What I am Reading

1. Michael Shermer, The Moral Arc. I am only a few pages in, and he already has cited Bill Dickens and Bryan Caplan, among others.

2. Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. This is a re-read for me. They share with me the view that risk-based capital rules contributed heavily to the crisis. They make a very subtle point, though. They do not believe that bankers went all-out to maximize the effective leverage of their banks. Thus, the authors reject the moral hazard arguments of deposit insurance and too-big-to-fail.

The way I would put their argument is this. Suppose that bank managers were, for whatever reason, actually quite concerned about risk exposure. They thought, even if incorrectly, that the value of keeping their franchises intact and avoiding trouble was very important. Even so, with the risk weights that regulators placed on different assets, the effective rate of return on mortgage securities was much higher than that on other asset classes, including low-risk mortgage loans. Thus, the risk-based capital rules, along with the lenient ratings by rating agencies of mortgage securities, served to steer capital into high-risk mortgage loans and thereby into feeding the housing bubble.

In making their argument that the crisis was in my terminology a cognitive failure rather than a moral failure, the authors point out that if bankers had merely wanted to maximize their exploitation of implicit and explicit guarantees, they could have acted differently. They could have held higher-risk, higher-return tranches of mortgage securities. They could have held less capital (before the crisis, major banks tended to have leverage ratios well below regulatory limits).

Peter Wallison and the N-word

He says,

By 2008, before the financial crisis, there were 55 million mortgages in the US. Of these, 31 million were subprime or otherwise risky. And of this 31 million, 76 % were on the books of government agencies, primarily Fannie and Freddie. This shows where the demand for these mortgages actually came from, and it wasn’t the private sector. When the great housing bubble (also created by the government policies) began to deflate in 2007 and 2008, these weak mortgages defaulted in unprecedented numbers, causing the insolvency of Fannie and Freddie, the weakening of banks and other financial institutions, and ultimately the financial crisis.

Remember what the Washington Post Style section proclaimed on January 1st. Narrative is out. Facts are in.

Of course, in addition to the Freddie and Fannie securities, there were lots of private-sector securities backed by risky mortgages. My contention is that this boom was fueled by risk-based capital rules, which stated that once these loans were packaged into securities, divided into tranches, and blessed by rating agencies as AAA, banks could earn three times the return on such mortgages as could be earned by originating and holding an old-fashioned, low-risk mortgage.

Narrative is the New Baloney Sandwich

Brad DeLong writes,

When it became clear in late 2008 that the orgy of deregulation coupled with global imbalances was confronting the global economy with a shock at least as dangerous as the Great Crash that had initiated the Great Depression. . .

Pointer from Mark Thoma.

Noting that on this year’s Washington Post list, “narrative” is in the “out” column, to be replaced this year by “facts,” I resolve in 2015 to use the phrase “I call Narrative” where I would have said “I call Baloney Sandwich.”

The phrase “orgy of deregulation” is a much-used narrative/baloney sandwich. Others have used it. Interestingly, in the version of the essay that appears on Project Syndicate, DeLong does not use it.

1. The facts are that one can just as easily blame the financial crash on an attempted tightening of regulation. That is, in the process of trying to rein in bank risk-taking by adopting risk-based capital regulations, regulators gave preference to highly-rated mortgage-backed securities, which in turn led to the manufacturing of such securities out of sub-prime loans.

2. The global imbalances that many of us thought were a bigger risk factor than the housing bubble did not in fact blow up the way that we thought that they would. The housing bubble blew up instead.

3. I call narrative whenever someone talks about the causes of the financial crisis without making any reference to looser mortgage lendings standards and/or without mentioning that government policies were hostile not to those institutions who dropped rigorous lending standards but to those who attempted to maintain them.

A “Tough” Capital Rule for Big Banks?

So the headline says. But from the actual article,

The extra core-capital requirement could be as high as 4.5 percent of risk-weighted assets on top of the baseline 7 percent defined under rules known as Basel III, according to analysts including Citigroup’s Keith Horowitz.

The term “risk-weighted” gives the banks a loophole you can drive a truck through. My guess is that if you had this rule in place in 2005, its main impact would have been to steer banks into holding more AAA-rated mortgage securities.

My Review of Peter Wallison’s Forthcoming Book

is here.

Wallison’s thesis is that policymakers in Washington underestimated the significance of the surge in nontraditional mortgages. What is perhaps even more deplorable is the way that these mortgages continue to be downplayed in the mainstream narratives of the crisis and in the policy responses that followed.

Meanwhile, CNN Money reports on programs that offer 3 percent down payments.

The new loans will only be doled out to those who buy private mortgage insurance, have a credit score of at least 620 and offer complete documentation of their income, assets and job status. And, to further mitigate risk, the agencies will require borrowers to receive home ownership counseling.

Once again, the government is pushing home borrowership, setting households up to fail and making the housing market more speculative. Of course, when the stuff hits the fan, the government officials involved will blame lenders, not themselves.

Central Planning, Capital Regulations, and the Risk Premium

Per Kurowski writes,

current credit-risk-weighted capital (equity) requirements for banks, allow banks to hold government debt and loans to the AAAristocracy against much less equity than when financing “risky” small businesses and entrepreneurs, and so that is de facto what you get.

Risk-based capital regulations may or may not help regulators manage bank risk. (I argued here that the results were quite the opposite.) But they certainly affect the allocation of capital.

Many economists say that there is a huge demand for risk-free assets, as if this were a puzzle. Why is the “free market” so risk averse? Well, the government tells banks that they can earn a higher return on equity holding what the government defines as risk-free assets. AAA mortgage securities, Greek sovereign debt, whatever.

Kurowski’s post reminds me that financial regulation serves to allocate capital, and capital allocation by government can be thought of as central planning. There is a major socialist calculation problem involved. Moreover, there is a tarbaby problem. As the capital regulations produce perverse outcomes, policy makers look for policies to correct the outcomes, and these policies lead to other perverse outcomes, etc.

How the Fed Became a Giant Hedge Fund

Jeffrey Rogers Hummel tells the story.

Phase Two of Bernanke’s policies transformed the Federal Reserve from a central bank confined primarily to managing the money supply into an institution that is now a giant government intermediary borrowing massive sums in order to allocate credit. In that respect, the Fed has become similar to Fannie or Freddie, with the important distinction that the Fed has greater discretion in subsidizing a wider variety of assets.

Target Bubbles?

Ian Talley (WSJ) reports,

Financial market risk-taking is reaching excesses comparable to those that precipitated the global financial meltdown, José Viñals said

That is the “top adviser to the International Monetary Fund,” according to the story.

My point is not that I agree or disagree. My point is to note the following:

1. It is easier to picture policy makers doing something about excessive risk taking now, after they have seen what can happen, than in 2006.

2. Nothing is being done about this alleged risk-taking.

3. Therefore, it is very hard to picture policy makers doing something about excessive risk-taking in 2006.

Identifying clear and present financial danger is not as easy as it appears to be in hindsight.

The Single Point of Entry Solution

Rebecca J. Simmons writes,

The critical element of the SPOE strategy is the recapitalization of the company’s material operating subsidiaries with the resources of the parent company. For the SPOE top-down approach to work effectively, there must be sufficient resources at the holding company level to absorb all the losses of the firm, including losses sustained by the operating subsidiaries.

SPOE is being touted as the solution to the too-big-to-fail problem. You have a gigantic bank holding company that gets in trouble. You (the FDIC) want to keep all the subsidiaries going, because you want depositors and counterparties not to panic. So you put the holding company into receivership, and only pay off shareholders and debtholders of the holding company after your are sure you have got money to do that.

I may not fully understand this. Here is what I think happens. The value of the subsidiaries as ongoing concerns is positive, say $100. However, if you subtract the value of the outstanding debt of the holding company, the value of the holding company is negative. With, say, $150 in outstanding debt, the holding company’s value is -$50. The receivership creates a new holding company, which will eventually be sold back to the public, but without the outstanding debt. When the new holding company is sold, the debtholders in the old company get first dibs on the proceeds, and if there is anything after that, the equity holders can get it. Again, I could be completely wrong about this, but that is my understanding.

Simmons continues,

The capitalization of the bridge financial company must be sufficient…not only to allow the operating subsidiaries to obtain needed capital from the bridge to continue operations but also to allow stakeholders and the broader public to view the entity as safe and viable as it transitions from failed firm to bridge financial company, and ultimately to emergence as a new firm.

The problem is that financial firms have multiple self-fulfilling states of equilibrium. There is a state in which everyone believes in you, so you pay low interest rates on your debt, and you are fine. There is a state in which counterparties do not believe in you, so your interest costs soar, and you are dead. One key question about SPOE is whether it can prevent a jump from the good equilibrium to the bad equilibrium.

Suppose that we had this strategy in place, with all of the legal means for implementation. I still believe that if JP Morgan Chase or Citigroup got into trouble, the Fed Chairman and the Treasury Secretary would be wetting their pants. In a crisis, the probability that they would go through with SPOE, rather than undertake an ad hoc bailout, is very low.

Francis Fukuyama on Big Banks

In his latest book, Political Order and Political Decay, he writes,

Though no one will ever find a smoking gun linking bank campaign contributions to the votes of specific congressmen, it defies belief that the banking industry’s legions of lobbyists did not have a major impact in preventing the simpler solution of simply breaking up the big banks or subjecting them to stringent capital requirements.

It is taking me a long time to finish Fukuyama’s book. It is long and repetitive. I think that every time I read something from him, my temptation is to condense it to something much shorter. If I post a review, I will let you know, and my guess is that if you read my review you will not need to read the book.

He favors a combination of state capacity, rule of law, and democracy. In terms of our three branches of government, the executive branch is responsible for state capacity, the courts are responsible for the rule of law, and legislatures are to respond to democracy.

(Bryan Caplan is not happy with the concept of state capacity. He suspects that it is a meaningless yay-word. If nothing else, Fukuyama seems to me to endow the word with meaning. It means that bureaucrats are effective and ethical, as in Singapore, rather than ineffective and corrupt, as in India.)

Many on the right consider the administrative state, meaning government agencies operating independently, to be a bug. For Fukuyama, it is a feature. In his view, one main reason that these agencies function poorly in this country is that they face too much interference from Congress and from the courts. In my view, agencies are as easily captured by special interests as are legislators.

If David Brooks ever gets around to reading this book, he will heart it. Like Brooks, Fukuyama longs for a political system in which an autonomous elite governs on behalf of the public good. In Fukuyama’s view, the libertarian efforts to constrain government, including checks and balances as well as federalism, end up backfiring. They make government less effective while not constraining its growth.

The ideas are worth chewing on. Do I believe that the elites would, for example, fix the unsustainable entitlements promises if we had a parliamentary system? Or do I believe that a stronger government would be worse rather than better? It’s a tough call.