Category Archives: markets

Freddie and Fannie Shareholders vs. Government

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Richard Epstein cries “Fraud.”

The initial bailout terms were contained in a Senior Preferred Stock Purchase Agreement (SPSPA). Under its terms, each corporation had to issue a new class of senior preferred stock to the United States, which bore interest at 10 percent per annum. That sum increased to 12 percent if Fannie and Freddie chose to conserve cash instead of paying dividends. For the next two or so years, as conditions in the housing market improved, the arrangement proceeded more or less as planned. The entire legal landscape, however, was radically changed in August 2012, when the Third Amendment to the 2008 SPSPA was passed. It called for a “net worth sweep” under which FHFA and Treasury entered into a deal that magically converted all the net receipts of Fannie and Freddie as “dividends” to be paid to the government.

Peter Wallison says it’s not so sad.

The original shareholders of Fannie and Freddie, as noted above, should have been wiped out by a receivership. The Treasury’s mistake in keeping shareholders’ rights “alive” was a windfall for this group. The shareholders that bought in after Fannie and Freddie were placed in the conservatorship were largely hedge funds, speculating on later developments. Speculation is certainly good, and is vital to price discovery, but in this case the hedge funds probably realized not only that Fannie and Freddie—because they continued to dominate the housing market—would eventually become profitable but also that they could probably push Congress to do what Entine recommends: allow these profitable companies to exit the conservatorship and resume their role as profit-making enterprises. That would have made a fortune for the hedge funds. Indeed, the Treasury’s move to extract all the profits from Fannie and Freddie was probably developed to prevent the success of this strategy. The Treasury was worried that it might succeed.

I’m with Wallison. If you bought Freddie or Fannie stock any time after 2008, you were not investing in fundamentally sound private businesses. You were buying a political lottery ticket. If the politicians had decided to perform financial CPR on Freddie and Fannie and then re-privatize them, you would have made a fortune. Given that they decided otherwise, you lost a pittance. Don’t sue because your lottery ticket lost. Don’t pay Richard Epstein to plead your case in public. Just tear up your worthless lottery ticket and shut up.

My Review of Calomiris and Haber

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Is here. An excerpt:

The authors posit a contrast between what they call liberal democracy and populist democracy. Liberal institutions are designed to limit the power of what James Madison called factions, in part by making the government relatively unresponsive to public clamor. Populist institutions are designed to increase the power of those who can command electoral majorities.

A central claim of the authors is that banking crises are more likely in heavily populist countries than in countries that are less populist. They cite Canada as an example of the latter. For instance, in Canada, Senators still obtain office by appointment, rather than by direct election.

Podcast with Calomiris and Haber

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Russ Roberts did the interview live.

I was in the audience, and I stammered out this question”

I’m trying to figure sort of what makes Canada’s banks stable, and the thing that comes to mind is charter value, that the–you only have 5 of them, and they are profitable, and so they don’t want to lose their charter, and so maybe that stabilizes things. First, I wonder if you agree with that. And secondly, if you do, what are the forces that keep that from happening in the United States? I think you mentioned the populist sentiment–people don’t want banks to be profitable. The government wanted to use banks for redistribution purposes. Should we be trying to head toward a system where banks have valuable charters and if so, how could we head that way?

I did not think that they answered the question well. When I was at Freddie Mac, the CEO, Leland Brendsel, was very clear on the fact that the company had a valuable charter that it needed to protect, and this included not taking excessive risk. That changed after I left. In part, it was a new CEO. In part, it was a political environment in which Congress was even more convinced than the private sector that there was no such thing as a loan application that you should turn down.

A lot of the banking deregulation in the 1980s and 1990s was designed to make banking more competitive. The quasi-monopoly power of “unit banks,” which Calomiris and Haber have such contempt for, was ended. But the result was to weaken the value of bank charters, which may have induced banks to take more risk. Gary Gorton made this point a few years ago.

In any event, if I had it to do over again, the question I would ask is, “What explains Switzerland?” Because a lot of their thesis is that banks emerge in order to feed government demand for borrowing to fight wars. Switzerland famously has a significant banking sector, but I don’t see it as having arisen to help finance Swiss imperialism.

John Cochrane’s Bank Reform

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He proposes,

For every dollar of short-term debt, pay the government (say) 10 cents. I don’t know the exact number either, but a wrong tax rate does a lot less damage than a wrong quanti[t]ative restriction.

Instead of telling banks what their ratio of debt to equity should be, let them choose that ratio, based on a tax that offsets the implicit subsidy to debt that comes from bailouts. Makes sense.

What I’m Reading

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I finished Gregory Clark’s new book. I put it in the must-read category. I hope to publish a review on line in the next few months.

I am now reading Fragile by Design by Charles Calomiris and Stephen Haber. I posted a few months ago on an essay they wrote based on the book. I also attended yesterday an “econtalk live,” where Russ Roberts interviewed the authors in front of live audience for a forthcoming podcast. You might look forward to listening–the authors are very articulate and they speak colorfully, e.g. describing the United States as being “founded by troublemakers” who achieved independence through violence, as opposed to the more boring Canadians.

I think it is an outstanding book, although in my opinion it is marred by their focus on CRA lending as a cause of the recent financial crisis. This is a flaw because (a) they might be wrong and (b) even if they are right, they will turn off many potential readers who might otherwise find much to appreciate in the book. Everyone, regardless of ideology, should read the book. It offers a lot of food for thought.

I am only part-way through it. The story as far as I can tell is this:

1. There is a lot of overlap between government and banking. Governments, particularly as territories coalesced into nation states, needed to raise funds for speculative enterprises, such as wars and trading empires. Banks need to enforce contracts, e.g., by taking possession of collateral in the case of a defaulted loan. Government needs the banks, and the banks need government.

2. If the rulers are too powerful, they may not be able to credibly commit to leaving banks assets alone, so it may be hard for banks to form. But if the government is not powerful enough, it cannot credibly commit to enforcing debt contracts, so that it may be hard for banks to form.

3. Think of democracies as leaning either toward liberal or populist. By liberal, the authors mean Madisonian in design, to curb power in all forms. By populist, the authors mean responsive to the will of popular coalitions of what Madison called factions.

4. If you are lucky (as in Canada), your banking policies are grounded in a liberal version of democracy, meaning that the popular will is checked, and regulation serves to implement a stable banking system. If you are unlucky (as in the U.S.), your banking policies are grounded in the populist version of democracy. Banking policy reflects a combination of debtor-friendly interventionism and regulations that favor rent-seeking coalitions who shift burdens to taxpayers. The result is an unstable system.

I may not be stating point 4 in the most persuasive way. I am not yet persuaded by it. In fact, I think libertarians will be at least as troubled as progressives are by some of the theses that the authors promulgate.

A Statistic to Know

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Last fall, Jesse Colombo wrote,

it is important to realize that around 50 percent of the SP500’s earnings are generated overseas

This means that our stock market is to some extent decoupled from our economy. Statistics like ratios of corporate profits to GDP are not necessarily going to be indicative of movements in income shares. Imagine a foreign subsidiary getting profits without generating and GDP whatsoever.

Defining a Bubble

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Justin Fox writes,

So maybe we should tweak the second sentence of Brunnermaier’s definition, to something like: Bubbles arise if the price far exceeds the asset’s fundamental value, to the point that no plausible future income scenario can justify the price. A little clunky, and of course “plausible” is a judgment call. But it does get at the idea that we shouldn’t be calling every last rise in P/E ratios a bubble.

Pointer from Mark Thoma.

I would tweak this definition back in Shiller’s direction. I think you have to know why people are buying the asset in order to know whether it is a bubble. If investors who are buying the asset have estimates of the discounted present value of the income from that asset that imply a negative real return, then it is a bubble.

To simplify, assume no aggregate inflation. That gets out of the way any difference between real income and nominal income or between real returns and nominal returns.

Suppose that I buy an asset that yields an income stream–rents, dividends, or what have you. Suppose that we discount this income stream at the risk-free rate, and the resulting real return is negative. Why, then, am I buying the asset?

1. Perhaps it has a “negative beta,” so it has tremendous diversification value. Let’s rule that one out.

2. I get utility out of owning the asset. This might apply to jewelry or paintings. Or I could get “extra utility” out of owning my house that is over and above what I save by not having to pay rent. Let’s ignore those cases, also.

3. I expect to be able to sell the asset at a higher price to someone else.

When (3) is the only way to get a positive return from holding the asset, then we have a bubble.

The difference between my definition and Fox’s is that his definition requires that we have an objective definition of “plausible.” Mine requires learning from investors what their estimates are for future income from the asset.

So with something like stocks, you have to know whether the people buying are projecting higher future earnings than what you think are plausible (in which case, no bubble) or whether they are projecting earnings that imply negative rates of return (in which case, bubble).

What is Financial Repression?

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Ken Rogoff and Carmen Reinhart are still paying attention to sovereign debt. In fact, there are so many links in this paper to recent work of theirs that surely another book is in the offing. Here, they write,

the current stage often ends with some combination of capital controls, financial repression, inflation, and default. This turn of the pendulum from liberalization back to more heavy-handed regulation stems from both the greater aversion to risk that usually accompanies severe financial crises, including the desire to prevent new ones from emerging, as well as from the desire to maintain interest rates as low as possible to facilitate debt financing. Reinhart and Sbrancia (2011) document how, following World War II (when explicit defaults were limited to the losing side), financial repression via negative real interest rates reduced debt to the tune of 2 to 4 percent a year for the United States, and for the United Kingdom for the years with negative real interest rates. For Italy and Australia, with their higher inflation rates, debt reduction from the financial repression “tax” was on a larger scale and closer to 5 percent per year. As documented in Reinhart (2012), financial repression is well under way in the current post-crisis experience.

(Can anyone find the 2012 paper? It’s not listed in the references.)

Reinhart’s story is that once upon a time, countries emerged from WWII with a lot of sovereign debt. They used financial repression to keep interest rates low, and they got out from under that debt. Then they liberalized, and the financial sectors went crazy, growing rapidly and fueling bubbles. Then the crash came, governments took on a lot of debt again, and now we are back in the cycle of financial repression.

As a story, this is cute. But I cannot buy into it, at least for the United States. Re-read my history of U.S. government debt. Most of the reduction in the ratio of debt to GDP from 1946-1979 was due to the government running primary surpluses in the 40’s, 50’s, and 60’s. That is, if you took out interest payments, outlays were below revenues. The negative real interest rates were during the Great Stagflation, and they only reduced the debt/GDP ratio by a small amount.

Also, I am not sure where the financial repression is coming from today. Reinhart cites risk-based capital requirements that favor sovereign debt, but we have had those since before the financial crisis.

I think my larger issue is that I am unclear about the concept of financial repression. Some possibilities.

1. Financial repression consists of regulations that subsidize purchases of government debt and/or penalize risky private investment. In this case, the interest-rate differential between private securities and government securities is wider than normal. How does one distinguish this from a shift in the risk premium due to market psychology?

2. Financial repression reduces the amount of financial intermediation. But what does that mean?

To me, financial intermediation consists of the financial sector holding long-term, risky assets and issuing short-term, risk-free liabilities. The nonfinancial corporate sector and the household sector get to issue long-term, risky liabilities and to hold short-term, risk-free assets. The household sector ultimately owns the equity in the nonfinancial corporate sector and in the financial sector. The government, through deposits insurance and ad hoc bailouts, has in some sense written put options on firms in the financial sector, and as taxpayers we are on the hook for those put options.

If the government comes up with regulations that make it more difficult for the financial sector to expand and exploit its put options, then you might call that financial repression. But in that case, it is not clear that financial repression is a bad thing.

Forecasts for 2014

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Politico asks several economists for forecasts. What ensues is mostly ideological axe-grinding. In contrast, Dean Baker plays it straight, and makes an actual forecast.

There is also some serious downside risk in the stock market. Its valuation is definitely high right now, although I wouldn’t necessarily say it is a bubble. Nonetheless, if people are expecting another year of large gains, then they must be smoking something strong. The real story is likely to be with the social media companies. When you have a start-up with no clear business plan, like Snapchat, that can sell for $3 billion, you know things have gotten nutty. Some of these companies will no doubt survive and be profitable, but it takes a lot of profits to justify a $3 billion market cap, to say nothing of the $34 billion for Twitter or $130 billion for Facebook. These prices will come back to earth, and 2014 is as good a year as any for it to happen.

Pointer from Menzie Chinn.

I am nervous about the stock market also. But my main prediction is for increased ideological axe-grinding.

John Cochrane Interview

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Self-recommending, but I also read it and recommend it. Tyler and Scott have commented on it already.

if we purge the system of run-prone financial contracts, essentially requiring anything risky to be financed by equity, long-term debt, or contracts that allow suspension of payment without forcing the issuer to bankruptcy, then we won’t have runs, which means we won’t have crises. People will still lose money, as they did in the tech stock crash, but they won’t react by running and forcing needless bankruptcies.

This sounds somewhat radical to me. On the one hand, you want to allow some financial intermediation, which I might define as opaque financial institutions that hold risky, long-term assets and issue riskless short-term liabilities. On the other hand, you don’t want bank runs. What I would like to see are deposit-like contracts in which under certain conditions penalties may be imposed for rapid withdrawals. In the middle of a bank run, you can withdraw your money, but you lose, say 10 cents on the dollar. That sort of contract would have saved AIG, for example. When Goldman and the other firms that held credit defaults swaps written by AIG wanted to make withdrawals (termed “collateral calls”) they would have had to think twice about it. I made this suggestion in real time, back in 2008.

The interview has many great sound bites, but my favorites are these:

I think coming up with new theories to justify policies ex post is a particularly dangerous kind of economics.

and

the need for special savings accounts for medicine, retirement, college, and so on is a sign that the overall tax on saving is too high. Why tax saving heavily and then pass this smorgasbord of complex special deals for tax-free saving? If we just stopped taxing saving, a single “savings account” would suffice for all purposes!

Of course, we are getting a lot of the “particularly dangerous kind of economics” in the wake of TARP and the stimulus. I wish that the new theories were being developed to better account for reality, whether or not they serve to justify policy.

Finally,

Time-varying risk premiums say business cycles are about changes in people’s ability and willingness to bear risk. Yet all of macroeconomics still talks about the level of interest rates, not credit spreads, and about the willingness to substitute consumption over time as opposed to the willingness to bear risk. I don’t mean to criticize macro models. Time-varying risk premiums are just technically hard to model. People didn’t really see the need until the financial crisis slapped them in the face.

I think of Minsky as offering a useful theory of time-varying risk premiums, but that is probably not what John has in mind.

I have not given you all of the good material in the interview, by any means.