Results for “risk-based” 15 found
If we have a U.S. recession this year, it will be a risk-based recession
U.S. consumers showed signs of strength in January, taking advantage of low oil prices to increase their spending and offering a welcome counterpoint to the gloom that has gripped investors and roiled markets since the start of the year.
Sales at retail stores and restaurants rose 0.2% in January from the prior month, the Commerce Department said Friday. And December’s retail sales were revised to a 0.2% gain instead of a drop, showing a better end to the year than initially estimated.
While that is good news for everyone, if only because of the implied wealth effect, it ought to give Keynesians special cheer. And from another WSJ piece:
The sharp drop this year in consumer-focused stocks is feeding fears of a recession, but those companies’ bonds are sending a more upbeat signal.
Bonds from companies such as retailers and restaurants, which are most closely tied to consumer-spending habits, have been strong performers this year, contrary to what analysts would expect if the economy were headed into a tailspin.
The disconnect is notable, because many investors view the bond markets as a more sober indicator of corporate financial health and economic conditions than stock markets.
A risk-based business cycle results when investors (and others) perceive an increase in the risk premium, and pull back their commitments accordingly. Here are previous MR posts on risk-based business cycle theory.
Another risk-based model of business cycles
I say if you don’t understand risk-based models, it is difficult to grasp why recovery has been so slow, or why the cycle was so tough to begin with. Here is Mete Kilic, Jessica A. Wachter:
What is the driving force behind the cyclical behavior of unemployment and vacancies? What is the relation between job creation incentives of firms and stock market valuations? This paper proposes an explanation of labor market volatility based on time-varying risk, modeled as a small and variable probability of an economic disaster. A high probability of a disaster implies greater risk and lower future growth, which lowers the incentives of firms to invest in hiring. During periods of high disaster risk, stock market valuations are low and unemployment rises. The risk of a disaster generates a realistic equity premium, while time- variation in the disaster probability generates the correct magnitude for volatility in vacancies and unemployment. The model can thus explain the comovement of unemployment and stock market valuations present in the data.
That is a new NBER working paper.
Friday assorted links
1. More on risk-based business cycles.
2. “Residents in apartment blocks locked-down by NSW Health are having their alcohol deliveries policed as part of a policy to limit the number of drinks being consumed each day.” It seems that quite a few of these people want more than six beers a day.
3. Claims of a fusion breakthrough at MIT. And building Arcadia, a new science funding institution.
4. What do Germans fear the most?
5. How effective is the China crypto trading ban?
The WHO Report on COVID-19
The Report of the WHO-China Joint Mission on Coronavirus Disease 2019 (COVID-19) is the best source of information on COVID-19 that I have seen.
The Joint Mission consisted of 25 national and international experts from China, Germany, Japan, Korea, Nigeria, Russia, Singapore, the United States of America and the World Health Organization (WHO). The Joint Mission was headed by Dr Bruce Aylward of WHO and Dr Wannian Liang of the People’s Republic of China.
Some of the language is more pro-China than is usual in an academic report but the report is full of credible data.
The bottom line is that there is good news and bad news. The good news is that due to extraordinary intervention the epidemic in China has been brought under control and is slowing to manageable levels.
In the face of a previously unknown virus, China has rolled out perhaps the most ambitious, agile and aggressive disease containment effort in history. The strategy that underpinned this containment effort was initially a national approach that promoted universal temperature monitoring, masking, and hand washing. However, as the outbreak evolved, and knowledge was gained, a science and risk-based approach was taken to tailor implementation. Specific containment measures were adjusted to the provincial, county and even community context, the capacity of the setting, and the nature of novel coronavirus transmission there.
…. China’s bold approach to contain the rapid spread of this new respiratory pathogen has changed the course of a rapidly escalating and deadly epidemic. A particularly compelling statistic is that on the first day of the advance team’s work there were 2478 newly confirmed cases of COVID-19 reported in China. Two weeks later, on the final day of this Mission, China reported 409 newly confirmed cases. This decline in COVID-19 cases across China is real.
… Based on a comparison of crude attack rates across provinces, the Joint Mission estimates that this truly all-of Government and all-of-society approach that has been taken in China has averted or at least delayed hundreds of thousands of COVID-19 cases in the country. By extension, the reduction that has been achieved in the force of COVID-19 infection in China has also played a significant role in protecting the global community and creating a stronger first line of defense against international spread. Containing this outbreak, however, has come at great cost and sacrifice by China and its people, in both human and material terms.
The bad news is that the WHO is worried that other countries do not have the capability or will to implement some of the same policies as China did.
Much of the global community is not yet ready, in mindset and materially, to implement the measures that have been employed to contain COVID-19 in China. These are the only measures that are currently proven to interrupt or minimize transmission chains in humans. Fundamental to these measures is extremely proactive surveillance to immediately detect cases, very rapid diagnosis and immediate case isolation, rigorous tracking and quarantine of close contacts, and an exceptionally high degree of population understanding and acceptance of these measures.
.. COVID-19 is spreading with astonishing speed; COVID-19 outbreaks in any setting have very serious consequences; and there is now strong evidence that non-pharmaceutical interventions can reduce and even interrupt transmission. Concerningly, global and national preparedness planning is often ambivalent about such interventions. However, to reduce COVID-19 illness and death, near-term readiness planning must embrace the large-scale implementation of high-quality, non-pharmaceutical public health measures. These measures must fully incorporate immediate case detection and isolation, rigorous close contact tracing and monitoring/quarantine, and direct population/community engagement.
I don’t think the WHO is the final authority on what to do, public health is their hammer. I have been dismayed, however, at the failure of the CDC, which surely prior to this crisis one would have rated as one of the best US organizations. As the NYTimes wrote:
The Centers for Disease Control and Prevention botched its first attempt to mass produce a diagnostic test kit, a discovery made only after officials had shipped hundreds of kits to state laboratories.
A promised replacement took several weeks, and still did not permit state and local laboratories to make final diagnoses. And the C.D.C. essentially ensured that Americans would be tested in very few numbers by imposing stringent and narrow criteria, critics say.
The failure of the CDC, which is a failure of the US government at the deepest levels, not just rot from the top, meant that we lost several weeks that we may have needed to avoid more stringent measures. We will know more in a week.
Read the whole thing.
Price Regulation in Credit Markets
From Cuesta and Sepulveda’s Price Regulation in Credit Markets: A Trade-off between Consumer Protection and Credit Access.
Interest rate caps are widespread in consumer credit markets, yet there is limited evidence on its effects on market outcomes and welfare. Conceptually, the effects of
interest rate caps are ambiguous and depend on a trade-off between consumer protection from banks’ market power and reductions in credit access. We exploit a policy in Chile that lowered interest rate caps by 20 percentage points to understand its impacts. Using comprehensive individual-level administrative data, we document that the policy decreased transacted interest rates by 9%, but also reduced the number of loans by 19%. To estimate the welfare effects of this policy, we develop and estimate a model of loan applications, pricing, and repayment of loans. Consumer surplus decreases by an equivalent of 3.5% of average income, with larger losses for risky borrowers. Survey evidence suggests these welfare effects may be driven by decreased consumption smoothing and increased financial distress. Interest rate caps provide greater consumer protection in more concentrated markets, but welfare effects are negative even under a monopoly. Risk-based regulation reduces the adverse effects of interest rate caps, but does not eliminate them.
Hat tip: Matt Notowidigdo.
U.S. core inflation exceeds forecast
Source here. As I’ve been saying, I see very little chance of an aggregate demand-based recession this year, the Fed’s December interest rate hike was not an obvious mistake, and we are not in any operative way in a liquidity trap right now.
How tight is monetary policy now?, and some remarks on ngdp and market monetarism
I say “not that tight,” while leaving room open for the possibility that it should be looser.
What metrics might we look at? Federal funds futures no longer expect imminent further rate hikes from the Fed. Expected rates of price inflation have been very close to two percent. No matter what you think about the structural component of labor supply, cyclical unemployment has recovered a great deal over the last few years. And that is through the period of “taper talk” of almost two years ago. Consumer spending is doing OK, not spectacular but not cut off at the knees. And while in very recent times price expectations are headed downwards away from two percent, this seems to stem from negative real shocks, to which the Fed has responded passively (perhaps unwisely). That’s different than the Fed tightening. There was a quarter point rate hike from December, which is a small tightening for sure, but I don’t see much more than that.
So in sum, those data do not suggest severe monetary tightness, though again I am open to the argument that monetary policy should be looser.
By the way, I agree with Scott Sumner that we should not equate low interest rates with loose money. Tight and loose money are multi-dimensional, cluster concepts, especially post-2008, and require reference to a variety of variables. And if you are wondering, from this list of Lars Christensen monetary policy indicators I accept only #2, at least in a 2016 global setting where other real economies are volatile.
Given that I don’t see monetary policy as so tight right now, I suggested that if we have a recession it was likely to be a risk premium recession. The big uptick in gold prices is consistent with this view, though hardly proof of it.
So what is the context here? I am worried that if the United States has a recession this year (still unlikely, in my view, but maybe 20%?), that recession will be blamed on “tight money.”
To get more specific yet, I am very much a fan of the ngdp rule approach to monetary policy, but I am uncomfortable with one strand in market monetarist thought. I worry when low ngdp growth is blamed for low growth rates of real gdp.
Ngdp is an accounting summation, so I still want to know the real cause of the slower growth in real gdp. Let’s unpack at the most basic level whether the active cause was Fed tightening on the nominal side, or instead a negative real shock, followed perhaps by excess Fed passivity. That is one reason why I think of it as information-destroying to cite ngdp as a cause of developments in rgdp.
More fundamentally, if a central bank is doing anything close to price inflation targeting, mentioning low ngdp and low real gdp growth rates is simply citing the same fact twice, or almost so, rather than explaining one variable with the other. Angus once called the ngdp invocation a tautology; I’m not sure that is the right terminology, but still I wish to look for independent, non-ngdp measures of monetary policy when deciding how to allocate the blame for a recession, to real or nominal factors.
For further context, I was disquieted by some recent Lars Christensen posts on monetary policy and the American economy. I read him as “revving up” to blame a possible recession on tight U.S. monetary policy. I don’t think he provides much evidence that money is tight enough to cause a recession, other than citing the deterioration of some real variables.
I would encourage market monetarists to define — now — how tight or loose monetary policy really is. Then stick with that assessment, based on whatever variables you consulted.
A year from now, I won’t count it if you say a) “well, ngdp growth is down, money was tight, therefore real gdp growth rates fell. Tight money must have been the problem because low rates of ngdp growth are tight money.”
I would count it if you say something like b): “the dollar shock [or some other factor] was worse than the Fed had thought. That started to push us into recession. The Fed should have loosened, but they didn’t, and so the slide into recession continued, when the Fed could have moderated it somewhat by pursuing an ngdp target.” (By the way, read Gavyn Davies on the strong dollar issue. Alternatively, here is a Marcus Nunes take which I think is citing ngdp in exactly the way I am worried about.)
I also would count it if you said “I see the Fed tightening a lot right now, a recession is likely coming,” although I might dispute your evidence for that tightening.
Here is a recent Scott Sumner post, mostly about me. It’s basically taking the other side of what I have been arguing, and I would suggest simply disaggregating the ngdp terminology into a more causal language of nominal and real shocks. Surely there are other independent, ex ante signs for judging the tightness of monetary policy, rather than waiting for ngdp figures to come in, which again is citing a transform of the real gdp growth rate as a way of explaining real gdp.
I find these issues come up many, many times in market monetarist writings. I think they have basically the right policy prescription, and could provide the world with billions or maybe even trillions of dollars of value, if only policymakers would listen. But I also think they are foisting a language of causality on the business cycle problem which the rest of economic discourse does not easily absorb, and which smushes together real and nominal shocks into a lower-information accounting variable, namely ngdp, and then elevating that variable into a not entirely deserved causal role. We ought to talk in terms of ex ante, independent measures of monetary policy looseness, not ex post measures which closely resemble indirect transforms of real gdp itself.
That, in a nutshell is why, although I usually agree with the market monetarists on policy, and their desire to lower the status of “hard money” doctrine within liberalism, and while I have long applauded and supported their efforts, I don’t call myself a market monetarist per se.
Addendum: Nick Rowe comments. And Marcus Nunes comments.
The Austrian theory of the business cycle continues its comeback
Except no one seems interested in calling it by that name. Here is the new NBER working paper by David López-Salido, Jeremy C. Stein, and Egon Zakrajšek, “Credit-Market Sentiment and the Business Cycle”:
Using U.S. data from 1929 to 2013, we show that elevated credit-market sentiment in year t – 2 is associated with a decline in economic activity in years t and t + 1. Underlying this result is the existence of predictable mean reversion in credit-market conditions. That is, when our sentiment proxies indicate that credit risk is aggressively priced, this tends to be followed by a subsequent widening of credit spreads, and the timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity. Exploring the mechanism, we find that buoyant credit-market sentiment in year t – 2 also forecasts a change in the composition of external finance: net debt issuance falls in year t, while net equity issuance increases, patterns consistent with the reversal in credit-market conditions leading to an inward shift in credit supply. Unlike much of the current literature on the role of financial frictions in macroeconomics, this paper suggests that time-variation in expected returns to credit market investors can be an important driver of economic fluctuations.
The paper is here, here are ungated copies. Here are some other related “Austrian” papers.
The resurrection of both Austrian and “risk-based” theories shows how alive and well macro has been of late, but at least in blog land you don’t hear that much about them…
My macroeconomic framework, circa 2015
A while ago Scott Sumner laid out at least part of his framework, I thought I should lay out some key parts of mine. Here goes:
1. In world history, 99% of all business cycles are real business cycles. No criticism of RBC can change this fact. Furthermore the propagation mechanism for a “Keynesian business cycle” (arguably a misleading phrase) also relies on RBC theory.
2. In the more recent segment of world history, a lot of cycles have been caused by negative nominal shocks. I consider the Christina and David Romer “shock identification” paper (pdf, and note the name order) to be one of the very best pieces of research in all of macroeconomics. Sometimes central banks tighten when they shouldn’t, and this leads to a recession, due mainly to nominal wage stickiness.
3. Workers are laid off because employers are often (not always) afraid to cut their nominal wages, for fear of busting workplace morale, or in Europe often for legal and union-related reasons.
4. Overall I favor a nominal gdp rule for monetary policy. But most of its gains would come in a few key historical episodes, such as 1929-1932, or 2008-2009. In most periods I don’t think we know what the correct monetary policy should be, nor do we know that it matters. Still, that uncertainty does not militate against an ngdp rule.
5. Once workers are unemployed, nominal wage stickiness is no longer the main reason why they stay unemployed. In fact nominal wage stickiness is largely taken out of the equation because there is no preexisting nominal wage contract for these workers. There may, however, be some residual stickiness due to irrational reservation wages, also known as voluntary unemployment due to stupidity. (You will find a different perspective in Scott’s musical chairs model, which I may cover more soon.)
5b. Monetary stimulus to be effective needs to be applied very early in the job destruction process of a recession. It is much harder to put the pieces back together again, so urgency is of the essence.
6. The successful reemployment of workers depends upon a matching problem, a’la Pissarides, Mortensen, and others. Yet this matching problem is poorly understood, and it can involve a mix of nominal and real imperfections. Sometimes it is solved more quickly than expected, such as in the recent UK experience, and other times more slowly than expected, as in current Spain. Most of the claims you will read about this reemployment of workers are wrong, enslaved to ideology or dogmatism, or at the very least unjustified. Hardly anyone wants to admit this.
7. Really bad recessions involve deficient aggregate demand, negative shocks to intermediation, some chronic supply-side problems, negative wealth effects, and increases in the risk premium, all together. It is hard to find a quick fix. Furthermore models where AS and AD curves are independent and separable are often misleading, despite their analytic convenience.
8. Given that weak AD is only one of the problems in a bad downturn, and that confidence, risk, and supply side problems matter too, the best question to ask about fiscal policy is how well the money is being spent. The “jack up AD no matter” approach is, in the final political equilibrium, not doing good fiscal policy any favors.
9. You should neither rule out nor overstate the relevance of Hayek and Minsky. Their views have much in common, despite the difference in ideological mood affiliation and who — government or the market — gets blamed for the downturn. For really bad recessions, usually both institutions are complicit to say the least.
10. All propositions about real interest rates are wrong.
There is more, but I’ll stop there for now.
The Great Divide over Market Efficiency
Clifford Asness and John Liew have an excellent piece in Institutional Investor on Fama, Shiller and The Great Divide over Market Efficiency. Asness and Liew are both students of Fama so you might expect them to come down squarely on the side of market efficiency but they are also co-founders of AQR Capital, an asset management firm ($100 billion under management) with an unusually empirically driven approach to investing. In addition to publishing and using its own research, for example, AQR sponsors the AQR Insight Award which:
…recognizes important, unpublished papers that provide the most significant, new practical insights for tax-exempt institutional or taxable investor portfolios.
The Insight award is worth up to $100,000 so the firm is serious in thinking that research can be profitable.
Asness and Liew argue that just a few anomalies are robust across time, countries, and asset markets, notably momentum and value. On value, they note that a trading strategy of high minus low, that is long a portfolio of cheap stocks (high book value to price) and short a portfolio of expensive stocks (low book value to price) has generated consistently high returns relative to (CAPM) risk over time, albeit not without occasional terrifying episodes.
The efficient market explanation is that book value to price is a stand-in for a non-diversifiable risk factor. The behavioral story is that “a lot of individuals and groups (particularly committees) have a strong tendency to rely on three-to five-year performance evaluation horizons.” As a result, they chase “winners” and flee “losers” over a 3-5 year horizon which generates momentum and the mispricing that makes the value strategy successful. As Asness and Liew put it “investors act like momentum traders over a value time horizon.”
Asness and Liew then follow up with a very astute counter-argument to the risk-factor story:
Also, many practitioners offer value-tilted products and long-short products that go long value stocks and short growth stocks. But if value works because of risk, there should be a market for people who want the opposite. That is, real risk has to hurt. People should want insurance against things like that. Some should desire to give up return to lower their exposure to this risk. However, we know of nobody offering the systematic opposite product (long expensive, short cheap)…the complete lack of such products is a bit vexing for the pure rational based risk-based story.
Lots of other history and insights.
Does boosting bank capital requirements limit output or growth?
Paul Krugman has an intemperate polemic against Alan Greenspan, for instance:
It’s terrible on all counts; but the most offensive thing intellectually is the incredible fallacy of claiming that higher capital requirements for banks amount to keeping resources idle…the man once revered as a demigod of finance doesn’t understand basic economics — or, more likely, that he chooses not to understand what he, amazingly, is still being paid to not understand.
There is no mention of the actual literature on this topic. Here is one summary of some common views:
Hall (1993) presents evidence that from 1990 to 1992 American banks have reduced their loans by approximately $150 billion, and argues that it was largely due to the introduction of the new risk-based capital guidelines. He goes even so far as to say that “To the extent that a “credit crunch” has weakened economic activity since 1990, Basle-induced declines in lending may have been a major cause of this credit crunch.” Hence, it is not an overstatement to say that Basel I did have an impact on bank behavior as it forced them to hold higher capital ratios than it otherwise would have been the case.
It is a common belief, though by no means universally held, that the implementation of Basel meant a slower U.S. recovery from the recession of the early 1990s. Here is a summary of some of the international evidence, plus there is a general literature survey in the first few pages at that link; see for instance Peek and Rosengren (the term “capital crunch” will help in Google searches). Perhaps the literature on the early 1990s may not apply today, but Greenspan’s claim is not incoherent a priori. Furthermore the Greenspan piece links to an FT piece which a) is consistent with his general account, and b) shows various Europeans, not all of whom are bankers, sharing the same worry for today, and c) makes it clear Greenspan is not committing the “Junker fallacy” of confusing paper holdings with real resource destructions. The negative effects come through a tax on financial intermediation. Maybe just maybe one could criticize Greenspan for not being clear enough on the mechanism, but he is still right on the comparative statics and certainly not spouting nonsense.
At the theoretical level, papers on Modigliani-Miller deviations, and the interrelation between production and finance, also make Greenspan’s argument acceptable, if not necessarily correct; one can even look to Joe Stiglitz here. Krugman admits that capital requirements lower bank risk-taking but of course that can lead to less lending and, in many future world-states, lower output. That may well be a good thing, since it lowers systemic risk and thus helps output in some world states, but it’s wrong to deny the significant possibility of a real opportunity cost.
Also, bank capital requirements are not well understood in terms of a pure Modigliani-Miller debt-equity swap. For one thing, the capital requirements favor some asset classes over others, and arguably in a way which limits expected growth. The capital requirements also involve a commitment to particular accounting standards.
On matters of policy, I do in principle favor significant increases in capital requirements for banks. But should we push to impose those tougher requirements today in such a weak economy? Perhaps Krugman would be eager but I’m not so sure. For all his worries about repeating the mistakes of 1937-8, Krugman doesn’t seem to recognize this may well be another step down that path.
My NYT column on the euro
I am bleary from my long trip home, so I am glad to have Arnold Kling to draw upon. Arnold writes:
His [Tyler’s] NYT column is a must-read. The bottom line:
“the euro, in retrospect, appears to have been a misguided attempt to equalize the values for some very unequal assets, namely the bank deposits of strong countries and those of weak countries. ”
Modern governments seem to play this role in the monetary system. For example, deposit insurance serves to equalize the values of deposits in strong and weak banks.
What I see Cowen as saying is that the euro project inevitably entailed a sort of deposit insurance for banks. However, this was never formalized. No European-wide insurance fund was set up, and no risk-based insurance premiums were charged. Instead, it was more or less expected that each national government would prop up its own banks. But this assumption has proven unworkable.
Read the whole thing.
Here is new talk of a Greek default, plus it seems the Finns are rebelling against the bailouts.
The new financial regulation bill
NEW REGULATORY AUTHORITY: Gives federal regulators new authority to seize and break up large troubled financial firms without taxpayer bailouts in cases where the firm's collapse could destabilize the financial system. Sets up a liquidation procedure run by the FDIC. Treasury would supply funds to cover the
up-front costs of winding down the failed firm, but the government would have to put a "repayment plan" in place. Regulators would recoup any losses incurred from the wind-down afterwards by assessing fees on financial firms with more than $50 billion in assets.
OVERALL A GOOD PROVISION, ALTHOUGH THE ACTUAL INCIDENCE OF THESE FEES IS TRICKIER THAN THE DESCRIPTION INDICATES.
FINANCIAL STABILITY COUNCIL: Would establish a new, 10-member Financial Stability Oversight Council, comprising existing regulators charged with monitoring and addressing system-wide risks to the nation's financial stability. Among its duties, the council would recommend to the Fed stricter capital, leverage and other rules for large, complex financial firms that are judged to threaten the financial system. In extreme cases, it would have the power to break up financial firms.
I'M NOT ENTHUSIASTIC, THOUGH PERHAPS IT WILL JUST BE A WASH. NONETHELESS IT REFLECTS A BAD AND DANGEROUS ATTITUDE ABOUT WHAT REGULATORS ARE CAPABLE OF.
VOLCKER RULE: Would curb propriety trading by the largest financial firms, though banks could make de minimus investments in hedge and private-equity funds. Those investments would be limited to 3% or less of a bank's Tier 1 capital. Banks would be prohibited from bailing out a fund in which they are invested.
IT'S HARD TO TELL WHAT ACTUAL RESTRICTIONS WILL BE IN PLACE AND MOST LIKELY THERE WILL BE MAJOR LOOPHOLES. YOU DON'T HAVE TO HATE THIS PROPOSAL — RECALL THE POPULARITY OF "NARROW BANKING" PROPOSALS IN THE 1990S AS A KIND OF SECOND-BEST REFORM, CONSIDERED BY MANY MARKET-ORIENTED ECONOMISTS. FURTHERMORE IF MARKETS ARE PRETTY LIQUID, KEEPING THE BANKS OUT OF THESE MARKETS MAY NOT HARM MUCH AT ALL. STILL, I'LL PREDICT THIS DOESN'T DO ANY GOOD.
DERIVATIVES: Would for the first time extend comprehensive regulation to the over-the-counter derivatives market, including the trading of the products and the companies that sell them. Would require many routine derivatives to be traded on exchanges and routed through clearinghouses. Customized swaps could still be traded over-the-counter, but they would have to be reported to central repositories so regulators could get a broader picture of what's going on in the market. Would impose new capital, margin, reporting, record-keeping and business conduct rules on firms that deal in derivatives.
I WAS AN EARLY PROPONENT OF THIS IDEA MYSELF, BUT LATELY I'VE STARTED TO WORRY ABOUT HOW WELL CAPITALIZED THIS CLEARINGHOUSE WILL NEED TO BE. I'LL STILL COUNT IT AS A NET PLUS, BUT I DON'T THINK WE'VE THOUGHT IT THROUGH VERY WELL.
SWAPS SPIN-OFF: Would require banks to spin off only their riskiest derivatives trading operations into affiliates, in a late-night compromise struck to scale back a controversial provision championed by Sen. Blanche Lincoln (D., Ark.). Banks would be able to retain operations for interest-rate swaps, foreign-exchange swaps, and gold and silver swaps among others. Firms would be required to push trading in agriculture, uncleared commodities, most metals, and energy swaps to their affiliates.
THE DEVIL IS IN THE DETAILS. MAYBE THE AFFILIATES ARE NOT "TOO BIG TO FAIL" BUT WHAT REALLY MATTERS ARE THE COUNTERPARTIES ON THE OTHER SIDE OF THE TRANSACTION. WE STILL BAILED OUT LTCM, REMEMBER THAT?
CONSUMER AGENCY: Would create a new Consumer Financial Protection Bureau within the Federal Reserve, with rulemaking and some enforcement power over banks and non-banks that offer consumer financial products or services such as credit cards, mortgages and other loans. The new watchdog would have authority to examine and enforce regulations for all mortgage-related businesses; banks and credit unions with assets of more than $10 billion in assets; pay day lenders, check cashers and certain other non-bank financial firms. Auto dealers won a hard-fought exemption from the Bureau's reach.
WE'LL SEE.
PRE-EMPTION: Would allow states to impose their own stricter consumer protection laws on national banks. National banks could seek exemption from state laws on a case-by-case, state-by-state basis if a state law "prevents or significantly interferes" with the bank's ability to do business – a higher bar than federal regulators currently must meet to pre-empt state rules. State attorneys-general would have power to enforce certain rules issued by the new consumer financial protection bureau.
THIS SHIFTS THE WORDING OF THE LAW, BUT DOES IT CHANGE THE POLITICAL EQUILIBRIUM? AGAIN, "WE;LL SEE."
FEDERAL RESERVE OVERSIGHT: Would mandate a one-time audit of all of the Fed's emergency lending programs from the financial crisis. The Fed also would disclose, with a two-year lag, details of loans it makes to banks through its discount window as well as open market transactions – activity the Fed currently doesn't disclose. Would eliminate the role of bankers in picking presidents at the Fed's 12 regional banks. Would also limit the Fed's 13(3) emergency lending authority by barring the central bank from using it to aid an
individual firm, requiring the Treasury Secretary to approve any lending program and prohibiting the participation of insolvent firms.
A MISTAKE, BUT THIS COULD HAVE BEEN MUCH WORSE.
OVERSIGHT CHANGES: Would eliminate the Office of Thrift Supervision, but after a fight, the Fed retained oversight of thousands of community banks. Would empower the Fed to supervise the largest, most complex financial companies to ensure that the government understands the risks and complexities of firms that could pose a risk to the broader economy.
OVERALL I AM PRO-FED AND SO THIS PLANK COULD HAVE BEEN MUCH WORSE, FORTUNATELY WE HAVE NOT REALLOCATED FED POWERS IN A MAJOR WAY TO LESSER REGULATORS.
BANK CAPITAL STANDARDS: Would set new size- and risk-based capital standards, including a prohibition on large bank holding companies treating trust-preferred securities as Tier 1 capital, a key measure of a bank's strength. Would grandfather trust-preferred securities for banks with less than $15 billion in assets, enabling them to continue treating the securities as Tier 1 capital. Larger banks would have five years to phase-out trust-preferred securities as Tier 1 capital.
IT'S BASEL III WHICH WILL REALLY MATTER AND WE SHOULDN'T EXPECT MUCH FROM THAT FORUM. WE'RE DROPPING THE BALL ON A MAJOR ISSUE.
BANK FEE: Would mandate the Oversight Council to impose a special assessment on the nation's largest financial firms to raise up to $19 billion to offset the cost of the bill. The fee would apply to financial institutions with more than $50 billion in assets and hedge funds with more than $10 billion in assets, with entities deemed high risk paying more than safer ones. The fee would be collected by the FDIC over five years, with the funds placed in separate fund in the Treasury and would not be usable for any other purpose for 25 years, after which any left-over funds would go to pay down the national debt.
THIS IS FOR PR, SO THE POLITICIANS CAN CLAIM TAXPAYERS WON'T BE ON THE HOOK AGAIN. RIGHT. ALSO, STUDY TAX INCIDENCE THEORY AND GET BACK TO ME.
DEPOSIT INSURANCE: Would permanently increase the level of federal deposit insurance for banks, thrifts and credit unions to $250,000, retroactive to January 1, 2008.
ALREADY DONE, SO TO SPEAK.
MORTGAGES: Would establish new national minimum underwriting standards for home mortgages. Lenders would be required for the first time to ensure that a borrower is able to repay a home loan by verifying the borrower's income, credit history and job status. Would ban payments to brokers for steering borrowers to high-priced loans.
DEVIL IS IN THE DETAILS.
SECURITIZATION: Banks that package loans would, broadly, be required to keep 5% of the credit risk on their balance sheets. Would direct bank regulators to exempt from the rules a class of low-risk mortgages that meet certain minimum standards. Regulators could permit alternative risk-retention arrangements for
the commercial mortgage-backed securities market.
WASTE OF TIME. YOU CAN JUST AS EASILY ARGUE THE PROBLEM WAS INSUFFICIENT SECURITIZATION. AND HOW HAVE SIMILAR RULES WORKED OUT FOR THE SPANISH?
CREDIT RATING AGENCIES: Would revamp the credit-rating industry, establishing a new quasi-government entity designed to address conflicts of interest inherent in the credit-rating business after the SEC studies the matter. Would also allow investors to sue credit-rating firms for a "knowing or reckless" failure to conduct a reasonable investigation, a lower liability standard than the firms were lobbying to get. Would establish a new oversight office within the SEC with the ability to fine ratings agencies and empowers the SEC to
deregister a firm that gives too many bad ratings over time.
THE BEST EQUILIBRIUM IS TO HAVE DISCREDITED RATINGS AGENCIES, NOT REVAMPED AND REREGULATED AGENCIES.
INVESTMENT ADVICE: Would give the SEC the authority to raise standards for broker dealers who give investment advice after the agency studies the issue. Would permit, but not require, the SEC to hold broker dealers to a fiduciary duty similar to the standard to which investment advisers are held.
COULD EASILY END UP MEANING NOTHING.
CORPORATE GOVERNANCE: Would give shareholders of public corporations a non-binding vote on executive pay and "golden parachutes," and would give the SEC the authority to grant shareholders proxy access to nominate directors.
COULD EASILY END UP MEANING NOTHING.
HEDGE FUNDS: Would require hedge funds and private equity funds to register with the SEC as investment advisers and to provide information on trades to help regulators monitor systemic risk.
COULD EASILY END UP MEANING NOTHING.
INSURANCE: Would create a new Federal Insurance Office within the Treasury Department to monitor the insurance industry, recommending to the systemic risk council insurers that should be treated as systemically important. Would require the new office to report to Congress on ways to modernize insurance
regulation.
I AGREE WE SHOULD NOT TRUST STATE-LEVEL REGULATORS WITH FIRMS SUCH AS AIG, BUT LET'S HAVE MODEST EXPECTATIONS ABOUT WHAT THIS OFFICE WILL ACHIEVE. IT PROBABLY WOULDN'T HAVE STOPPED THE AIG DEBACLE EITHER.
-By Victoria McGrane, Dow Jones Newswires
THE BOTTOM LINE: THE GOOD PARTS OF THE BILL AREN'T NEARLY AS GOOD AS THEY SHOULD BE, AND THE BAD PARTS BECAME MUCH BETTER WITH TIME. THE BIGGEST OMISSIONS ARE SIMPLE AND TOUGHER RESTRICTIONS ON LEVERAGE AND REFORM OF THE MORTGAGE AGENCIES. OVERALL CONSIDER THIS A VICTORY FOR THE STATUS QUO AND YOU SHOULD REALIZE THAT THE UNDERLYING PROBLEMS HAVE NOT BEEN SOLVED.
How did the Garn-St. Germain act matter?
Campbell and Hercowitz, which I found from a Krugman link, write:
The Monetary Control and the Garn-St.Germain Acts of 1980 and 1982 allowed market innovations that dramatically reduced these equity requirements: Greater access to sub-prime mortgages, mortgage refinancing, and home equity loans, reduced effective down payments and increased effective repayment periods. More important for the short run, it enabled households to cash-out previously accumulated home equity, which in 1982 amounted to 71 percent of GDP. This was followed by a huge wave of household borrowing.
Maybe I’ll deal with the 1980 Act another time. but on Garn-St. Germain those claims are not easy for me to verify. (Their paper is a theory paper and offers no further evidence or narrative. Here is also an earlier Krugman piece of relevance.)
Here is one summary of what the Garn-St. Germain Act did. Maybe this summary is incomplete but it is hard to see how Garn-St. Germain is responsible for either the current crisis or for the more general decline in national savings rates. The closest I come to finding a relevant passage is:
(7) the act preempted state restrictions on enforcement by lenders of
due-on-sale clauses in most mortgages for a three year period ending
October 15, 1985, and authorized state chartered lenders to offer the
same kinds of alternative mortgages permitted nationally chartered
financial institutions.
Over time most institutions moved away from the state charter and those mortgages already were legal at the national level.
Or try this summary of the Act, from a book. Again, the connection is hard to see. In fact Garn-St. Germain freed up S&Ls from investing so much in home mortgages. You can blame that (partially) for the S&L crisis, but the current real estate bubble? Or the general rise in indebtedness which started in the 1980s?
Here’s a recent empirical paper on the rise in U.S. household indebtedness. Not surprisingly, it emphasizes demographic factors as the main causes. pp.18-19 discuss financial innovation as a contributing cause but there is not a peep about Garn-St. Germain. The authors do cite a paper by Wendy Edelberg, who pinpoints some of these innovations as coming in the mid-1990s and resulting from greater risk-based pricing of loans.
On mortgages, a lot of the relevant deregulation occurred at the state level or the problem was the simple lack of enforcement of anti-fraud laws. Government-promoted low or zero down payment mortgages date back at least to Section 235 of HUD, from 1968 (a disaster, by the way) and Garn-St. Germain is hardly a turning point in that history.
Maybe I’m wrong about Garn-St. Germain. If so, I’d like to learn how and I am asking you, readers, to set me straight.
Mindles Dreck is the Dreck of my dreams
I’d like to reproduce chunks of his old yet prescient post (or go here and scroll down to 22 January):
Pundits continue to link the Enron debacle to a need for increased regulation,
especially of derivatives. What most of these people…don’t appreciate is that regulation and/or accounting rules are the
most fertile breeding ground for derivatives and synthetic or packaged
securities. Regulations and accounting rule-inspired transactions
describe the bulk of the well known derivative-related blow-ups of the
last two decades. Proscriptive regulation and the derivative trade have
a symbiotic relationship.Investors and operating companies buy derivatives for two basic
purposes: speculation and risk transfer. A derivative, (a financial
contract based on the price of another commodity, security, contract or
index) either eliminates an exposure, creates an exposure, or
substitutes exposures. That last one, substituting exposures, is
important to heavily regulated investors.For example, insurance companies were a goldmine for derivatives
salespeople in the last two decades, only slowing down in the late
1990s. The fundamental reason for this is not because insurance
executives were stupid, but because they manage their investments in a
thicket of proscriptive regulation. Insurance companies have to respond
to their national regulatory organization (the NAIC), their home state
insurance department and the insurance departments of states in which
they sell or write business. They file enormous statutory reports every
quarter using special regulatory pricing, and calculate complex
risk-based capital reports and "IRIS" ratios regularly.Even though the insurance industry has been heavily regulated
throughout the entire post-war era, the incidents of fraud and
financial mismanagement have been numerous and spectacular. Remember Marty Frankel?
Mutual Benefit Life? For each of these cases that are in the news,
there are many smaller ones you don’t hear about. Some of that may be
the nature of the industry, but it doesn’t make a prima facie case for more regulation…Insurance companies often need the yield of less creditworthy
obligations. So derivative salesmen see an opportunity to engineer
around the regulations. They package securities that substitute price
volatility for the proscribed credit risk. Then the investor can be
compensated for taking some additional risk, and the banker can be
compensated for creating the opportunity. A simple example of this is
the Collateralized Bond Obligation (CBO). A CBO is created by buying a
bunch of bonds, usually of lower credit quality, putting them in a
"special purpose vehicle" (SPV) and then issuing two or more debt
instruments from the SPV. The more senior instruments can obtain an
investment grade rating based on the "cushion" created by the junior
debt tranche. The junior bond absorbs, for example, the first 10% of
losses in the entire portfolio and only when losses exceed that amount
will the senior obligations be impaired. The junior instruments, known
as "Z-Tranches" become "toxic waste", suitable only for speculators and
trading desks with strange risks to lay off (or, in a famous 1995 case,
the Orange County California Treasurer).A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing – they decrease frequency of loss but increase the severity.
So they blow up infrequently, but when they do it’s often a big mess.
Ratings-packaged instruments are less risky than the pool of securities
they represent but often riskier and less liquid than the investment
grade securities for which they are being substituted. As a result,
they pay a yield or return premium (even net of high investment banking
fees). That premium may or may not be enough to pay for their risk. But
they pass the all-important credit rating process and are therefore
sometimes the only choice for ratings-restricted portfolios reaching
for yield.…[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests
that regulation is often the derivative salesman’s best friend.
Complicated rules encourage complex transactions that seek to conceal
or re-shape their true nature. Regulated entities create demand for
complex derivatives that substitute proscribed risks for admitted
risks. If a new risk is identified and prohibited, the market starts
inventing instruments that get around it. There is no end to this
process. Regulators have always had this perversely symbiotic
relationship with Wall Street. And the same can be said for the
ridiculously complicated federal taxation rules and increasingly
byzantine Financial Accounting Standards, both of which have inspired
massive derivative activity as the engineers find their way around the
code maze.
Dreck, in case you don’t know, used to blog with Megan McArdle over at Asymmetric Information. Here is what happens when you enter "Star Dreck" into YouTube.