame. (Bernanke, though he became chairman of the Fed only in 2006, was on the board of governors from 2002 and then was head of the Council of Economic Advisors.)
Shouldn’t someone with an independent perspective have been charged with this task? Paul Volcker, whom we heard so much about during the transition? Warren Buffett, whose name Obama liked to use on the campaign trail? Austan Goolsbee? Christina Romer? What happened to the best and the brightest?
All I can think is that Obama basically doesn’t think that financial regulation is that important. Or he thinks that the existing system is close enough. Or he figured that Congress would have the final word, anyway.
Or maybe Larry Summers will pull a rabbit out of his hat since, according to the Times, he is in charge anyway. While I have criticized his anti-regulatory positions of a decade ago, by his reputation – brilliant, strong-willed, etc. – I would expect more from him than from the bank regulators who helped bring us the crisis.
By James Kwak
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Wednesday, June 10, 2009
Deconstructing Judge Posner's Writings on The Bailout
Judge Posner is a favorite of mine, but I do not agree with him on very much. Herein is a good analysis of his recent writings, by Simon Johnson's sidekick James Kwak, who to me seems just as spot-on as Simon.
The Baseline Scenario
Posner, Part II: What Now?
Posted: 09 Jun 2009 04:30 AM PDT
Note: After writing this, I read Brad DeLong’s better review of Posner’s book (hat tip Felix Salmon). I won’t be offended if you go read that instead.
Part I of my comments on Richard Posner’s epic blog discussed the concept of blame. Today I am going to discuss his approach to some policy questions.
Posner’s crisis book is boldly titled “A Failure of Capitalism.” The problem is that when the lens through which you see the world is capitalism – or, more precisely, a flavor of economics that works out to justify capitalism in virtually every instance – it’s not clear what’s left over when capitalism fails.
Posner’s method is simple, and I can do it, too. Basically, for any policy, extrapolate out its effect until you can demonstrate that it will lead to a bad (and preferably non-intuitive) outcome – typically by changing the incentives for rational actors so that they no longer maximize profits and thereby social utility. When you do this enough, it becomes such second nature that you forget to spell out your arguments. Here’s a simple example:
While cramdown would have benefited some homeowners, it would have hurt lenders and thus have undermined the bank bailouts.
That’s the whole argument. Filling in the blanks, Posner is saying that because you have decided (a) to bail out banks, you cannot undertake another policy (b) - which may have its own costs and benefits – because it is in some way contrary to policy (a).
And here is Posner’s entire argument against “trillions of dollars of proposals of long-term social reform” being pushed by “the adminstration:”
Apart from creating enormous economic risks, the ambitious long-run proposals are ill timed; by further unsettling the business environment, they will further slow the economic recovery.
Leave aside the fact that the “social reform” proposals go unnamed – maybe he means health care – and that the “enormous economic risks” are unexplained. Focus on the second half of that sentence. Posner is saying that policies that create uncertainty for business necessarily impede growth. First off, this is not the situation here. Let’s assume he’s talking about health care or carbon emissions: in both cases, the uncertainty is created by the fact that everyone knows our current non-policies are unsustainable, and therefore it is precisely businesses who want systemic reform. They may not want it in the form Barack Obama wants, but they want to know what the future looks like; that’s why many major carbon emitters are lobbying for cap-and-trade (and free emissions permits), because they want to avoid a carbon tax. Second, even if uncertainty is bad for growth, Posner assumes that the benefits of those policies will not outweigh their costs; there is a tacit assumption that the benefits of government policy can never outweigh their effect on economic growth.
Obviously, I’m just warming up for the main course. Here’s Posner on fixing the banking sector:
Impatience with the [Public-Private Invesetment Program] leads some economists to advocate the government’s “nationalizing” the weak banks [I assume by this he means FDIC-style takeovers], but that would be a mistake. This is not only because of the manifest inability of the government to manage banks competently, but also because the vexing problem of valuing the overvalued assets cannot be avoided in this way. The banks are not broke; if the government takes them over, it will have to compensate the owners for the net value of the assets that the government takes, including any overvalued assets that, despite being overvalued, have some value. Perhaps what the government could do would be to take (with compensation) all the good assets of the bank, leaving the overvalued ones with the shareholders; then the bank’s balance sheet would be “clean.” But then what would it do with the bank? Run it? Sell it? The practical complications would be immense.
First, the “vexing problem of valuing the overvalued assets” does go away. If the government takes over a bank, it can transfer assets from the bank to another entity (the famous “bad bank”) at any price, or no price at all, because there is no one to negotiate with. The government does have to recapitalize the thing that is left over, and the less it “pays” for the assets the more capital it will have to add later; but how much capital the bank requires does not depend on the assets that have been removed from its balance sheet. Even if you accept that the bank in question is not broke, the amount the government might have to compensate shareholders is not the book value of their equity, but the market value – which, for Citigroup, was down in the $20 billion range at one point.
Second, and more importantly, Posner simply assumes that government ownership – in any form – is a bad thing. This is in keeping with his legacy. By contrast, though, he is relatively sanguine about the UAW’s retiree benefit trust.
Concern has been expressed that, subject to possible modifications by the bankruptcy judge, Chrysler will be controlled by the United Auto Workers and therefore managed inefficiently, as worker-managed firms typically are. But it is not true that the UAW will manage Chrysler. Not the union, but the Chrysler retirement plan, will be a shareholder in the reorganized company (in fact the principal shareholder), and it will have a fiduciary duty to maximize shareholder value rather than to increase the earnings and benefits of the current workers.
Posner clearly understands that majority owners are not managers, and that they have fiduciary duties to all shareholders. And he is willing to give the benefit of the doubt to the UAW, of all organizations. The retiree benefit trust he refers to has a board of overseers, slightly under half of whom are nominated by the UAW. But most if not all sensible advocates of bank takeovers recommended selling cleaned-up banks back into the private sector and – if that is not feasible, as would be likely for the big ones – putting the government’s stake in a trust with independent trustees. The “manifest inability of the government to manage banks competently” is just a talking point; no one thinks that pension funds, mutual funds, and life insurance companies can manage banks competently, either, yet no one is bothered by the fact that they are the primary shareholders of most public companies.
Once you recognize that free-market answers are not necessarily, unequivocally, always right, then you realize that most interesting questions can be argued one way or the other. And so Posner takes his issues on a case-by-case basis – which ends up being unsatisfying.
Take his post on banking regulation, which is full of intelligent thoughts but ultimately no recommendations. Systemic risk regulator? Bad idea, Posner says. It would deter banks from becoming big; he implies that bigness is good, without coming out and saying it – “the result may be a less efficient banking industry, if scale and position in financial markets confer substantial benefits” (emphasis added). And 100 small banks are just as risky as 20 big banks, he asserts. (I think that depends on the risk you are protecting against; it’s hard to see how five little insurance companies could have replicated the damage that AIG caused.) And it would only add to bureaucratic turf wars, because “presumably” the other regulatory agencies would be left in place.
What about going back to the old rules? Also bad. It would “reduce the availability of credit” – which is bad by assumption. And, besides, it’s impossible, because financial intermediation naturally escapes regulation through the magic of competitive markets – the activities you want to regulate will simply shift to unregulated institutions. Here’s an example:
The regulators could put a ceiling on the bank’s debt-equity ratio to limit the downside risk. But how would they determine the ratio? And would they impose a ceiling on the debt-equity ratio of all potential lenders?
This amounts to saying: (a) if there’s no perfect way to set a leverage cap, there’s no point in bothering; and (b) there’s no point in trying to regulate all institutions that could lend money.
Then Posner veers toward the theory that the Community Reinvestment Act, along with Fannie and Freddie, is really to blame. You would think he would agree, since those are forms of government intervention. But he knows that, in fact, the CRA, Fannie, and Freddie were bit players in the subprime debacle, so that can’t be the answer, either.
So in the end, Posner’s answer to the question he poses, “How Should the Banking Industry Be Regulated?,” is “not any way that anyone has suggested so far.” It seems that instead of using his talents to defend free-market capitalism, he is using those talents to shoot down any proposal anyone might make as hopelessly naive. Which is unfortunate, because I’m sure he could contribute more to the debate.
By James Kwak
“There Were Ratings That We Saw That Made No Sense To Us.”
Posted: 08 Jun 2009 07:30 PM PDT
This American Life had another good financial crisis episode by the Planet Money team this past weekend. There’s a story on regulatory holes by Chana Joffe-Walt and one on rating agencies by Alex Blumberg and David Kestenbaum. The latter had some money quotes (starting around the 40-minute mark).
Jim Finkel, Dynamic Credit, which creates structured products: “There were ratings that we saw that made no sense to us. We knew the rating agency models and metrics, and we could replicate them ourselves, and we couldn’t make sense of what they were doing.”
Felicia Grumet (sp?), Bear Stearns, who was involved in creating structured products: “It makes me feel really bad, so actually it’s very hard for me to acknowledge . . . I knew what I was doing. I knew I was doing things to get around the rules. I wasn’t proud of it, but I did it anyway.”
One of the heroes is Mabel Yu, a buy-side bond analyst at Vanguard, who couldn’t get the rating agencies to explain the ratings they were giving to structured products – and therefore refused to recommend them internally at Vanguard. Who knew? Not only do you get lower costs at Vanguard, but better fund management, too? (I have most of my money at Vanguard, but it’s in all in index funds or near-index funds, so I guess I wasn’t benefiting from Yu’s research.)
By James Kwak
The Baseline Scenario
Posner, Part II: What Now?
Posted: 09 Jun 2009 04:30 AM PDT
Note: After writing this, I read Brad DeLong’s better review of Posner’s book (hat tip Felix Salmon). I won’t be offended if you go read that instead.
Part I of my comments on Richard Posner’s epic blog discussed the concept of blame. Today I am going to discuss his approach to some policy questions.
Posner’s crisis book is boldly titled “A Failure of Capitalism.” The problem is that when the lens through which you see the world is capitalism – or, more precisely, a flavor of economics that works out to justify capitalism in virtually every instance – it’s not clear what’s left over when capitalism fails.
Posner’s method is simple, and I can do it, too. Basically, for any policy, extrapolate out its effect until you can demonstrate that it will lead to a bad (and preferably non-intuitive) outcome – typically by changing the incentives for rational actors so that they no longer maximize profits and thereby social utility. When you do this enough, it becomes such second nature that you forget to spell out your arguments. Here’s a simple example:
While cramdown would have benefited some homeowners, it would have hurt lenders and thus have undermined the bank bailouts.
That’s the whole argument. Filling in the blanks, Posner is saying that because you have decided (a) to bail out banks, you cannot undertake another policy (b) - which may have its own costs and benefits – because it is in some way contrary to policy (a).
And here is Posner’s entire argument against “trillions of dollars of proposals of long-term social reform” being pushed by “the adminstration:”
Apart from creating enormous economic risks, the ambitious long-run proposals are ill timed; by further unsettling the business environment, they will further slow the economic recovery.
Leave aside the fact that the “social reform” proposals go unnamed – maybe he means health care – and that the “enormous economic risks” are unexplained. Focus on the second half of that sentence. Posner is saying that policies that create uncertainty for business necessarily impede growth. First off, this is not the situation here. Let’s assume he’s talking about health care or carbon emissions: in both cases, the uncertainty is created by the fact that everyone knows our current non-policies are unsustainable, and therefore it is precisely businesses who want systemic reform. They may not want it in the form Barack Obama wants, but they want to know what the future looks like; that’s why many major carbon emitters are lobbying for cap-and-trade (and free emissions permits), because they want to avoid a carbon tax. Second, even if uncertainty is bad for growth, Posner assumes that the benefits of those policies will not outweigh their costs; there is a tacit assumption that the benefits of government policy can never outweigh their effect on economic growth.
Obviously, I’m just warming up for the main course. Here’s Posner on fixing the banking sector:
Impatience with the [Public-Private Invesetment Program] leads some economists to advocate the government’s “nationalizing” the weak banks [I assume by this he means FDIC-style takeovers], but that would be a mistake. This is not only because of the manifest inability of the government to manage banks competently, but also because the vexing problem of valuing the overvalued assets cannot be avoided in this way. The banks are not broke; if the government takes them over, it will have to compensate the owners for the net value of the assets that the government takes, including any overvalued assets that, despite being overvalued, have some value. Perhaps what the government could do would be to take (with compensation) all the good assets of the bank, leaving the overvalued ones with the shareholders; then the bank’s balance sheet would be “clean.” But then what would it do with the bank? Run it? Sell it? The practical complications would be immense.
First, the “vexing problem of valuing the overvalued assets” does go away. If the government takes over a bank, it can transfer assets from the bank to another entity (the famous “bad bank”) at any price, or no price at all, because there is no one to negotiate with. The government does have to recapitalize the thing that is left over, and the less it “pays” for the assets the more capital it will have to add later; but how much capital the bank requires does not depend on the assets that have been removed from its balance sheet. Even if you accept that the bank in question is not broke, the amount the government might have to compensate shareholders is not the book value of their equity, but the market value – which, for Citigroup, was down in the $20 billion range at one point.
Second, and more importantly, Posner simply assumes that government ownership – in any form – is a bad thing. This is in keeping with his legacy. By contrast, though, he is relatively sanguine about the UAW’s retiree benefit trust.
Concern has been expressed that, subject to possible modifications by the bankruptcy judge, Chrysler will be controlled by the United Auto Workers and therefore managed inefficiently, as worker-managed firms typically are. But it is not true that the UAW will manage Chrysler. Not the union, but the Chrysler retirement plan, will be a shareholder in the reorganized company (in fact the principal shareholder), and it will have a fiduciary duty to maximize shareholder value rather than to increase the earnings and benefits of the current workers.
Posner clearly understands that majority owners are not managers, and that they have fiduciary duties to all shareholders. And he is willing to give the benefit of the doubt to the UAW, of all organizations. The retiree benefit trust he refers to has a board of overseers, slightly under half of whom are nominated by the UAW. But most if not all sensible advocates of bank takeovers recommended selling cleaned-up banks back into the private sector and – if that is not feasible, as would be likely for the big ones – putting the government’s stake in a trust with independent trustees. The “manifest inability of the government to manage banks competently” is just a talking point; no one thinks that pension funds, mutual funds, and life insurance companies can manage banks competently, either, yet no one is bothered by the fact that they are the primary shareholders of most public companies.
Once you recognize that free-market answers are not necessarily, unequivocally, always right, then you realize that most interesting questions can be argued one way or the other. And so Posner takes his issues on a case-by-case basis – which ends up being unsatisfying.
Take his post on banking regulation, which is full of intelligent thoughts but ultimately no recommendations. Systemic risk regulator? Bad idea, Posner says. It would deter banks from becoming big; he implies that bigness is good, without coming out and saying it – “the result may be a less efficient banking industry, if scale and position in financial markets confer substantial benefits” (emphasis added). And 100 small banks are just as risky as 20 big banks, he asserts. (I think that depends on the risk you are protecting against; it’s hard to see how five little insurance companies could have replicated the damage that AIG caused.) And it would only add to bureaucratic turf wars, because “presumably” the other regulatory agencies would be left in place.
What about going back to the old rules? Also bad. It would “reduce the availability of credit” – which is bad by assumption. And, besides, it’s impossible, because financial intermediation naturally escapes regulation through the magic of competitive markets – the activities you want to regulate will simply shift to unregulated institutions. Here’s an example:
The regulators could put a ceiling on the bank’s debt-equity ratio to limit the downside risk. But how would they determine the ratio? And would they impose a ceiling on the debt-equity ratio of all potential lenders?
This amounts to saying: (a) if there’s no perfect way to set a leverage cap, there’s no point in bothering; and (b) there’s no point in trying to regulate all institutions that could lend money.
Then Posner veers toward the theory that the Community Reinvestment Act, along with Fannie and Freddie, is really to blame. You would think he would agree, since those are forms of government intervention. But he knows that, in fact, the CRA, Fannie, and Freddie were bit players in the subprime debacle, so that can’t be the answer, either.
So in the end, Posner’s answer to the question he poses, “How Should the Banking Industry Be Regulated?,” is “not any way that anyone has suggested so far.” It seems that instead of using his talents to defend free-market capitalism, he is using those talents to shoot down any proposal anyone might make as hopelessly naive. Which is unfortunate, because I’m sure he could contribute more to the debate.
By James Kwak
“There Were Ratings That We Saw That Made No Sense To Us.”
Posted: 08 Jun 2009 07:30 PM PDT
This American Life had another good financial crisis episode by the Planet Money team this past weekend. There’s a story on regulatory holes by Chana Joffe-Walt and one on rating agencies by Alex Blumberg and David Kestenbaum. The latter had some money quotes (starting around the 40-minute mark).
Jim Finkel, Dynamic Credit, which creates structured products: “There were ratings that we saw that made no sense to us. We knew the rating agency models and metrics, and we could replicate them ourselves, and we couldn’t make sense of what they were doing.”
Felicia Grumet (sp?), Bear Stearns, who was involved in creating structured products: “It makes me feel really bad, so actually it’s very hard for me to acknowledge . . . I knew what I was doing. I knew I was doing things to get around the rules. I wasn’t proud of it, but I did it anyway.”
One of the heroes is Mabel Yu, a buy-side bond analyst at Vanguard, who couldn’t get the rating agencies to explain the ratings they were giving to structured products – and therefore refused to recommend them internally at Vanguard. Who knew? Not only do you get lower costs at Vanguard, but better fund management, too? (I have most of my money at Vanguard, but it’s in all in index funds or near-index funds, so I guess I wasn’t benefiting from Yu’s research.)
By James Kwak
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