Category Archives: Financial Crises

Knowledge vs. Incentives

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Ing-Haw Cheng, Sahil Raina, and Wei Xiong write,

Our analysis shows little evidence of securitization agents’ awareness of a housing bubble and impending crash in their own home transactions. Securitization agents neither managed to time the market nor exhibited cautiousness in their home transactions. They increased, rather than decreased, their housing exposure during the boom period through second home purchases and swaps into more expensive homes. This difference is not explained by differences in financing terms such as interest rates, or refinancing activity, and is more pronounced in the relatively bubblier Southern California region compared to the New York metro region. Our securitization agents’ overall home portfolio performance was significantly worse than that of control groups. Agents working on the sell-side and for firms which had poor stock price performance through the crisis did particularly poorly themselves.

Of course, the bad incentives in the securitization market could have selected for people who believed in the housing bubble. Still, I believe that the authors have dispelled a notion that the “insiders” knew more than the “outsiders” about the housing bubble.

UPDATE: James Hamilton comments

Suppose we gave an individual securitization agent perfect foresight of what was to come, that is, exact knowledge of the current and future path of their personal bonuses, stock options, and career path. If they had this information, would they have made the same decisions as they actually made in 2005-2006? If so, that would be confirmation that the basic problem was one of misaligned incentives.

Cyprus: Have a Nice Day

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The New York Times reports

In the early hours of Saturday morning, after 10 hours of talks, finance ministers from euro area countries, the International Monetary Fund and the European Central Bank agreed on terms that include a one-time tax of 9.9 percent on Cypriot bank deposits of more than 100,000 euros, and a tax of 6.75 percent on smaller deposits, European Union officials said.

Pointer from Tyler Cowen, who thought it worthy of a follow-up. A couple of further thoughts:

My understanding is that the depositors would receive bank equity in exchange for debt. No one believes that this will make them happy. (Perhaps the depositors should be asked to read Admati and Hellwig?) In fact, every economist I have read has pretty much the same reaction as mine to this policy.

While a surprise tax on bank deposits may seem like the best idea that the eurocrats could come up with under the circumstances, it might not bode well for the longer term. In terms of the two drunks model, this looks like both drunks falling down without making it home.

Consider: Suppose that you hold bank deposits in a bank in a fiscally troubled country, such as Italy, Portugal, Spain, or Japan. You are deciding whether to keep those deposits there. Until Friday, you had not considered that the government might confiscate a portion of your deposits. Now, how much assurance do you need that your deposits will not be suddenly taxed in order to keep you from running to your bank and shifting your funds elsewhere? Solve for the equilibrium, as Tyler would say.

Banks and Government

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The second of my essays on the function of banks. In this one, I talk about their relationship with government.

Think of two friends who walk to a neighborhood bar every Saturday night. On a given Saturday, the first friend may be too drunk to walk without assistance, and he may have to lean on the second friend in order to make it home. The following Saturday, it could be the second friend who needs to be supported in order to get home. However, if both of them get too drunk and try to lean on one another to get home, they may collapse together.

This is how I picture the current situation in Europe. Many European banks are unsteady. They need government guarantees and capital injections in order to stay in business. At the same time, many European governments are heavily indebted and running large deficits. They need banks to continue to lend to them in order to fund their spending.

Read the whole thing. My prescription for addressing the relationship between banks and governments is to try to apply the approach of “limited guarantees, for limited purposes.”

Fiscal Crunch Time

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John Cochrane links to a WSJ editorial and a working paper by Greenlaw, Hamilton, Hooper, and Mishkin. The authors make the point that I have been making, which is that when government has accumulated a lot of debt, an increase in interest rates can be catastrophic. This almost forces the central bank to abandon its inflation-fighting goals when the crunch hits.

On the basis of intellectual history, there is another prominent economist who one might expect to endorse and amplify these concerns. He would dismiss the current low interest rates as Wile E. Coyote market behavior. He would trot out diagrams illustrating multiple equilibria. But that economist seems to have disappeared.

Kyle Bass thinks that this scenario will appear in Japan before it strikes Europe or the United States. If you are familiar with John Mauldin, then you know what Bass is going to say.

Most of the questions that Bass gets are “What should an ordinary investor buy?” Interestingly, I get that question a lot from friends on the left. I think that all of us happen to be at an age, close to 60, where the worst case scenario is that your savings take a big hit. If you were 40, you would figure that your human capital is still your most important asset. If you were 80, you would say that you don’t have to worry about how far your savings will go.

I would say that my worries would go away if the politics in this country shifted toward the right. Presumably, that is not where my friends on the left are coming from. My guess is that they connect their fears about preserving the value of their savings with doubts about the capitalist system in general.

Bass suggests oil wells, apartments, and firms with productive assets. I have shifted in that direction the past couple of years, so anyone who has been betting on the U.S. stock market as a whole has been doing better than I have lately. And I hope they continue to do so. Because there is no hedge against a breakdown of the social fabric, which is what Bass is predicting for Japan. There, if he is correct, the worst case scenario for a 60 year old is about to become reality.

John Cochrane on Banking, Expert Forecasting

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1. He liked Admati and Hellwig more than I did.

Ms. Admati and Mr. Hellwig do not offer a detailed regulatory plan. They don’t even advocate a precise number for bank capital, beyond a parenthetical suggestion that banks could get to 20% or 30% quickly by cutting dividend payments. (I would go further: Their ideas justify 50% or even 100%: When you swipe your ATM card, you could just sell $50 of bank stock.)

I think he is being careless. My own essay tries to consider why households would prefer to hold bank debt rather than bank equity. Keep in mind, however, that all of us agree that the relationship between government and banks is problematic, and that the problems are not solved by regulation.

2. He cites a nice essay by Alex Pollock listing statements by regulators prior to the housing crisis that showed their mindset before the crisis. They thought they had everything under control. In 2009, they changed their minds. Now, with Dodd-Frank, they tell us they have everything under control again. Note that Pollock could have included many more pre-crisis quotes, such as the “before” quote from Ben Bernanke.

Of course, Bernanke still believes that we live in mediocristan. On the outlook for long-term interest rates, the other day He said,

While these forecasts embody a wide range of underlying models and assumptions, the basic message is clear–long-term interest rates are expected to rise gradually over the next few years, rising (at least according to these forecasts) to around 3 percent at the end of 2014. The forecasts in chart 4 imply a total increase of between 200 and 300 basis points in long-term yields between now and 2017.

Of course, the forecasts in chart 4 are just forecasts, and reality might well turn out to be different. Chart 5 provides three complementary approaches to summarizing the uncertainty surrounding forecasts of long-term rates. The dark gray bars in the chart are based on the range of forecasts reported in the Blue Chip Financial Forecasts, the blue bars are based on the historical uncertainty regarding long-term interest rates as reflected in the Board staff’s FRB/US model of the U.S. economy, and the orange bars give a market-based measure of uncertainty derived from swaptions. These three different measures give a broadly similar picture about the upside and downside risks to the forecasts of long-term rates. Rates 100 basis points higher than the expected paths in chart 4 by 2014 are certainly plausible outcomes as judged by each of the three measures, and this uncertainty grows to as much as 175 basis points by 2017.

Pointer from Mark Thoma.

Jeff Sachs on the Administration’s Budget Plans

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He writes,

In effect, he would allow rising outlays on mandatory programmes such as Medicaid and Social Security and debt servicing to crowd out public investments that are vital for America’s long-term economic future…

Mr Obama probably hoped that when the moment of truth arrived, when the spending cuts started to bite, the American people would support higher taxes rather than the spending cuts long called for in his own budget proposals. And perhaps they will still do so. Yet he has never presented an alternative with more robust tax revenues in order to fund a higher sustained level of public investments and services.

Pointer from Tyler Cowen.

I know that the conventional wisdom is that Republicans and conservatives are hopelessly irrational and self-contradictory on fiscal policy. Let us stipulate that such is the case. That does not mean that the Democrats and progressives are rational and coherent. If someone on the left can point me to a budget that does what you want, does not lead to explosive deficits, and does not depend on spending an imaginary dividend of “lower health care costs, through magic,” I would like to see it.

To put it this another way, I think that even if the entire conservative side of the political spectrum were to collapse tommorrow, the left still could not govern.

The Debt the Italians Owe to Themselves

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The Wall Street Journal reports on generational conflict in Italy.

Over the past two decades Italy has run €1.3 trillion in such [primary] surpluses, averaging 4% of GDP a year, says Giuseppe Alvaro, an economist in Rome and an expert on Italy’s national accounts. Public debt has nonetheless risen—it is now €2 trillion—and the austerity must continue. Because much of today’s working population has never benefited from excess public spending, “they may feel rather reluctant to give back what they never received,” Mr. Alvaro says.

Pointer from Tyler Cowen.

As I pointed out in Lenders and Spenders, the problem with deficit spending is that it creates an arbitrary distribution of burden within a country, causing political conflict.

We are very likely to replicate the Italian experience. Local governments are going to raise taxes and reduce services, in order to pay pension benefits to retired government workers. And at some point the Federal government will have to run large primary surpluses, just as Italy has been forced to do, with similar consequences.

In an earlier post, Tyler comments on the observation that few people in Washington are worried about the deficit. Tyler’s riposte:

That is why you should care about the budget deficit.

I have been thinking along similar lines. The arguments that Thoma, Krugman, and others make for not worrying about the deficit are, in fact, a major reason why I worry about the deficit. Conversely, if they would argue in favor of worrying about the deficit, then I might be less worried about it.

Ben Bernanke, Before and After

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1. Before (June 12, 2006):

in the area of market risk, advances in data processing have enabled more analytically advanced and more comprehensive evaluations of the interest rate risks associated with individual transactions, portfolios, and even entire organizations. Institutions of all sizes now regularly apply concepts such as duration, convexity, and option-adjusted spreads in the context of analyses that ten years ago would have taxed the processing capabilities of all but a handful of large institutions. From the perspective of bank management and stockholders, the availability of advanced methods for managing interest rate risk leads to a more favorable risk-return tradeoff. For supervisors, the benefit is a greater resilience of the banking system…

Today, credit-risk management encompasses both loan reviews and portfolio analysis. Moreover, the development of new technologies for buying and selling risks has allowed many banks to move away from the traditional book-and-hold lending practice in favor of a more active strategy that seeks the best mix of assets in light of the prevailing credit environment, market conditions, and business opportunities. Much more so than in the past, banks today are able to manage and control obligor and portfolio concentrations, maturities, and loan sizes, and to address and even eliminate problem assets before they create losses. Many banks also stress-test their portfolios on a business-line basis to help inform their overall risk management.

2. After (March 22, 2012):

A second, very important problem was that during this period, financial transactions were becoming more and more complex but the ability of banks and other financial institutions to monitor and measure those risks was not keeping up. That is, their IT systems and resources they devoted to risk management were insufficient…So if in 2006 you asked a bank about the effect if house prices fell 20 percent, it probably would have greatly underestimated the impact on its balance sheet because it did not have the capacity to measure accurately or completely the risks that it was facing.

For (2) I am quoting from the version of Bernanke’s lectures that is printed in The Federal Reserve and the Financial Crisis, sent to me Princeton University Press. Perhaps someone can find a written transcript on line.

Given (1), I find (2) to be disingenuous. Also, in the lecture “Response to the financial crisis,” Bernanke says

when the mortgage-backed securities started going bad, it became evident that AIG was in big trouble and its counterparties began demanding cash or refusing to fund AIG, and it came under tremendous pressure.

In our estimation, the failure of AIG would have been basically the end. It was interacting with so many different firms. It was so interconnected with both the U.S. and the European financial systems and global banks.

This is also disingenous. The problem at AIG was the demands for collateral coming from Goldman Sachs and a number of foreign banks. It was those institutions that needed bailing out, not AIG. I still like what I wrote back in October of 2008.

It is highly unlikely that the buoyancy of the U.S. economy depends on the liveliness of the Liar’s Poker game of mortgage securities trading. We should resist panic reactions and emergency bailouts.

My alternative to bailouts was what I termed the stern sheriff approach. I wrote,

I think that the people who insist on Treasuries as collateral should have to pay a financial penalty, just as someone who has a CD at a bank can be assessed a penalty for early withdrawal. By punishing liquidity preference, we could stop the liquidity squeeze.

The government could have made it difficult for Goldman Sachs and other counterparties to grab low-risk assets from AIG. Staying within the law, simply requiring those counterparties to go to court would have done the trick. Instead, the government essentially seized AIG, paid off the counterparties, and then sold off huge chunks of AIG to avoid taking a loss. If the government was going to exercise arbitrary power that way, it could just as easily have exercised that power to keep AIG liquid and force Goldman and the others to raise short-term funds through other means.

Tyler Cowen on Inflation: “Probably Not”

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He writes,

Everything we were taught about the monetary base is wrong in a world with interest on reserves (IOR). A large base can sit there forever. The price level is not proportional to the base, changes in the base, etc. It just isn’t. The broader aggregates, such as M2, haven’t grown so rapidly.

But consider the scenario that worries me. Our debt continues to increase. Nominal interest rates rise, so the government has to borrow more just to finance the debt. Congress wants to avoid having to cut spending elsewhere, and the Fed is asked to do its part.

Tyler points out that the Fed could increase its purchases of Treasuries without increasing the money supply. However, the mechanism for doing this is to raise the interest rate that it pays on reserves. That mechanism does not solve the problem of lowering the government’s interest costs, which is what I think is the nub of the scenario that I am talking about.

My guess is that in practice, for a variety of reasons, when the cost of government debt starts to rise, the Fed is not going to be willing/able to sterilize its funding of the debt, through IOR or any other means. We are going to see both intended and unintended monetary expansion, and that will produce inflation.

As usual, let me say that I am not blaming the Fed or saying that inflation is just around the corner. When really out-of-control inflation emerges, it is a fiscal phenomenon.

Two Articles on Retirement

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First, Sunday’s lead story in the Washington Post.

For the first time since the New Deal, a majority of Americans are headed toward a retirement in which they will be financially worse off than their parents, jeopardizing a long era of improved living standards for the nation’s elderly, according to a growing consensus of new research.

You know you are headed for a low-quality article when it starts that way.

1. First off, that sentence may turn out to be wrong. Living standards for those about to retire may well turn out to be fantastic.

2. To the extent that Americans are potentially outliving their saving, it has a lot to do with the “outliving” aspect. People are living longer.

3. Revealed preference suggests that people think that they are in good enough financial shape to retire. Anecdotes and exceptions aside, the average trend is toward retiring younger, not older. Even though people are much healthier at age 65 then they used to be, and many jobs are less physically demanding.

4. The article never addresses the fact that from an aggregate saving point of view, Social Security is the problem, not the solution. It creates disincentives to work and save, so that we have less output and less capital than otherwise.

Next, a story from Kiplinger’s.

Retiring abroad can offer a host of advantages over buying a condo in Florida. Living expenses can be cheaper, cultural experiences richer and the lifestyle more satisfying — even in some places in Europe.

The article proceeds to list eight inexpensive places. I do not see elderly people wanting to pull up their roots and move to faraway places. If they are willing to do so for a lower cost of living, then that would be a sign that financial issues really are pressing. On the other hand, my guess is that staying for a month in one of the recommended cities will appeal to a lot of people who are looking for relatively low-cost trip.