Category Archives: markets

Killing Financial Institutions with Kindness

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Viral V. Acharya and Bruce Tuckman write,

Well, heck, I can’t copy/paste from the paper. Anyway, they suggest that when the lender of last resort provides funding to firms with illiquid assets, those firms remain too highly levered and actually increase their risk of default. They mention a number of solutions, but it seems to me that Bagehot had yet another–lend freely, but at a penalty rate. If the lender of last resort charges a high interest rate, then the recipient firms have an incentive to sell assets sooner rather than later.

Fun Re-reading

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For the macro book that I am working on, I wanted to refresh my memory for how the financial crisis played out. I went back to blog posts that I wrote in 2007. You can find them here. Scroll down to December, and look for posts “subprime daily briefing” (sometimes named slightly differently).

I staked out an early position against bailing our borrowers. I have no regrets there. At one point I said that the total wealth loss from the crisis would not be as large as the loss from popping the dotcom bubble–I think I was wrong about that.

I also staked out an early position in favor of capital forbearance by bank regulators, meaning that they would not force banks to sell assets at distressed prices to meet capital requirements. I still think that compared with what regulators actually did, this was a better approach.

Also interesting are the various links from the posts. For example, I found a paper by Michael Bordo, dated September 28, 2007.

Many of the financial crises of the past involved financial innovation which increased leverage. The 1763 crisis was centered on the market for bills of exchange, Penn Central on the newly revived (in the 1960s) commercial paper market, the savings and loan crisis of the early 1980s on the junk bond market, LTCM on derivatives and hedge funds.

In the most recent episode, the financial innovation derived from the securitization of subprime mortgages and other loans has shifted risk away from the originating bank into mortgage and other asset backed securities which bundle the risk of less stellar borrowers with more creditworthy ones and which were certified by the credit rating agencies as prime . These have been absorbed by hedge funds in the US and abroad, by offshore banks and in the asset backed commercial paper of the commercial and investment banks. As Rajan ( 2005) argued, shifting the risk away from banks who used to have the incentives to monitor their borrowers to hedge funds and other institutions which do not, rather than reducing overall systemic risk increased it by raising the risk of a much more widespread meltdown in theevent of a tail event as we are currently witnessing.

Creative Destruction in the Cultural Eye

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I saw the Ben Stiller “remake” of “The Secret Life of Walter Mitty.” I rarely watch movies, and I do not like many of those that I do see. Had the main character not been named Walter Mitty, no one would have suggested that it in any way resembles or rips off the Danny Kaye version or the original Thurber story. The movie starts out slowly, but it picks up about half way through.

What interested me was that a main theme was the evil of the “destruction” part of “creative destruction.” The background for the plot of the movie is that Life Magazine, where Mitty works, is about to disappear as a print publication. A cardboard-character villain comes to supervise the inevitable staff cuts. It strikes me that this depiction of obsolete businesses as the innocent victims of evil corporate villains has appeared in a number of movies in recent years (and again, I have only a small sample). Some possible reasons for this:

1. This is the zeitgeist. Many people are have lost jobs or are afraid of losing jobs, and this theme draw them in.

2. Showing the benefits from creative destruction is not as compelling. As an acquaintance of mine once said, in fiction, having a hero is optional. But you must have a compelling villain.

3. Hollywood has always been anti-business.

Meanwhile, Paul H. Rubin writes,

If we think in competitive terms, we say, “Wal-Mart has outcompeted small firms and driven them out of business.” If we take a cooperative view of the same event, we say, “Wal-Mart has done a better job of cooperating with customers by selling them things on better terms, and the small firms were not able to cooperate as well.” Same facts, but a very different emotional reaction.

Pointer from Mark Thoma. Somehow, I do not think that this is the magic cure for reducing the cultural bias against markets.

Finance and Macro

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Nick Rowe writes,

Here’s a very simple (and totally inadequate) theory of the rate of interest: it is set by the Bank of Canada. Add or subtract adjustments for risk, duration, liquidity, and earnings growth, and you get the equilibrium earnings yield on stocks. Take the reciprocal, and you get the P/E ratio. Done.

Why is that theory totally inadequate? Because the Bank of Canada does not set interest rates in a vacuum. It sets the rate of interest it thinks it needs to set to keep inflation at the 2% target. And that interest rate in turn depends on things like the demand for goods, and the Phillips Curve, and on the inflation target. And the demand for goods in turn depends on things like desired saving and investment, both in Canada and around the world. And those in turn depend on time-preference, and expectations of future income, and on the marginal rates of transformation of present goods into future goods, and whether there will be a demand for those future goods or a recession.

Read the whole thing.

This first paragraph reminds me that I have meant to write an imaginary Q&A with Scott Sumner.

Q: Why did the stock market go up about 2 percent the other day?

SS: Because the Fed announced an expansionary policy.

Q: But the Fed announced that it was tapering its purchases of assets, although they issued a “forward guidance” that interest rates would remain low. Given the somewhat contradictory announcement, how do we know that it was expansionary?

SS: Because the stock market went up about 2 percent.

Nick’s second paragraph reminds us that central bank policy is also endogenous. That is the way that I think of it.

So what’s my explanation for the rise in the market, which was obviously in response to the Fed announcement? A couple of possibilities.

1. Perhaps they read the taper announcement as an indication that the Fed has information that the economy is doing well. They took it as good news.

2. Perhaps a few key Wall Street gurus interpreted the announcement as good news, because of (1) or because they are devoted followers of Scott Sumner or because of the meds they were on or whatever. Then everyone else realized that if the gurus were optimistic then stocks would go up, so they pushed stocks up. It was collective irrationality. As Fischer Black famously said, the stock market is efficient only to a factor of 2.

The way I reconcile finance with macro is that I minimize the weight I give to macro. Markets are happy to let the Fed wiggle around an interest rate or two, as long as it does not wiggle too hard on an interest rate that really matters to the economy. If the Fed were to wiggle too hard on a rate that matters, the markets would find a way around that particular part of the money market in order to make that interest rate matter less. As an economist, your best bet is to treat interest rates and stock prices as determined by financial markets, rationally or otherwise (I vote otherwise), and not by the Fed.

Margin Requirements and Entrance Fees

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Tyler Cowen writes,

Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.

Think of what AIG was doing when it was writing credit default swaps on mortgage securities. It was taking tail risk by writing out-of-the-money options. If you believe Gary Gorton, they were fine, except that in 2008 their counterparties demanded collateral that they did not have, not because the options were in the money but because the options were closer to being in the money.

Today, if you want to pick up the nickels that you can earn by taking tail risk, you need to put up more margin. What Tyler is suggesting is that this increases the demand for safe assets relative to what it was prior to 2008. So even if the real return on T-bills is negative, they are worth it for financial institutions who use them to meet margin requirements on trades that enable them to make a profit.

If the financial institution is helping the economy by taking the tail risk, then it’s all fine. But Tyler suggests that the financial institution is not helping the economy (AIG was an enabler of the housing bubble). In that case, we would be better off with less tail-risk taking, which in turn would reduce the demand for safe assets and lead to a better allocation of saving and investment.

Stricter bank regulation may or may not help. The effect of risk-based capital regulations was to increase the demand for AAA-rated securities, which in turn increased the demand for credit default swaps written by AIG. So that was a case in which stricter bank regulation actually created (apparent) profit opportunities in taking tail risk. If regulation still has that effect, then it will increase the fundamental distortion in financial markets.

Janet Yellen on the Housing Bubble

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In a speech from 2005.

House prices could be high for some good, fundamental reasons. For example, there have been changes in the tax laws that reduce the potential tax bite from selling one home and buying another. Another development, which may be making housing more like an investment vehicle in the U.S., is that it’s now easier and cheaper to get at the equity—either through refinancing, which has become a less costly process, or through an equity line of credit. These innovations in mortgage markets make the funds invested in houses more liquid. There are also constraints on the supply of housing in a number of markets, including the Bay Area. Probably the most obvious candidate for a fundamental factor is low mortgage interest rates. Even so, the consensus seems to be that the high price-to-rent ratio for housing cannot be fully accounted for by these factors. So, while I’m certainly not predicting anything about future house price movements, I think it’s obvious that the housing sector represents a serious issue for monetary policymakers to consider.

…In my view, it makes sense to organize one’s thinking around three consecutive questions—three hurdles to jump before pulling the monetary policy trigger. First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble?

My answers to these questions in the shortest possible form are, “no,” “no,” and “no.”

In hindsight, her third “no” is the most persuasive. Her point is that regulatory policy could have served to deflate the bubble more directly than monetary policy. However, political leaders at the time were primarily focused on policies that served to inflate the bubble.

The pointer is from John Hussman, a Stanford-trained investment adviser who is concerned that we are in the midst of an equity bubble. He writes,

while price/earnings multiples appear only moderately elevated, those multiples themselves reflect earnings that embed record profit margins that stand about 70% above their historical norms.

Read Hussman’s entire essay. My comments:

1. I share the concern that stock prices may be overvalued.

2. However, I am not convinced that there is anything but a psychological connection between monetary policy and stock valuation.

3. One can hope that even a large “correction” in stock prices would not produce a financial crisis. It seems that debt, rather than equity, is the main cause of financial crises.

4. Therefore, I would not be appealing to the Fed to try to pop the (alleged) stock market bubble.

Pro-cyclical Capital Requirements

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Tobias Adrian and Nina Boyarchenko write,

Value-at-Risk constraints were incorporated in the Basel II capital framework, which was adopted by major security broker-dealers in the United States—the investment banks—in 2004. Thus, capital constraints are imposed by regulation. In our staff report, we embed the risk-based capital constraint in a model with three sectors: a production sector (firms), a financial intermediary sector, and a household sector. Intermediaries serve two functions: 1) they create new production capacity through investment in the productive sector, and 2) they provide risk-bearing capacity to the households by accumulating wealth through retained earnings. The tightness of the capital constraint—measured by the maximal allowed ratio between intermediary leverage and one over the VaR on the intermediary’s assets—thus affects household welfare. When this ratio is decreased, the intermediaries are more restricted in their risk-taking and can therefore finance less investment. At the same time, since intermediaries take on less leverage and less risk, the systemic risk of the intermediary sector decreases. Accordingly, there is a trade-off between the amount of risk-taking and the price of credit in the real economy.

Pointer from Mark Thoma.

Using value-at-risk to regulate capital is one of the worst ideas ever. First, it assumes a normal distribution of returns, which is not valid far from the mean. Second, as the authors point out, it tends to be procyclical. Third, it is not a measure of the size of the loss in a bad scenario; instead, it is a measure of the size of the loss in scenario that is just a bit better than a bad scenario.

A better approach would be to spell out a specific scenario–an x percent drop in house prices, or a y percent decrease in bond prices, or something along those lines.

Why Interest on Reserves?

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Scott Sumner writes,

Back in late 2008 a few money market funds got into trouble and were in danger of “breaking the buck.” That’s due to their policy of pricing each share at $1. The solution is to allow the price to fluctuate. The Fed should have given the industry 6 months to prepare for negative interest rates. Instead they bailed them out and propped up interest rates at 25 basis points, in order to insure they would never break the buck.

If not for the money market industry the Fed could have already cut the fed funds target to around negative 0.25%, and the same for the interest rate on reserves. In that case (and assuming the IOR also applied to vault cash) it’s likely that most of the ERs would exit the banking system and end up in safety deposit boxes. But three trillion dollars is a lot of Benjamins, and despite the cash hoards you observe in places like Japan, a more likely outcome would have been hyperinflation. Obviously that would not be allowed, so what this thought experiment really shows is that with that sort of negative IOR the Fed could have gotten the stimulus it wanted with much less QE.

The decision to pay interest on reserves is one of the great mysteries of the 2008 response to the financial crisis. In terms of monetary policy, it is clearly contractionary, and a financial crisis seems like an odd time to engage in a contractionary policy.

The Fed acts in mysterious ways. At the time, the Fed said,

Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.

Which to me says exactly nothing. It could be that the only way to find out the basis of the Fed decision is with an audit.

Bill Dudley Hearts Big Banks

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The New York Fed Chief says,

I am not yet convinced that breaking up large, complex firms is the right approach. In particular, these firms presumably exist, in large part, because there are scale or network effects that allow these firms to offer certain types of services that have value to their global clients. These benefits might be lost or diminished if such firms were broken up. In addition, the costs incurred in breaking up such firms need to be considered. Finally, the breakup of such firms would not necessarily result in a significant reduction in overall systemic risk if the resulting component firms were still, collectively, systemic.

He cites no evidence about “scale or network effects,” and he knows enough economics to know that those firms need not exist “in large part” because of them. In financial markets where a few basis points can be a tremendous advantage, the too-big-to-fail subsidy can be much more important than any legitimate scale economies. As for considering the costs of breaking up such firms, how does that cost compare to the cost of another financial crisis?

The point that smaller firms could have systemic risk is true, but not decisive. Smaller firms, because they cannot expect bailouts, would act in a more disciplined manner. They and their creditors would have to make decisions knowing that under most circumstances they, not the taxpayers, will bear the consequences.

A Finance Practitioner’s Perspective

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John Hussman writes,

the past 13 years have chronicled the journey of valuations – from hypervaluation to levels that still exceed every pre-bubble precedent other than a few weeks in 1929. If by 2023, stock valuations complete this journey not by moving to undervaluation, but simply by touching pre-bubble norms, we estimate that the S&P 500 will have achieved a nominal total return of only about 2.6% annually between now and then.

He uses the Shiller P/E ratio as his measure of over- or under-valuation. Thanks to Timothy Taylor for the pointer.

What I found even more interesting was a paragraph later in Hussman’s essay.

On careful analysis, however, the clearest and most immediate event that ended the banking crisis was not monetary policy, but the abandonment of mark-to-market accounting by the Financial Accounting Standards Board on March 16, 2009, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The change to the accounting rule FAS 157 removed the risk of widespread bank insolvency by eliminating the need for banks to make their losses transparent. No mark-to-market losses, no need for added capital, no need for regulatory intervention, recievership, or even bailouts. Misattributing the recovery to monetary policy has contributed to a faith in its effectiveness that cannot even withstand scrutiny of the 2000-2002 and 2007-2009 recessions, and the accompanying market plunges. This faith is already wavering, but the loss of this faith will be one of the most painful aspects of the completion of the present market cycle.

And I cannot resist the subsequent paragraph:

The simple fact is that the belief in direct, reliable links between monetary policy and the economy – and even with the stock market – is contrary to the lessons from a century of history. Among the many things that are demonstrably not true – and can be demonstrated to be untrue even with simple scatterplots – are the notions that inflation and unemployment are negatively related over time (the actual correlation is close to zero and slightly positive), that higher inflation results in lower subsequent unemployment (the actual correlation is positive), that higher monetary growth results in subsequent employment gains (the correlation is almost exactly zero), and a wide range of similarly popular variants. Even “expectations augmented” variants turn out to be useless. Examining historical evidence would be a useful exercise for Econ 101 students, who gain an unrealistic sense of cause and effect as the result of studying diagrams instead of data.