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From an entertaining article in the Financial Times that develops the analogy between the interconnectedness of financial instruments and biological ecosystems.
“From an individual firm’s perspective, these strategies looked like sensible attempts to purge risk through diversification: more eggs are being placed in the basket,” says Mr Haldane. “Viewed across the system as a whole, however, it is clear now that these strategies generated the opposite result: the greater the number of eggs, the greater the fragility of the basket – and the greater the probability of bad eggs.”
That is what a mathematical ecologist would have predicted if he or she had known what was going on in the world of finance. The tropical rainforest, for example, has so many interdependent species that it is more vulnerable to an external shock than the simpler ecological diversity of savannahs and grasslands.
I wonder what prescription naturally arises from this perspective? Total laissez-faire so that the financial system can suffer enough crashes, extinctions, and re-organizations to find a configuration that is stable for the long run? Would we someday see Business schools sending missions out to shuttering financial institutions clamoring for intervention in the name of preserving derivative-diversity. What is the analog of sexual reproduction and random genetic mixing?
Nobel Laureate Eric Maskin gives an extended interview at The Browser arguing that economic theory was indeed equipped to see and understand the roots of the financial crisis. Its a unique interview because Eric picks 5 or so academic articles, discusses them in detail and weaves together a story of the crisis based on these. The story has some standard ingredients: bank runs, moral hazard, liquidity crises, and contagion. He illustrates each of these with a specific paper. The story also has some non-standard ingredients, such as leverage cycles described in a paper by Fostel and Geanakoplos.
The interview concludes thusly,
Q: So policymakers, especially people in Congress, need to read these papers.
A: Yes, or at least understand what’s in them. I think most of the pieces for understanding the current financial mess were in place well before the crisis occurred. If only they hadn’t been ignored. We’re not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them.
Highly recommended.
I have read and heard anecdotal evidence that litigation in the United States is countercyclical. Usually this is cynically explained by saying that when times are tough everybody is looking to make an extra buck. But of course everybody is looking to make an extra buck when times are good too.
All of business activity relies on relationships that are partially supported by contracts and partially supported by trust. Trust fills in the gaps of incomplete contracts. When the contract is not followed to the letter, your interest in maintaining a healthy relationship smooths things over.
Bad times raise uncertainty about whether there are any gains left from this relationship in the future. This undermines trust and the result is that the courts are called in to fill the gaps.
There are a couple of natural ways to test this theory. First the countercyclical nature of litigation should vary across sectors. Thick markets with relatively anonymous actors should see less impact of economic downturns on the rate of litigation. Also, the effect outlined above is based on the assumption that contracts are written in good times and litigated in bad times. If the downturn is expected to last, then new contracts should tend to be more complete, taking into account the increased appetite for litigation. The result should be less litigation in longer downturns than in shorter ones.
I thank Rosemary for the conversation.
Iceland is seeing a small baby boom.
The Icelandic press buzzed with the good news. One article quoted a midwife in the town of Húsavik who noted a bump in births in June and July — an auspicious nine months after the worst of Iceland’s meltdown. Wrote blogger Alda Sigmundsdóttir: “I think many, many of us must have sought solace in love and sex and all that good stuff.”
Italians too, and condom sales were brisk at the low point of the recession in the US. But historical pattern has been procyclical procreation*
“total fertility” — roughly, the average number of children per woman during her childbearing years — was 2.53 in 1929 and had slid to 2.15 by 1936. Then came the baby boom of postwar prosperity: The birth rate crossed 3 in 1947 and remained above that threshold until the mid-1960s. The next trough, 1.74, came in 1976 — a year earlier, unemployment had hit a postwar peak of 8.5%.
The article is in the Wall Street Journal.
__________
*The pun involving “hump” is an exercise left to the reader.
I grew up in southern California which means that everything I ever needed to know I learned on the 405. Driving in traffic serves as a useful metaphor for a lot of life and it wasn’t until this morning that I made the connection and started to understand what Simon Johnson has been talking about all this time in blog posts like What Is Finance Really?
The parallels are clear between financial markets and driving in traffic. Arbitrage is the controlling force. For example, on the freeways arbitrage equalizes the traveling time across lanes, the commuters version of the efficient markets hypothesis.
You don’t have to have spent much time on the freeways to understand why arbitrage is not always efficient. An individual driver can get where he is going faster by changing lanes, but since there is a fixed capacity on the road this is always at the expense of somebody else. In equilibrium the total distance traveled by all is the same as if everybody were required to stay in their lanes. The arbitrage turns out to be a pure social loss due to the increased frequency of accidents.
Addendum: Calculated Exuberance has a nice take.
Ohio has approved bringing slot machines to race tracks, expecting to bring in close to $1 billion in taxes and license fees.
“Look, we are one of the few large states in the country that fixed our budget problems without raising taxes,” [Chairman of the State Democratic Party Chris] Redfern said.
…
Ohio is far from alone when it comes to budget problems. According to the Center on Budget and Policy Priorities, a Washington-based think tank, every state but Montana and North Dakota is up against shortfalls in the 2009 and 2010 fiscal years.
Politicians are turning to gambling to help close that gap, sometimes with the backing of voters. For example, in the 2008 election cycle, Colorado voters backed the expansion of table gaming and betting limits at casinos; Missouri voters approved the end of “loss limits” during casino sessions.
Meanwhile, Delaware’s legislature has legalized sports betting in casinos, although that is being fought in the courts by the major professional sports leagues. Pennsylvania and Illinois are moving to place video poker machines in bars.
NPR had the story.
The link I posted previously was somewhat outdated as it mentioned only that furloughs were under consideration. As a part of the recent budget agreement, the UC furlough is now a done deal. Here are some more recent stories.
I have heard that, system-wide, professors will take an 8% cut in pay. The word “furlough” usually means something like a temporary layoff. Here it means that workers will have shorter hours and commensurately lower pay. For example, UC non-faculty staff will have a few days off each month.
What are the marginal hours where Professors will be furloughed? Saturdays. That is, no classes will be cut, all administrative duties remain intact, pay is cut 8%. Presumably this means that my colleagues in UC system will be doing 8% more surfing the web when they are not in the classroom.
How do you cut the price of a status good?
Mr. Stuart is among the many consumers in this economy to reap the benefits of secret sales — whispered discounts and discreet price negotiations between customers and sales staff in the aisles of upscale chains. A time-worn strategy typically reserved for a store’s best customers, it has become more democratized as the recession drags on and retailers struggle to turn browsers into buyers.
Answer: you don’t, at least not publicly. Status goods have something like an upward sloping demand curve. The higher is the price, the more people are willing to pay for it. So the best way to increase sales is to maintian a high published price but secretly lower the price.
Of course, word gets out. (For example, articles are published in the New York Times and blogged about on Cheap Talk.) People are going to assign a small probability that you bought your Burberry for half the price, making you half as impressive. An alternative would be to lower the price by just a little, but to everybody. Then everybody is just a little less impressive.
So implicitly this pricing policy reveals that there is a difference in the elasticity of demand with respect to random price drops as opposed to their certainty equivalents. Somewhere some behavioral economists just found a new gig.
The financial markets are deregulated, banks are “too big to fail”, interest rates were kept low by Alan Greenspan etc…are these the only issues that caused the financial crisis?
Malcolm Gladwell has a very interesting article suggesting overconfidence played a role in causing the bubble that eventually burst. The main protagonist in the story is Jimmy Cayne, former C.E.O. of Bear Stearns. The man was sometimes confident and perhaps over confident:
The high-water mark for Bear Stearns was 2003. The dollar was falling. A wave of scandals had just swept through the financial industry. The stock market was in a swoon. But Bear Stearns was an exception. In the first quarter of that year, its earnings jumped fifty-five per cent. Its return on equity was the highest on Wall Street. The firm’s mortgage business was booming. Since Bear Stearns’s founding, in 1923, it had always been a kind of also-ran to its more blue-chip counterparts, like Goldman Sachs and Morgan Stanley. But that year Fortune named it the best financial company to work for. “We are hitting on all 99 cylinders,’’ Jimmy Cayne told a reporter for the Times, in the spring of that year, “so you have to ask yourself, What can we do better? And I just can’t decide what that might be.’’ He went on, “Everyone says that when the markets turn around, we will suffer. But let me tell you, we are going to surprise some people this time around. Bear Stearns is a great place to be.’’
Gladwell connects overconfidence to success at some games people play in nature and refers to work by biological anthropologists. This all seems quite interesting and I can see chasing it up for fun. But he then goes on to try to connect Cayne’s overconfidence to his success at bridge – appreantly he is an excellent player and it helped him get his job at Bear Stearns. This is a disconnect. Bridge is a zero-sum game. Behavioral biases such as overconfidence lead people to make mistakes and hence lose out more than people who judge hands correctly. If Cayne is good at bridge, he must judge probabilities accurately rather than exaggerating his odds of success. This then implies that he is less likely to be overconfident than others working in finance who are perhaps bad at bridge and poker as they are overaggressive.
So, while Gladwell may have a point to make, he does not do it convincingly as his main example concerns a protagonist who is less likely to be overconfident as he is good at zero-sum games.
Goldman Sachs and JP Morgan have quickly returned the money they got from the government. The CEO Of JP Morgan sees it as a badge of honor:
Amid the surge, Jamie Dimon, JPMorgan’s chief executive, has cemented his status as one of America’s most powerful and outspoken bankers. He has vocally distanced himself from the government’s financial support, calling the $25 billion in taxpayer money the bank received in December a “scarlet letter” and pushing with Goldman Sachs, Morgan Stanley and others to repay the money swiftly. Those three banks repaid the money last month.
Whether a bank returns the money quickly and even if they never got any of it, the bank gained from the intervention. Why? Because if AIG, to name the key firm, had gone down, the chain of interlinked insurance contracts that it sold would have been worth nothing. This would impact the whole financial system, including Goldman Sachs etc. That’s why credit was coming to a halt as no-one knew the value of the insurance contracts that were supposedly providing a safety net.
So, taxpayers bailing out AIG helped all these banks, even those who did not participate in the government program. (It’s a classic free-rider problem in public good provision.) So, where’s my Goldman bonus since I helped to save the financial system?
In Japan, robots makeup a measurable fraction of the manufacturing workforce:
In 2005, more than 370,000 robots worked at factories across Japan, about 40 percent of the global total, representing 32 robots for every 1,000 manufacturing employees, according to a report by Macquarie Bank. A 2007 government plan for technology policy called for one million industrial robots to be installed by 2025. That will almost certainly not happen.
Robots are apparently the first to be let go in Japan in a recession. And the cuts go even deeper.
Roborior by Tmsuk — a watermelon-shape house sitter on wheels that rolls around a home and uses infrared sensors to detect suspicious movement and a video camera to transmit images to absent residents — has struggled to find new users. A rental program was scrapped in April because of lack of interest.
Here is the story from the New York Times.
See the press release here. The practical significance of this is that trade in IOUs is subject to standard regulation. Brokers or other intermediaries facilitating trade between buyers and sellers must be registered as exchanges with the SEC. In related news, the three largest banks in California will stop redeeming IOUs tomorrow. Its going to be a nice summer for the Check Cashers. Note that the IOUs pay 3.75% interest, tax free.
There has been a run on one of the largest banks in an economics-themed online role-playing game called Eve. The event merited an article at the BBC. The run was triggered when Ricdic, an executive of the bank made off with a large sum of virtual lucre and exchanged it for real-world cash.
Eve Online has about 300,000 players all of whom inhabit the same online universe. The game revolves around trade, mining asteroids and the efforts of different player-controlled corporations to take control of swathes of virtual space.
It has now emerged that Ricdic used the cash to put down a deposit on a house and to pay medical bills.
“I’m not proud of it at all, that’s why I didn’t brag about it,” Ricdic told Reuters. “But you know, if I had to do it again, I probably would’ve chosen the same path based on the same situation.”
Apparently, the bank had tremendous reserves and has so far withstood the run. Here is more information. Either real-world bank regulators have something to learn from Eve or the other way around because here is Ricdic’s comeuppance:
Ricdic has now been thrown out of the game as trading in-game cash for real money is against Eve Online’s terms and conditions.
The rules governing play within Eve would not have sanctioned Ricdic if he had simply stolen the cash and used it in the game, nor if he had bought kredits with real dollars.
Fedora Flourish: BoingBoing
At the blog Everything Finance, Jonathan Parker breaks down the implications of the State of California issuing IOUs to rollover its debts, essentially creating a new currency whose value is pegged to the US Dollar. He makes a number of interesting points including the observation that since California cannot print Dollars, and cannot issue (conventional) debt, the IOUs place the State in a predicament reminiscent of financially-distressed countries having to defend a pegged exchange rate.
And unfortunately, the history of fixed exchange rates in practice includes lots and lots of these effective defaults. Governments that can issue these i.o.u.’s and have trouble balancing budgets tend to issue a greater value of their currencies than they have the will or ability to maintain. And default follows.
Prior to “maturity” will these IOUs trade at some market price reflecting the probability of default? One question is whether banks will be interested in buying IOUs, offering liquidity in return for the asset and a premium? The strategic issue is whether politically the State will find it more or less attractive to default if the IOUs are still largely held by private citizens, or instead mostly by banks?
My guess is that, in a crisis, a small number of banks would more effectively pressure the State to meet their obligations than if IOU holdings were less concentrated. If so, then I would expect banks to be buying IOUs at a steep discount. But does this create a Grossman-Hart style free-rider problem analogous to tendering shares in takeover bids?
We used to be in denial that there were any bubbles, now everything is a bubble. This article in the Chronicle of Higher Education sounds the alarm on higher education (tassle twirl: lone gunman.)
Is it possible that higher education might be the next bubble to burst? Some early warnings suggest that it could be.
With tuitions, fees, and room and board at dozens of colleges now reaching $50,000 a year, the ability to sustain private higher education for all but the very well-heeled is questionable. According to the National Center for Public Policy and Higher Education, over the past 25 years, average college tuition and fees have risen by 440 percent — more than four times the rate of inflation and almost twice the rate of medical care. Patrick M. Callan, the center’s president, has warned that low-income students will find college unaffordable.
Meanwhile, the middle class, which has paid for higher education in the past mainly by taking out loans, may now be precluded from doing so as the private student-loan market has all but dried up.
The analogy to the housing bubble is certainly tempting. Pell grants and Stafford Loans are to Colleges what Fannie and Freddie are to housing. It is undeniable that easy access to credit fueled rises in tuition. It is not a stretch to think of these loan programs as essentially subsidies to Universities as they raise tuition dollar for every dollar of loans that are essentially forgiven.
But the analogy doesn’t go any farther than that. There is no speculation fueling demand for higher education. There is a permanent and measurable difference in earnings for college graduates. There will continue to be a robust market for credit to students because, to borrow a phrase, consumption wants to be smoothed. And unlike subsidized loans for housing, there is a real externality that justifies continued federal presence in the student loan market.
Phillip Swagel was the Assistant Secretary for Economic Policy at the Treasury from December 2006 to January 2009, the peak of the financial crisis. He has written a post-mortem of Treasury’s anticipation of, and response to, the financial crisis. This includes the decision to support the buyout of Bear Stearns, to allow Lehman Brothers to fail, to bail out AIG (the very next day) and the proposal and later abandonmnet of the use of TARP funds to buy toxic assets.
This is absolutely essential reading. Swagel has been very thorough and very honest. Here are the highlights of this 52 page retrospective. (Helmet Hoist: the Baseline Scenario.)
Anticipation of the Crisis Henry Paulson was organizing economists at the Treasury to prepare for stress to the financial system as early as Summer 2006 when he was appointed Treasury Secretary.
Secretary Paulson also talked regularly about the need for financial institutions to prepare for an end to abnormally loose financial conditions.
They recognized that recent financial innovation and increased international integration would pose novel challenges if there were a shock to the system. Nevertheless, Swagel acknowledges that they significantly underestimated the threat of the housing downturn as a potential shock. Here is an eye-opener.
What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007. This was something pointed out by staff from the Federal Deposit Insurance Corporation (FDIC), who had already (correctly) pointed out that the situation in housing was bad and getting worse and would have important implications for the banking system and the broader economy.
Initial Reactions to the Developing Crisis The first two major policy proposals emerged in August 2007. One was focused on increasing transparency of the quality of mortgages underlying asset-backed securities.
The paradox was that this database did not exist already—that investors in mortgage-backed securities had not demanded the information from the beginning.
The second was an early incarnation of what was eventually TARP. The MLEC was a kind of “bad bank” intended to hold toxic assets off bank balance-sheets while the market adjusted and re-priced them. This was the earliest expression of the Treasury stance that the assets are underpriced by the market and what was needed was patience for the turmoil in the markets to cool down. The banks didn’t go for it:
While banks dealt with the problem on their own, the MLEC episode looked to the world and to many within Treasury like a basketball player going up in the air to pass without an open teammate in mind—a rough and awkward situation.
Neither of these plans “came to fruition.” In the case of MLEC, the reason is implicit in the above quote, but Swagel is silent on what happened to the database idea.
Addressing the Housing Crisis Directly There is a long discussion in the article about various policies to intervene directly in the housing market. The general theme here is that Treasury, and especially White House Staff, were resistant to any policy that would appear to help out “irresponsible homeowners.” While Congress enacted some policies aimed at mortgage modifications, the White House would not go farther than removing red tape to streamline the modification process for mortgage servicers. The effects of all of these policies were limited:
As a practical matter, servicers told us that considerations of moral hazard meant that they did not write down principal on a loan when the borrower had the resources to pay—never. They would rather take the loss in foreclosure when an underwater borrower walked away than have to take multiple losses when entire neighborhoods of homeowners asked for similar write downs of loan principal.
(By the way, a game theorist would call this “reputation effects” rather than moral hazard, but that’s beside the point…)
Bear Stearns, Lehman, AIG There is not much explanation for why the Fed decided to make loans to JPMorgan to help them buy out Bear Stearns. Essentially, Swagel is saying they were caught off-guard, saw serious problems with a Bear-Stearns failure, and had to act quickly.
At Treasury, two additional lessons were learned: (1) we had better get to work on plans in case things got worse, and (2) many people in Washington, DC did not understand the implications of non-recourse lending from the Fed. This latter lesson was somewhat fortuitous, in that it took some time before the political class realized that the Fed had not just lent JP Morgan money to buy Bear Stearns, but in effect now owned the downside of a portfolio of $29 billion of possibly dodgy assets.
Why did they bail out AIG but not Lehman?
In sum, AIG was larger, more interconnected, and more “consumer facing” than Lehman. There was little time to prepare for anything but pumping in money—and at the time only the Fed had the ability to do so for AIG. Eventually the AIG deal was restructured with TARP funds being used to replace Fed lending in order to give AIG a more sustainable capital structure and avoid a rating agency downgrade that would have triggered collateral calls.
But there are regrets.
As time went on, it became clear that AIG was a black hole for taxpayer money and perhaps a retrospective analysis will demonstrate that the cost-benefit analysis of the action to save AIG came out on the other side. But this was not apparent at the time.
Fannie and Freddie Interestingly, the debate about whether to take ownership of the GSEs centered not around moral hazard, but whether making explicit the already implicit government guarantees of their debt would threaten to downgrade Treasuries.
putting the GSEs into conservatorship raised questions about whether their $5 trillion in liabilities would be added to the public balance sheet. This did not seem to Treasury economists to be a meaningful issue, since the liabilities had always been implicitly on the US government balance sheet—and in any case were matched by about the same amount of assets. But the prospect that rating agencies might downgrade U.S. sovereign debt was unappealing.
TARP and its Abandoment The econ-blogosphere’s favorite topic. What was Treasury’s rationale for proposing to use reverse auctions to buy “toxic assets.” Swagel vociferously denies that the intention was to inject capital by overpaying for assets. Instead, they had a multiple-equilibrium view. Committing to buy enough of the assets would restore confidence in their value and would unstick the markets. But he has a difficult time explaining this without it sounding like overpaying for assets.
if Treasury were to get the asset prices exactly right in the reverse auctions, those prices will be higher than the prices that would have obtained before the program was announced. That difference means that by paying the correct price, Treasury would be injecting capital relative to the situation ex-ante. And the taxpayer could still see gains—say if the announcement and enactment of the TARP removes some uncertainty about the economy and asset performance, but not all. Then prices could rise further over time. But the main point is that it is not necessary to overpay to add capital.
Surprisingly, Swagel says that Treasury had reverse auctions “ready to go” in October 2008. Why were they never started?
A concern of many at Treasury was that the reverse auctions would indicate prices for MBS that were so low they would make other companies appear to be insolvent if their balance sheets were revalued to the auction results.
Swagel suggests that their auction consultants (Ausubel and Cramton) had a way to deal with this but,
to some at Treasury the whole auction setup looked like a big science project.
Parting Shot He concludes with the following.
An honest appraisal is that the Treasury in 2007 and 2008 took important and difficult steps to stabilize the financial system but did not succeed in explaining them to a skeptical public. An alternative approach to this challenging necessity is to use populist rhetoric and symbolic actions to create the political space under which the implicit subsidies involved in resolving the uncertainty of legacy assets can be undertaken. It remains to be seen whether this approach will be successful in 2009.
The federal government owns preferred stock in many of the banks it has bailed out. According to the NYT, it is thinking about converting this preferred stock to common stock. The article also claims that this reduces the need for a further capital infusion and hence the need to go back to a feisty Congress for more money.
How could that be? Isn’t the re-labeling of stocks going to leave banks with exactly the same amount of capital and not change anything? This is just rearranging chairs on the Titanic.
The key sentence is the article is:
The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity.
Preferred stock used to recapitalize banks does not come with voting rights but does come with a compulsory dividend. It is 5% now and rises to 9% after five years. In that sense, the preferred stock are more like debt that equity. There is a risk that a bank defaults on this in the same way it could default to other debt holders. Converting it to common stock implies the government gets voting rights but gives up the dividend. This reduces the payments the bank has to make on a regular basis and hence makes it more liquid. This appears to be the main idea. It is good for the banks as their debt obligations are reduced. It makes it more likely they survive.
What about taxpayers? They are taking on more risk as their stake is more junior than before. There are two countervailing effects. First, maybe the probability of bankruptcy goes down as a result of this so the risk goes down. Second, the initial decision to acquire preferred stock may have been politically expedient in which case it did not maximize shareholder/taxpayer value. There is the perception of a big political cost of being seen to nationalize banks. The initial plan reflected this political constraint. This plan is a move to pay this cost to avoid the new political constraint, the cost of going to Congress. So, maybe the Congress constraint is helping Obama to move to the economic optimum from the constrained political optimum as one political constraint cancels out the other.
On Friday the 13th of February, the City of Chicago saw the first of a planned series of parking meter rate hikes which will eventually quadruple the hourly parking rate in the downtown area. This is happening because last year the City of Chicago sold the cash flow from parking fees for approximately $1 billion to a private investment fund. (No doubt soon to be securitized and tranched into Meter-Backed Securities. Quick: tell me how to price CDS protection against the event that Daley renegs once the billion is spent.)
The deal enables Chicago Parking LLC to raise fees according to a set schedule over the next ten years. After that, further rate increases must be approved by the City Council. The contract expires in 75 years.
Why would the City go for such a deal? Yes it is starved for cash and parking meters currently hard-wired at 50 cents an hour in most of the city are long overdue for an uptick. But this just argues for a fee increase, it doesnt explain why the meters should be privatized.
The economics of privatization are straightforward in this case. The city seeks bids for the parking meter cash flow. A bidder offers an upfront payment and a schedule for price increases. The upfront payment will be no less than the present value of the cash flow as determined by the new prices. Competition will ensure that the payment will be exactly this cash flow. This means that the high bidder will be the one who demands a price that maximizes the present value of cash flows. In other words, the monopoly price.
Remember from your textbook microeconomics that the monopoly price is associated with inefficiently low quantity. Zero marginal cost doesnt make this any less damaging, in fact it implies that on many streets there will be empty spaces all day long. Cozy, inviting parking spaces will be utilized by nobody.
Again the city could set the monopoly price on its own, so we still have the puzzle of why, if the City is willing to allow monopoly pricing it has to use a private entity as its agent. The answer is not because the City wants its cash up front. Apparently it does want its cash up front but it could always just borrow against the parking cash flows.
The only answer I can come up with is a commitment problem. The City could certainly borrow against the cash flows and set the monopoly price but then the City itself would be the target of the uproar that will soon occur when drivers in the city realize that their cars are now worthless. The political pressure would force the fees to be kept low and the City would then have to find another way to finance its parking debt. In fact, foreseeing this, no lender would be willing to lend the full present value of monopoly cash flows.
By contractually delegating the fee-setting to a private agent, the City effectively commits never to lower fees so that the monopoly cash flow is guaranteed and the City can extract it all in an upfront payment.
What’s your favorite crisis euphemism?
In trying to rebrand dodgy financial instruments, treasury secretaries like Paulson and Timothy Geithner are continuing a recent tradition. So much of the finance sector’s innovation in the past 30 years, it turns out, wasn’t developing new stuff, but rather developing new ways of talking about pre-existing stuff. In the 1980s, labeling risky debt offerings as junk bonds was an intentionally ironic feint (pros knew that the instruments possessed real value). But as junk bonds went mainstream in the 1990s, they evolved into “high-yield debt”—their liability became an asset. Frank Partnoy, a reformed derivatives trader who teaches law at the University of San Diego, recalls that at Morgan Stanley in the 1990s, “we were constantly coming up with new acronyms” to describe similar financial instruments. The goal: to present products, some of which had been discredited, in a more favorable light.
I like “distressed assets.” Clearly the poor damsels need to be rescued from those nasty banks. Or is the image rather one of “gently used” furniture?
The article is “Bubblespeak” and it’s at Slate.com. (nod to Language Log.)
This post from Mark Thoma is useful in spelling out some of the accounting behind the Geithner plan and its old incarnation due to Paulson and co. But we cannot asssess the policy unless we come to grips with the Treasury’s motives for intervening in the first place. When we do the picture changes a lot and it becomes clear that this amounts to a blanket insurance policy for the banks.
Suppose that a bank has a stockpile of toxic assets, and suppose that this bank is solvent only if those assets value at least $X. When TALF comes to negotiate the purchase of these assets, we know that the bank will not accept anything less than $X for them. Accepting less than $X turns a concern which is potentially solvent (under rosy assumptions about a recovery in the market for the assets) into one which is certainly insolvent. The balance sheet woud now be transparent and the bank will be shut down.
So TALF either results in no sale, or a sale above $X. A sale at $X or higher ensures that the bank is solvent and therefore amounts to guarantee of the bank’s liabilities.
I am not expert enough to know whether guaranteeing the bank’s liabilities is a good idea (I suspect it is not the best), but I can say this. If free insurance is what the Treasury wants out of TALF, then TALF is a bad way to do it. A simpler and far better way is to simply declare that the bank’s liabilities are backed by the government. It amounts to the same thing if TALF were to work properly. But there are many ways TALF could go wrong.
For example, there is no assurance that under TALF the bank will actually use the $X cash from the sale to stay in business. No doubt Geithner will make sure that an AIG-style transfer to executives and shareholders will not happen but there are too many other possibilities to guard against in law. By contrast, a real insurance guarantee means that the money does not change hands until the creditors come calling and then it goes directly to the creditors without the bank ever touching it.
A second problem with TALF is that the government typically does not know the exact value of $X. To be sure that it actually covers $X, it would have to accept the high probability that it overpays. With a real insurance policy there is no need to guess at X because it will be revealed when the bank defaults.
BTW, I made a related, but somewhat different point about TALF’s predecessor here (pretty technical.)
Banks who bought CDS protection from AIG could, and did, hedge against failure of AIG by buying CDS protection against AIG default. So where’s the problem?
The problem facing the banks had AIG failed has less to do with their $ exposure to AIG and more with their position exposure to AIG. For example, let’s say I buy $100mm of protection from AIG and then I buy protection on AIG to hedge against the case of AIG’s bankruptcy. Let’s say AIG does in fact go bust. In the ideal scenario the collateral plus the AIG hedges offset exactly my CDS MTM exposure against AIG, then the banks don’t actually lose money. However, the problem is that they are now long risk $100mm of protection (because their $100mm short risk position against AIG is now gone). What happens then is the market realizes that a dozen banks have massive long risk positions in much of the same trades that they will all now try to hedge at the same time. Spreads blow up and the banks lose.
There is much more in this interesting article.
NPR had a story this morning about the rise of loan sharking in Italy as a fallout from the credit crisis. The question to ask is why is the credit crunch affecting banks but not loan sharks? Credit is credit so why does the credit crisis make lending cheaper for loan sharks than for banks? Put differently, if loan sharks have an advantage over banks why didn’t they have the same advantage before the crisis?
A simple story is based on a fundamental problem with the way credit markets operate. The market for credit is like any other market with supply and demand and a price. The price is the interest rate. The problem with the credit market is that the price often cannot serve its usual market-clearing purpose. When the supply of credit goes down, the interest rate should rise to clear the market. Clearing the market means reducing demand to bring it back in line with the low supply. The problem is that high interest rates reduce demand by disproportinately driving away borrowers who are good credit risks and leaving a pool of borrowers who are now more risky on average. This makes lending even more costly, reducing supply, driving the price up again…
The effect is that there may be no way to clear the market by raising interest rates. Instead credit must be rationed. This is part of the story of the credit crisis. By itself it doesn’t explain the rise of loan sharks yet because loan sharks face the same problem.
One way to improve rationing is to increase collateral requirements. But borrowers who are already excessively leveraged (the other part of the credit crisis story) will not have additional collateral to compete for the rationed loans. Here is where the loan shark comes in. Loan sharks use a form of collateral that banks do not have access to: kneecaps. Highly leveraged borrowers who are rationed out of the credit market cannot post collateral to service their debt so they turn to loan sharks.
here are my two simple ways of thinking about fiscal stimulus.
from the perspective of the stimulee: the federal government is right now the cheapest source of capital. in fact capital has never been cheaper. the treasury can borrow at record low interest rates. unfortunately the banking system is not doing its job as an intermediary channeling this credit to the bridge-builders. so the bridge-builders effectively borrow directly from the source by accepting stimulus dollars and promising to pay them back in the future with taxes.
(of course there is a wedge between the amount i receive in stimulus ($X) and the amount I pay in taxes ($X/N) and this makes me inefficiently eager to accept it. this is why stimulus should focus on public projects where the benefits are dispersed equally.)
from the perspective of government. we accept that there are things government should be producing, in particular public projects where the benefits are dispersed equally. the government has flexibility in the timing of these investments. since the investment requires coupling labor with the government’s capital, the optimal timing is during times of (otherwise) unemployment when labor is relatively cheap.
so we don’t have to think about multipliers and we don’t have to think about Keynesian effective demand. The government acting optimally to smooth expenditures should spend a lot now. Yes, it means spending must be correspondingly reduced in the future and critics would worry that this won’t happen. But there will come a time when interest rates are higher and it is more costly for the government to borrow and under pretty much any theory you have of how spending is determined, at the margin at least, that will have the effect of reducing spending.
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