Category Archives: Financial Crises

What I’m Reading

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New books by Kevin Williamson and by Tim Kane and Glenn Hubbard. Both take as their premise the thesis that the U.S. is on an unsustainable fiscal course. In The End Is Near and It’s Going to be Awesome, Williamson treats this as an opportunity, while in Balance, Kane and Hubbard treat it as a threat. Perhaps it would be appropriate at some point to jointly review them at length.

If I might boil the Kane-Hubbard book down to one sentence, it would be that without a balanced budget amendment to avert fiscal collapse, America will lose its great power status. I can imagine conservatives, thinking in terms of the civilization-barbarism axis, nodding firmly in agreement. However, by the same token, I can picture progressives and libertarians shrugging with indifference.

Williamson appears to be in the latter category. So far (I am less than 1/3rd finished), the book is assembling a standard array of libertarian arguments. Anyone who already resonates to the freedom-coercion axis is bound to like it. My guess is that Williamson is headed toward an embrace of what I have called civil societarianism. So far, it looks as though he is arguing for views that I share, although he expresses them with greater certitude.

The Home Borrowership Crisis

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Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen of the Boston Fed write,

the facts refute the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors. Instead, they argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices

This paper from last year was cited the other day by Scott Sumner.

One quibble I have is that the paper makes it sound as if the only variable that shifted during the run-up to the crisis was house price expectations. In fact, the proportion of loans with down payments less than 10 percent shot up (even the authors have a figure showing that the market share of loans with down payments under 5 percent nearly doubled, to almost 30 percent of loans, in just four years–from 2002 to 2006), the proportion of loans backed by non-owner-occupied properties (i.e., speculative investments) went from roughly 5 percent to roughly 15 percent, and the proportion of loans that went to borrowers with lower credit scores also rose.

Of course, the expectations of rising home prices helped fuel the decline in lending standards, because you cannot be punished for making a bad loan in a rising market. And the deterioration in lending standards helped fuel rising home prices, because it broadened the market to buy homes. Hence the bubble.

Facts About Austerity in the U.S.

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From CBO head Doug Elmendorf. I focused on the 7th slide, comparing 2012 with 40-year averages. The figures are as a percent of GDP.

Category 40-year average 2012
Net Interest 2.2 1.4
All other spending 7.9 9.1
Defense 4.7 4.3
Social Security and Medicare 6.2 7.9
Revenue 17.9 15.8

Pointer from James Hamilton. I hope Mark Thoma will link to me here, because he is forever linking to posts that spin the fiscal data in a way that is very different from how I see it. What stands out to me is this:

Where is the austerity in the budget, i.e., the biggest shortfall in spending from the 40-year average? It is in “net interest.” It is definitely not in domestic discretionary spending (the “all other spending” category).

The “austerity” comes from low interest rates, which cause interest payments to be low. Think about that.

I note that yesterday’s employment report showed that the first four months of 2013, under “austerity,” were much better than 2009, under “stimulus.” I know that other things were not equal. They never are. Any macroeconomist can argue that he is always right, because the interpretation of data has so many degrees of freedom.

More Trouble for Risk Weights

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From Viral V. Acharya, Robert Engle, and Diane Pierret.

Macroprudential stress tests have been employed by regulators in the United States and Europe to assess and address the solvency condition of financial firms in adverse macroeconomic scenarios. We provide a test of these stress tests by comparing their risk assessments and outcomes to those from a simple methodology that relies on publicly available market data and forecasts the capital shortfall of financial firms in severe market-wide downturns. We find that: (i) The losses projected on financial firm balance-sheets compare well between actual stress tests and the market-data based assessments, and both relate well to actual realized losses in case of future stress to the economy; (ii) In striking contrast, the required capitalization of financial firms in stress tests is found to be rather low, and inadequate ex post, compared to that implied by market data; (iii) This discrepancy arises due to the reliance on regulatory risk weights in determining required levels of capital once stress-test losses are taken into account. In particular, the continued reliance on regulatory risk weights in stress tests appears to have left financial sectors under-capitalized, especially during the European sovereign debt crisis, and likely also provided perverse incentives to build up exposures to low risk-weight assets.

UPDATE: A reader forwards a link to these slides, in which Mark Flannery points out that Basel risk weights are based on book values, rather than market values.

Some Sentences

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1. From Reihan Salam.

Right now, we’re stuck in a political debate in which a federal government that spends, say, 24 percent of GDP represents tyranny while a federal government that spends 19 percent of GDP represents a free society, irrespective of state and local expenditures, tax expenditures, off-balance-sheet activities, and the cost of regulatory initiatives. The end result is that we have endless debates over spending levels while ignoring, for example, the shadow nationalization of the mortgage market and the perverse buck-passing dynamic created by cooperative federalism programs that fuels the growth of state and local government.

2. From Philip Moeller.

“The best childhood personality predictor of longevity was conscientiousness—the qualities of a prudent, persistent, well-organized person,” according to the two professors (he at the University of California—Riverside, and she at La Sierra University). “Conscientiousness … also turned out to be the best personality predictor of long life when measured in adulthood.”

3. Carmen Reinhart.

it is certainly more difficult for a central banker to raise interest rates with a debt to gross domestic product ratio of over 100 percent than it is when this ratio stands at 39 percent. Therefore, I believe the shift towards less independence of monetary policy is not just a temporary change.

Charles Calomiris on Politics and Banking

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From the WSJ:

That anti-populist political system — known in political science as liberal constitutionalism or liberal democracy — is a key ingredient in Canada’s stable banking track record, Mr. Calomiris contends in his paper, which is a summary of a much longer book he’s written with Stephen Haber due out in September. That’s because this kind of political system makes it difficult for political majorities to gain control of the banking system for their own purposes, the authors contend.

Having only experienced the American system, I think of politics and banking as hopelessly entangled. As I recently put it,

Politicians want to make credit allocation decisions. Whatever its nominal purpose, bank regulation is used to enable politicians to undertake credit allocation.

Calomiris seems to take the same point of view, but he argues that some political systems are less susceptible to interest groups gaining control of bank regulation. I am interested in reading more about the research. Meanwhile, you should at least read the whole WSJ piece.

Basel and the So-Called Savings Glut

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Thomas Hoenig and I have new commentaries expressing similar thoughts. Hoenig said,

We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights. The objective is to maximize a firm’s return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management. This creates the illusion that banking organizations have adequate capital to absorb unexpected losses. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets. This “leveraging up” has served world economies poorly.

Read the whole thing. Then read my latest essay.

So what accounts for the low interest rate on long-term bonds, particularly those of the U.S. government? It is not “quantitative easing.” It is not a mysterious shift in preferences among savers. It is that banks, which enjoy enormous advantages in attracting funds from savers due to actual and perceived protection offered by governments, have a strong incentive to direct these savings into financial instruments that their regulators have designated as having little or no risk. Risk-based capital regulations may be ineffective at promoting bank safety. But they are plenty effective at allocating capital away from productive private investments and toward government bonds.

I also thought the Hoenig quote worth including in the essay.

Kling’s Law of Bank Capital Regulation

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Thomas L. Hogan, Neil Meredith, and Xuhao Pan write,

we find that the standard capital ratio is significantly better than the RBC ratio as an indicator of bank risk and performance and that using both ratios simultaneously does not produce better results. Taken in conjunction with the other available evidence, our findings indicate that RBC regulations lead to more risk-taking by individual banks, and more overall risk in the banking system, without improving the effectiveness of the Fed’s capital regulations.

RBC = risk-based capital. Kling’s law is that the capital measure used by regulators will, over time, come to be outperformed by a measure that the regulators are not using. So, if you are using standard capital, risk-based capital measures will better predict bank risk, and conversely.

The reason can be found in my essay, The Chess Game of Financial Regulation.

Regulatory systems break down because the financial sector is dynamic. Financial institutions seek to maximize returns on investment, subject to regulatory constraints. As time goes on, they develop techniques and innovations that produce greater returns but which can also undermine the intent of the regulations.

The Basel Did It

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Ken Rogoff has described a mystery.

As policymakers and investors continue to fret over the risks posed by today’s ultra-low global interest rates, academic economists continue to debate the underlying causes. By now, everyone accepts some version of US Federal Reserve Chairman Ben Bernanke’s statement in 2005 that a “global savings glut” is at the root of the problem. But economists disagree on why we have the glut, how long it will last, and, most fundamentally, on whether it is a good thing.

Brad DeLong suggests that this is

a catastrophic market failure in the inability of financial markets to properly mobilize the risk-bearing capacities of society as a whole

So who done it? My nominee is Basel. The Basel capital accords blessed certain assets as “low risk.” This fueled growth of Freddie and Fannie. Then, in 2000, private securities with AAA ratings were added to the list, fueling a boom there. We know how that turned out.

The financial crisis served to differentiate two types of investments–the ones that get bailed out and the ones that don’t. Investors naturally have a preference for the former. That means big banks can get cheap credit. And what does Basel tell them they can do with their cheap credit? Buy government bonds.

So what we have had over the past ten years is a massive exercise in credit allocation by the world’s bank regulators. They offer explicit and implicit guarantees to banks that invest in assets officially designated as low risk, and now they are shocked, shocked to find capital pouring into exactly those assets.

Macro-Prudential Tools

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Olivier Blanchard explains, (link fixed)

It’s very clear that the traditional monetary and fiscal tools are just not good enough to deal with the very specific problems in the financial system. This has led to the development of macro-prudential tools, which what may or may not become the third leg of macroeconomic policies.

[Macroprudential tools allow a central bank to restrain lending in specific sectors without raising interest rates for the whole economy, such as increasing the minimum down payment required to get a mortgage, which reduces the loan-to-value ratio.] In principle, they can address specific issues in the financial sector. If there is a problem somewhere you can target the tool at the problem and not use the policy interest rate, which basically is kind of an atomic bomb without any precision.

The big question here is: How reliable are these tools? How much can they be used? The answer — from some experiments before the crisis with loan-to-value ratios and during crisis with variations in cyclical bank capital ratios or loan-to-value ratios or capital controls, such as in Brazil — is this: They work but they don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere.

Although Blanchard is appropriately cautious about these tools, I do not think that he is sufficiently cynical. I wrote,

Politicians want to make credit allocation decisions. Whatever its nominal purpose, bank regulation is used to enable politicians to undertake credit allocation.