Month: October 2008

Still more countercyclical assets

Pretty soon we’ll get to the point where almost everything in this economy of ours is booming:

All over sunny San Diego,
tough economic times
have forced people to cut back on their $4 lattes and sushi dinners.
But one new business is booming — and ka-booming — precisely
because of frustration from the worst financial crisis to hit the
United States in decades.  Welcome to Sarah’s Smash Shack, where pent-up patrons can relieve
stress by hurling dinnerware and bric-a-brac against a wall, as hard as
they can, day and night, seven days a week.  San Diego entrepreneur Sarah Lavely charges her clients $10 and up
to pulverize plates and glasses during 15-minute intervals. Music
blares, clients dress in protective gear and a neon sign urges them to
"Break More Stuff."(…)San Diego may boast surf and sunshine year round, but it also has
its share of black economic clouds. Its real estate market has been hit
hard by the high rate of foreclosures in California, the second highest
in the nation, and its unemployment rate has risen to 6.4 percent from
4.8 percent in a year

Here is the link and I thank John de Palma for the pointer.

Is there any scenario for a break-up of the Euro zone?

Let’s say a Eurozone country faces a bank failure and the debt of the failing bank is very large relative to that country’s gdp.  This could happen in many countries.  The fiscal authority of that country cannot do the bailout on its own, in part because the resources are not there and in part because the country lacks the political unity for raising taxes.  The other EU countries cannot be persuaded to ante up.  The country in question either loses its major bank, and suffers the concomitant fall out, or it creates "on the spot" monetary policy to save the bank.  That means creating a domestic currency and suddenly announcing that the accounts of the bank will be reimbursed in terms of that currency rather than Euros.

I believe the odds of this outcome are relatively small.

That said, the "easy" option is for the ECB to do the bailout in terms of Euros.  A non-unanimity-requiring procedure for this should be worked out in advance to a greater degree than is currently the case.  And such a procedure may need to be worked out soon, while it is still unclear who would be the winners and losers from such an arrangement.

Unintended consequences

…the financial benefit to Paulson of accepting the call of duty is surely greater than that enjoyed by any other public servant in U.S. history.  Goldman Sachs has long had a policy that all deferred compensation becomes payable promptly to any partner who accepts a senior position in the federal government.  Congress passed a law a quarter-century ago that people taking senior appointed federal position who convert their investments into either an index fund or a blidn trust can do so upon assuming office with zero taxable capital gain until such investments are later sold.  If Paulson took advantage of these provisions, they enabled him to sell his shares in Goldman Sachs without raising any public questions without tax and to diversity his large personal invetments in a single stroke.  For just over two years’ service, the saings in Paulson’s personal income taxes could have been as large as $200 million.  Paulson had no interest in diversifying his investments and had never sold a share of Goldman Sachs stock.

I wonder what the total benefits for Paulson have turned out to be.  Indeed, it is rare that taking a job in government is such a good business decision (please note: I am not suggesting any conspiracy or evil intentions here).

That passage is from Charles Ellis’s The Partnership: The Making of Goldman Sachs.  This book gets better and better, as you keep on reading it.  Definitely recommended.

George Halverson on health care reform

Ah, remember that topic?  Ezra Klein does.  The book is called Health Care Reform Now! and the author is CEO at Kaiser Foundation Health Plan.  That may not sound like an encouraging combination but in fact this is one of the most intelligent health care policy books around.  The analysis of cost inflation, lack of early care, and billing for procedures is perceptive throughout.  The policy proposals involve electronic medical records for everyone, legally required health insurance, enforcing that mandate through the tax system (will he really cut off EITC to kids?), high-deductible plans for the high-income insured, covering some of the uninsured through an expansion of Medicaid (expand SCHIP and cover the single poor), offering primary care-first health insurance plan to the remaining poor uninsured, and finance the whole thing through a health care sales tax.  I like that last part best of all.  Plus he wants to reform the entire infrastructure of health care and institute more pay for performance.

I’m puzzled as to how he avoids destructive "notches" (implicit high marginal tax rates) across different individual margins and what private insurance companies will do with perfect access to everyone’s electronic health care records.  And he doesn’t focus enough on encouraging innovation or dismantling bureaucracy and barriers to entry.  Still, this is one of the most substantive books out there on health care economics.  Recommended to anyone who might be tempted.

Addendum: I’ve now read through the comments and I have to admit I am a little disappointed.  I don’t favor Halverson’s solutions overall though I do favor a much greater role for integrated HMOs.  The more important point is that I should be able to cover a book, and discuss its virtues, without having to come down on it, or for it, in a partisan way.

Plan B, from Luigi Zingales

Find it here.  In a nutshell:

Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property.

Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level.  Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property.

…In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.

Zingales also stresses that half-hearted attempts at bank recapitalization are unlikely to work at this time; he thinks that at least $600 billion would be needed.

This piece has many interesting points throughout, it is worth a full read.  Here is a concordance of writings of Luigi Zingales on the credit crisis.

Do researchers suffer from winner’s curse?

OH NY GOD…READ THIS!!!!!!!!!!!!!!!!!

From The Economist:

In economic theory the winner’s curse refers to the idea that
someone who places the winning bid in an auction may have paid too
much…The same thing may be happening in scientific publishing, according
to a new analysis. With so many scientific papers chasing so few pages
in the most prestigious journals, the winners could be the ones most
likely to oversell themselves–to trumpet dramatic or important results
that later turn out to be false. This would produce a distorted picture
of scientific knowledge, with less dramatic (but more accurate) results
either relegated to obscure journals or left unpublished.

My colleague Omar Al-Ubaydli was part of this work.  Fortunately, it is mentioned on the very cover of the magazine.  Nonetheless I believe it is true and it is most true for "hot" fields.  The original paper is here.

Hypotheses which are too simple to be true as stated

We need a new banking system.  A new banking system takes years to
build.  We will be in an economic downturn for years and because this
crisis is global it will not be better than Japan in the 1990s.  It is
hard to build a new banking system through the current, old, nearly
insolvent banking system.  Maybe some smart person has a
plan to build a new banking system through the old system, while
avoiding toxic contamination through the problems of low-solvency
institutions.  That smart person remains silent.  I have not given up
hope.  The Great Depression had bank failures, we have bank zombies.

Humpty-Dumpty theories

One version of pessimism is to wonder how easily a banking system can be put back together again.  Just as a physical bubble is an asymmetric process (it is easier to pop one than to rebuild it), maybe a banking system is similar.  It’s built up over time by lots of lattice work and investment in complementary processes and assets.  Once it pops away it can’t be easily reconstructed, even if the reconstruction plan targets the initial cause of the problem (low capitalization).  One implication of this view is that initial recapitalization of banks — say about a year ago –was a much more urgent matter than we realized at the time.

A more optimistic take is the "bounce" view: things have to fall far enough so that they hit the floor and get a bounce, pushing them back up again.

In the last two days I have started to entertain the possibility that the Humpty-Dumpty view is in fact correct.

How will a capitalization plan actually work?

I’m all for bank capitalization but the problem is this: the Fed has been lending hundreds of billions to banks for many moons.  Right now the banks are just sitting on the money, for the most part. 

To be sure, Treasury equity is not the same as debt to the Fed, but are they so different?  Keep in mind the Fed has been a softie to A.I.G. ($30 billion more), so the Fed is hardly a loan shark and in some ways the Fed’s I-can’t-just-stop-rolling-it-over-when-I-want contribution is a bit like preferred equity.

To put it another way, will partial government ownership so much change bank incentives for the better?

Which is it?

1. Treasury capitalization will matter to the extent that Treasury equity has some different properties than from-the-Fed debt, but this isn’t nearly as much of an effect as any published sum for a Treasury capital inflow would indicate.

2. Treasury equity will work because of some legal or regulatory difference between equity and debt which we are otherwise unwilling to abolish.

3. Treasury equity will work because it is a hidden giveaway to bad banks (by the way, this is arguably what happened in Sweden).  But of course we could do the giveaway more directly if not for bad PR.

Inquiring minds wish to know.

Three other points:

4. Capitalization might have a bigger marginal oomph in Europe than here, because the ECB hasn’t been going crazy lending out reserves as the Fed has.

5. If the key is to get banks up and running again, we want bank CEO contracts with lots of bonus compensation on the profit upside and those contracts are more important the "worse" is the bank.  Ouch.

6. If such a plan will raise the value of lots of banks, by a lot, none of the shareholders will wish to sell early at low prices, a’la Grossman and Hart 1980, and the Treasury will be back in a bind.

That is what Alex and I talked about over dinner.  I conclude that the crisis will not end anytime soon.

How will partially nationalized banks behave?

This is a question about models, not a question about the real world. 

We are used to invoking shareholder unanimity theorems, whether they are justified or not.  But say the U.S. government owns twenty percent of each major bank.  Exactly what instructions do they give the management?  ("Hey, guys, just get stuff going again!"?)  Presumably the twenty percent shareholder wants something different, and more in line with the public interest, than the desires of the remaining eighty percent.  Are we to assume that the twenty percent wins out?  Can managers be sued for violating their fiduciary responsibilities?  Does the twenty percent explicitly tell the managers to do something other than maximize profit?  What if the eighty percent votes to override them?

What are control rights worth in these situations?

You might argue that the mere fact of recapitalizing the bank will cause the eighty percent to want what the government shareholder wants.  That is not in general true, especially if the government is pulling its capital back out at some point.

You might argue that the government involvement is a kind of insurance and it makes the older equity claims more like debt (insurance on the downside but loss of some potential upside gains).  The newly neutered "debtholders" still might not want the bank to be very active, as evidenced by the stagnant nature of some explicit current debt markets. 

I hear this recurring voice: "Hey, you guys, just get stuff going again!"  It’s an odd basis for corporate governance.

I am not sure what is the proper way to model this set-up.

Addendum: Greg Mankiw proposes non-voting shares.

The countercyclical asset, a continuing series

It is getting worse: home vaultsThe Times of London reports:

Sales of household safes have surged as wealthy savers concerned about the
health of banks opt to keep cash at home.

Leading safe manufacturers contacted by The Times said that they had
seen a big increase in demand. Many predicted that fears of meltdown in the
banking sector would mean a further rush before Christmas.

One company said that sales had increased by a quarter, while another said
that its staff had received calls from panicking investors who now wanted to
keep their savings locked away at home.

Here are previous installments in the series.