Larry Ball Gets Pushback

From Stephen G. Cecchetti and Kermit L. Schoenholtz:

There is certainly room for debate, but we see the question of whether Lehman’s net worth was negligible or sharply negative as ancillary to the real issue. In important ways, lending to a bank of doubtful solvency is little different from lending to one that is certainly so. It will continue to put other institutions, and therefore the system, at risk. In this case, central bank lending to Lehman, an institution widely thought to be bankrupt, would have tarnished everyone else.

Pointer from Mark Thoma. My thoughts:

1. For those of us inclined to agree with this point, an implication is that Citigroup should have been allowed to fail. In fact, the whole bailout policy was misguided. Remember how some banks were forced to take bailout funds even if they did not want them? The idea was exactly to “tarnish everyone else” in order to avoid tarnishing the insolvent banks!

2. Regardless of the merits of letting Lehman fail, one of Ball’s main points still stands. That is, Bernanke and others have been lying by claiming that the decision was based on legal considerations. Ball did not find any evidence that the Fed made a judgment based on such considerations. In fact, it appears that it was not the Fed’s judgment at all, and instead Hank Paulson was calling the shots.

Paulson, Bernanke, and Lehman, continued

James B. Stewart writes,

One of the more intriguing questions Professor Ball tackles is why Mr. Paulson, rather than Mr. Bernanke, appears to have been the primary decision maker, when sole authority to lend to an institution in distress rests with the Fed. The answer, he suggests, is to be found more in psychology than data.

“By many accounts, Paulson was a highly assertive person who often told others what to do, and Bernanke was not,” Professor Ball writes. “Based on these traits, we would expect Paulson to take charge in a crisis.”

Pointer from Mark Thoma.

Stewart, who did his own reporting on the events, supports Professor Ball’s view. My reading of Paulson is that he is a high-testosterone guy. My reading of Bernanke is that he isn’t. I have always viewed Paulson as the great villain of the financial crisis response. I do not believe that any of the bailouts were justified, and I view him as the driver of the bailouts.

Suppose you take a Bagehot view, which is that in a crisis the central bank should lend freely, on good collateral, at a penalty rate. In the case of Bear Stearns, my recollection is that the Fed took on crummy collateral. Ball claims that Lehman had good collateral that the Fed could have lent against.

The Fed and Lehman

Laurence Ball writes,

The people in charge in 2008, from Ben Bernanke on down, have said repeatedly that they wanted to save Lehman, but could not do so because they lacked the legal authority. . .

I conclude that the explanation offered by Fed officials is incorrect, in two senses: a perceived lack of legal authority was not the reason for the Fed’s inaction; and the Fed did in fact have the authority to rescue Lehman. I base these broad conclusions on the following findings:

  • There is a substantial record of policymakers’ deliberations before the bankruptcy, and it contains no evidence that they examined the adequacy of Lehman’s collateral, or that legal barriers deterred them from assisting the firm.
  • Arguments about legal authority made by policymakers since the bankruptcy are unpersuasive. These arguments involve flawed interpretations of economic and legal concepts, and factual claims that do not appear to be accurate.
  • From a de novo examination of Lehman’s finances, it is clear that the firm had ample collateral for a loan to meet its liquidity needs. Such a loan could have prevented a disorderly bankruptcy, with negligible risk to the Fed.
  • More specifically, Lehman probably could have survived by borrowing from the Fed’s Primary Dealer Credit Facility on the terms offered to other investment banks.

In short: Bernanke lied, Lehman died.

My thoughts:

1. Whenever you look at government policy in financial markets, assume that the primary goal is to allocate credit to preferred borrowers, particularly toward governments themselves. This goes for regulatory policy and so-called monetary policy.

2. I am inclined to interpret the decisions made in 2008 as credit allocation decisions based on Hank Paulson’s personal whims. Note that Ball says

The record also shows that the decision to let Lehman fail was made primarily by Treasury Secretary Henry Paulson. Fed officials deferred to Paulson even though they had sole authority to make the decision under the Federal Reserve Act.

The decisions helped some investment banks, including Goldman Sachs (the “AIG bailout” was mainly a funneling of short-term Treasury securities to Goldman and other investment banks). The decisions hurt Freddie Mac, Fannie Mae, and Lehman. I think that is what Paulson wanted to see happen.

3. Whereas Ball seems to suggest that the Fed should have bailed out Lehman, I am more inclined to believe that the government should have allowed institutions to go through bankruptcy or to make concessions among themselves. By the latter, I mean that if nobody bails out AIG, then maybe Goldman and the others decide that “collateral calls” are only going to hurt themselves in the long run, so they allow AIG to keep some near-term liquidity, and it ultimately survives.

4. The consensus story from the establishment is that Bernanke and Paulson saved the country from another Great Depression. Maybe that story is right, but with my heterodox views I do not believe it. I think that many ordinary citizens do not believe it, either. The widespread suspicion of the establishment gave rise to such phenomena as the Tea Party and, arguably, Donald Trump. It would be easier to defend the establishment if you could say that Bernanke was telling the truth.

Jason Collins on John Kay

Jason makes it sound like Kay’s book is worth reading.

One of the most interesting threads in the books is that many of the regulatory mantras are about the financial intermediaries, not the end users. The drives for transparency and liquidity in particular come in for criticism by Kay. First, the demand for transparency is a sign of the problem

The quoted passage that follows strikes me as very good. I also have argued that non-transparency is in some sense the point of financial intermediation. If I know everything about a bank’s portfolio, then I do not need the bank. I can just buy the portfolio myself.

Ed Kane on Financial Regulation

The headline on the interview is confusing, but his remarks are not.

She [Hillary Clinton] goes part way toward Senator Sanders in proposing to give regulators more power to break up financial firms. But federal regulators have a lot of authority already. The key is to give them the incentive to use that authority. When a bank is in distress, fear of disrupting the system becomes their dominant concern.

Pointer from Mark Thoma. Kane has been around for a long time, and he has been for right for a long time. In the 1980s, he was among those warning about the weakness of capital requirements and the political power of big banks. The fact that his warnings today are similar tells you that Dodd-Frank and other responses to the financial crisis were not sufficient.

The Big Short on Outsider Personalities

This weekend I watched The Big Short. The movie makes a big deal, as does the book, about the odd personalities of the investors who saw the financial crisis coming more clearly than others. Some thoughts on that:

1. If the typical normal person (or normal investor or normal regulator) saw a financial crisis coming, then it would not occur.

2. At any one time, there are lots of outsiders forecasting extreme events. If you bet on outsiders all the time, most of the time you will lose.

3. The challenge for insiders is to filter out the noise from outsiders without filtering out the signal.

4. You filter out signal when you hold as sacred hypotheses beliefs that really should be questioned. As the movie points out, the hypothesis that AAA-rated securities are safe was sacred. The hypothesis that house prices never go down in more than a few locations at the same time was sacred. The hypothesis that new risk management techniques made old-fashioned mortgage underwriting standards obsolete was sacred.

5. People with outsider personalities are less likely to fall into the trap of holding hypotheses as sacred. If you don’t need to get along with the insiders, then you question them. You question them when they are right and you question them when they turn out to be wrong.

6. As you know, I think that MIT economics has produced a set of insiders who hold sacred hypotheses. Math equals rigor. AS-AD. Market failure always justifies government intervention. Etc. The Book of Arnold is an attempt to call them out on it.

Market Monetarism Watch

David Beckworth, with Romesh Ponnuru, makes the NYT.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy.

In a way, this is an easy argument to make.

1. A recession is, almost by definition, the economy operating below potential.

2. Operating below potential is, almost by definition, a shortfall in aggregate demand. The only other type of adverse event is a supply shock, which reduces potential but does not force the economy to operate below that reduced potential.

3. The Fed controls aggregate demand.

4. Therefore, all recessions are the fault of the Fed. Either by commission or omission, the Fed has messed up if we have a recession.

It is an easy argument to make, but I believe close to none of it. I do not believe in the AS-AD framework. And I do not believe (3). If you do not know why I have my views, go back and read posts under the categories “PSST and Macro” and “Monetary Economics.”

My view is that the housing boom and the accompanying financial mania helped hide some underlying adjustment problems in the economy. The crash, the financial crisis, and the response to that crisis all helped to aggravate those underlying adjustment problems. I suspect that, on net, the bailouts and the stimulus diverted resources to where they were less useful for maintaining employment than would have been the case if the government had not intervened. My basis for this suspicion is my belief that people who do not need help are often more effective at extracting money from the government than people who do need it.

There has been much other commentary on the op-ed–see Scott Sumner’s post.

Greg Ip on The Big Short

He says,

But what I think it’s not including in that story is the extent to which these Wall Street guys honestly thought that what they were doing wasn’t that risky. They thought that a Double-A- or Triple-A-rated security had so much protection through various ways, there’s just no way this thing could blow up. And I would say that, in terms of going forward, one of the challenges we as the public and citizens and our government is: How do you create a financial system, how do you create an economy that both gives us the safety that we need to both be happy and to prosper and to take risks without destroying our selves but doesn’t create those fatal levels of complacency?

This is from a Russ Roberts podcast, with much more in the conversation.

Opaque Leverage and Self-Deception

Regarding the movie The Big Short, Tyler Cowen wrote,

There is no central villain, none whatsoever. The filmmakers succeed in showing how the collective actions of many, operating together, can give rise to structural problems and systemic risk. And yet the story remains suspenseful.

People prefer stories with villains.

I think that the story of the financial crisis has to include leverage. Individual home buyers did not put up much of their own capital. The lenders did not put up much of their own capital. The mortgage securities were structured and rated so that banks could hold them with minimal capital.

However, some of this leverage was opaque. People did not understand the way that AIG was contractually obligated to put up billions in collateral if prices moved against them. People did not understand that while Fannie Mae and Freddie Mac were reporting that their sub-prime exposure was less than 2 percent, their exposure to risky loans was closer to 30 percent. People did not understand that mortgage securities rated AAA were not really comparable to AAA-rated bonds. People did not understand that banks had created “structured investment vehicles” and other dodges that made them much more levered than they appeared to be. And by “people,” in all cases I mean regulators and investors.

But finally, the opaque leverage was less intentional bad behavior on the part of financial executives than it was self-deception. Suppose that you had asked executives in 2007 to answer honestly, “Relative to what people outside the firm think, how exposed are you to a decline in house prices and problems in the mortgage market?” My guess is that almost all of them would have said, “We are less exposed than other people think.” And they would have been telling the truth from their point of view.

That is what made the speculators in The Big Short so special. They managed to dig through to reality.

And don’t forget that I coined the term, “Suits vs. Geeks Divide.”