Monthly Archives: February 2013

Partisanship is Not the Problem

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Mike Riggs writes,

the OMB’s September 2012 report says that under sequestration the National Drug Intelligence Center would lose $2 million of its $20 million budget. While that’s slightly more than 8.2 percent (rounding error or scare tactic?), the bigger problem is that the National Drug Intelligence Center shuttered its doors on June 15, 2012–three months before the OMB issued its report to Congress.

Progressives think that the problem with government is partisanship and gridlock. Or that politicians are too busy. In fact, the problem is an institution that has taken on so many functions that it is necessarily unwieldy and dysfunctional.

My Housing Finance Course

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Has finally started.

My goal is to help mid-level staff at regulatory agencies on the Hill understand some important characteristics of mortgage risk and the mortgage business.

As Ed Pinto points out, there is still room for improvement in mortgage regulation.

Last month it was the Consumer Financial Protection Bureau (CFPB) promulgating its Dodd-Frank Act mandated Qualified Mortgage rule (QM). Dodd-Frank imposed QM to set minimum mortgage standards. Yet it is now being touted as making sure “prime” loans will be made responsibly. True to the government’s long history of promoting excessive leverage, QM sets no minimum down payment, no minimum standard for credit worthiness, and no maximum debt-to-income ratio. The rule provides an eight-year pass for loans approved by a government-sanctioned underwriting system.

The WSJ reports on a study by Brandeis University researchers:

Home ownership is the biggest contributor to net worth. But white families, the researchers say, buy homes and start acquiring equity on average eight years earlier than black families, largely because white families can lean on their own families for help with down payments. Because of less access to credit, lower incomes and government policies, they say, the homeownership rate for white families is 28.4% higher than for black families.

Brandeis is all about the oppressor-oppressed narrative. One of the complaints I have about housing policy is that the assumption is that home ownership drives wealth accumulation rather than the other way around. I will address the issue of housing and wealth creation in the course.

Philip Swagel writes,

The initial steps of reform will involve creating the government capability to sell secondary insurance on MBS, setting up the common securitization platform to allow new firms to compete with Fannie and Freddie, and gradually increasing the private capital required for MBS to qualify for the guarantee.

This is an example of the sort of uninformed policy wonk suggestion that my course is designed to warn against. It assumes (a) that securitization of mortgages is something that the government must support and (b) that there is zero institutional knowledge needed to run the business safely.

I do not intend in my course to get into the specifics of regulatory proposals. However, I will clearly lay out the factors that generate risk in mortgage lending. Policy makers can then pay attention to this information, or they can ignore it. I have little hope that a Philip Swagel, a Joseph Stiglitz, or a Martin Feldstein will take the course, or that they will stop pontificating about mortgage markets from a state of ignorance. Instead, my dream is that mid-level staffers will absorb some wisdom and use it to ward off some of the worst ideas coming from the academic types.

Jonathan Haidt’s Three-Axis Model

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I recommend this half-hour video. He talks about a near-far axis, in which people close to you matter more than people far away. He talks about a hierarchy axis, in which you treat people higher on the totem pole differently from people who are lower down. And he talks about a divinity axis, where some actions are considered sacred and others disgusting. However, there is much more in his talk, which I think you will find stimulating.

For politics, I prefer my own three-axis model, but Haidt is very interesting. You can see that I have borrowed his views on libertarians as logical thinkers.

Vickies and Thetes

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Ross Douthat writes,

Yet the decline of work isn’t actually some wild Marxist scenario. It’s a basic reality of 21st-century American life, one that predates the financial crash and promises to continue apace even as normal economic growth returns. This decline isn’t unemployment in the usual sense, where people look for work and can’t find it. It’s a kind of post-employment, in which people drop out of the work force and find ways to live, more or less permanently, without a steady job. So instead of spreading from the top down, leisure time — wanted or unwanted — is expanding from the bottom up. Long hours are increasingly the province of the rich.

Pointer from Reihan Salam.

As befits his role as a conservative NYT columnist, Douthat gives this a civilization vs. barbarism spin.

Here the decline in work-force participation is of a piece with the broader turn away from community in America — from family breakdown and declining churchgoing to the retreat into the virtual forms of sport and sex and friendship. Like many of these trends, it poses a much greater threat to social mobility than to absolute prosperity. (A nonworking working class may not be immiserated; neither will its members ever find a way to rise above their station.) And its costs will be felt in people’s private lives and inner worlds even when they don’t show up in the nation’s G.D.P.

Note: Joseph Sunde thinks along similar lines.

The Role of Banks

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1. I write,

Franco Modigliani and Merton Miller point out that the real assets in the economy (fruit trees, oil wells, office buildings, and so on) are all owned ultimately by households. That fact is not changed by the way that financial claims are rearranged into debt and equity. As Miller was fond of putting it, “No matter how many slices you cut, it’s still the same pizza.”

Read the whole thing. It seems as though I constantly come across folks making broad generalizations about what to do about banks that are not grounded in an understanding of what banks do. My essay is an attempt to address that problem. It was provoked by receiving a new book by Anat Admati and Martin Hellwig.

2. Evan Soltas writes,

I can estimate that the average hour worked in the financial industry generates nearly 30 times the average per-man-hour profit in the rest of the economy. That’s up from six times the average in 1964.

This could very well be a question of global comparative advantage, but I find that hard to believe on the basis of the employment figures. It seems substantially more likely, rather, that the financial sector’s profitability comes from the implicit and explicit subsidies of a market with high barriers to entry.

Pointer from Phil Izzo.

Keep in mind that the interesting fact is the increase in the relatively profitability of the financial sector. I think this creates quite a puzzle.

Have barriers to entry increased? Not in any obvious way. Much of the infamous deregulation that took place since the 1960s was designed to increase competition, which should have reduced profitability (Gary Gorton even argues that we need to reverse that, to increase profitability in finance in order to give banks an incentive to hang on to their franchises). We got rid of restrictions on interstate banking. The erosion and repeal of Glass-Steagall were hailed at the time as allowing commercial banks and investment banks to compete on one another’s turf.

Has the subsidy increased? That is a more difficult question. But I do not immediately see how it has.

If one thinks in terms of natural forces, for an industry’s profits to increase, one needs some of the following:

1. An increase in demand.

2. An increase in efficiency.

3. Enough barriers to entry to maintain profit margins.

I suspect that (2) is very important. Off hand, would not finance benefit more than other industries from information technology?

I would tell a story in which the main barrier to entry in finance is the value of reputation. In other industries, innovation creates opportunities for upstarts. In finance, it is more likely to create opportunities for those few incumbent firms that adopt technology quickly and intelligently, because upstarts cannot establish reputations rapidly enough. Thus, one might expect to see a big expansion of profits in the industry as a whole, concentrated in a relatively few firms.

Incidentally, this model may fit higher education going forward. If the Internet creates opportunities for tremendous increases in efficiency, then the “profits” may accrue to universities with strong reputations who adopt technology quickly and intelligently. I would prefer to see competition from upstarts, but first someone must find a way to overcome the reputation advantage of the incumbents.

Health Care Costs Near the End of Life

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Timothy Taylor writes,

say for the sake of argument that such cases could be identified, and spending in this area could be reduced by half. If attainable, cuts of this size would be $70 billion in annual savings, which is certainly a substantial sum. But to keep it in perspective, total U.S. health care spending is in the neighborhood of $2.6 trillion. Thus, the potential gains from even fairly aggressive limits on end-of-life health care spending through Medicare is a little under 3% of total U.S. healthcare spending.

Read the whole post. Many people think that the share of health care spending in the last year of life is high and rising. In fact, it is fairly stable at about 7 percent of total health care spending (note that Taylor’s figures only include Medicare spending, not Medicaid or private spending).

The Debt the Italians Owe to Themselves

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The Wall Street Journal reports on generational conflict in Italy.

Over the past two decades Italy has run €1.3 trillion in such [primary] surpluses, averaging 4% of GDP a year, says Giuseppe Alvaro, an economist in Rome and an expert on Italy’s national accounts. Public debt has nonetheless risen—it is now €2 trillion—and the austerity must continue. Because much of today’s working population has never benefited from excess public spending, “they may feel rather reluctant to give back what they never received,” Mr. Alvaro says.

Pointer from Tyler Cowen.

As I pointed out in Lenders and Spenders, the problem with deficit spending is that it creates an arbitrary distribution of burden within a country, causing political conflict.

We are very likely to replicate the Italian experience. Local governments are going to raise taxes and reduce services, in order to pay pension benefits to retired government workers. And at some point the Federal government will have to run large primary surpluses, just as Italy has been forced to do, with similar consequences.

In an earlier post, Tyler comments on the observation that few people in Washington are worried about the deficit. Tyler’s riposte:

That is why you should care about the budget deficit.

I have been thinking along similar lines. The arguments that Thoma, Krugman, and others make for not worrying about the deficit are, in fact, a major reason why I worry about the deficit. Conversely, if they would argue in favor of worrying about the deficit, then I might be less worried about it.

Paul Romer on Separation of Powers

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He writes,

the evidence suggests that giving citizens the ability to “vote with their feet” will not discipline the leaders of a community. More fundamentally, the evidence shows that while the opportunity to vote is one difference between public and private systems of city governance, it is not the most significant one. In private systems, it is the lack of a separation of powers between an executive and an independent judiciary that is the more troubling weakness.

Deterring crime is one of the essential challenges for any large city. All of the evidence suggests that deterrence on this scale requires people to investigate crimes, and people to punish those who commit them. When private organizations carry out these functions, the decisions about which offenses to prosecute, and — crucially — how to determine whether a person is guilty of an offense, are made by the same people who exert executive authority. The actions of these private organizations give us a useful — and troubling — window into what can happen in the absence of an independent judiciary.

The examples he gives of poorly-behaved institutions with both police and judicial powers are Penn State and the Catholic Church. As he points out, the opportunity for customers to exit does not provide a sufficient incentive for the police-judicial systems to function properly. Does that mean, as Romer suggests, that policing and judicial powers must be separate in order to work well?

In his examples, the policing and judicial functions are bundled with other services, and those other services are what drive the choices of most consumers. I think that the same holds true for cities. A city provides a bundle of services, many of which come from the private sector–jobs, entertainment, etc. If you want fair, efficient law enforcement, the built-in incentives can be pretty weak.

If these functions were privatized, would it in fact work out badly if policing and dispute resolution were provided by the same agency? Perhaps, but I do not think Romer’s examples settle the issue.

For example, in a hotel, suppose that one of the guests is accused by another guest of creating a disturbance. Does the hotel have to use separation of powers in order to take care of the issue? I think not.

[note: I drafted this post a while ago, but as far as I know I have not run it. If I have, apologies for the duplication.]

It All Sounds So Simple

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Richard Thaler writes,

To me, the ideal health care delivery system would include…A fee for health rather than fee for service model. Doctors and hospitals should be paid for keeping their patients well. Paying them for doing more tests and surgeries creates bad incentives.

Pointer from Tyler Cowen and Mark Thoma.

When Thaler plays chess, does he think even one move ahead? I am sure that my readers do not need me to tell them how doctors would respond to a “fee for health” incentive system, do I?

To be fair, Thaler has some reasonable ideas in the column. But this particular gambit was so weak that he was “dead out of the opening” as far as I was concerned.

Ben Bernanke, Before and After

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1. Before (June 12, 2006):

in the area of market risk, advances in data processing have enabled more analytically advanced and more comprehensive evaluations of the interest rate risks associated with individual transactions, portfolios, and even entire organizations. Institutions of all sizes now regularly apply concepts such as duration, convexity, and option-adjusted spreads in the context of analyses that ten years ago would have taxed the processing capabilities of all but a handful of large institutions. From the perspective of bank management and stockholders, the availability of advanced methods for managing interest rate risk leads to a more favorable risk-return tradeoff. For supervisors, the benefit is a greater resilience of the banking system…

Today, credit-risk management encompasses both loan reviews and portfolio analysis. Moreover, the development of new technologies for buying and selling risks has allowed many banks to move away from the traditional book-and-hold lending practice in favor of a more active strategy that seeks the best mix of assets in light of the prevailing credit environment, market conditions, and business opportunities. Much more so than in the past, banks today are able to manage and control obligor and portfolio concentrations, maturities, and loan sizes, and to address and even eliminate problem assets before they create losses. Many banks also stress-test their portfolios on a business-line basis to help inform their overall risk management.

2. After (March 22, 2012):

A second, very important problem was that during this period, financial transactions were becoming more and more complex but the ability of banks and other financial institutions to monitor and measure those risks was not keeping up. That is, their IT systems and resources they devoted to risk management were insufficient…So if in 2006 you asked a bank about the effect if house prices fell 20 percent, it probably would have greatly underestimated the impact on its balance sheet because it did not have the capacity to measure accurately or completely the risks that it was facing.

For (2) I am quoting from the version of Bernanke’s lectures that is printed in The Federal Reserve and the Financial Crisis, sent to me Princeton University Press. Perhaps someone can find a written transcript on line.

Given (1), I find (2) to be disingenuous. Also, in the lecture “Response to the financial crisis,” Bernanke says

when the mortgage-backed securities started going bad, it became evident that AIG was in big trouble and its counterparties began demanding cash or refusing to fund AIG, and it came under tremendous pressure.

In our estimation, the failure of AIG would have been basically the end. It was interacting with so many different firms. It was so interconnected with both the U.S. and the European financial systems and global banks.

This is also disingenous. The problem at AIG was the demands for collateral coming from Goldman Sachs and a number of foreign banks. It was those institutions that needed bailing out, not AIG. I still like what I wrote back in October of 2008.

It is highly unlikely that the buoyancy of the U.S. economy depends on the liveliness of the Liar’s Poker game of mortgage securities trading. We should resist panic reactions and emergency bailouts.

My alternative to bailouts was what I termed the stern sheriff approach. I wrote,

I think that the people who insist on Treasuries as collateral should have to pay a financial penalty, just as someone who has a CD at a bank can be assessed a penalty for early withdrawal. By punishing liquidity preference, we could stop the liquidity squeeze.

The government could have made it difficult for Goldman Sachs and other counterparties to grab low-risk assets from AIG. Staying within the law, simply requiring those counterparties to go to court would have done the trick. Instead, the government essentially seized AIG, paid off the counterparties, and then sold off huge chunks of AIG to avoid taking a loss. If the government was going to exercise arbitrary power that way, it could just as easily have exercised that power to keep AIG liquid and force Goldman and the others to raise short-term funds through other means.