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Naked CDS. Let me define it first. A Credit Default Swap (CDS) is a bet that some debtor, say the government of Argentina, is going to default on their debt. When you buy a CDS you are buying a claim to a payment made in the event that there is a default. When you sell a CDS you are betting that there will be no default and you won’t have to make that payment.
The conventional role of a CDS is an insurance instrument. If you hold Argentinian bonds and are worried about default, you can buy CDS to insure against that risk. (In the event of default you are out one bond but you get compensation in the form of your CDS payout.) Naked CDS refers to an unconventional role: selling a CDS contract to someone who doesn’t actually hold the bond.
There is a very interesting argument that naked CDS can poison the financial well, and I believe it is in this paper by Yeon-Koo Che and Rajiv Sethi. (I haven’t actually read the paper but I discussed it with Ahmad Peivandi and I think I get the gist of it. Fair warning: don’t assume that what follows is an accurate account of the paper, but whether or not it is accurate, it’s an interesting argument.)
Suppose that Argentina needs to issue new bonds in order to roll over its debt. The market for these bonds consists of people who are sufficiently optimistic that Argentina is not going to default. Such people have a demand for bets on the solvency of the Argentinian government. Argentina wants to capitalize on this demand.
In a world without naked CDS the government of Argentina has market power selling bets. You make your bet by purchasing the bonds. Market power enables the Argentinian government to mark up the price of its bonds, selling to the most optimistic buyers, and thus raise more capital for a given issue. This reduces the chance of a default.
A market for naked CDS creates an infinitely elastic, perfectly competitive supply of bets. Someone who is optimistic that there will be no default can now bet their beliefs by selling a naked CDS rather than purchasing bonds. If the Argentinian government tries to exercise its market power, they will prefer to trade competitively priced CDS bets instead. Thus, the market for naked CDS destroys the government’s market power completely. There are welfare effects of this.
- The downside is that the government is less likely to raise enough to roll over its debts and therefore more likely to default.
- But the upside is that people get to make more bets. Without competition from CDS, there are people who are willing to bet at market prices but are excluded due to the exercise of market power. This deadweight loss is eliminated.
But how you evaluate these welfare effects turns on your philosophical stance on the meaning of beliefs. One view is that differences in beliefs reflect differences in information and market prices reflect the aggregated information behind all of the traders’ beliefs. If competition drives the price of bonds down it is because it allows the information behind the pessimists’ beliefs to be incorporated. If you hold this view you are less concerned about 1 because investors who would have bought bonds at marked-up prices must have been at least partially fooled.
Another view is that beliefs are just differences of opinion, more like tastes than information. If the price of beer is low that doesn’t make me like beer any less. If this is your view then you really worry about 1 because those pessimists who drive the price down aren’t any better informed than the optimists. The concern about 1 is a rationale for banning naked CDS. But by the same argument you also care a lot about 2. Every bet between people with different beliefs, people who agree to disagree, is a Pareto improvement.
The bottom line is that arguments against naked CDS based on 1 probably also need to account for 2.
We believe that $600 billion in stimulus over two years would create 2.5 million jobs relative to what would happen in the absence of stimulus. However, this falls well short of filling the job shortfall and would leave the unemployment rate at 8 percent two years from now. This has convinced the economic team that a considerably larger package is justified.
In the movie Inside Job, George Soros makes an analogy that made an impression on me. He talks about how oil tankers have partitions in their hulls with their oil divided across the compartments. That way when the seas are rough the oil sloshes around within its own restricted space rather than the entire cargo splashing forward and back the full length of the ship, as would happen if there were no partitions. This obviously makes the tanker more stable.
The analogy is to financial markets and regulation. Erecting partitions to make the market less liquid should improve stability. At first you say, oh that’s a nice piece of rhetoric but financial markets aren’t anything like oil tankers. At least I said that.
But let’s take it for a spin. Let’s analyze the partitioned tanker but forget that it is a mechanical system and instead analyze it in the same way we would use equilibrium theory to analyze a market. Here goes.
There is a shock (rough seas) and the oil starts to spill to one end of the boat. But the partition stops the oil from going where it wants to go. There is a friction in the market. The oil in one compartment and the empty space in the adjacent compartment want to make a voluntary exchange. And it would be Pareto improving (otherwise they wouldn’t want to do it.) But that partition is stopping them. This is welfare-reducing.
Moreover, there is a powerful incentive for arbitrage. Any small leak in the partition would allow equilibrium to be reached by removing the friction, allowing the oil to go where it wants to go, and relieving some internal pressure. That must be welfare-improving.
If you think about it, market models pretty much stop there. Pareto improving trades should and do happen. Financial innovation brings down those partitions and that’s good. What is almost always missing is any way of talking about the hard-to-define but clearly very real externality that is the effect of these trades on the stability of the system as a whole. That’s about process and transitional dynamics, not about equilibrium.
Indeed, in equilibrium the oil in the tanker is in the same place whether or not the partitions are there.
Grading still hangs over me but teaching is done. So, I finally had time to read Kiyotaki Moore. It’s been on my pile of papers to read for many, many years. But it rose to the top because, first, my PhD teaching allowed me to finally get to Myerson’s bargaining chapter in his textbook and Abreu-Gul’s bargaining with commitment model and, second, because Eric Maskin recommends it as one of his key papers for understanding the financial crisis. So, some papers in my queue were cleared out and Kiyotaki-Moore leaped over several others.
I see why the paper has over 2000 cites on Google Scholar.
The main propagation mechanism in the model relies on the idea that credit-constrained borrowers borrow against collateral. The greater the value of collateral “land” , the greater the amount they can borrow. So, if for some reason next period’s price of land is high, the greater is the amount the borrower can borrow against his land this period. Suppose there is an unexpected positive shock to the productivity of land. This increases the value of land and hence its price. This capital gain increases borrowing. An increase in the value of land increases economic activity. It also increases demand for land and hence the price of land. This can choke off some demand for land. The more elastic the supply of land, the smaller is the latter dampening effect. So there can be a significant multiplier to a positive shock to technology.
(Why are borrowers constrained in their borrowing by the value of their land and rather than the NPV of their projects? Kiyotaki-Moore rely on a model of debt of Hart and Moore to justify this constraint. While Hart-Moore is also in my pile, I did not finally have time to read it. I did note they have an extremely long Appendix to justify the connection between collateral and borrowing! The main idea in Hart Moore is that an entrepreneur can always walk away from a project and hold it up. As his human capital is vital for the project’s success, he will be wooed back in renegotiation. The Appendix must argue that he captures all the surplus above the liquidation value of the land. Hence, the lender will only be willing to lend up to value of collateral to avoid hold up.)
But how do we get credit cycles? As the price of land rises, the entrepreneurs acquire more land. This increases the price of land. They also accumulate debt. The debt constrains their ability to borrow and eventually demand for land declines and its price falls. A cycle. Notice that this cycle is not generated by shocks to technology or preferences but arises endogenously as land and debt holdings vary over time! I gotta think about this part more….
I double-checked to make sure it wasn’t April 1 when I saw this story in the Independent:
The Queen asked ministers for a poverty handout to help heat her palaces but was rebuffed because they feared it would be a public relations disaster, documents disclosed under the Freedom of Information Act reveal.
Royal aides were told that the £60m worth of energy-saving grants were aimed at families on low incomes and if the money was given to Buckingham Palace instead of housing associations or hospitals it could lead to “adverse publicity” for the Queen and the Government.
Check out their request.
It’s actually a really great article, you should check it out. It has this:
The fashion modeling market also has a formal mechanism in place, known as the “option,” to ensure all tastemakers get in on the action. An option is an agreement between client and agent that enables the client to place a hold on the model’s future availability. Like options trading in finance markets, an option gives the buyer the right, but not the obligation, to make a purchase. In the modeling market, it enables clients to place a hold on the model’s time, but unlike finance options trading, model options come free of cost; they are a professional courtesy to clients, and also a way for agents to manage models’ hectic schedules.
And it even has this:
In behavioral economics, Coco Rocha’s success is a case of an information cascade. Faced with imperfect information, individuals make a binary choice to act (to choose or not to choose Coco) by observing the actions of their predecessors without regard to their own information. In such situations, a few early key individuals end up having a disproportionately large effect, such that small differences in initial conditions create large differences later in the cascade.
Naming rights raise a lot of money. Think of professional sports stadiums like Chicago’s own US Cellular Field (does US Cellular still exist??) The amazing thing to me is that when Comiskey Park changed names to “The Cell,” local media played right along and gave away free advertising by parroting the name in their daily sports roundups. Somehow the stadium knew that this coordination/holdup problem would be solved in their favor.
We should seize on this. But not by selling positive associations to corporations that want to promote their brand. Instead lets brand badly-behaving corporations with negative associations.
The Exxon Valdez oil spill is a name that stuck. Every single time public media refer to that event they remind us of the association between Exxon and the mess they made. No doubt we will continue to refer to the current disaster as the BP Gulf spill or something like that. That is good.
But why stop there? (Positive) advertisers have learned that you can slip in the name of a brand before, after, and in-between just about any scripted words and call it an ad. The Tostitos Fiesta Bowl. The Bud Lite halftime show. The X brought to you by Y. These are positive associations.
Think of all the negative events and experiences that are just waiting to be put to use as retribution by negative association. ”And today I am here to announce that the BP National Debt will soon reach 15 trillon Dollars.” Or “The BP recession is entering its fifth consecutive quarter with no end in sight.”
Why are we wasting hurricane names on poor innocents like Katrina and Andrew? I say for the 2010 hurricane season we ditch the alphabetical order and line em up in order of egregiousness. “Hurricane Blackwater devastates the Florida Coast. Tropical Storm Halliburton kills hundreds in Central America.”
The nice thing about negative naming is that supply is virtually unlimited. Cities don’t go selling the names of every street in town because selling the marginal street requires lowering the price. But you can put the name of every former VP at Enron and Arthur Andersen on their own parking meter and the last one makes you want to spit just as much as the first. Hey, what about parking tickets? This parking ticket is brought to you by Washington Mutual.
Suddenly the inefficiency of city bureaucracy is a valuable social asset. Welcome to the British Petroleum DMV, please take your place in line number 8. And some otherwise low-status professions will now be able to leverage that position to provide an important public service. ”There’s some stubborn tartar on that molar, Ms. Clark, I’m going to have to use the Toyota Prius heavy-duty scaler. You might feel some scraping. Rinse please.”
“Good Afternoon, Pleasant Meadow Morturary, will you be interested in Goldman Sachs cremation services today?” Or ”Mr. Smith we are calling to confirm your appointment for a British Petroleum colonoscopy on Monday. Please be on time and don’t eat anything 24 hours prior.”
Just as positive name-association is a lucrative business, these ne’er-do-wells would of course pay big money to have their names removed from the negative icons and that’s all for the better. If the courts can place a cap on their legal liability this gives us a simple way to make up the difference.
And I am ready to do my part. As much as I like one-word titles Sandeep and I are going to add a subtitle to our new paper. Its going to be called “Torture: Sponsored by BP.”
Now that Roger Myerson is one. Today at Northwestern he presented his new work on A Moral Hazard Model of Credit Cycles. It attracted a huge crowd, not surprisingly, and introduced a whole new class of economists to the joy and sweat of a Roger Myerson lecture.
(Roger apparently hasn’t read my advice for giving talks.) Listening to Roger speak is not only thoroughly enlightening and entertaining, its calisthenics for the mind. I once brought a pen and pad to one of his talks and outlined his nested digressions. It is absolutely a thing of beauty when every step down the indentation ladder is paired with a matching step on the way back up. When he finally returns to the original stepping off point, no threads are left hanging.
Keeping track of all this in your head and still following the thread of the talk is a bit like Lucy and Ethel wrapping candy.
Still, I think I got the basic point. Roger has a model of credit cycles that falls out naturally from a well-known feature of dynamic moral hazard. In his model, banks are intermediaries between investors and entreprenuers and they are incentivized via huge bonuses to invest efficiently. These bonuses are paid only when the bankers retire with a record of success.
These backloaded incentives mean that bankers are trusted with bigger funds the closer they are to retirement. That’s when the coming payout looms largest, deterring bankers from diverting the larger sums for their own benefit. Credit cycles are an immediate result. Because bankers handle larger sums near their retirement than those just starting out, their retirement means that total investment must go down. So the business cycle tracks the age demographics of the banking sector.
(It’s the Cocoon theory of business cycles, because if you could extend the lives of bankers you would enhance the power of incentives, lowering the moral hazard rents and increasing investment.)
Regular readers of this blog will know that I consider that a good thing.
The financial crisis is motivating a search for new models of asset markets and their interaction with the real economy. It seems obvious that, for example the housing bubble can only be explained by a model in which asset prices are bid up by the activity of highly optimistic investors or speculators. Models which build in these divergent beliefs (and not just differences in information) are, perhaps very surprisingly to outsiders, only recently coming to mainstream economic theory.
Alp Simsek asks whether the presence of optimistic traders can inflate the price of assets, say housing prices. It seems obvious, but remember that investment in housing is leveraged using collateralized loans where the house itself is the collateral. If the optimists are borrowing from the “realists” to buy houses at overinflated prices, and they are offering up the house as collateral, then surely the realists aren’t willing to lend?
Alp shows that this logic sometimes holds, but not always. And he formalizes a precise way of measuring optimism which determines whether the presence of optimists will inflate asset prices, or alternatively their optimism will be filtered due to realists’ witholding of credit.
Suppose that you are a realist and you are making a loan to me to purchase a house. A year later we will see whether housing prices have gone up or down. If they go up, I will pay off the loan and realize a profit. If they go down I will default on the loan. A key idea is to understand that the loan effectively makes us partners in the purchase of the house. I own it on the upside (and I pay you back your loan) and you own it on the downside. We pay for the house together too: you contribute the loan amount and I contribute the down pament.
The equilibrium price of the house will be determined by how much we, as partners, are willing to pay. I am an optimist and I would like to pay a lot for it, but I am financially constrained so my contribution to the total price is some fixed amount, my down payment. Thus, our total willingness to pay is determined by how much you are willing to pay to enter this partnership.
Now we can see how my optimism plays a role. Suppose I am more optimistic than you in the sense that I think there is a lower probability of default than you. It turns out this doesn’t make our willingness to pay any higher than it would be if I were a realist just like you. That’s because you own the house in the event of default so it’s the probability that you assign to default that enters into our total value, not the probability that I assign. It’s true that I assign a higher probability to the good event that the price goes up, but I am already putting all of my cash into the partnership. I can’t do anything more to leverage this form of optimism.
But suppose instead that the way in which I am more optimistic than you is slightly different. We both assign the same probability to default, i.e. the event that the price falls. Where we differ is in terms of our beliefs conditional on the price going up. In particular I think that conditional on the upside, the expected price increase is higher than you think it is. Now we have a new way to leverage our partnership. Since I expect to have a higher upside, I am prepared to offer you a higher payment in the event of that upside. (That is, I am willing to pay back a larger loan amount.) And the promise of that higher payment on the upside coupled with the same old house on the downside makes this a strictly more attractive partnership for you and you are willing to pay more to enter it. (That is, you are willing to loan more to me.)
Indeed these collateralized loans seem to be the ideal contracts for us to make the most of our differences in beliefs. And once we see how that works, it is easy to go from there to a theory of a dynamic housing bubble. Tomorrow there might be optimistic investors who will partner will creditors to bid up housing prices. Today, you and I might have differences in beliefs about the probability that those optimistic investors might materialize. If I am more optimistic than you about it, you and I can enter into a partnership which leverages our different beliefs about tomorrow’s differences in beliefs, etc.
There is an important thing to keep in mind when considering models with heterogenous beliefs. We don’t have a good handle on welfare concepts in these models. For example, in Simsek’s model the efficient allocation is to give the asset to the optimists. Indeed, the financial friction is only an impediment to achieving an efficient allocation. A planner, faced with the same constraint, would not do anything different than the market. If we apply standard welfare notions like this, then these models are not a good framework for discussing financial reform.
From an entertaining article in the Financial Times that develops the analogy between the interconnectedness of financial instruments and biological ecosystems.
“From an individual firm’s perspective, these strategies looked like sensible attempts to purge risk through diversification: more eggs are being placed in the basket,” says Mr Haldane. “Viewed across the system as a whole, however, it is clear now that these strategies generated the opposite result: the greater the number of eggs, the greater the fragility of the basket – and the greater the probability of bad eggs.”
That is what a mathematical ecologist would have predicted if he or she had known what was going on in the world of finance. The tropical rainforest, for example, has so many interdependent species that it is more vulnerable to an external shock than the simpler ecological diversity of savannahs and grasslands.
I wonder what prescription naturally arises from this perspective? Total laissez-faire so that the financial system can suffer enough crashes, extinctions, and re-organizations to find a configuration that is stable for the long run? Would we someday see Business schools sending missions out to shuttering financial institutions clamoring for intervention in the name of preserving derivative-diversity. What is the analog of sexual reproduction and random genetic mixing?
Nobel Laureate Eric Maskin gives an extended interview at The Browser arguing that economic theory was indeed equipped to see and understand the roots of the financial crisis. Its a unique interview because Eric picks 5 or so academic articles, discusses them in detail and weaves together a story of the crisis based on these. The story has some standard ingredients: bank runs, moral hazard, liquidity crises, and contagion. He illustrates each of these with a specific paper. The story also has some non-standard ingredients, such as leverage cycles described in a paper by Fostel and Geanakoplos.
The interview concludes thusly,
Q: So policymakers, especially people in Congress, need to read these papers.
A: Yes, or at least understand what’s in them. I think most of the pieces for understanding the current financial mess were in place well before the crisis occurred. If only they hadn’t been ignored. We’re not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them.
I have read and heard anecdotal evidence that litigation in the United States is countercyclical. Usually this is cynically explained by saying that when times are tough everybody is looking to make an extra buck. But of course everybody is looking to make an extra buck when times are good too.
All of business activity relies on relationships that are partially supported by contracts and partially supported by trust. Trust fills in the gaps of incomplete contracts. When the contract is not followed to the letter, your interest in maintaining a healthy relationship smooths things over.
Bad times raise uncertainty about whether there are any gains left from this relationship in the future. This undermines trust and the result is that the courts are called in to fill the gaps.
There are a couple of natural ways to test this theory. First the countercyclical nature of litigation should vary across sectors. Thick markets with relatively anonymous actors should see less impact of economic downturns on the rate of litigation. Also, the effect outlined above is based on the assumption that contracts are written in good times and litigated in bad times. If the downturn is expected to last, then new contracts should tend to be more complete, taking into account the increased appetite for litigation. The result should be less litigation in longer downturns than in shorter ones.
I thank Rosemary for the conversation.
Iceland is seeing a small baby boom.
The Icelandic press buzzed with the good news. One article quoted a midwife in the town of Húsavik who noted a bump in births in June and July — an auspicious nine months after the worst of Iceland’s meltdown. Wrote blogger Alda Sigmundsdóttir: “I think many, many of us must have sought solace in love and sex and all that good stuff.”
Italians too, and condom sales were brisk at the low point of the recession in the US. But historical pattern has been procyclical procreation*
“total fertility” — roughly, the average number of children per woman during her childbearing years — was 2.53 in 1929 and had slid to 2.15 by 1936. Then came the baby boom of postwar prosperity: The birth rate crossed 3 in 1947 and remained above that threshold until the mid-1960s. The next trough, 1.74, came in 1976 — a year earlier, unemployment had hit a postwar peak of 8.5%.
The article is in the Wall Street Journal.
*The pun involving “hump” is an exercise left to the reader.
I grew up in southern California which means that everything I ever needed to know I learned on the 405. Driving in traffic serves as a useful metaphor for a lot of life and it wasn’t until this morning that I made the connection and started to understand what Simon Johnson has been talking about all this time in blog posts like What Is Finance Really?
The parallels are clear between financial markets and driving in traffic. Arbitrage is the controlling force. For example, on the freeways arbitrage equalizes the traveling time across lanes, the commuters version of the efficient markets hypothesis.
You don’t have to have spent much time on the freeways to understand why arbitrage is not always efficient. An individual driver can get where he is going faster by changing lanes, but since there is a fixed capacity on the road this is always at the expense of somebody else. In equilibrium the total distance traveled by all is the same as if everybody were required to stay in their lanes. The arbitrage turns out to be a pure social loss due to the increased frequency of accidents.
Addendum: Calculated Exuberance has a nice take.
Ohio has approved bringing slot machines to race tracks, expecting to bring in close to $1 billion in taxes and license fees.
“Look, we are one of the few large states in the country that fixed our budget problems without raising taxes,” [Chairman of the State Democratic Party Chris] Redfern said.
Ohio is far from alone when it comes to budget problems. According to the Center on Budget and Policy Priorities, a Washington-based think tank, every state but Montana and North Dakota is up against shortfalls in the 2009 and 2010 fiscal years.
Politicians are turning to gambling to help close that gap, sometimes with the backing of voters. For example, in the 2008 election cycle, Colorado voters backed the expansion of table gaming and betting limits at casinos; Missouri voters approved the end of “loss limits” during casino sessions.
Meanwhile, Delaware’s legislature has legalized sports betting in casinos, although that is being fought in the courts by the major professional sports leagues. Pennsylvania and Illinois are moving to place video poker machines in bars.
NPR had the story.
The link I posted previously was somewhat outdated as it mentioned only that furloughs were under consideration. As a part of the recent budget agreement, the UC furlough is now a done deal. Here are some more recent stories.
I have heard that, system-wide, professors will take an 8% cut in pay. The word “furlough” usually means something like a temporary layoff. Here it means that workers will have shorter hours and commensurately lower pay. For example, UC non-faculty staff will have a few days off each month.
What are the marginal hours where Professors will be furloughed? Saturdays. That is, no classes will be cut, all administrative duties remain intact, pay is cut 8%. Presumably this means that my colleagues in UC system will be doing 8% more surfing the web when they are not in the classroom.
How do you cut the price of a status good?
Mr. Stuart is among the many consumers in this economy to reap the benefits of secret sales — whispered discounts and discreet price negotiations between customers and sales staff in the aisles of upscale chains. A time-worn strategy typically reserved for a store’s best customers, it has become more democratized as the recession drags on and retailers struggle to turn browsers into buyers.
Answer: you don’t, at least not publicly. Status goods have something like an upward sloping demand curve. The higher is the price, the more people are willing to pay for it. So the best way to increase sales is to maintian a high published price but secretly lower the price.
Of course, word gets out. (For example, articles are published in the New York Times and blogged about on Cheap Talk.) People are going to assign a small probability that you bought your Burberry for half the price, making you half as impressive. An alternative would be to lower the price by just a little, but to everybody. Then everybody is just a little less impressive.
So implicitly this pricing policy reveals that there is a difference in the elasticity of demand with respect to random price drops as opposed to their certainty equivalents. Somewhere some behavioral economists just found a new gig.
The financial markets are deregulated, banks are “too big to fail”, interest rates were kept low by Alan Greenspan etc…are these the only issues that caused the financial crisis?
Malcolm Gladwell has a very interesting article suggesting overconfidence played a role in causing the bubble that eventually burst. The main protagonist in the story is Jimmy Cayne, former C.E.O. of Bear Stearns. The man was sometimes confident and perhaps over confident:
The high-water mark for Bear Stearns was 2003. The dollar was falling. A wave of scandals had just swept through the financial industry. The stock market was in a swoon. But Bear Stearns was an exception. In the first quarter of that year, its earnings jumped fifty-five per cent. Its return on equity was the highest on Wall Street. The firm’s mortgage business was booming. Since Bear Stearns’s founding, in 1923, it had always been a kind of also-ran to its more blue-chip counterparts, like Goldman Sachs and Morgan Stanley. But that year Fortune named it the best financial company to work for. “We are hitting on all 99 cylinders,’’ Jimmy Cayne told a reporter for the Times, in the spring of that year, “so you have to ask yourself, What can we do better? And I just can’t decide what that might be.’’ He went on, “Everyone says that when the markets turn around, we will suffer. But let me tell you, we are going to surprise some people this time around. Bear Stearns is a great place to be.’’
Gladwell connects overconfidence to success at some games people play in nature and refers to work by biological anthropologists. This all seems quite interesting and I can see chasing it up for fun. But he then goes on to try to connect Cayne’s overconfidence to his success at bridge – appreantly he is an excellent player and it helped him get his job at Bear Stearns. This is a disconnect. Bridge is a zero-sum game. Behavioral biases such as overconfidence lead people to make mistakes and hence lose out more than people who judge hands correctly. If Cayne is good at bridge, he must judge probabilities accurately rather than exaggerating his odds of success. This then implies that he is less likely to be overconfident than others working in finance who are perhaps bad at bridge and poker as they are overaggressive.
So, while Gladwell may have a point to make, he does not do it convincingly as his main example concerns a protagonist who is less likely to be overconfident as he is good at zero-sum games.
Goldman Sachs and JP Morgan have quickly returned the money they got from the government. The CEO Of JP Morgan sees it as a badge of honor:
Amid the surge, Jamie Dimon, JPMorgan’s chief executive, has cemented his status as one of America’s most powerful and outspoken bankers. He has vocally distanced himself from the government’s financial support, calling the $25 billion in taxpayer money the bank received in December a “scarlet letter” and pushing with Goldman Sachs, Morgan Stanley and others to repay the money swiftly. Those three banks repaid the money last month.
Whether a bank returns the money quickly and even if they never got any of it, the bank gained from the intervention. Why? Because if AIG, to name the key firm, had gone down, the chain of interlinked insurance contracts that it sold would have been worth nothing. This would impact the whole financial system, including Goldman Sachs etc. That’s why credit was coming to a halt as no-one knew the value of the insurance contracts that were supposedly providing a safety net.
So, taxpayers bailing out AIG helped all these banks, even those who did not participate in the government program. (It’s a classic free-rider problem in public good provision.) So, where’s my Goldman bonus since I helped to save the financial system?
In Japan, robots makeup a measurable fraction of the manufacturing workforce:
In 2005, more than 370,000 robots worked at factories across Japan, about 40 percent of the global total, representing 32 robots for every 1,000 manufacturing employees, according to a report by Macquarie Bank. A 2007 government plan for technology policy called for one million industrial robots to be installed by 2025. That will almost certainly not happen.
Robots are apparently the first to be let go in Japan in a recession. And the cuts go even deeper.
Roborior by Tmsuk — a watermelon-shape house sitter on wheels that rolls around a home and uses infrared sensors to detect suspicious movement and a video camera to transmit images to absent residents — has struggled to find new users. A rental program was scrapped in April because of lack of interest.
Here is the story from the New York Times.
See the press release here. The practical significance of this is that trade in IOUs is subject to standard regulation. Brokers or other intermediaries facilitating trade between buyers and sellers must be registered as exchanges with the SEC. In related news, the three largest banks in California will stop redeeming IOUs tomorrow. Its going to be a nice summer for the Check Cashers. Note that the IOUs pay 3.75% interest, tax free.
There has been a run on one of the largest banks in an economics-themed online role-playing game called Eve. The event merited an article at the BBC. The run was triggered when Ricdic, an executive of the bank made off with a large sum of virtual lucre and exchanged it for real-world cash.
Eve Online has about 300,000 players all of whom inhabit the same online universe. The game revolves around trade, mining asteroids and the efforts of different player-controlled corporations to take control of swathes of virtual space.
It has now emerged that Ricdic used the cash to put down a deposit on a house and to pay medical bills.
“I’m not proud of it at all, that’s why I didn’t brag about it,” Ricdic told Reuters. “But you know, if I had to do it again, I probably would’ve chosen the same path based on the same situation.”
Apparently, the bank had tremendous reserves and has so far withstood the run. Here is more information. Either real-world bank regulators have something to learn from Eve or the other way around because here is Ricdic’s comeuppance:
Ricdic has now been thrown out of the game as trading in-game cash for real money is against Eve Online’s terms and conditions.
The rules governing play within Eve would not have sanctioned Ricdic if he had simply stolen the cash and used it in the game, nor if he had bought kredits with real dollars.
Fedora Flourish: BoingBoing
At the blog Everything Finance, Jonathan Parker breaks down the implications of the State of California issuing IOUs to rollover its debts, essentially creating a new currency whose value is pegged to the US Dollar. He makes a number of interesting points including the observation that since California cannot print Dollars, and cannot issue (conventional) debt, the IOUs place the State in a predicament reminiscent of financially-distressed countries having to defend a pegged exchange rate.
And unfortunately, the history of fixed exchange rates in practice includes lots and lots of these effective defaults. Governments that can issue these i.o.u.’s and have trouble balancing budgets tend to issue a greater value of their currencies than they have the will or ability to maintain. And default follows.
Prior to “maturity” will these IOUs trade at some market price reflecting the probability of default? One question is whether banks will be interested in buying IOUs, offering liquidity in return for the asset and a premium? The strategic issue is whether politically the State will find it more or less attractive to default if the IOUs are still largely held by private citizens, or instead mostly by banks?
My guess is that, in a crisis, a small number of banks would more effectively pressure the State to meet their obligations than if IOU holdings were less concentrated. If so, then I would expect banks to be buying IOUs at a steep discount. But does this create a Grossman-Hart style free-rider problem analogous to tendering shares in takeover bids?
Is it possible that higher education might be the next bubble to burst? Some early warnings suggest that it could be.
With tuitions, fees, and room and board at dozens of colleges now reaching $50,000 a year, the ability to sustain private higher education for all but the very well-heeled is questionable. According to the National Center for Public Policy and Higher Education, over the past 25 years, average college tuition and fees have risen by 440 percent — more than four times the rate of inflation and almost twice the rate of medical care. Patrick M. Callan, the center’s president, has warned that low-income students will find college unaffordable.
Meanwhile, the middle class, which has paid for higher education in the past mainly by taking out loans, may now be precluded from doing so as the private student-loan market has all but dried up.
The analogy to the housing bubble is certainly tempting. Pell grants and Stafford Loans are to Colleges what Fannie and Freddie are to housing. It is undeniable that easy access to credit fueled rises in tuition. It is not a stretch to think of these loan programs as essentially subsidies to Universities as they raise tuition dollar for every dollar of loans that are essentially forgiven.
But the analogy doesn’t go any farther than that. There is no speculation fueling demand for higher education. There is a permanent and measurable difference in earnings for college graduates. There will continue to be a robust market for credit to students because, to borrow a phrase, consumption wants to be smoothed. And unlike subsidized loans for housing, there is a real externality that justifies continued federal presence in the student loan market.
Phillip Swagel was the Assistant Secretary for Economic Policy at the Treasury from December 2006 to January 2009, the peak of the financial crisis. He has written a post-mortem of Treasury’s anticipation of, and response to, the financial crisis. This includes the decision to support the buyout of Bear Stearns, to allow Lehman Brothers to fail, to bail out AIG (the very next day) and the proposal and later abandonmnet of the use of TARP funds to buy toxic assets.
This is absolutely essential reading. Swagel has been very thorough and very honest. Here are the highlights of this 52 page retrospective. (Helmet Hoist: the Baseline Scenario.)
Anticipation of the Crisis Henry Paulson was organizing economists at the Treasury to prepare for stress to the financial system as early as Summer 2006 when he was appointed Treasury Secretary.
Secretary Paulson also talked regularly about the need for financial institutions to prepare for an end to abnormally loose financial conditions.
They recognized that recent financial innovation and increased international integration would pose novel challenges if there were a shock to the system. Nevertheless, Swagel acknowledges that they significantly underestimated the threat of the housing downturn as a potential shock. Here is an eye-opener.
What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007. This was something pointed out by staff from the Federal Deposit Insurance Corporation (FDIC), who had already (correctly) pointed out that the situation in housing was bad and getting worse and would have important implications for the banking system and the broader economy.
Initial Reactions to the Developing Crisis The first two major policy proposals emerged in August 2007. One was focused on increasing transparency of the quality of mortgages underlying asset-backed securities.
The paradox was that this database did not exist already—that investors in mortgage-backed securities had not demanded the information from the beginning.
The second was an early incarnation of what was eventually TARP. The MLEC was a kind of “bad bank” intended to hold toxic assets off bank balance-sheets while the market adjusted and re-priced them. This was the earliest expression of the Treasury stance that the assets are underpriced by the market and what was needed was patience for the turmoil in the markets to cool down. The banks didn’t go for it:
While banks dealt with the problem on their own, the MLEC episode looked to the world and to many within Treasury like a basketball player going up in the air to pass without an open teammate in mind—a rough and awkward situation.
Neither of these plans “came to fruition.” In the case of MLEC, the reason is implicit in the above quote, but Swagel is silent on what happened to the database idea.
Addressing the Housing Crisis Directly There is a long discussion in the article about various policies to intervene directly in the housing market. The general theme here is that Treasury, and especially White House Staff, were resistant to any policy that would appear to help out “irresponsible homeowners.” While Congress enacted some policies aimed at mortgage modifications, the White House would not go farther than removing red tape to streamline the modification process for mortgage servicers. The effects of all of these policies were limited:
As a practical matter, servicers told us that considerations of moral hazard meant that they did not write down principal on a loan when the borrower had the resources to pay—never. They would rather take the loss in foreclosure when an underwater borrower walked away than have to take multiple losses when entire neighborhoods of homeowners asked for similar write downs of loan principal.
(By the way, a game theorist would call this “reputation effects” rather than moral hazard, but that’s beside the point…)
Bear Stearns, Lehman, AIG There is not much explanation for why the Fed decided to make loans to JPMorgan to help them buy out Bear Stearns. Essentially, Swagel is saying they were caught off-guard, saw serious problems with a Bear-Stearns failure, and had to act quickly.
At Treasury, two additional lessons were learned: (1) we had better get to work on plans in case things got worse, and (2) many people in Washington, DC did not understand the implications of non-recourse lending from the Fed. This latter lesson was somewhat fortuitous, in that it took some time before the political class realized that the Fed had not just lent JP Morgan money to buy Bear Stearns, but in effect now owned the downside of a portfolio of $29 billion of possibly dodgy assets.
Why did they bail out AIG but not Lehman?
In sum, AIG was larger, more interconnected, and more “consumer facing” than Lehman. There was little time to prepare for anything but pumping in money—and at the time only the Fed had the ability to do so for AIG. Eventually the AIG deal was restructured with TARP funds being used to replace Fed lending in order to give AIG a more sustainable capital structure and avoid a rating agency downgrade that would have triggered collateral calls.
But there are regrets.
As time went on, it became clear that AIG was a black hole for taxpayer money and perhaps a retrospective analysis will demonstrate that the cost-benefit analysis of the action to save AIG came out on the other side. But this was not apparent at the time.
Fannie and Freddie Interestingly, the debate about whether to take ownership of the GSEs centered not around moral hazard, but whether making explicit the already implicit government guarantees of their debt would threaten to downgrade Treasuries.
putting the GSEs into conservatorship raised questions about whether their $5 trillion in liabilities would be added to the public balance sheet. This did not seem to Treasury economists to be a meaningful issue, since the liabilities had always been implicitly on the US government balance sheet—and in any case were matched by about the same amount of assets. But the prospect that rating agencies might downgrade U.S. sovereign debt was unappealing.
TARP and its Abandoment The econ-blogosphere’s favorite topic. What was Treasury’s rationale for proposing to use reverse auctions to buy “toxic assets.” Swagel vociferously denies that the intention was to inject capital by overpaying for assets. Instead, they had a multiple-equilibrium view. Committing to buy enough of the assets would restore confidence in their value and would unstick the markets. But he has a difficult time explaining this without it sounding like overpaying for assets.
if Treasury were to get the asset prices exactly right in the reverse auctions, those prices will be higher than the prices that would have obtained before the program was announced. That difference means that by paying the correct price, Treasury would be injecting capital relative to the situation ex-ante. And the taxpayer could still see gains—say if the announcement and enactment of the TARP removes some uncertainty about the economy and asset performance, but not all. Then prices could rise further over time. But the main point is that it is not necessary to overpay to add capital.
Surprisingly, Swagel says that Treasury had reverse auctions “ready to go” in October 2008. Why were they never started?
A concern of many at Treasury was that the reverse auctions would indicate prices for MBS that were so low they would make other companies appear to be insolvent if their balance sheets were revalued to the auction results.
Swagel suggests that their auction consultants (Ausubel and Cramton) had a way to deal with this but,
to some at Treasury the whole auction setup looked like a big science project.
Parting Shot He concludes with the following.
An honest appraisal is that the Treasury in 2007 and 2008 took important and difficult steps to stabilize the financial system but did not succeed in explaining them to a skeptical public. An alternative approach to this challenging necessity is to use populist rhetoric and symbolic actions to create the political space under which the implicit subsidies involved in resolving the uncertainty of legacy assets can be undertaken. It remains to be seen whether this approach will be successful in 2009.
The federal government owns preferred stock in many of the banks it has bailed out. According to the NYT, it is thinking about converting this preferred stock to common stock. The article also claims that this reduces the need for a further capital infusion and hence the need to go back to a feisty Congress for more money.
How could that be? Isn’t the re-labeling of stocks going to leave banks with exactly the same amount of capital and not change anything? This is just rearranging chairs on the Titanic.
The key sentence is the article is:
The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity.
Preferred stock used to recapitalize banks does not come with voting rights but does come with a compulsory dividend. It is 5% now and rises to 9% after five years. In that sense, the preferred stock are more like debt that equity. There is a risk that a bank defaults on this in the same way it could default to other debt holders. Converting it to common stock implies the government gets voting rights but gives up the dividend. This reduces the payments the bank has to make on a regular basis and hence makes it more liquid. This appears to be the main idea. It is good for the banks as their debt obligations are reduced. It makes it more likely they survive.
What about taxpayers? They are taking on more risk as their stake is more junior than before. There are two countervailing effects. First, maybe the probability of bankruptcy goes down as a result of this so the risk goes down. Second, the initial decision to acquire preferred stock may have been politically expedient in which case it did not maximize shareholder/taxpayer value. There is the perception of a big political cost of being seen to nationalize banks. The initial plan reflected this political constraint. This plan is a move to pay this cost to avoid the new political constraint, the cost of going to Congress. So, maybe the Congress constraint is helping Obama to move to the economic optimum from the constrained political optimum as one political constraint cancels out the other.
On Friday the 13th of February, the City of Chicago saw the first of a planned series of parking meter rate hikes which will eventually quadruple the hourly parking rate in the downtown area. This is happening because last year the City of Chicago sold the cash flow from parking fees for approximately $1 billion to a private investment fund. (No doubt soon to be securitized and tranched into Meter-Backed Securities. Quick: tell me how to price CDS protection against the event that Daley renegs once the billion is spent.)
The deal enables Chicago Parking LLC to raise fees according to a set schedule over the next ten years. After that, further rate increases must be approved by the City Council. The contract expires in 75 years.
Why would the City go for such a deal? Yes it is starved for cash and parking meters currently hard-wired at 50 cents an hour in most of the city are long overdue for an uptick. But this just argues for a fee increase, it doesnt explain why the meters should be privatized.
The economics of privatization are straightforward in this case. The city seeks bids for the parking meter cash flow. A bidder offers an upfront payment and a schedule for price increases. The upfront payment will be no less than the present value of the cash flow as determined by the new prices. Competition will ensure that the payment will be exactly this cash flow. This means that the high bidder will be the one who demands a price that maximizes the present value of cash flows. In other words, the monopoly price.
Remember from your textbook microeconomics that the monopoly price is associated with inefficiently low quantity. Zero marginal cost doesnt make this any less damaging, in fact it implies that on many streets there will be empty spaces all day long. Cozy, inviting parking spaces will be utilized by nobody.
Again the city could set the monopoly price on its own, so we still have the puzzle of why, if the City is willing to allow monopoly pricing it has to use a private entity as its agent. The answer is not because the City wants its cash up front. Apparently it does want its cash up front but it could always just borrow against the parking cash flows.
The only answer I can come up with is a commitment problem. The City could certainly borrow against the cash flows and set the monopoly price but then the City itself would be the target of the uproar that will soon occur when drivers in the city realize that their cars are now worthless. The political pressure would force the fees to be kept low and the City would then have to find another way to finance its parking debt. In fact, foreseeing this, no lender would be willing to lend the full present value of monopoly cash flows.
By contractually delegating the fee-setting to a private agent, the City effectively commits never to lower fees so that the monopoly cash flow is guaranteed and the City can extract it all in an upfront payment.
What’s your favorite crisis euphemism?
In trying to rebrand dodgy financial instruments, treasury secretaries like Paulson and Timothy Geithner are continuing a recent tradition. So much of the finance sector’s innovation in the past 30 years, it turns out, wasn’t developing new stuff, but rather developing new ways of talking about pre-existing stuff. In the 1980s, labeling risky debt offerings as junk bonds was an intentionally ironic feint (pros knew that the instruments possessed real value). But as junk bonds went mainstream in the 1990s, they evolved into “high-yield debt”—their liability became an asset. Frank Partnoy, a reformed derivatives trader who teaches law at the University of San Diego, recalls that at Morgan Stanley in the 1990s, “we were constantly coming up with new acronyms” to describe similar financial instruments. The goal: to present products, some of which had been discredited, in a more favorable light.
I like “distressed assets.” Clearly the poor damsels need to be rescued from those nasty banks. Or is the image rather one of “gently used” furniture?
This post from Mark Thoma is useful in spelling out some of the accounting behind the Geithner plan and its old incarnation due to Paulson and co. But we cannot asssess the policy unless we come to grips with the Treasury’s motives for intervening in the first place. When we do the picture changes a lot and it becomes clear that this amounts to a blanket insurance policy for the banks.
Suppose that a bank has a stockpile of toxic assets, and suppose that this bank is solvent only if those assets value at least $X. When TALF comes to negotiate the purchase of these assets, we know that the bank will not accept anything less than $X for them. Accepting less than $X turns a concern which is potentially solvent (under rosy assumptions about a recovery in the market for the assets) into one which is certainly insolvent. The balance sheet woud now be transparent and the bank will be shut down.
So TALF either results in no sale, or a sale above $X. A sale at $X or higher ensures that the bank is solvent and therefore amounts to guarantee of the bank’s liabilities.
I am not expert enough to know whether guaranteeing the bank’s liabilities is a good idea (I suspect it is not the best), but I can say this. If free insurance is what the Treasury wants out of TALF, then TALF is a bad way to do it. A simpler and far better way is to simply declare that the bank’s liabilities are backed by the government. It amounts to the same thing if TALF were to work properly. But there are many ways TALF could go wrong.
For example, there is no assurance that under TALF the bank will actually use the $X cash from the sale to stay in business. No doubt Geithner will make sure that an AIG-style transfer to executives and shareholders will not happen but there are too many other possibilities to guard against in law. By contrast, a real insurance guarantee means that the money does not change hands until the creditors come calling and then it goes directly to the creditors without the bank ever touching it.
A second problem with TALF is that the government typically does not know the exact value of $X. To be sure that it actually covers $X, it would have to accept the high probability that it overpays. With a real insurance policy there is no need to guess at X because it will be revealed when the bank defaults.
BTW, I made a related, but somewhat different point about TALF’s predecessor here (pretty technical.)
Banks who bought CDS protection from AIG could, and did, hedge against failure of AIG by buying CDS protection against AIG default. So where’s the problem?
The problem facing the banks had AIG failed has less to do with their $ exposure to AIG and more with their position exposure to AIG. For example, let’s say I buy $100mm of protection from AIG and then I buy protection on AIG to hedge against the case of AIG’s bankruptcy. Let’s say AIG does in fact go bust. In the ideal scenario the collateral plus the AIG hedges offset exactly my CDS MTM exposure against AIG, then the banks don’t actually lose money. However, the problem is that they are now long risk $100mm of protection (because their $100mm short risk position against AIG is now gone). What happens then is the market realizes that a dozen banks have massive long risk positions in much of the same trades that they will all now try to hedge at the same time. Spreads blow up and the banks lose.
There is much more in this interesting article.