Mistakes or Necessary Benign-Neglect? (fg)

.... asks Oxford economist John Muellbauer on vox.eu. To him,

When future economic historians look back to trace the triggers for the October 2008 financial panic and the unnecessarily severe recession of 2009, they will likely put their fingers on two.

* The failure to keep Lehman Bros functioning as a going concern.
* The failure of the ECB and the Bank of England to use their interest rate setting firepower to organise a substantial globally co-ordinated interest rate cut (the 8 October 2008 cut was too timid).

Personally, I do not think his assesment is accepted by a majority of eonomists. In particuar, many commentators advocated the breakup of Lehman Bros. It should be a warning signal to financial markets to prevent moral hazard. Moreover, it was by now way cristal clear (to put it in the marvelous words of ECB president Trichet) that the overdue adjustment in the financial indutry will spill over that fast and massive. With inflationary pressure still on the upside risk, it was a good advice to let interest rates at a still moderate but not expansionary level.

Especially, the role of a lender of last liquditiy was perfectly played by international central banks. Rate cuts would not have been the solution to efficient liquidity management. Therefore, asking for a pre-emptive reduction of interest rates may have been ex-post an interesting advice; holding non-rate-cutting central banks responsible for the recession is too myopic - albeit the mistakes were indeed made at the beginging of the decade.

Angry economists (amv)

Economic science has been perverted, economic teachings has been perverted, economic policy has been perverted --- all by politics. To continue down our current path is to reinforce the perverse folly of politics that has threatened the viability of the current economic system. (Peter Boettke)

or:

My main beef with economists is that standard macroeconomics does such a poor job of describing what is going on. The textbooks models are pretty much useless. Where in the textbooks is "liquidity preference" a demand for Treasury securities? Where in the textbooks does it say that injecting capital into banks is a policy tool?

Graduate macro is even worse. Have the courses that use representative-agent models solving Euler equations been abolished? Have the professors teaching those courses been fired? Why not?

I have always thought that the issue of the relationship between financial markets and the "real economy" was really deep. I thought that it was a critical part of macroeconomic theory that was poorly developed. But the economics profession for the past thirty years instead focused on producing stochastic calculus porn to satisfy young men's urge for mathematical masturbation. (Arnold Kling)

But don't worry:

Words ought to be a little wild, for they are the assaults of thoughts on the unthinking. (J.M. Keynes)

For the latter: HT P. Krugman

Bagehot's Rule (amv)

Should central banks supply any increase in liquidity preference? Yes. Should central banks back up insolvent cooperations? No. George Selgin:

Who can forget the end of “Planet of the Apes” when Charlton Heston, kneeling before the half-buried remains of the Statue of Liberty, slams his fists into the sand and cries, “You maniacs! You blew it up! Ah, damn you ...damn you all to hell!”

Now imagine the same scene, but with a half-buried Morgan Stanley building standing in for Miss Liberty and a time-traveling Walter Bagehot playing the lead, and you’ve got the perfect Hollywood dramatization of the real-life tragedy that, with luck, is having its denouement on Wall Street.

Bagehot? The great Victorian man of letters, best remembered today as the second and most celebrated editor of the British magazine, The Economist, wasn’t exactly a hunk. But he certainly could have delivered those futile last lines with real conviction, for he was among the first to recognize the vast destructive potential of that newfangled weapon of Victorian finance: the modern central bank.

Bagehot first alerted readers to this potential, and offered his suggestions for containing it, in an article that appeared in The Economist after the great panic and credit crisis of 1866. That panic witnessed the spectacular collapse of Overend, Gurney and Co., which had long been Great Britain’s premier investment house.

Bagehot understood that, during such panics, the Bank of England alone commanded the confidence needed to serve other financial firms as a “lender of last resort.” But as Bagehot put it later in his book “Lombard Street: A Description of the Money Market” (1873), the bank’s “faltering way”—its arbitrary and inconsistent use of its unique lending powers—only tended to make things worse. “The public,” Bagehot wrote, “is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made. ...And until we have on this point a clear understanding with the Bank of England, both our ability to avoid crises and our terror at crises will always be greater than they would otherwise be.”

The ultimate source of trouble, Bagehot believed, was the very existence of the Bank of England and the special privileges it enjoyed. But because nothing save a revolution seemed likely to do away with the “Old Lady of Threadneedle Street,” as it was called, Bagehot’s preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at “penalty” rates. The restrictive provisions were supposed to limit aid to otherwise solvent firms panic had rendered illiquid.

Bagehot’s recommendation has since become a sort of master precept of central banking—albeit one that’s mainly honored in the breach by central bankers.

To be fair to today’s central bankers, there’s never been much agreement on how to apply Bagehot’s rule in practice. Just what do “good collateral” and “penalty rates” mean in times like these?

While no one may precisely be able to define good collateral, and one can debate whether the rate at which banks offer to lend unsecured funds to other banks, known as the London Interbank Offered Rate, or LIBOR rate, plus 8 percent constitutes a “penalty” rate, who even pretends that recent central bank lending has been based on good collateral?

But rescuing insolvent firms is the least of it. The real damage comes from the Treasury’s utter lack of any consistent last-resort lending rule. The recently enacted financial institutions bailout bill does little to clarify this.

That’s just the sort of thing that troubled Bagehot almost a century and a half ago, when central banks were still in their swaddling clothes. Yet central bankers and governments still don’t get it, despite the lip service they pay to this great thinker from our past.

Source: The Independent Institute

It just ain’t so! (amv)

Larry White on regulation failures, the solvency vs. liquidity problem, and Krugman:

The teaser:

The Federal Reserve’s interventions in the recent subprime-mortgage crisis have included—at its own initiative, without precedent, and without congressional oversight—the extension of credit lines to investment banks and the lending of Treasury bills to “primary” securities dealers. The traditional role of the central bank as a “lender of last resort” is to make loans only to commercial banks, because the traditional rationale is to protect the economy’s payment system. The hope of the traditional last-resort lender is to avoid a collapse of the economy’s money stock by injecting reserves into the commercial banking system when there is an extraordinary “internal drain” of reserves (namely bank runs). In the recent crisis, by contrast, there has been absolutely no threat of a shrinking money stock. Investment banks do not issue checking deposits, are not subject to bank runs, and are not part of the payment system. Neither are securities dealers. The Fed’s expansions of its own role therefore had nothing to do with protecting the payment system or stabilizing the money supply. The Fed’s new moves were rather made in the hope of protecting investment banks and securities dealers from the consequences of holding portfolios overweighted with mortgage-backed securities, or exotic derivatives based on such securities, while keeping levels of capital inadequate for such portfolios. The reason that some financial institutions have been having trouble rolling over their debts is fundamentally the market’s uncertainty about their solvency. It is not a liquidity problem.

By blunting the market penalty for financial imprudence, the Fed is breeding a new kind of moral hazard. If the next crisis is worse than this one, moral hazard —not failure to regulate—will be high on the list of suspects. The Fed is currently lending hundreds of billions of Treasury securities from its portfolio and taking junk assets as collateral. In a few years we will be able to tabulate the losses to the American taxpayer.

Krugman declares: “We now know that things that aren’t called banks can nonetheless generate banking crises, and that the Fed needs to carry out bank-type rescues on their behalf. It follows that hedge funds, special investment vehicles and so on need bank-type regulation. In particular, they need to be required to have adequate capital.” It just ain’t so. Solvency problems for hedge funds and investment banks do not constitute a banking crisis as normally understood. What we now know—and already knew—is that financial firms, especially if they believe they can count on a government bailout, can get into trouble by holding highly leveraged portfolios of risky assets. The way to alleviate the problem is to cure them of that belief by letting them and their counterparties take their lumps.The potential for failure of a hedge fund, investment bank, or other financial institution is no rationale for new legal restrictions on them. Their shareholders and those who lend to them can and should determine how much capital is adequate.

Source: The Freeman

War, Crisis, and Economics (amv)

The market has failed. Policy failed by leaving the market on its own. Policy ought to step in and re-regulate. This is the common interpretation of the recent crisis. It comes as no surprise, since anti-capitalistic presumptions were widespread before. What is surprising, however, is how easily government distortions are blanked out, even those who are otherwise on top of the agenda. I mean the War in Iraq and in Afghanistan.

Warfare distorts economic activity. The government spends money to reshape the capital and production structure. By forced saving, government hypes investments in very special kinds of capital goods, those which do never mature in consumption goods but are rather used to destroy (human) capital elsewhere. Beyond a level sufficient to ensure protection against external enemies, spending on war is unproductive. War often proved to be the long-run alternative for trade. To reshape the economy and to defend the warranted structure of production, government needs funds to compete with the consumer on resources. The Bush-Administration piled up a huge stock of national debt. No president before has such a bad record. And here is the link to the financial crisis:

If an increase in money does not supply an increase in the demand for credit, funds are limited by savings at home and abroad. If government borrows, it has to crowd out private investments, that is, it has to attract funds planned for private investments by offering higher interest rates. The adjustment of the capital structure in favour of a war-economy would express itself in lower capital values of peace-production. There is no reason for expectations to take off. There is no bubble, but gains here and losses there. But what happens if the central bank targets interest rates? In this case the central bank has to purchase government bonds (or in fact use much more subtle measures) and thereby increase the money supply. Thus, even inflation-targeters with a strong commitment to stability produce savings in disguise. There you find the myth that US-debt has is financed by foreign savings as such. The increase in nominal incomes of those who benefit from the reshaped structure of the economy, if they do not save themselves, are made available to foreign investors by imports of goods and services. International savers purchase US-government bonds with new money, motivated by the increase in purchasing power of foreign currencies relative to the US-Dollar (if the detoriation of the Dollar is expected to be overcompensated by the Dollar-return of the investments). The inflationary impact of lower productivity growth due the expenditures on war is multiplied by the central bank which ironically attempts to ensure neutrality of money in a world with price and wage rigidities. If foreign savers take up the additional money, asset price inflation is especially high due to the higher money circulation on financial markets. Asset price inflation boosts distortions in credit standards and opens all gates for unfounded price speculations.

The financial crisis is therefore also a crisis of Big Government, of reckless government spending in conjunction with central bankers, who manipulate the interest rate. Note that central bankers do so for others reasons than in the past. We are lucky that very good economists head our central banks. Our problem is their pretty bad models of the economy. The major mistake is the Keynesian presumption that the interest rate is a purely monetary phenomenon, that central banks should target the interest rate to ensure a full-employment level of effective aggregate demand.

Regulation boosts systemic risk: George Kaufman (amv)

The Teaser:

Although banking may be more fragile than other industries, this does not imply a higher breakage or failure rate. Rather, greater fragility implies "handle with greater care," much as it does with glass and porcelain objects. And apparently that is what the private market did in the United States when the proper incentives to encourage such behavior were in place. Before the introduction of government safety nets, banks held considerably higher capital ratios and assumed considerably less credit and interest rate risks in their portfolios. The average annual failure rate for U.S. banks from the end of the Civil War in 1865 to before the establishment of the Federal Reserve System in 1914 was somewhat lower than for nonbank firms, although the annual variance was greater (Kaufman 1996). In addition, losses to depositors as a percent of deposits at failed banks were lower than losses to creditors at failed nonbanks (Kaufman 1994). Jack Carr, Frank Mathewson, and Neil Quigley (1995) describe the stability of the Canadian banking system before the introduction of deposit insurance in 1967. Anna Schwartz (1988) argues that until the recent worldwide rash of bank failures--which are described in Herbert Baer and Daniela Klingebiel (1995), Gerald Caprio and Daniela Klingebiel (1995), Gillian Garcia (1995), Charles Goodhart (1995, particularly chapter 16), and Zenta Nakajima and Hiroo Taguchi (1995)--while banks failed, bank panics and contagion had almost disappeared in developed countries, other than the United States, by the late 1920s.

Ironically, the introduction of government regulations and institutions in the United States intended to provide protection against the fragility of banks appears to have unintentionally increased both the fragility of the banks and their breakage rate. By providing a poorly designed and mispriced safety net under banks for depositors, first through the Federal Reserve's discount window lender of last resort facilities in 1914, and then reinforced by the FDIC's deposit guarantees in 1934, market discipline on banks was reduced substantially. As a result, the banks were permitted, if not encouraged, to increase their risk exposures both in their asset and liability portfolios and by reducing their capital ratios. As noted by Edward Kane (1985, 1989, and 1992), George Benston and Kaufman (1995), Kaufman (1995a), George Selgin (1989), and others, this represents a classic and predictable moral hazard behavior response. Public (taxpayer) capital has largely replaced private (shareholder) capital as the ultimate protector of depositors. For example, in its 1994 Annual Report, the FDIC (1995: 35) declared that "the FDIC remains today the symbol of banking confidence."

Moreover, it could also be argued that the introduction of the safety net encouraged the federal government to impose greater risk on the banks. For example, national banks were not permitted to make mortgage loans before the Federal Reserve Act in 1913 and then only one-year loans until 1927. Likewise, the government did not encourage banks and thrifts to make long-term fixed-rate mortgages until after the introduction of deposit insurance. It is interesting to speculate whether the government would have introduced such risk increasing policies in the absence of a safety net.

But, in addition, as repeatedly emphasized by Kane (1989, 1995a and b), the establishment of the Federal Reserve and FDIC in the U.S. introduced severe principal-agent problems. The Federal Reserve was charged with acting as the lender of last resort to the macroeconomy by, among other things, offsetting the impact of losses of reserves from the banking system for reasons such as a run to currency by depositors or gold outflows that threatened to reduce the money supply below appropriate levels. But the Federal Reserve was given discretion with respect to when and to what extent to do so. Unfortunately, as Milton Friedman and Anna Schwartz (1963) document, when the banking system experienced a run into currency during the Great Depression from 1929 to 1933, which dramatically reduced aggregate bank reserves, money supply, and bank credit, the Federal Reserve failed to inject sufficient offsetting reserves. As a result, the simultaneous attempt by nearly all banks to contract by selling assets led to large fire-sale losses and the largest number of bank failures in U.S. history.

The rest of it: Bank Failures, Systemic Risk, and Public Policy by George G. Kaufman

Myron Scholes on regulation (amv)

Nobel Laureate Myron Scholes:

There is now a rising chorus among regulators, politicians and academics claiming that the freedom to innovate in the financial domain should be curtailed.

This stemmed from the apparent recent failures in mortgage finance and credit default swaps and the apparent need for governments and central banks to “bail out” failing and failed financial institutions around the world directly through capital infusions and indirectly by providing a wide array of liquidity facilities and guarantees. They claim that freedom in global financial markets has proceeded at too rapid a pace without controls—in particular with an incentive system that rewards risk-taking at the expense of government entities—and as a result “throwing sand in the gears” of innovation will reduce “deadweight costs” and “moral hazard” issues.

Obviously, these same proponents for re-regulation fail to measure the benefits of the myriad financial innovations that have succeeded since regulatory constraints were relaxed in the 1970s. And they fail to account for the vast increase in the wealth of the global economy that has resulted from the freedom to innovate.

Economic theory suggests that financial innovation must lead to failures. And, in particular, since successful innovations are hard to predict, the infrastructure necessary to support innovation needs to lag the innovations themselves, which increases the probability that controls will be insufficient at times to prevent breakdowns in governance mechanisms. Failures, however, do not lead to the conclusion that re-regulation will succeed in stemming future failures. Or that society will be better off with fewer freedoms. Although governments are able to regulate organisational forms, they are unable to regulate the services provided by competing entities, many yet to be born. Organisational forms change with financial innovations. Although functions of finance remain static and are similar in Africa, Asia, Europe and the United States, their provision is dynamic as entities attempt to profit by providing services at lower cost and greater benefit than competing alternatives.

We would be derelict to regulate the financial industry heavily without attempting to understand the cost and benefits of regulation and without a thorough understanding of the causes of this crisis. With haste, new forms of regulation will probably not lead to less chance of further crisis and failures. History suggests that even the most heavily regulated banking (and broker/dealer) sectors have collapsed or nearly collapsed on myriad previous occasions. New regulations have supplanted old regulations to no avail. I reference here the Kindleberger – Aliber book, “Manias, Panics, and Crashes”, wherein myriad crashes or related incidents throughout the centuries are listed and discussed.

Crises are caused by banks having too much leverage. They face an “inflexibility trap” and “negative convexity”. Generally, a shock occurs, a “fat-tailed event”, and as a result a bank suffers a loss on a product line such as subprime mortgages that, in turn, requires it to reduce the risk of its equity. To do so, it must issue additional equity or sell risky assets to pay back debt. With leverage, to reduce risk needs action. If the bank attempts to raise equity capital, however, it faces the “inflexibility trap”. By issuing equity, debt holders have more capital supporting their debt and are better off. Equity holders must be worse off. That is, on the announcement of the offering, the price of existing shares fall. This follows from option theory. When governments infuse capital into banks, the new capital benefits the debt holders. This is the true “moral hazard”.

The simple remedy, therefore, is to require banks to have less leverage or—its converse—to have additional equity capital. This garners flexibility. And flexibility is valuable. It is an option. We can measure its value and price it accordingly. If society is to provide the option, it should charge for it in advance, and then it becomes the supplier of contingent capital to the financial system. This creates the correct incentives. This is not regulation; this is economics.

“Negative convexity” arises as firms are required to invest to make money for their shareholders. When everyone else is driving over the speed limit, there is pressure to drive quickly as well; that is, more leverage to increase the return on equity capital. When a shock forces entities to reduce risk, they find it difficult to do so for many other entities are also attempting to liquidate positions at the same time. Not all the cars can slow down in time to prevent an accident. In financial markets liquidity prices increase dramatically, creating “fat tails”, and entities are unable to sell assets to reduce risks. With losses in one area, banks need to sell other more liquid assets. This, in turn, requires other banks to liquidate assets to reduce their risk. Liquidity prices increase and asset values fall across all markets as banks demand liquidity to reduce risk. This causes a deleveraging cascade in the financial markets affecting the capital of all banks.

Although I don’t have the data available, I predict that bank capital ratios have fallen dramatically over the last 20 years, with deregulation of the banking sector in the 1990s, coupled with the advent of the Bank for International Settlements’ implementation of Value at Risk, portfolio theory, that is in vogue to determine bank capital, and with changes in accounting rules.

Certainly, with additional equity capital, the return on equity capital of financial entities would fall, but the value of the enterprise would not be affected. Modigliani and Miller, over 50 years ago, wrote a classic paper in financial economics, demonstrating that the value of the firm is independent of its debt-to-equity ratio. For this and related work, each was awarded the Nobel prize in economics. Although the required rate of return on debt is less than that of equity, the required return on equity increases with additional debt to just offset debt’s lower cost. In its simplest form why would an investor pay more for a leveraged firm than an unleveraged firm if she could acquire the unleveraged firm at a lower price and create the same capital structure on personal account? Their simple and elegant model has withstood many academic attacks including issues such as the tax deductibility of debt or bankruptcy costs. Miller argued in his 1977 presidential address to the American Finance Association that these issues are second order, “akin to a horse and rabbit stew – one horse and one rabbit.” Although additional equity capital and less debt capital will not reduce the total value of the bank, it will reduce the expected return on equity. This is of no consequence, however, since with less debt the risk of the equity is correspondingly less. The return-to-risk tradeoff is unaffected. Investors will need to expect a lower return on equity capital. If individuals, hedge funds, etc, want to achieve a greater expected rate of return with commensurately more risk, they are able to achieve such by leveraging on their personal accounts. Remember, however, that leverage is a two-edged sword. Wonderful when things are going well; a cancer when things are going badly. Since there are few costs and many benefits to this approach, capital requirements and pricing flexibility are the correct way to regulate banks going forward. Since this is the correct economic response, it trumps regulating the financial system heavily going forward. There is no need to “throw sand into the gears” to slow down innovation and new products. Capital is the solution and it is a form of “light regulation”.

Source: The Economist.com ; A debate with Joe Stiglitz.

A Defense on Paul Krugman's Nobel Price (fg)

Many commentators on the nobel price going to Paul Kurgman claimed that it is more a political signal rather than pure scientific reasoning. To them, Krugman offers the wrong economic and policital statements in his columns in the NYT. President of the Amercian Economic Association Avinash Dixit now steps into the breach for Krugman. Although he has resentiments against Krugman's writings

I have not said anything about Krugman’s popular writings, most importantly because they are not the reason for his “ennobelment,” but also to a small extent because I sometimes dislike his polemical and combative style of writing at the same time as I agree with the substance of his criticisms.

he still thinks that Krugman won the Nobel Prize rightly.

In the last 10 years, Krugman has achieved fame in a much larger arena with his columns in the New York Times. These offer strong views on economics and politics, and they have been harshly critical of the Bush administration on most issues. It is no wonder that they attract adulation from readers who share his views on these matters and hatred from the other side. The former delight in his Nobel Prize, and the latter are shocked and dismayed by it, but both these reactions are mistaken. The prize has nothing to do with the Op Ed columns and would have come to Krugman just the same if he had never written a single one of them. The prize celebrates his achievements in science, not in the policy arena. It is therefore important to summarise and clarify exactly what those achievements are.

The Political Economy of the bailout (amv)

In a recent post, I expressed my scepticism for government measures to bailout the financial sector. I stressed knowledge problems. Arnold Kling worries about the concentration of power. And rightly so:

Whether the economy needs a "plan," or whether the plan will help the markets, is beside the point. The plan serves to consolidate power. Four weeks ago, the Fed and the Treasury had far more power than anyone can intelligently use. Still, they came to Congress requesting more power. Then, when the bill was passed, Paulson took even more power than what it sounded like the legislation was giving. [...]

What I call the "suits vs. geeks divide" is the discrepancy between knowledge and power. Knowledge today is increasingly dispersed. Power was already too concentrated in the private sector, with CEO's not understanding their own businesses.

But the knowledge-power discrepancy in the private sector is nothing compared to what exists in the public sector. What do Congressmen understand about the budgets and laws that they are voting on? What do the regulators understand about the consequences of their rulings?

We got into this crisis because power was overly concentrated relative to knowledge. What has been going on for the past several months is more consolidation of power. This is bound to make things worse. Just as Nixon's bureaucrats did not have the knowledge to go along with the power they took when they instituted wage and price controls, the Fed and the Treasury cannot possibly have knowledge that is proportional to the power they currently exercise in financial markets.

Source: Econlog

Who Trusts Governments? (fg)

I highly recommend amv's post. To him, and I agree, government bailouts won't cure the very root of the mess; it may just postpone the necessary re-thinking and adjustment in over-invested financial markets.

Politicans announced these days that they will provide free-lunch packages by hook or by croock. Let's see how financial market indiciators reacted. The following figure shows the TED, i.e. the difference between the three-month interbank lending rate and the three-month Treasury bill, indicating to the overall uncertainty and distrust in the interbanking market. Although the bail-out program is waiting in the pipeline (and believe me it will come!), market participants don't accept the rescue plan overwhelmigly; they dislike to smell the rat of catharses. In particualr, don't think that the tiny decline in the LIBOR rate last days looks like the process towards a normalization. This is just the reflex of overall falling interest rates which appears to be the result of the neccessary adjustment in the real and financial economy (see my former post on the urgency of a recession).

To sum up, the most impressive indicator, the TED spread, still remains at extraordinary high levels. Financial markets need to learn that the actually good idea of credit derivatives to transfer risk was feeded with cheap money, especially across the atlantic. It generated massive systemic risk in the financial system heated up by intransparency and wrong incentives. You may find a comprehensive analysis of the nature and consequences of credit risk transfer here.


UPDATE: I am not the only one who recognized that credit markets are not impressed by bailout plans. See Mish's Global Economic Trend Analysis.

5 Gegenthesen zum Hohenheimer Appell (amv)

Am 8. Oktober 2008 haben mehrere Hohenheimer Ökonomen einen Appell an Banken, Politik, Wissenschaft, Unternehmen, Medien und Bürger gerichtet, einen Appell an jeden Einzelnen. Demnach sei eine „gravierende Wirtschaftskrise“ nur abzuwenden, soweit alle ihrer Verantwortung bewusst werden und entsprechend handeln. Die Krise ist ein psychologisches Massenphänomen, eine irrationale Reaktion des Marktes, der nur mit Vernunft und Bedacht zu begegnen sei. Dies ist die gute Nachricht: Da die Krise in unseren Köpfen ist, können wir ihr durch Glauben und Hoffnung entkommen. Als Beweis des guten Willens sollen Banken ihre Bilanzen offenlegen und untereinander „Solidarität“ zeigen. Wissenschaftler sind aufgerufen zur politisch durchsetzbaren Unabhängigkeit. Soweit Medien außerstande sind objektiv zu berichten, sind sie angehalten ihre Berichterstattung einzustellen. Der Bürger soll all dem Glauben und Vertrauen entgegenbringen - und sein Geld auf dem Konto lassen. Das alles in zwölf Thesen.

Gegenthese 1 - Nicht das Unmögliche fordern: Ökonomen wissen um die Kraft des Anreizes. Ihr sprechen wir immerhin den Marktprozess zu. Sie steht hinter Adam Smiths Metapher der Unsichtbaren Hand. Es ist üblich auch der Hand des Staates individuelle (Stimmen-)Maximierung zu unterstellen. Unser Menschenbild ist dass des immerwährend Wählenden, in seinen Entscheidungen stets abhängig von seinem Kontext. Umso mehr überrascht der Aufruf, individuelle Anreize einfach zu ignorieren. Solidarität zwischen Banken ist eine ungewöhnliche Vorstellung, ebenso wie die, sich selbst zensierender Medien. Die gleichzeitige Offenlegung der Bankbilanzen, zum Beispiel, scheitert am Gefangenendilemma. Öffnen konkurrierende Banken ihre Bilanzen nicht, so stünde die einzelne Bank allein mit heruntergelassener Hose vor einem höchst aufmerksamen Publikum. Öffnen die anderen Banken ihre Bilanzen doch, so ist es relativ unproblematisch spätestens am nächsten Morgen nachzuziehen. Trotz Appell bleibt die dominante Strategie abzuwarten. Dies gilt ebenso für den Aufruf an die Politik, die Finanzkrise nicht im Wahlkampf auszuschlachten, Stimmen nicht zu maximieren. Die Geschichte zeigt, dass solche allgemeinen Appelle an das Gemeinwohl selten fruchten. Vielmehr müssen Institutionen derart konfiguriert werden, dass sie Eigennutz in allgemeine Wohlfahrt übersetzen.

Gegenthese 2: Der Markt braucht Regeln. Aber er gibt sie auch vor: Ohne Zweifel stimmen die Spielregeln auf den Finanzmärkten nicht. Sicherlich benötigt es neuer Regulierung. Und sollte die Regulierung gelungen sein, so ist ihre internationale Anwendung nur zu begrüßen. Schwierig ist allein die Auswahl. Welche Institutionen helfen? Welche Regeln harmonieren? Selbst unkontroverse Maßnahmen, wie die Verschärfung von Eigenkapitalvorschriften, lassen sich nur schwer optimieren. Die Notwendigkeit für Eigenkapital resultiert aus Unsicherheit, Risiko und asymmetrischer Information. Es sind Kosten, welche wir in Kauf nehmen, um mit bekannten und unbekannten Wahrscheinlichkeiten umgehen zu können. Doch ist unsere Wohlfahrt das Ergebnis von Risiken, die nichtsdestotrotz eingegangen wurden. Es gilt ein Maß, ein Optimum, zu finden. Dabei werden notwendigerweise Fehler gemacht. Der Vorteil des dezentralen Wettbewerbs ist die Auslese, die auf Fehler folgt. Der Informationsbedarf des Einzelnen ist dabei gering; der Wettbewerb als Prozess selektiert anonym. Es stellt sich angesichts der Finanzkrise die Frage, wie das gesamtwirtschaftliche Investitionsverhalten sich trotzdem von den realwirtschaftlichen Bedingungen entfernen konnte. Weshalb lässt die notwendige Bereinigung in Folge von Erwartungsfehlern auf sich Warten? Weshalb türmen sich Fehlallokationen auf, bis sie zu solch weitreichenden Kapitalverlusten führen müssen?

Gegenthese 3 – Psychologie ist weder Ursache noch Lösung: Gerade weil der Erfolg des Marktprozesses nicht auf individuelle Einsicht beruht, sondern systematisch selektiert, ist das psychologische Wohlbefinden in der Erklärung der Finanzkrise sekundär. Es ist nur der älteste und offensichtlichste Erklärungsversuch. Dabei hat die andauernde Inflation der Vermögenswerte eine realwirtschaftliche Dimension. Sie ist nachhaltig, wenn die ihr zugrundeliegenden Investitionen einen entsprechenden Anstieg des allgemeinen Produktivitätswachstums forcieren. Wir haben in der Tat rapiden Technologischen Fortschritt hinter uns und es ist zumindest vorstellbar, dass im Zuge des noch andauernden Strukturwandels und der zunehmenden institutionellen Inkompatibilität, Übertreibungen forciert werden. Dies sind dann Kosten des Fortschritts, und ihre Minimierung kann uns eben diesen kosten. Doch mit manchen Kosten müssen wir nicht leben. Die Fehlallokationen auf dem Immobilienmarkt gehen auf veränderte Regulierungen zurück. Deregulierung ist hier der falsche Begriff. Etablierte und wohlbewährte Spielregeln wurden verändert. Privilegien wurden gewährt. Es ging dabei auch um jenes Allgemeinwohl, das uns heute leiten soll. Selbst kapitallose Geringverdiener, so der damalige politische Wille, sollten Zugang zu Hauseigentum haben. Heute sind wir überrascht, dass Eigentum nicht verordnet werden kann, das Kreditexpansion an sich keinen Wohlstand schafft.

Gegenthese 4 – Die Psychologie dominiert, wenn die Geldpolitik es zulässt: Die Neuregulierungen auf den Immobilienmärkten erklärt aber nur eine partielle Krise, eine Allokationskrise. Soweit Realkapital tatsächlich fehlgeleitet ist, bleiben Kapitalwerte unten. Nettoinvestitionen bleiben aus. Wahrscheinlich ist eine breite Disinvestition, während der bestehende Bestand durch das durch fallende Preise gestiegene Realeinkommen absorbiert wird. Die gesamtwirtschaftliche Dimension der Finanzkrise wird durch eine das Realwachstum übersteigende Wachstumsrate der Nominalausgaben ins Spiel gebracht. Nur ein stabiler geldpolitischer Ordnungsrahmen gewährleistet, dass Eigenkapitalquoten Orientierung bieten. Ein allgemeiner Anstieg der Vermögenspreise in Folge einer anhaltenden Kreditexpansion ist auch ein Anstieg im Nominalwert von Sicherheiten. Rapide Kreditexpansion birgt demnach die Gefahr in sich, ihre Kontrollen zu erodieren. In diesem Kontext haben es Illusionen leicht, Fuß zu fassen. Finanzinnovationen, die für dieses Umfeld konzipiert werden, erweisen sich als wenig nachhaltig. Die hohen Kapitalverluste heute (überschießend, da der Markt mit systemischen Krisen schwer umgehen kann), sind notwendige Korrekturen der vergangenen Kreditexpansion und zunehmenden Geldzirkulation auf Finanzmärkten. Der Aufkauf der jeweiligen Finanztitel durch die Zentralbank oder das Finanzministerium ändern nichts an den strukturellen Anpassungen, die die Realwirtschaft ohnehin durchschreiten muss. Dazu gehört auch der Finanzmarktsektor selbst. Wie der Immobilienmarkt scheint er überinvestiert: Zu viele und zu teure Mitarbeiter; zu hohe Kapazitäten. Die Rekapitalisierung der Banken ist insoweit keine wirkliche Lösung. Wir verschieben nur das Problem.

Gegenthese 5 – Mittel- und langfristig ist staatliche Intervention wenig hilfreich: Die optimale Höhe des Kredithebels hängt von allen anderen Regeln und Riten ab, die die Stabilität des Marktprozesses bedingen. Das Regulierungsproblem ist demnach komplex, gekennzeichnet durch institutionelle Komplementaritäten, Interdependenz und schiere Größe. So signalisiert die Notwendigkeit zu verschärften Eigenkapitalvorschriften möglicherweise vergangene Regulierungsfehler, die an anderer Stelle das System destabilisiert haben. Die Auslese von Institutionen, zu denen auch die subtileren Konventionen und Verhaltenkodizes gehören, ist daher kaum zentral zu koordinieren. Es bedarf eines wettbewerblichen Selektionsprozesses, analog zu dem auf Märkten. Leider diskriminiert die Auslese zwischen Institutionen nicht mit der gleichen Schärfe, wie die auf Gütermärkten. Spontane Ordnungen entstehen dennoch, sie sind nur nicht perfekt. Leider teilen Politik und Gesellschaft dasselbe Wissens- und Erkenntnisproblem. Der Unterschied: Private Entscheider adaptieren erfolgversprechende Handlungsmuster und verwerfen sie im Scheitern. Schlechten Entscheidern, solchen die systematisch daneben liegen, wird über den erleideten Verlust in Kapital und Einkommen die Verfügungsgewalt über knappe Ressourcen entzogen. Erfolgreichern Entrepreneuren wird diese Verfügungsgewalt in die Hände gespielt. Zentral getroffene Entscheidungen leben hingegen davon, eben diese Selektion auszuhebeln. Regeln sind obligatorisch, gelten für alle gleichzeitig. Sie geben nur jenen eine Wahl, die dafür eintreten können. Sie verzerren die Einkommensverteilung zugunsten jener, die Löcher in die Regulierung reißen. Zentrale Entscheidungen sind nur effizient, wenn sie auf Anhieb treffen. Also selbst wenn die Politik über ihren Schatten springt und sich glaubhaft dem Gemeinwohl verpflichtet, sehe ich keinen Rechtfertigung in einer leichtfertigen Einladung an das Gewaltmonopol sich den Finanzmärkten anzunehmen, sich „zu kümmern“ und „Vorstellungen zu entwickeln“.

"You Cannot Be Serious! Paul Krugman's Nobel Prize" (amv)

by Peter Boettke:

I will be writing a lot more about this, but the Swedes just made perhaps the worst decision in the history of the prize today in naming Paul Krugman the 2008 award winner. It is not that Krugman's work is entirely without merit, but it always had major problems with it. Right now I have to get over my shock and horror and write a commissioned piece on this. But today I would say is a sad day for economics, not a day to be celebrated. Mises supposedly said during his dying days that he hoped for another Hayek, as I am picking up my jaw from the floor I am hoping for another Samuelson or Arrow to get the award rather the hackonomics that was just honored.

This comes close to my own reaction.

Source: Austrian Economics

Nothing but an enormous baloney sandwich (amv)

My comrades at the coffee.house know me - in my darker hours - as highly impatient with the pseudo-scientific ado of modern macroeconomists, more interested in playing with Matlab and other fancy tools than in serious economic reasoning and theoretical consistency. A look at the history of economic thought shows that Classical and interwar economists had a much deeper understanding of the economy than most of their scientistic and overconfident successors. Like financial markets, the macroeconomic profession is overinvested. Hidden by the overblown mathematical Newspeak you often find mercantilistic reasoning, outdated at least since Smith's Wealth of Nations. The macro-bubble now seem obvious to others as well. I am glad to find an authority such as Kling on my side:

The Paulson plan was so bad that just about anything is better. But I'm ready to rip into academic economists. I've been thinking more about Joe Stiglitz's valid criticisms of what I call the Lost Generation of macroeconomists, and I'm getting more and more steamed. If you stacked up everything written by the leading macro folks of my generation and later (actually, starting a few years earlier also), you would have nothing but an enormous baloney sandwich. Ordinarily, I don't dwell on the fact that these people who were no smarter than me back-scratched each other into the best journals, the prestigious professorships, the important conferences, etc. But sometimes, especially now, I think about how badly they have failed intellectually. They are the precise academic equivalent of Wall Street executives who enjoyed golden parachutes while bankrupting their firms.

Is bank recapitalization a good idea? Probably not, if you think that the main problem with the financial sector is that it is bloated. The best way to restore confidence in banks is to identify the ones that are insolvent and shut them down. The FDIC knows how to do this. They should roll up their sleeves and get to work.

Anyone who wants to stop mortgage foreclosures needs to have his head examined. How many of the bad loans are investor loans, where the borrower never occupied the house? 20 percent of them? 50 percent? 70 percent? We know that in the last years of the bubble more than 15 percent of mortgages were for non-owner-occupied (the true figure might actually be higher than reported, because it is common to fraudulently claim that you will be using the home as a residence when you will not). Investor loans default at a much higher rate than regular loans, somewhere between 3 and 10 times as much. If it's 4 times as much, then already we can be surmise that a majority of bad loans are investor loans. The best thing to do with those is to foreclose ASAP.

My view of the crisis is that every sector of the establishment has been discredited. The financial establishment has been discredited. Government policymakers and regulators have been discredited. And academic economics has been discredited. The fact that we now have all three on the same page about policy going forward is hardly comforting.

Source: Econlib

My soul mate (amv)

is Don Boudraux:

Listening to politicians, regardless of party, discuss economics makes me sick both to my head and to my stomach. And the only people who are not similarly affected, I fear, are persons whose knowledge of economics is sufficiently scant -- or whose ethics are sufficiently perverted -- to protect their senses from being insulted by what issues forth from the mouths of politicians speaking on economic topics.

So as an economist, I am no more interested in having Sen. Obama (or Sen. McCain) come to GMU's campus to lecture us on "how to manage the economy" than I would be, say, to have O.J. Simpson come to GMU's campus to lecture us on how to manage one's marriage.

Source: Cafe Hayek

"Joe Stiglitz. Word!" (amv)

by Arnold Kling:

I probably am misusing the teenage slang. I mean to say that I agree with what Stiglitz says here. (Fast-forward until you get to the first seated panelist speaking.)

1. He says that macroeconomics of the past 30 years has been a huge detour. The folks that Mankiw would call the engineers were fixated with monetarism. The academics were fixated with representative-agent models. As Stiglitz points out, in a representative-agent model, the borrower and the lender are the same person. Why? Because, as I've been saying, careful thinking about this gives one a headache.

2. Microeconomists didn't foresee the massive market failure that results from adverse incentives in financial markets--people rewarded for short-term gains and not punished for long-term losses.

3. Finance theory assumes lognormal distributions and continuous liquidity. See my thoughts on credit default swaps.

My view of Stiglitz is that he believes that smart people in Washington can correct market failures. Ironic, given that the point of his talk is how mainstream economists in macro, micro, and finance got it wrong.

My own view is that Hayek was an optimist. You can think of Hayek as looking at government and markets trying to solve the same problem, with government working like a mainframe computer and markets working like distributed computing. The distributed model processes information more efficiently.

I think Hayek was an optimist, because he looks at government as trying to solve the problem of allocating resources efficiently. I look at government as concentrated power, subject to manipulation and corruption.

Source: Econlib

Some shadow prices: betting on the 2008 Nobel Prize in economics (amv)

2008 Nobel Prize in Economics - Mon 10/13

To Win Outright or a Share of the 2008 Nobel Prize:

101 Martin Feldstein
+751

102 Thomas Sargent
+1181

103 Robert Barro
+1299

104 Paul Romer
+1344

105 Jagdish Bhagwati
+1359

106 Paul Krugman
+1617

107 N. Gregory Mankiw
+4310

Check Pinnaclesports.com

Monday we'll know.

Daily Show's Moment of Zen and national debt (fg)

Panic, Panic, Panic (fg)

Just read the press releases of major central banks around the world. Here you find the articles just published by the FED and the ECB. Well, this is indeed international monetary policy coordination:

Throughout the the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in current financial crisis, central banks have engaged in continuous close consultation and financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, Sveriges Riksbank and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

The Governing Council of the ECB, by means of teleconferencing, has taken the following monetary policy decisions:
1. The minimum bid rate on the main refinancing operations of the Eurosystem will be reduced by 50 basis points to 3.75 %, with effect from the main refinancing operation to be settled on 15 October 2008.
2. The interest rate on the marginal lending facility will be reduced by 50 basis points to 4.75 %, with immediate effect.
3. The interest rate on the deposit facility will be reduced by 50 basis points to 2.75 %, with immediate effect.

In the euro area, upside inflationary risks have recently decreased further. It remains imperative to avoid broad-based second-round effects in price and wage-setting. Keeping inflation expectations firmly anchored in line with our objective and securing price stability in the medium term will support sustainable growth and employment and contribute to financial stability.

Information on the actions taken by the other central banks is available at the following websites:

Bank of Canada: www.bank-banque-canada.ca
Bank of England: www.bankofengland.co.uk
Federal Reserve Board: www.federalreserve.org
Sveriges Riksbank: www.riksbank.com
Swiss National Bank: www.snb.ch
Bank of Japan: www.boj.or.jp

and

Joint Statement by Central Banks

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

Federal Reserve Actions
The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this action in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures.

Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation.

The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-3/4 percent. In taking this action, the Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Boston.

Information on Actions Taken by Other Central Banks
Information on the actions that will be taken by other central banks is available at the following websites:

Bank of Canada Leaving the Board
Bank of England Leaving the Board
European Central Bank Leaving the Board
Sveriges Riksbank (Bank of Sweden) Leaving the Board
Swiss National Bank Leaving the Board

Bearing Risks (fg)

Who should bear the risks? According to John Cochrane: German Hedgefunds .... if you want to understand the whole story watch this.

A short note on risk monitoring (fg)

One point which was not fully discussed these days in political and media circles is the manner how banks re-organized their banking activities due to changing regulation. I still can remember the debates on Basel I and Basel II. Many politicians claimed that with higher lending standards and better monitoring, banks would not fell further in love with insensate profit-risk lending practices. According to the regulator, exisiting internal monitoring of debtors was insufficient to prevent bad credit to get onto banks' balance sheets.

The consequences were shifts of bank assets away from lending on the basis of the banker’s private views about the borrower - regulators considered this hard to quantify and a little suspect – towards lending on the basis of an external credit rating. Avinsh Persaud on vox.eu:

One of the implications of this risk sensitivity is that bankers were given incentives to enhance the credit rating of lending to reduce their capital charges and improve their profitability. They did so in multiple ways with Bear Sterns, Lehman Brothers, and AIG often acting as the brokers. The result was that the unit of lending was no longer a known borrower, but an indivisible hodge-podge of bits of originated and purchased loans and hedges that when combined, justified good ratings.

The evolving complexity of such business activity was highly intransparent, especially for portfolio managers; meanwile the latter were heavily invested in such structured products. Now changing views on the whole issue triggered - as Persaud calls - high uncertainty premia reflected in liquidity: a revenge of relationship banking.

It's regulation, stupid! II (amv)

My Fantasy Testimony by Arnold Kling

This weekend I typed up "draft testimony" on what caused the mortgage/financial crisis. Like anyone wants to hear it. Anyway, I'll paste it in below the fold.

Draft TestimonyArnold Kling - October 5, 2008

Forty years ago, depository institutions handled mortgage credit risk very differently than they do today. Back then, the depository institution, which was typically a savings and loan association, held mortgages that were underwritten by its own employees, given to borrowers and backed by homes in its own community. These were almost always 30-year, fixed-rate loans, with borrowers having made a significant down payment, often 20 percent of the price of the home. Call this approach to mortgage lending "Method A."

Today, mortgage loans held by depository institutions are often in the form of securities. These securities are backed by loans originated in distant communities by unknown borrowers, underwritten by mortgage brokers or other personnel not employed by the depository institution. The loans are often not 30-year fixed-rate loans, and the borrowers have typically made down payments of 5 percent or less, including loans with no down payment at all. Call this approach to mortgage lending "Method B."

If you compare the two methods using common sense, then Method B does not pass a simple sanity check. In fact, the current financial crisis consists of banks that are up to their necks in Method B.

Method A suffered a breakdown in the 1970's, because inflation was allowed to get out of control. The 6 percent mortgage interest rates that were commonly charged by savings and loans became untenable when inflation and interest rates soared to double-digit levels. The savings and loan industry went out of business. Whether Method B could survive a similar shock is unclear. The right lesson to learn from the 1970's was not that we should use Method B. The right lesson to learn is that we should not let inflation get out of hand.

Many articles have been written by economists from academia and Wall Street extolling the benefits of Method B. They speak of the wonderful innovation of mortgage securities and the supposed efficiency of the secondary mortgage market. In fact, if Method B were to compete fairly with Method A in a market test, Method B would fail. To survive against Method A, Method B requires government favors and subsidies. It always has, and it always will.

The secondary mortgage market began in 1968, when the United States formed the Government National Mortgage Association (GNMA). GNMA pooled loans originated under programs by the Federal Housing Administration (FHA) and the Veterans Administration (VA) and sold these pools to investors. The purpose of this, as with the quasi-privatization of the Federal National Mortgage Association (Fannie Mae) that took place that year, was to take Federally guaranteed mortgage loans off of the books. President Johnson, fighting an unpopular war in Vietnam, wanted to save himself the embarrassment of having to come to Congress to ask for larger and larger increases in the ceiling on the national debt.

Thus, the first steps toward mortgage securitization were taken in order to disguise financial reality using accounting gimmicks. It has been the same ever since.

In the early 1980's, the savings and loan industry was imploding. The savings and loans held many mortgages that had lost value, due to inflation and high interest rates. Under the accounting rules prevailing at the time, they could record the mortgages at their original book values--as long as they did not sell them. The S&L's were stuck. If they did not sell mortgages, they would lack the cash to pay depositors. If they did sell mortgages, they would have to recognize losses, and regulators would shut them down.

The solution was a program called Guarantor at Freddie Mac and Swap at Fannie Mae. Under this program,, an S&L paid Fannie or Freddie a fee to pool loans into securities, which were retained by the S&L. The S&L could then use the securities as collateral to obtain loans. The key to the whole operation was an accounting ruling that allowed the S&L's to maintain the fictional book values of the mortgages held as securities,, even though lenders were using much lower market values when providing the collateralized loans to the S&L's. This accounting ruling came from fierce lobbying by Wall Street, which wanted to broker the loans to the S&L's.

Freddie Mac, Fannie Mae, and Wall Street extracted large fees from this program. Ultimately, most of the S&L's failed, with losses borne by taxpayers. The Guarantor and Swap programs increased the cost, both directly by transferring wealth out of the S&L's and indirectly by allowing defunct S&L's to remain in business and continue gambling with other people's money.
Following the demise of the S&L's, regulators established capital requirements and other rules that made Method A lending very expensive relative to Method B lending. Freddie Mac and Fannie Mae were given freedom to leverage their guarantee at much higher ratios of assets to capital than were Method A lenders. In fact, the capital regulations even told banks that holding private mortgage securities under Method B was less risky and therefore required less capital than Method A lending. The result was that Method B came to dominate the American mortgage market. Had the playing field been level, Method A would have remained in place, and Method B likely would never have gotten started.

The regulations that favored Method B were heavily influenced by the lobbying activities of Freddie Mac, Fannie Mae, and Wall Street investment bankers. The secondary mortgage market lobby made large campaign contributions to key legislators. Their influence tilted regulations to favor Method B. Thanks to the regulatory advantages given to Method B, Freddie, Fannie, and the investment banks earned large profits. It was a triangular trade: contributions for favors for profits.

The recent "rescue plan" can be viewed in this context. It attempts to revive the otherwise moribund mortgage securities market. It is another large favor being granted to Method B.

There has been a flight to safety in credit markets in recent weeks. What is probably a necessary and significant consolidation in the financial sector has turned into a rout.

Under the circumstances, there are two policy imperatives. First, regulators must sort out the banks that are sound from those that are insolvent. The insolvent institutions need to be merged or closed as expeditiously as possible. Sound banks should be encouraged to make loans to qualified borrowers. Some forbearance of capital requirements may be appropriate in order to ensure that good borrowers do not get turned down. Finally, there may be some banks that are neither clearly insolvent nor clearly sound, in part because of questions concerning the values of their mortgage securities. These banks should be allowed to continue operating, under close supervision, perhaps with loans from the Federal Reserve.

Under no circumstances is it justified to attempt to revive the mortgage securities markets. Resumption of active trading in those markets is neither necessary nor sufficient to address tightness in credit markets caused by the flight to safety.

Next, I wish to turn to examine the state of the housing market. One of the characteristics of Method B lending has been loans with low down payments. This caused a wave of speculation, leading to a sharp rise in house prices followed by a sudden decline. In fact, this is to be expected when most homes are bought with little or nothing down. When prices or rising, anyyone can afford a home. When prices are falling, on one can.

I wish to emphasize that I support the effort to increase the rate of home ownership among minorities and people with low incomes. The problem with Method B lending is not the color of anyone's skin or the content of anyone's credit report. The problem is the absence of a reasonable down payment. In my view, assistance with saving for a down payment would be better than a system that subsidizes indebtedness. I think of buying a home with little or no money down as home borrowership, not home ownership.

The housing market today is distorted and out of balance. The slogan "Let's keep borrowers in their homes" is rather useless, considering that many borrowers never occupied their homes to begin with. The Washington Post of December 10, 2007, contained a very illuminating story of people with very modest incomes who bought two and three homes during the speculative frenzy. (http://www.washingtonpost.com/wp-dyn/content/article/2007/12/09/AR2007120901197.html)

The plural of anecdote is data. In an article published in the Federal Reserve Bulletin of December 2007, economists Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner reported that the share of mortgage loans going for non-owner-occupied housing went from 6.4 percent in 1996 to 17.3 percent and 16.5 percent in 2005 and 2006, respectively. (http://www.federalreserve.gov/pubs/bulletin/2007/articles/hmda/default.htm)

The United States today has an unusually large inventory of unoccupied housing units, which speculators have been unable to sell or rent. Given the unoccupied housing glut, attempts by policymakers to try to boost house prices are likely to prove futile. As long as the housing market remains out of balance, the valuation of mortgage securities will be problematic. As difficult and painful it may seem in the short run, it probably would be better to work through the foreclosure process and let prices adjust to levels that bring supply and demand into balance in the housing market than to prolong the state of imbalance and uncertainty by trying to prevent foreclosures. This is particularly true for the many homes that were bought for speculation, not as primary residences.

Finally, I wish to call your attention to a communication gap that exists between the financial engineers who design and value mortgage securities and the executives and regulators who make important decisions about how they are used. I call this the problem of the "suits" (the executives) and the "geeks" (the financial engineers). In many cases, the suits at banks and other financial institutions are putting these securities in their portfolios without appreciating their risk characteristics. Regulators, too, seem unaware of the threats posed by these complex instruments.

Charles Duhigg of the New York Times has written two stories, one about Freddie Mac on August 5th (http://www.nytimes.com/2008/08/05/business/05freddie.html?hp) and one about Fannie Mae on October 4th (http://www.nytimes.com/2008/10/05/business/05fannie.html?hp), that illustrate the suits vs. geeks divide. Each story cites former mid-level executives of the companies who issued warnings about risk, mis-pricing, and under-capitalization. But the geeks were ignored by the suits.

Robert Merton, a Professor of finance at Harvard and a Nobel Laureate, suggests that the decisionmakers who I call "suits" need better training in modern mathematical finance. That is one solution. Another solution would be to try to limit the ways in which under-educated "suits" can expose their firms and our economy to risk. As I indicated earlier, I do not believe that the mortgage securities market would have emerged without regulatory favoritism. If such favoritism were taken away, and the mortgage securities market were to fade away as a result, then the communication gap between the suits and the geeks would cease to be a problem.

Source: Econlib

It's regulation, stupid! (amv)

Anatomy of a Train Wreck - Causes of the Mortgage Meltdown
by Stan J. Liebowitz

The teaser:

Why did the mortgage market melt down so badly? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be?

This report concludes that, in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs, and housing activists universally praised the decline in mortgage-underwriting standards as an “innovation” in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The price bubble, along with relaxed lending standards, allowed speculators to purchase homes without putting their own money at risk.

The recent rise in foreclosures is not related empirically to the distinction between subprime and prime loans since both sustained the same percentage increase of foreclosures and at the same time. Nor is it consistent with the “nasty subprime lender” hypothesis currently considered to be the cause of the mortgage meltdown. Instead, the important factor is the distinction between adjustable-rate and fixed-rate mortgages. This evidence is consistent with speculators turning and running when housing prices stopped rising.

The rest: here

Some Thoughts on Mark-to-Market Quotes (fg)

"Suspending mark-to-market accounting, in essence, suspends reality."
Beth Brooke, global vice chair at Ernst & Young LLP, WSJ, Sept 30, 2008

"Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick."
analyst Dane Mott, JPMorgan Chase & Co., Bloomberg

"Suspending the mark-to-market prices is the most irresponsible thing to do. Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings."
Diane Garnick, Invesco Ltd., Bloomberg

HT: CalculatedRisk