Category Archives: Financial Crises

Two Thoughts on William Niskanen

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I had only one close encounter with him. That was when he went to a Congressman’s office to argue against TARP and he invited me to join in the meeting. My observations about him:

1. He was highly principled. If he disagreed with a libertarian article of faith (such as the view that “starve the beast” would lower spending), he would say so. But he was certainly no friend of the establishment’s belief in itself and in big government. He knew that the elites were solidly for TARP, and that made him all the more willing to try to stop it.

2. He was modest and gentlemanly. He would have been the last person to engage in trolling for self-aggrandizement.

What I’m Reading

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Two books that attack conventional economic modeling, especially in light of the financial crisis. I have a preview copy of Economics for Independent Thinkers, by Daniel Nevins. I have a review copy of The End of Theory, by Richard Bookstaber. I am likely to recommend the former. The latter is certain to make it onto my list of “best books of the year.”

It is interesting that both authors have backgrounds in applied option pricing. So do I. Is it a coincidence that we all ended up taking heterodox positions? If you toss in Fischer Black and Nassim Taleb, you start to wonder if there isn’t something in the option pricing water.

A reader points to Diane Coyle’s negative review of Bookstaber. She writes,

his complaints about economics are both wearily familiar territory and decreasingly true; economics is and has been changing a lot. In finance specifically, think of Andrew Lo’s new book, Adaptive Markets.

I disagree with her on all counts. One indication that Coyle has missed the point is that she thinks that Bookstaber’s critique applies only to macro/finance. I can readily apply it to the way economists model the demand for health insurance, the demand for home ownership, and principal-agent contracts, among other microeconomic phenomena.

I am drafting a review essay, which reads in part,

If I could reduce it to a bumper sticker, it would read, “Stare more at the world and less at your model.”

…All of the major fields in economics are inclined to follow strict technical procedures at the expense of realism. In the 1500s, if mapmakers had been similarly inward-looking and rigid, they would have continued to draw maps of the globe that ignored the lands discovered by Columbus and subsequent explorers, insisting that “The state of cartography is good.”

Turning to a relatively minor passage that resonated with me, here is Bookstaber’s description of the role of collateral in repurchase agreements and derivative bets on p. 159:

Let’s say your bookie demands that you put up $20,000 of collateral for a marker on a $15,000 bet. You give him your gold Rolex watch, worth $20,000. He comes back to you a week later and tells you that you need to put up another $3,000. Why? “People, they aren’t so much interested in these Rolexes anymore. It’s marked down to $17,000.” …You say, “Wait, I see prices for watches just like it, anywhere from $20,000 to $24,000.” He says, “Hey, do you owe them money or do you owe me money? You’ve got the marker, and I’ve got the watch, and I say that today it’s worth $15,000.”

By appraising collateral, notably mortgage securities, at low values, investment banks like Goldman Sachs caused runs on other firms. Gary Gorton termed it the “run on repo.”

[note: the following paragraph is my own. Although I cannot confirm that Bookstaber would endorse it, to me it seems likely that he would.]

But it was not just repo. The run on AIG was to demand collateral for credit default swaps. Think of a credit default swap as flood insurance and think of collateral as used because you don’t entirely trust that the insurance company will have the wherewithal to pay off. You have a house near a river, and when you get flood insurance you have the insurance company give you some Treasury bills as collateral, until the insurance policy expires. Then, a big rain comes, and the river starts to rise. Your house is still dry, but you are more worried, so you ask for more Treasury bills as collateral. That is what Goldman Sachs and the other investment banks did to AIG during the crisis. As it turned out, most of the houses never got flooded (that is, most of the bonds that AIG insured did not default), but the demands to put up more safe securities as collateral became impossible to meet, especially because similar demands were being made all over Wall Street for firms engaged in derivatives and repurchase agreements.

The quoted passage does not in any way capture the book’s larger, more ambitious theme. I was struck by it because it fit my understanding of what happened, which policy makers at the time seemed to me to miss. Had they been cognizant of the real problem, they would have applied a remedy closer to the one that I was proposing at the time. I called this the “stern sheriff” model, and it would have meant telling Goldman and other firms to stop making their outlandish collateral calls.

When to break up the big banks

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Stephen G. Cecchetti and Kermit L. Schoenholtz write,

From our perspective, by raising the odds of an effective resolution, FIBA (as a complement to Dodd-Frank) boosts the credibility of the U.S. regime. Over time, foreign regulators also may be reassured that the Chapter 14 mechanism is similar to the FDIC’s SPOE strategy, which they have welcomed. In both cases, the regime’s credibility depends on the presence of living wills and adequate loss-absorbing capital.

Pointer from Mark Thoma.

No, I don’t expect you to be able to follow what they are saying, even if you read the whole post. What it boils down to, and this is a mainstream view, is that with the right tools in place, the next time a big bank gets into trouble, the regulators will be able to “resolve” it without a bailout.

In effect, they are saying that we do not need to break up big banks now, and in fact that would be a bad idea. But when a crisis comes along, then, by golly, that will be a marvelous time to break up the big banks. The way I see it, “resolution” is nearly synonymous with breakup.

Again, this is a mainstream view. But to me, it could hardly be more absurd. In the middle of a crisis, the appeal of an untried approach for breaking up big banks is going to be nil. If you cannot break them up now, when there is no crisis, you will never break them up. Bailouts are an absolute given.

Needed: A March for Fiscal Responsibility

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John Cochrane writes,

We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our “reserve currency” status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world.

That is at the end of a long post that makes points that I have made over the years.

If I were an editor

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I would be very hard on a lot of manuscripts. As a result, fewer published books would fail to meet my standards. By the same token, a lot of authors would be really frustrated, and they would give up trying to meet my standards.

I thought of this when I received a review copy of Andrew W. Lo’s Adaptive Markets from Princeton University Press. Lo is highly respected and warmly regarded in the field of finance. He could write a book consisting of “Mary had a little lamb” written forward and backward 10,000 times and still get good blurbs and lots of library purchases. So as a publisher you don’t want to throw an aggressive editor like me at him.

But gosh. The introduction does not tell the reader anything about where the book is going. There is no conclusion to tell you where you have been. The middle reads like a transcript of every lecture he has ever given to first-year students or business practitioners.

This book makes me appreciate Sebastian Mallaby and Greg Ip all the more. In Foolproof, Ip gave us the distinction between economists as engineers and economists as ecologists. Lo speaks the language of ecology, yet on p. 371, he writes,

if there’s one single proposal that unambiguously moves us closer to a more stable and robust financial ecosystem, it’s to develop better measures of systemic risk.

Spoken like a true engineer.

There are a lot of fun stories in the book, and I imagine that would entertain a young finance student. But not me.

Financial Policy if I were in charge

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This afternoon, I am supposed to participate in a discussion of financial regulatory policy. There are so many participants, including big shots like John Taylor and John Cochrane, that I may end up not saying anything. I probably will just hand out the post that I put up in 2010, which I still like very much. Here it is:

1. Extricate the government from the mortgage market as soon as is practical. I foresee reducing the maximum mortgage amounts that of Freddie and Fannie to zero in stages over a period of three years, then selling off their portfolios two years after that. I would even get rid of FHA. I would also get rid of the mortgage interest deduction. My guess is that the market would evolve toward higher down payments, and probably toward mortgages like the Canadian five-year rollover.

2. Housing aid to poor people would take the form of vouchers. No other Federal involvement in housing.

3. I would support a law that says that lenders must not make loans with the intent of exploiting borrower ignorance. Allow case law to develop to define rules and norms in support of that principle, rather than try to come up with fool-proof regulations.

4. Break up the top 10 banks into 40 banks. I think that is the best solution to the “too big to fail” problem, although there is no perfect solution to Minsky-type financial cycles.

5. Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.

6. Define priorities for creditors in a bank bankruptcy. I think that the solution to the social value–or lack thereof–of derivatives and other exotic instruments can be handled by the priority assigned to them. I would assign them a low priority. That is, first ordinary depositors get paid off. Then holders of ordinary debt. Other contracts, such as swaps or derivatives, come after that. I think that this would provide all the incentives needed either to curb derivatives or lead them to be traded on an organized exchange. I don.t think that getting them onto an organized exchange should be sought after as an end in itself.

7. Get rid of the corporate income tax, which encourages excess leverage. If the private sector, including banks, had lower debt/equity ratios, the financial system would be sounder.

8. Develop emergency response teams and backup systems that can ensure that the basic components of the financial system, particularly transaction processing, can survive various disaster scenarios, both technological and financial.

The overarching principle I have is that we should try to make the financial system easy to fix. The more you try to make it harder to break, the more recklessly people will behave. By reducing the incentives for debt finance and for exotic finance, you help promote a financial system that breaks the way the Dotcom bubble broke, with much lesser secondary consequences.

[Postscript:

1. I took four books to the meeting, and I got autographs from their authors.

2. We are not supposed to talk about what was said.

3. I did not hand anything out. I requested to be called on at one of the discussions, but my time came just as people had been promised a coffee/bathroom break, so I did not receive very much attention. I tried to say that it is futile to try to make the financial system hard to break. Crises come from surprises, and you cannot outlaw surprises. I suggested instead the approach of making the system easy to fix. Have backup systems to keep ATMs working (Paulson and Bernanke claimed that without TARP the system would have been so frozen that ATMS would have run out of cash. That was a sales pitch that the “common man” needed TARP and I think it was probably a lie, but in any case a backup system would be a good idea.); backup systems for settlement and clearing of transactions on exchanges in case a financial derivatives exchange blows up; and changing the tax bias to favor equity rather than debt.

4. A commenter says that eliminating the mortgage interest deduction would be a blow to the middle class. Actually, if you assume an across-the-board tax cut so that the change is “revenue neutral,” it probably helps the middle class. The benefits of the deduction go mainly to the rich. In fact, you could just cap the deduction at a low level and leave the middle-class borrower alone, and still get most of the revenue from it. But for me, the point of getting rid of the deduction is not to get revenue, but to change the incentives on leverage. So I do not want to cap it. Instead, I would prefer to have it phase out over a period of 5 or 10 years for people who have mortgages.]

The Source of Systemic Financial Risk

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Charles Calomiris says that it is the political system.

There are two important systemic threats to financial stability: government policies that subsidize mortgage risk, and government policies that insure bank debts (and, more generally, that subsidize bank default risk through a variety of channels, including—but not limited to—“toobig-to-fail” protection).

As you know, I have some simple solutions to the problem of subsidizing mortgage risk.

1. Do not provide government guarantees or subsidies for investor loans, meaning mortgages on non-owner-occupied homes. I have linked to a study that found that over one third of mortgage lending in 2006 went to people who were buying a house in addition to the one that they occupied.

2. Do not provide government guarantees or subsidies for loans that extract equity from homes, including second mortgages and cash-out refinances.

These simple, logical steps would have been sufficient to prevent the financial crisis of 2008. However, they would be fiercely opposed by industry trade groups, such as the Mortgage Bankers Association.

Biggs’ BIG for Social Security

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Andrew Biggs writes,

Under the plan, Social Security would guarantee that all retirees, regardless of work history or earnings, are lifted out of poverty in old age. Thus, while Social Security currently offers no minimum benefit, a strong minimum benefit would be established at the poverty threshold. Over time, however, the maximumUnder the plan, Social Security would guarantee that all retirees, regardless of work history or earnings, are lifted out of poverty in old age. Thus, while Social Security currently offers no minimum benefit, a strong minimum benefit would be established at the poverty threshold. Over time, however, the maximum Social Security benefit would be reduced so that eventually all retirees would receive essentially the same monthly benefit. Social Security benefit would be reduced so that eventually all retirees would receive essentially the same monthly benefit.

Much of the essay tries to debunk some myths about saving for retirement. Some people, myself included, have bought into “facts” that show that Americans do not save. But Biggs writes,

But recent Census Bureau research that relied on IRS administrative data, which counts IRA and 401(k) withdrawals in whatever form they are made, found that from 1984 to 2007 the percentage of new retirees receiving private retirement-plan benefits doubled and median benefit payouts more than doubled. (This study focused on retired women, but it looked at total household incomes and included male spouses, if present.) Thanks to rising private retirement benefits, real total incomes for the median retiree household rose by 58%. In the CPS, which undercounts private retirement benefits, total household incomes rose by only 21%.

The Fiscal Outlook

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The Committee for a Responsible Federal Budget reports,

CBO finds debt held by the public will roughly double as a share of the economy over the next three decades, rising from 77 percent in 2017 to 150 percent by 2047.

…A number of major federal trust funds face exhaustion in the coming years, including the Highway Trust Fund in 2021, the Social Security Disability Insurance Trust Fund in 2023, the Medicare Part A (Hospital Insurance) Trust Fund in 2025, and the Social Security Old-Age and Survivors Insurance Trust Fund in 2031.

Of course, for the press, this is a yawner. It’s the CBO “scoring” of the health care bill that makes front page news.

We are not Singapore

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John Mauldin writes,

Forty-one percent of Americans have no savings at all. An article in Forbes cites data that shows that just 37% of Americans have savings to cover an emergency that costs over $500.

…Simply put, most Baby Boomers will be down to subsistence living by the time they are 80, living on Social Security and other government benefits, with help from any capable children.

He points out that Social Security benefits are typically less than $20,000 a year, and the system is not exactly in robust financial shape. And Medicare does not completely relieve beneficiaries of out-of-pocket expenses.

Perhaps a lot of these people own homes. That would mean not having to spend any money on rent, and in a pinch they could take out a mortgage to finance emergency expenses. Still, I think that a culture of not accumulating financial savings is worrisome.