Category Archives: Financial Crises

What is the Meaning of Too Big to Fail?

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Timothy Taylor writes,

It seems to me that the key here is to remember that maybe some institutions are too big to fail, but they aren’t too big to suffer! In particular, they aren’t too big to have their top managers booted out–without bonuses. They aren’t too big to have their shareholders wiped out, and the company handed over to bondholders–who are then likely to end up taking losses as well. One task of financial regulators should be to design and pre-plan an “orderly resolution” as they call it. The trick is to devise ways so that if these systemically important firms run into financial difficulties, the tasks and external obligations of certain large financial firms will not be much disrupted, for the sake of financial stability,but those who invest in those firms and who manage them will face costs.

Taylor points to an interesting report on the banks that are currently classified as too big to fail.

I think that when the time comes, “orderly resolution” will always seem to be an oxymoron. The bankruptcy of Lehman Brothers was resolved in an orderly way. The only problem was that one creditor, Reserve Primary, had loaded up on Lehman paper, so its money market fund shares were no longer worth a dollar each. The Wall Street-Washington axis saw this as a catastrophic event, and thus was launched TARP and other bailouts. In restrospect, these seem to have been mostly robbing Peter to pay Paul: taking money from GM investors and giving it to the unions, selling off AIG’s profitable lines of business in order to provide cash to Goldman Sachs and foreign banks, etc.

The way to think about this issue is to remember how Freddie Mac and Fannie Mae handled their too-big-to-fail status. They knew that their biggest risk was political risk, so they acquired tremendous political muscle. Conversely, members of Congress knew that Freddie and Fannie would be pliable, so these members leaned on Freddie and Fannie to pursue “affordable housing” goals. We know how that worked out.

Political officials and big banks have plenty of opportunities for mutual gains at the expense of taxpayers. That is why I have long favored breaking up big banks. It’s not that big banks produce more inherent instability. It’s that they produce more inherent cronyism.

Jeremy Stein on Credit Markets

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His says,

a fundamental challenge in delegated investment management is that many quantitative rules are vulnerable to agents who act to boost measured returns by selling insurance against unlikely events–that is, by writing deep out-of-the-money puts. An example is that if you hire an agent to manage your equity portfolio, and compensate the agent based on performance relative to the S&P 500, the agent can beat the benchmark simply by holding the S&P 500 and stealthily writing puts against it, since this put-writing both raises the mean and lowers the measured variance of the portfolio.7 Of course, put-writing also introduces low-probability risks that may make you, as the end investor, worse off, but if your measurement system doesn’t capture these risks adequately–which is often difficult to do unless one knows what to look for–then the put-writing strategy will create the appearance of outperformance.

The whole speech is a must-read. One more excerpt:

Quantifying risk-taking in credit markets is difficult in real time, precisely because risks are often taken in opaque ways that escape conventional measurement practices. So we should be humble about our ability to see the whole picture, and should interpret those clues that we do see accordingly.

Tracking the Financial Crisis Lawsuits

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Let’s see.

1. The Justice Department is suing a rating agency (Standard and Poor’s). The rating agencies are creatures of the SEC (which created their oligopoly and encouraged them to be paid by the raters rather than the customers of the ratings).

2. The SEC is suing Freddie and Fannie, which are creatures of the Department of Housing and Urban Development, under which the two firms were regulated and also given lending quotas for “affordable housing.”

So, when is HUD going to sue a company that is a creature of the Justice Department, just to complete the circle?

One way to view the period 2005-2009 is as a massive destruction of property rights by the government. First, they destroy the right of Freddie, Fannie, and commercial banks to maintain lending standards. Then they confiscate the property of holders of securities in GM and Chrysler to pay off the labor unions. Then they sell off AIG’s assets in order to bail out Goldman Sachs and several large foreign banks. And of course, the government has made every effort to keep banks from enforcing mortgage contracts, while extracting large fines from banks.

It’s beyond crony capitalism. It’s protection-racket capitalism.

No, I am not saying that the private firms did everything right. But whatever the problem with markets, government extortion is not likely to prove to be a good solution.

Housing and Wealth Destruction

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Thomas J. Sugrue writes,

The bursting of the real estate bubble has been a catastrophe for the broad American middle class as a whole, but it has been particularly devastating to African Americans. According to the Center for Responsible Lending in Durham, North Carolina, nearly 25 percent of African Americans who bought or refinanced their homes between 2004 and 2008 (and an equivalent share among Latinos) have already lost or will end up losing their homes—compared to 11.9 percent of white families in the same situation. This disparate impact of the housing crash has made the racial gap in wealth even more extreme. As Reid Cramer, director of the Asset Building Program at the New America Foundation, puts it, “Basically, we have gone from an average minority family owning 10 cents to the dollar compared to the average white family to now owning less than a nickel.” The median black family today holds only $4,955 in assets.

Sugrue can only process this through the oppressor-oppressed model. He blames predatory lending. If he could open his eyes a little wider, he might be able to see the role played by government housing policy. Some notes:

1. From a wealth-destruction perspective, you cannot just look at the people who lost their homes. People who stayed current on their mortgages nonetheless experienced wealth destruction.

2. Probably more borrowers were “victimized” by Freddie Mac, Fannie Mae, and FHA than by Wall Street. That is, my guess is that a majority of the homeowners whose wealth has been crushed paid for their homes with loans backed by one of those agencies.

Speaking of housing, Luigi Zingales finds some numbers regarding occupancy fraud.

In fact, the authors find that more than 6% of mortgage loans misreport the borrower’s occupancy status, while 7% do not disclose second liens.

You get a lower rate by saying you plan to live in the home, so speculators will often lie about that. One of the reasons that programs to “help owners stay in their homes” are not doing very much is that a lot of those owners never occupied the homes in the first place.

Zingales references a working paper that I cannot find. Thus, I cannot tell whether the borrowers defrauded the lenders or the lenders defrauded the investors who bought the loans. I always presume that it is the borrower instigating the fraud. However, Zingales says that the bankers should be prosecuted. He makes it sound as if the lenders would record a loan internally as backed by an investment property and report it to investors as an owner-occupied home. That would require a much more complex conspiratorial action on the part of the lender, and until I learn otherwise, I will doubt that it happened.

Geithner, Wallison, and History

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What is the legacy of Timothy Geithner? In an essay, I write,

In 2009, at the height of the financial crisis, there was widespread public and political support for making serious changes to how Wall Street and the financial sector operated. Presented with an opportunity to break these too-to-big-to-fail banks down to a size where an institution could be allowed to fail without threatening the entire national economy, Geithner instead attempted to restore the status quo. This was a win for the biggest banks, but the nation as a whole may eventually come to regret his policies.

The American Enterprise Institute sent me a copy of Peter J. Wallison’s Bad History, Worse Policy, which provides Wallison’s take on the financial crisis and the Dodd-Frank legislation. At $90, the book is priced for libraries and specialists. The book reprints his essays written over the period 2004-2012, with some added commentary in hindsight.

My guess is that a decade from now Wallison will look better than Geithner. In particular, I think that Wallison will be vindicated on the following points:

1. Freddie Mac and Fannie Mae lowered their lending standards considerably during the housing bubble, under political pressure. On p. 169, Wallison quotes from Fannie Mae’s 10K disclosure form for 2006:

We have made, and continue to make, significant adjustments to our mortgage sourcing and purchase strategies in an effort to meet HUD’s increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses. [emphasis added]

2. As a result, Freddie and Fannie purchased large amounts of high-risk mortgages, helping to fuel the housing bubble.

3. Dodd-Frank was enacted in order to enshrine a narrative of the financial crisis. That narrative attributes the crisis primarily to predatory lending and to financial deregulation.

4. The narrative enshrined in Dodd-Frank is false. Predatory lending was a minor factor, especially relative to government housing goals. There are few actual examples of financial deregulation, and the examples most often cited (such as the repeal of portions of Glass-Steagall) had little or no bearing on the crisis.

5. The most significant impact of Dodd-Frank is to entrench the largest banks, as they benefit from their status of “too big do fail.”

Incidentally, Wallison probably would disagree with me that we should go so far as to break up the big banks.

Wallison calmly presents evidence. His enemies would do well to try to do the same.

The Greek Phillips Curve

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Tyler Cowen writes,

Prices are sticky, AD is falling, and almost all of the adjustment is in quantities. Yet this still doesn’t explain why prices are inching up, and furthermore it is grossly at variance with the actual empirical literature on price stickiness (much neglected in the blogosphere I should add), which is not nearly as strong as wage stickiness.

This is one of several explanations Tyler finds unsatisfactory for the fact that unemployment is so high in Greece and yet inflation is still greater than zero there. In a follow-up, he writes,

For a simple point of comparison, the rate of U.S. price deflation in 1932 was greater than ten percent with overall deflation running at about twenty-five percent over a period of a few years. More recently, Japan had nine straight years of core CPI deflation and Greece cannot even manage anything close to that. Just what is the Greek Phillips Curve supposed to look like?

I recommend a recent article by Marga Peeter and Ard den Reijer. I may be confused about what I am reading, but it appears to me that the Phillips Curve in Greece shifted adversely over a period of a decade. To put this another way, the natural rate of unemployment in Greece may be quite high.

If my reading is correct, then aggregate demand policies, including converting to a cheaper currency, would not do much for Greece. If workers’ reservation wages are high relative to productivity, you are going to have a lot of unemployment.

The Recession and World Trade

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From the DHL Global Connectedness Index 2012.

The Netherlands retains the top rank on this year’s DHL Global Connectedness Index, and 9 of the 10 most connected countries are in Europe.

Pointer from Timothy Taylor. (How does he find these things?) Taylor writes,

Globalization is near an all-time high by this measure [world exports of goods and services divided by world GDP], but notice that it after the drop associated with the Great Recession, this measure of globalization is about the same in 2011 as it was in 2007.

It is not clear why a statistic with GDP in the denominator should experience a drop during a recession. However, my guess is that the answer has to do with the location of the recession. If some emerging economies continued growing while Europe slumped, one would observe world GDP holding up better than world trade.

From a PSST perspective, all GDP is trade. Some of it is intra-border and some of it is cross-border. Trade patterns that were based on unsustainable conditions, primarily inefficient firms remaining in business, were broken by the conditions that emerged in 2008. Firms go out of business all the time. All the time, new businesses are starting and some are growing. I take the view that since 2008 an unusually large number of troubled firms failed and unusually small number of high-growth businesses emerged. To me, calling this a decline in aggregate demand is begging the question–it is simply putting another label on the phenomenon, not explaining it. It could be that stress at banks is a cause of it, but I think instead that it is a symptom. But that leaves me struggling to tell a story that accounts for the sudden, sharp drop in GDP that took place in 2008-2009.

A Defensive Question

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The IGM expert panel is asked whether they agree with

Because all federal spending and taxes must be approved by both houses of Congress and the executive branch, a separate debt ceiling that has to be increased periodically creates unneeded uncertainty and can potentially lead to worse fiscal outcomes.

Almost nobody disagrees, so I will not argue. Instead, let me propose a defensive question. Ask the experts to agree or disagree with the following:

Because the ratio of debt to GDP cannot keep growing indefinitely, the failure of the executive branch and the Senate to offer a sustainable long-term Budget creates unneeded uncertainty and can potentially lead to worse fiscal outcomes.

I would venture to suggest that this is a more serious source of uncertainty and political friction than the debt ceiling.

I also would venture to offer this guide to budget politics: those who maximize the symbolic significance of short-term budget controversies do so in order to avoid acting on the long-term problem.

Annie Lowrey on the Capital of the Empire

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She writes in the New York Times Magazine.

“We get about 15 cents of every procurement dollar spent by the federal government,” says Stephen Fuller, a professor of public policy at George Mason University and an expert on the region. “There’s great dependence there.” And with dependence comes fragility. About 40 percent of the regional economy, Fuller says, relies on federal spending…

The amorphous war on terror and the creation of the Department of Homeland Security — plus the wars in Afghanistan and Iraq — bloated the country’s spending by about $1 trillion. The contracting dollars that were pumped into the local economy, Fuller says, more than doubled between 2000 and 2010, when it reached $80 billion a year.

However, elsewhere she advocates more deficit spending now to stimulate growth. The most charitable interpretation I can give is that she thinks in terms of “good” spending and “bad” spending on the part of government. The former adds to overall economic growth. The latter just sucks wealth into Washington. The bad spending comes from President Bush and the war on terror. The good spending comes from President Obama and the stimulus.

Some concerns that I have.

1. A lot of the wealth goes to lobbyists for whom the distinction between good spending and bad spending is not meaningful.

2. A lot of the influence on the direction of the spending comes from lobbyists for whom the distinction between good spending and bad spending is not meaningful.

3. The good spending is justified as needed temporarily to boost the economy. But will this temporary spending ever subside? The Keynesian argument for countercyclical government spending seems to get made when the economy gets weak but never when the economy is strong.

4. For that matter, there is also an asymmetry in the argument for more government spending when interest rates are low. I would give this more credibility if those making the argument had ever advocated reducing government spending because interest rates were high.

Of course, my own view is that the evidence that more spending by the federal government benefits the economy as a whole is not compelling. I find it much more believable that such spending benefits Washington.