Month: September 2008

What really caused the financial crisis?

Kashyap, Rajan, and Stein have lots of explanation but here is the initial bottom line:

The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept
on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing.

In other words, one problem was not enough (!) securitization.  They also call for counter-cyclical capital requirements.  They like mandatory capital insurance — with payments triggered by capital disasters — even better.  My main worry, of course, is how we should regulate (or not) the entities which offer this insurance.  Will they too engage in liquidity transformation and if so who ensures them?

And, going back to banks, part of the governance problem was this:

…it is very hard, especially in the case of new products, to tell whether a financial manager is generating true excess returns adjusting for risk, or whether the current returns are simply compensation for a risk that has not yet shown itself but that will eventually materialize.

Their phrase "recapitalization as a public good" should not soon be forgotten.  And it is leverage which is dangerous, a lesson becoming clearer every day.

This paper is essential reading for anyone following the crisis and it makes more sense than just about anything else I’ve read on the topic.  I thank David L., a loyal MR reader, for the pointer.

Who should make this decision come January 20?

Israel gave serious thought this spring to launching a military strike
on Iran’s nuclear sites but was told by President George W Bush that he
would not support it and did not expect to revise that view for the
rest of his presidency, senior European diplomatic sources have told
the Guardian.

Here is the story, from The Guardian.  I hope you all have given this matter some thought…

Greg Mankiw defends the Paulson plan (from a distance)

Read the whole thing, which is full of economics.  I think the bottom line is this part:

…that’s [capital injection] a complement to an asset purchase plan, not a substitute — and it’s one allowed by the Treasury proposal and indeed envisaged in some cases. But that will take much longer to implement than an asset purchase. That’s why it’s a complement not a substitute — Treasury needs to act now.

In other words, we are going to get both the Paulson plan and the Dodd plan, or some modified versions thereof.  It was never either/or.  Note that if Greg’s arguments are correct things are very bad indeed.  The outstanding open question is why markets don’t now, pre-plan, successfully trade the toxic assets in sufficient quantities.  But they don’t.

Quotable quotes

Mercedes scoffs at such notions. "It is really, really difficult to harm a horse with massage, especially if all you’re using is your hands."

Here is the story and that is from The Washington Post.  Apparently it is legal to give a human a massage in Maryland, and legal to shoe a horse in Maryland, but not legal to give a horse a massage in Maryland unless you own that horse.  And there is no way to get the appropriate license.  The Institute for Justice is taking up the case.

A Supply Side Approach to the Crisis

Yesterday I pointed out that credit is still robust.  Growth rates are declining, however, and many people say the real crunch is around the corner.  Thus, today I want to suggest a new approach to dealing with the crisis that will have benefits regardless of how the crisis unfolds.

I see the key issue as follows: Banks bridge the gap between savers and firms.  We want to keep capital flowing to firms even when some of the bridges collapse.  One approach tries to prop up the collapsed bridges, a second approach tries to route funds across substitute bridges.  A third approach is to increase the flow pressure – in other words, I suggest a temporary but large stimulus to savings.

I suggest that for the next 12 months contributions to an IRA account will never be taxed.  We can modify this in various ways to cap contributions at a certain level etc.  We can even make the proposal progressive – for the next 12 months contributions to an IRA account will never be taxed and the government will match $1 for every $10 saved for anyone with income below a certain threshold.  The main idea is to increase savings.

The increase in savings will help deal with our current problems by offsetting any credit crunch.  (Some of the savings will also help to recapitalize banks.)  In addition, the U.S. needs a higher savings rate regardless.  During the 1990s as measured savings rates declined to zero commentators argued that rising asset values compensated.  Well asset values are now falling so true savings are negative – thus we need to increased savings.

A big benefit of this proposal – lower taxes, higher savings and a savings bonus to those with lower incomes – is that it should appeal to both the right and the left.

Questions that are rarely asked

Was September 2008 the month of greatest increase in United States Wealth in History?

Doesn’t the long term economic impact of 5-10 trillion dollars of offshore oil overwhelm the trillion dollars from the bailout?

That’s from Andrew, a loyal MR reader.  He sends along this link.  I have not myself done any calculations of the fiscal benefits from such oil (which are distinct from the price effect, which is likely small).  Does anyone know a number?

At first I thought he was going to mention the recent decline in the price of oil, which on average you can expect to be permanent.  The real lesson, I would say, is how much coordination (or lack thereof) matters and how badly representative agent models perform in explaining the most important economic changes.

Interest rate swaps

The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative
market. The notional amount outstanding as of December 2006 in OTC
interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from
December 2005.

That’s from Wikipedia.
You’ll see other estimates as well, although they fall within a few
hundred trillion of this number.  If it makes you feel any better, swap
numbers usually measure the total liabilities in the market, not the
size of the swapped payments.  So you could argue that "the real
number" is maybe 1/20th of this or so, with error margins of only
trillions remaining.

Oddly economists don’t have a clear explanation for swaps.  In a
classic "plain vanilla" swap you trade a fixed rate interest payment
for a floating rate payment and of course the swaps occur across
currencies as well.  So here’s a typical story: Bank A takes out a
floating rate loan in terms of Swiss francs (from C) and Bank B takes
out a fixed rate loan in terms of Japanese yen (from D).  Bank A and
Bank B then decide they each would rather have each others’ liabilities
and so they swap interest payments.  That’s called the comparative
advantage theory.

But why didn’t Bank A borrow in yen from D to begin with?  And why
didn’t Bank B borrow in Swiss Francs from C to begin with?  OK, they
"changed their minds."  Is that how you get to all those trillions?

Or maybe lender D didn’t trust Bank borrower A in the first place
and would have charged an excess risk premium.  But then why does Bank
B trust Bank A so much? 

Is there a regulatory arbitrage argument here?  Under Basel I, a
bank might prefer to get a non-risky loan off its books to avoid the
associated capital requirements.  Clearly that drives some of the
market but regulators have been working on
remedying that problem and no one was expecting the swaps market to
disappear as a result.  Furthermore the interest rate swaps predated
the Basel agreements.  Another regulatory arbitrage argument cites the
difference between the U.S. and Eurodollar markets.

Here is one survey of explanations for interest rate swaps.  The explanations mostly seem lame and question-begging to me.  Here is another survey of potential explanations of interest rate swaps.  Good luck and I hope you have JSTOR access.  Here is a useful non-gated summary.

It is a shame that economists have devoted so little attention to
understanding interest rate swaps.  It’s hard to get the data for doing
first-rate quantitative finance work, so the topic tends to be
ignored.  Right now it would be nice to know how much of this market is
real gains from trade and how much is a zero- or even negative-sum game
of some kind.  I believe that practitioners have a better sense of this
than do the academics, myself included.

The bright side is that — as far as we’ve been told — this
massive, unregulated interest rate swaps market has not been a major
driver for troublesome counterparty risk.  The credit default swaps
have been the culprit there, in part because those latter markets are
based on large, discrete default events, which kick in quickly and
require very large surprise payments.

Betting markets in everything

Will Congress approve a bail-out package for banks before September 30?  Right now the contract is selling at about 79, which usually translates roughly into a 79 percent chance of approval. 

Note however that the marginal utility of money here does differ across worldstates.  Assume that the marginal utility of money is higher (people are poorer) with no bail-out.  That makes some people want to bet against the bail-out as a form of insurance, thereby raising the price of the "no bail-out" contract.  (Addendum: that was bad phrasing — no one has to intend insurance as long as the MUs of money differ across the world-states.)  In other words, the real implied chance of a bail-out is higher than 79 percent.

Jeffrey Ely’s mortgage proposal

We all need more creative thinking and Jeff is one of the best people to supply it:

True just sending money is not incentive compatible. But there is no reason to bail out homeowners. Just intervene in any mortgage default. Seize the property and continue making the mortgage payments. In the short run rent the property back to the homeowner.

This is what I have been advocating to my colleagues. I don’t know why it is not under discussion. Before going with the arbitrary implememtation that Paulson is proposing now there should be some convincing argument that it’s more efficient than this alternative. It is clearly the most direct approach and therefore should be the default (so to speak.)

Thoughts?  Unlike Tyler (and some others), Jeff is not obsessed with Jonathan Swift.

Can the subsidy be redirected?

Claire asks me:

If one is going to throw a huge pot of money at solving the crisis, is there any way to give it to anybody ‘lower’ in the chain?

Ideally we could send money to anyone about to default.  The obvious problem is that everyone would then pretend to be in that position. 

So I have a modest proposal.  The Fed/Treasury can identify those parts of the country with the most foreclosures.  They can buy or confiscate empty homes in those areas and destroy them.  That will raise the price of the remaining homes.  Anyone who is otherwise about to default could then sell the home at a high enough price (fingers crossed) to get out of the deal alive.  This would stop home prices from falling and it would limit the number of future defaults.

Buying the current already-foreclosed homes also would recapitalize the banking system but if you wanted to punish banks (not my goal) you could just seize the homes.  Of course the elasticities may not work out in such a way for this plan to forestall financial disaster but I’ve heard worse ideas.

And if you want to save the homes from outright destruction, you could offer 20-year, no-resale residencies in the homes to some group that won’t otherwise be buying an American home.  Alex suggests offering the homes to potential immigrants ("have I got a deal for you…") or how about giving away the homes to current low-asset recipients of Medicaid?  Dealing the homes away in the right manner could win back some money for the government or help out others in a very humane way.

Where is the Credit Crunch?

Back in February I pointed out that despite all the talk of a credit crunch commercial and industrial loans were at an all-time high and increasing.  At the time, Paul Krugman and others responded that this was just temporary as firms drew on previously existing lines of credit.  Well here we are in September and bank credit continues to look very robust.  As Robert Higgs points out consumer loans are up, commercial and industrial loans are up, even real estate loans are up.  Overall, total  bank credit is up with just a slight sign of leveling off in recent weeks.  So where is the credit crunch?

A credit crunch does exist in the sector of the market based on short-term, asset backed securities.  In addition, interbank lending is unusually risky.  But in light of what I have just said the "credit crunch" takes on a new meaning and potential new solutions are suggested.  The first question I have is this.  Investment banks were selling these securities and using the money to lend to whom?  I do not know the answer.  But let’s suppose that the money being raised in these markets was being lent to productive businesses.  If so, then any solution should focus on feeding those businesses that are starved for credit.

I look at the situation as follows.  Banks are bridges between savers and investors.  Some of these bridges have collapsed.  But altogether too much attention is being placed on fixing the collapsed bridges.  Instead we should be thinking about how to route more savings across the bridges that have not collapsed.  Government lending may be one way of doing this but why lend to prop up the broken bridges?  Instead, why not lend directly to the investors who are in need of funds?  After all, if these investors exist and have valuable projects that’s where the money is!  Let the broken bridges collapse, taking the shoddy builders with them.  Instead focus on the finding and rescuing the victims of any credit crunch, the investors who need funds.

Now here is a hypothesis.  It may be that there just aren’t that many firms in need of funds.  First, one reason that bank lending is up may be that firms with good projects have already turned to the substitute bridge of ordinary bank loans.  Second, I wonder how much real lending was actually being generated by asset backed securities.  Could it not be that most of the funds generated were used to buy more asset backed securities?  (The growth in these securities is certainly suggestive of that possibility).  If that is the case then it explains why the real economy has been remarkably resilient to the "credit crunch."

Now perhaps I am wrong about all this.  Bernanke has access to a lot more data than I do and he seems very worried.  I’d still like to know, however, which credit-worthy firms are credit starved.  And I’d suggest that we ought to think more about alternative bridges that will connect credit-starved firms with savers.    

Paulson plan vs. Dodd plan: my email to Eric Posner

I thought the original Paulson plan was terrible with regard to rule of law, and in that sense I thought the equity stake idea of Dodd was better.  A modified Paulson plan might be as good, it is hard to say.

[Eric now blogs that the Dodd plan gives the Treasury more power than current versions of the Paulson plan.  His post is very important.]

In reality I expect that either the Paulson or the Dodd plan would have to move quickly to incorporate some aspects of the other.  We’ll likely get some version of both loan-buying and equity shares, in any case.

The key factor is what kind of institutions are set up for making the next round of decisions.  That’s not getting much attention but of course there is no reason to think this is the final step or the final change in conditions.

Think of a barrel of apples, some good, some less good.  To oversimplify, the Paulson plan has the government buy some of the bad apples.  The Dodd plan has the government buy a 20 percent share in the barrel.  In both cases government buys something.

My intuitive rule of thumb is to want the government to be doing its buying in the better organized, more liquid market.  They are less likely to screw that up.  That tends to favor the Dodd plan in my view.

I like one other feature of the Dodd plan.  Our government loves cash revenue.  Furthermore the U.S. economy is set up so the "public choice" advantage of the government owning banks for the long haul is not so obvious.  We don’t have "insider-based" capital markets, for instance, so owning a bank wouldn’t give a politician so much chance to dole out loan favors.  I believe our government would be in a hurry to reprivatize those banks in return for the cash.  The Paulson plan, as I understand it, does not have an equally clear end game.

I may put this email of mine, or an edited version of it, on MR, check there for reader comments…


Night thoughts: How or whether do equity holdings give the government "upside" in eventual bank recovery?  Holding equity yields nothing if the banks never recover.  If the banks will recover, you would think a loan from the Fed would suffice.  But we’ve already tried that.  So what exactly are the assumptions here?  Somehow it is the Fed/Treasury actions which *cause* the banks to recover.  How does that happen?  They overpay for the loans at mysterious prices?  That just puts the Dodd plan back into all the problems of the Paulson plan.  If the government ends up overpaying for loans in the Dodd plan, and then someday gets 20 percent of that overpayment back through its equity share, is not a huge positive advertisement.  (Isn’t simply "knowing when to stop the subsidies" the best way to protect the taxpayers?)  And in the meantime, what kind of credit guarantees is the government offering these banks and their creditors?

Don’t forget Mark Thoma’s good analysis: "So, by having the government take a share of any upside, the result may
be less willingness of the private sector to participate in

It is easy to say that the Paulson plan is worse.  (Oddly I think the Paulson plan makes most sense in Paul Krugman’s multiple equilibria model for asset values.)  But you shouldn’t think that the Dodd plan is very good.  Most of the Dodd plan boosterism I’ve seen doesn’t look very closely at how it actually going to work.  There’s lots of talk about justice and the taxpayers getting upside and then a reference to the RFC from the New Deal.

Finally, in my view the Paulson plan makes (partial) sense if a) the major banks are in much worse shape than anyone is letting on, and b) you believe in multiple equilibria confidence models for these underlying asset markets.  I’m not saying those assumptions are true, but it would be nice to start by confronting the exact assumptions under which each plan might prove better than the other.

Economists Speak

An excellent Open Letter on the Bailout signed by many economists.  Hat tip to Justin Wolfers.

As economists, we want to express to Congress our great concern for the plan
proposed by Treasury Secretary Paulson to deal with the financial crisis. We are
well aware of the difficulty of the current financial situation and we agree
with the need for bold action to ensure that the financial system continues to
function. We see three fatal pitfalls in the currently proposed

1) Its fairness. The plan is a
subsidy to investors at taxpayers’ expense. Investors who took risks to earn
profits must also bear the losses.  Not every business failure carries systemic
risk. The government can ensure a well-functioning financial industry, able to
make new loans to creditworthy borrowers, without bailing out particular
investors and institutions whose choices proved unwise.

2) Its
Neither the mission of the new agency nor its
oversight are
clear. If  taxpayers are to buy
illiquid and opaque assets from troubled sellers, the terms, occasions, and
methods of such purchases must be crystal clear ahead of time and carefully
monitored afterwards.

3) Its long-term effects.  If the plan is
enacted, its effects will be with us for a generation. For all their recent
troubles, Americas dynamic and innovative private capital markets have brought
the nation unparalleled prosperity.  Fundamentally weakening those markets in
order to calm short-run disruptions is desperately short-sighted.

these reasons we ask Congress not to rush, to hold appropriate hearings, and to
carefully consider the right course of action, and to wisely determine the
future of the financial industry and the U.S. economy for years to come.