Government’s Cost of Capital

Deborah Lucas writes,

Collectively, government investment and insurance operations dwarf those of the largest commercial banks. The size and scope of activities have grown over the last several decades to include the explicit and implicit guarantees of too-big-to-fail private and international financial institutions and non-financial firms, direct and guaranteed loans, and more traditional insurance and guarantee programmes such as for bank deposits.

She adds,

a universal mistake is that governments take their cost of capital to be their borrowing rate, irrespective of the risk of the investment under consideration.

Pointer from Mark Thoma.

Ever since the Basel Capital accords were adopted, the government in effect dictated that private bank loans must carry a risk premium over government bonds. Along with that, you have the mistake that Lucas identifies, which is the government evaluating its own loan guarantees and investment projects at a risk premium of zero.

Here is where this leads: if a private firm has to earn 8 percent interest to undertake a risky construction project, but the government can borrow at 2 percent to undertake that same project, then if that project is undertaken at all, it will be undertaken by the government rather than by the private sector. Thus, the system is rigged to put government in charge of where investment takes place.

We end up with something close to the worst of all worlds. Owners and managers of nominally private financial institutions earn outstanding returns. But we have capital allocation that closely approximates what would result from a socialist system.

Macro Theory and Macro Practice

John Cochrane writes,

Perhaps academic research ran off the rails for 40 years producing nothing of value. Social sciences can do that. Perhaps our policy makers are stuck with simple stories they learned as undergraduates; and, as has happened countless times before, new ideas will percolate up when the generation trained in the 1980s makes their way to [the] top of policy circles.

I was with him up to the semicolon. But Fischer and his students made it to the top of policy circles some time ago. My sense is that their policy decisions are not driven by the models that they taught graduate students. They are going on the basis of intuition, and the intuition is in turn shaped more by the undergraduate IS/LM story than by anything else.

My own view is that the tools that they are playing with have very little impact on financial markets or the economy. Meanwhile, the bank regulations, both formal rules and informal slaps on the wrist, play a huge rule in directing bank capital toward government bonds and away from commercial loans. And that capital allocation has real consequences.

I Do Not Understand SPOE

It stands for Single Point of Entry, and I wrote about it here. Peter Wallison and Paul Kupiec say that it won’t work.

Our analysis of the largest banks shows that most of these institutions could fail without causing their parent BHCs to be in default of danger of default. For the parent BHCs to be in danger of default, they would have to experience massive losses simultaneously in many or all of their bank and nonbank subsidiaries.

…For BHCs that will clearly become insolvent if their bank subsidiary fails, the SPOE can be invoked, but the mechanism it uses to prevent financial market disruptions is an extension of the government safety net…It will protect all large bank 39 creditors from losses by transferring bank losses to the parent BHC’s creditors and potentially to unaffiliated institutions that will be assessed to repay the OLF. Here, the SPOE strategy—because it promises to bail out failing large banks— reinforces the TBTF problem at the largestbanking institutions.

Think of two cases:

1. A bank subsidiary is in bad shape, but the overall holding company has positive value.
2. The holding company is insolvent.

I thought, perhaps naively, that the SPOE approach is not worth anything in case (2), but that it was supposed to apply to case (1).

However, Wallison and Kupiec say that the FDIC lacks the legal authority to implement SPOE in case (1). Their argument is that the FDIC was given a mandate to come up with a way to liquidate a failed bank, and SPOE is a way to recapitalize a failed bank, using the net worth of the holding company.

I think that the larger problem is the one I raised in my earlier post. I think that you tend to jump straight from an apparently solvent bank inside a solvent holding company to case (2) without stopping at case (1).

Perhaps I will gain more understanding of SPOE by watching the video of this event.

Annuities

Timothy Taylor writes,

Annuities may turn out to be one of those products that people don’t like to buy, but after they have taken the plunge, they are glad that they brought. One can imagine an option where some degree of annuitization of wealth could be built into 401(k) and IRA accounts. For example, it might be that the default option is that 30% of what goes into your 401(k) or IRA goes to a regular annuity that kicks in when you retire, another 20% goes to a longevity annuity that kicks in at age 80, and the other 50% is treated like a current retirement account, where you can access the money pretty much as you desire after retirement. If you wanted to alter those defaults, you could do so. But experience teaches that many people would stick with the default options, just out of sheer inertia–and that many of them would be glad to have some additional annuity income after retirement.

The theory of an annuity is that you insure against the risk of outliving your money. Economists tend to be big fans of annuities, and they view the reluctance of people to buy annuities as a behavioral economics puzzle.

I actually think that it is perfectly rational to shun annuities. My reasons:

1. You are charged more than the actuarially fair premium. Part of that is overhead and profit, and maybe part of that is adverse selection–the insurance company has good reason to fear that you are in better health than someone else your age. In any event, the result is that an annuity reduces your consumption possibilities by as much as would be the case if you over-estimated your lifespan by several years and budgeted accordingly.

2. Taylor notes that

people fear that they might need to make a large expense in the future, perhaps for health care or to help a family member, and if they have annuitized a large share of their retirement wealth they would lose that flexibility.

This is a very reasonable fear. An annuity is risk-reducing if the only risk you face is additional longevity. In fact, other risks may be more serious. You could easily find yourself needing to take out a loan if your savings are tied up in an annuity and your spouse requires a home health aide. (Speaking of which, long-term care insurance is something that I think does make sense, but you should buy it to get through age 75 and then self-insure thereafter).

3. It is reasonable to think in terms of declining consumer expenditures as you age. Will I really spend as much at age 90 as I spend at age 60? Medicare will cover many health expenses, and if I need to spend more of my own money on health care it is likely that I will have much less interest in vacation travel or buying a new car.

4. It is possible to substitute inter-generational insurance. If my mother-in-law had outlived her money, we could have supported her. From our family’s perspective, self-insuring in this way was cheaper than buying an annuity.

Target the S&P 500?

Lifted from the comments:

EMH has me puzzled. Since stocks are linked to the economy you must also conclude that long-range predictions of the economy are no better than throwing darts. Yet many economists seem to believe that the Fed could in fact target NGDP and therefore create the economy they want in some respect (obvisously there are plenty of variables they can’t control). Is a variable really efficient if someone can target it?

To put it more simply perhaps, the Fed COULD target the S&P 500 if they wanted to (essentially pick a value). If an entity exists that can control a variable then isn’t it impossible for that variable to be completely unknowable?

1. Long-range predictions of the economy are not much better than throwing darts. Even projections of a year ahead are not much better than just guessing that the real GDP will grow by 2.5 percent.

2. I think that Scott Sumner would say that the Fed could target the level of the S&P 500. That is a nominal variable.

3. However, the Fed cannot target the real return on stocks. If the Fed targets an S&P 500 of 2200 for one year from now, and this is credible, then the S&P 500 has to rise today to the point where the expected real return is comparable to that on other assets.

4. Part of the EMH is that markets anticipate what the Fed will do. So the Fed cannot suddenly surprise markets by targeting an S&P 500 of 2200. If you extend that, you would say that the Fed cannot suddenly surprise markets by targeting a particular level of NGDP.

5. I think there is a bit of tension between believing in the EMH and believing that the Fed can choose any NGDP value it wants. I think Scott is aware of the tension, and I forget how he resolves it.

6. I think that bringing up the stock market is a very good way to raise the issue of whether the Fed can target any nominal variable.

7. Of course, I am not the one who has to defend the proposition that the Fed can target nominal variables. I believe that financial markets can do what they want with asset prices, and that money and prices are consensual hallucinations.

Sunday’s Washington Post

It had two long pieces that angered me. Usually, I let these things go. It’s a waste of time trying to play Whack-a-Mole with those with whom you disagree. But I’ll waste my time this time.

1. Here is Barry Ritholtz.

Finance is filled with colorful phrases such as “Spoos,” “Vol,” “Monte Carlo simulation,” and “Gaussian Copula.” In these columns, I try to eschew the usual Wall Street jargon. But I have used the phrase “secular cycles” (most recently here), and a reader recently called me on it. To redress that error, this week I will discuss what a secular — vs. cyclical — market is, its significance and what it might mean to your portfolios.

What made me angry is that the Wall Street jargon to which he refers has some theoretical content to it. There may be erroneous assumptions baked in, and practitioners who know the jargon are capable of making really bad decisions.

But he is making it sound as though “secular market,” and in particular “secular bull market,” is a generally accepted scientific concept that can be used to predict future stock prices. I think that this article should have at the very beginning a huge disclaimer that says “I am about to present a concept that has absolutely zero rigorous research behind it.”

Every attempt to analyze the stock market must start with the efficient markets hypothesis. As far as I know, there is no alternative that is sufficiently robust to yield strong predictions of market movements that hold up for long periods out of sample.

Note that I am not saying that I can predict the market better than he can. I am not saying that there aren’t a zillion other stock market columnists serving baloney sandwiches every day. What I resent about this particular column is his sheer pretentiousness. He is passing off his baloney sandwich as if it were expert knowledge. That is what ticks me off.

2. We Need a National Food Policy, by Mark Bittman, Michael Pollan, Ricardo Salvador and Olivier De Schutter.

They do not say, and indeed they could not possibly say, that we now have a free market in food. Among other criticisms of current policy, they write,

in February the president signed yet another business-as-usual farm bill, which continues to encourage the dumping of cheap but unhealthy calories in the supermarket.

The problem is not that we lack a food policy. The problem is that these four authors would like to see a different food policy.

The article strikes me as a classic “moral will” story. That is, experts know the right policy. All we need is the moral will to execute it. There is no acknowledgment of either the socialist calculation problem (centralized experts may not have the information they need to actually make a better food policy than the market) or the public choice problem (government as an institution is ripe for capture by interest groups).

Of course, you could say that libertarians have our own “moral will” story. We think that people need the moral will to resist campaigns to put the national government in charge of everything.

Canadian Banking and U.S. Banking

Timothy Taylor writes,

Clearly, the U.S. has a larger share of financial activity happening in the “other financial institutions” area, while Canada has a larger share of its financial activity happening explicitly in the banking sector. The Canadian economy is of course closely tied to the U.S economy. But the recession in Canada was milder than in the U.S., perhaps in part because Canada’s financial sector was less exposed to the issues of shadow banking.

Two interesting possibilities:

1. The Canadian shadow banking sector is underdeveloped. Canada is an ok place to get a mortgage or a commercial loan, but for more sophisticated financial transactions you have to go elsewhere.

2. The American shadow banking sector is overdeveloped. Our financial institutions are playing a game of hide-and-seek from the regulators, and shadow banking has emerged to enable banks to produce balance sheets that appear (to regulators) to be safer than they really are.

Of course, both of these could be true to some extent. I am more inclined to believe (2).

As an aside, I have no idea how one could measure the size of the shadow banking sector with any precision. I picture large books of derivatives, and do you look at gross or net exposure, current market value or potential value at risk, etc.?

The Single Point of Entry Solution

Rebecca J. Simmons writes,

The critical element of the SPOE strategy is the recapitalization of the company’s material operating subsidiaries with the resources of the parent company. For the SPOE top-down approach to work effectively, there must be sufficient resources at the holding company level to absorb all the losses of the firm, including losses sustained by the operating subsidiaries.

SPOE is being touted as the solution to the too-big-to-fail problem. You have a gigantic bank holding company that gets in trouble. You (the FDIC) want to keep all the subsidiaries going, because you want depositors and counterparties not to panic. So you put the holding company into receivership, and only pay off shareholders and debtholders of the holding company after your are sure you have got money to do that.

I may not fully understand this. Here is what I think happens. The value of the subsidiaries as ongoing concerns is positive, say $100. However, if you subtract the value of the outstanding debt of the holding company, the value of the holding company is negative. With, say, $150 in outstanding debt, the holding company’s value is -$50. The receivership creates a new holding company, which will eventually be sold back to the public, but without the outstanding debt. When the new holding company is sold, the debtholders in the old company get first dibs on the proceeds, and if there is anything after that, the equity holders can get it. Again, I could be completely wrong about this, but that is my understanding.

Simmons continues,

The capitalization of the bridge financial company must be sufficient…not only to allow the operating subsidiaries to obtain needed capital from the bridge to continue operations but also to allow stakeholders and the broader public to view the entity as safe and viable as it transitions from failed firm to bridge financial company, and ultimately to emergence as a new firm.

The problem is that financial firms have multiple self-fulfilling states of equilibrium. There is a state in which everyone believes in you, so you pay low interest rates on your debt, and you are fine. There is a state in which counterparties do not believe in you, so your interest costs soar, and you are dead. One key question about SPOE is whether it can prevent a jump from the good equilibrium to the bad equilibrium.

Suppose that we had this strategy in place, with all of the legal means for implementation. I still believe that if JP Morgan Chase or Citigroup got into trouble, the Fed Chairman and the Treasury Secretary would be wetting their pants. In a crisis, the probability that they would go through with SPOE, rather than undertake an ad hoc bailout, is very low.

Bank Breakup Worries

1. I am worried that breaking up the biggest banks would not make the system safer.

I do not believe that having smaller banks would have prevented the 2008 crisis or the next crisis. I do not believe that regulatory policy can prevent such crises. My only solution for systemic financial risk is to try to make the financial system easier to fix when it does break. I think it is easier to fix when there is less debt, so I would look for ways to reduce incentive to take on debt. Instead of subsidies for mortgage borrowing, how about subsidies for down-payment saving? Instead of favorable tax treatment for debt, why not favor equity–or at least be neutral between the two? etc.

For me, breaking up the banks is not a safety issue. It is instead an issue of restoring democracy and the rule of law. Really big banks are crony banks, whose interactions with government officials are at the highest levels. Instead, I would like to see the biggest banks dealt with by career civil servants who are following clear, predictable rules and guidelines.

2. I am worried that it would be difficult to define size.

Once you decide that banks above a certain size should be broken up, you need a definition of size. Among the problems with doing this, the first one that comes to my mind is accounting for derivatives. If you ignore derivatives, then in very short order banks will mutate their loan portfolios into derivative books. But if you try to include derivatives, then the whole notional-value vs. market-value argument is going to kick in. Also, gross exposure vs. net exposure.

Instead, I am attracted to using the amount of insured deposits as a measure of size. It is a clean measure that cannot be gamed using accounting transactions. It is a measure of the potential impact of the bank on the FDIC. Charging a risk premium that is graduated by size would be a reasonable rule-of-law approach to discouraging large banks. Banks could avoid the risk premium by spinning off branches. The giants that were assembled by mergers could be dis-assembled by spin-offs.

3. I am worried about large shadow banks.

You can do a lot of banking without a lot of deposits. You can finance with commercial paper. You can finance with repo. You can write a ton of derivatives. I do not think that this is bad per se. But, just as with large commercial banks, large shadow banks could acquire the political power of large commercial banks.

I welcome suggestions for dealing with shadow banking. I am not thinking about how to reduce the risk of shadow banking. My view is that systemic risk is systemic risk, and you cannot get rid of it by breaking up banks.

What I am concerned with is the political power that might be concentrated in a large financial institution. The problem is that, once you get away from deposits, measuring “large” becomes quite tricky.

Policy Theater

[Wow. I wrote the rest of this post between Tuesday and Thursday, to go up Saturday. Friday’s Wapo has a very long front-page story on the influence of donors on the agenda at the Brookings Institution. Martin Baily and Doug Elliot, listed below, are with Brookings.]

Eric Garcia writes,

Financial regulation experts said Tuesday breaking up large banks could be costly while offering no additional safety-benefits for the economy.

I was on the panel at the Bipartisan Policy Center, and I argued in favor of breaking up big banks, but I am not mentioned in the story.

The panel was called to discuss a research paper commissioned for the Center and written by Martin Baily, Doug Elliot, and Phillip Swagel. The paper says that (a) we have little reason to worry about too-big-to-fail, because the FDIC is on its way to having enough authority to resolve big bank failures, (b) there are economies of scale in banking at the very highest levels, (c) there are transition costs to breaking up big banks, in that employees and customers would be left hanging waiting to see how the re-org falls out, and (d) breaking up big banks would not get rid of systemic risk, anyway.

I agree entirely with (d). I thought that (c) was a fair point, but there is such a thing in the corporate world as a spin-off, and it can be done. I disagreed with (a) and I was unpersuaded by (b).

I was invited to a pre-panel breakfast. However, when I got there, I soon felt out of place. Part of it was that the breakfast sandwiches were not what I would eat for breakfast (or any time). Another part of it was that the setting was larger and more formal than I had expected. Instead of a few panelists milling around, it was an executive conference table, and Elliot, Swagel, and I were the only panelists there. The rest of the approximately fifteen men (plus one woman) around the table were from trade associations (such as the American Bankers’ Association), except for two from Bank of America.

So I excused myself to go to the bathroom, got back on the elevator, went downstairs to a cafe next door, got a little food and tried to collect my thoughts. I discarded most of my talking points, which had been focused on left-vs.-right issues in narrating the financial crisis and financial regulation. I tried to come up with something appropriate for an audience of bank lobbyists.

When I got back upstairs, the breakfast was still underway. Elliot and Swagel proceeded to give the main points of the paper, with the K street folks nodding in approval. Elliott made a crack about not being able to persuade opponents who refuse to be persuaded by evidence, and I was the only one who didn’t laugh. Meanwhile, I perused a copy of the annual report of the Bipartisan Policy Center, because it happened to be on a shelf behind my seat. I thumbed through the annual report, looking for its list of donors. I cannot say that I was surprised to find in that list Bank of America, the American Bankers’ Association, etc.

A few minutes before 10 AM, the rest of the panelists assembled. I asked Baily, as an expert on productivity statistics, whether he thought that any economist would claim to have a reliable measure of bank output. “Of course not,” he replied, nearly breaking into a laugh. I was glad to hear that response, because it reinforced my view that econometric estimates of scale economies in banking are not reliable. When you measure economies of scale, you are comparing the ratio of output to inputs at different-sized firms. It’s rather difficult to do that if you cannot measure the numerator.

Then came the panel. I was a bit embarrassed to be in a chair with no desk in front of me. I was wearing high-topped gym shoes, in order to lessen a mild but nagging foot injury. Continue reading