Friday, February 27, 2009

Zombie everything

I think this post from the boys at The Economist goes in the right direction.  They correctly point out that it might be difficult to fix the economy if you are not even sure what the problem is.  For example ...

Maybe it's the Zombie banks:

In one corner, we have Paul Krugman and Adam Posen. Mr Krugman cites Mr Posen in a blog post today, saying:

The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under TARP, closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses. The result then, and the emerging result now, is that the banks' top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch.

These, in Mr Krugman's words, are, "[Z]ombie banks, unable to supply the credit the economy needs". The problem is that the economy will stagnate without a functioning banking system. Government transfers to the financial system, to date, are far too small to make the banks whole, and transfers of sufficient size would represent an enormous giveaway to shareholders. The solution, in this case, is nationalisation.

But the again, maybe it's the Zombie borrowers:

In a second corner we have Richard Caballero, Anil Kashyap, and Takeo Hoshi, who argue that the big problem with Japanese banks was not that they could not provide adequate credit to the economy, but that they continued to supply credit to the economy when they shouldn't have. In a paper titled, "Zombie lending and depressed restructuring in Japan", they write:

This paper explores the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s. The investigation focuses on the widespread practice of Japanese banks of continuing to lend to otherwise insolvent firms. We document the prevalence of this forbearance lending and show its distorting effects on healthy firms that were competing with the impaired firms...

Aside from a couple of crisis periods when regulators were forced to recognize a few insolvencies and temporarily nationalize the offending banks, the banks were surprisingly unconstrained by the regulators.

The problem is that zombie banks kept credit flowing to "zombie borrowers". Without good investment opportunities available (given economic conditions) these loans merely propped up failing firms.

Or, finally, it might be the Zombie consumers:

And in a third corner, we have Martin Wolf and Richard Koo. They argue that the root of the Japanese lost decade wasn't the banks at all—it was household debt. Mr Wolf writes:

Most of the decline in Japanese private spending and borrowing in the 1990s was, argues Mr Koo, due not to the state of the banks, but to that of their borrowers. This was a situation in which, in the words of John Maynard Keynes, low interest rates – and Japan's were, for years, as low as could be – were "pushing on a string". Debtors kept paying down their loans.

The problem is that households will neuter monetary policy by working to pay down their unmanageable debts. Banks are not an issue at all, so long as they aren't threatening the financial system by failing. The solution here is too prevent systemic collapse as cheaply as possible. In all likelihood, this involves propping up bad banks until they can earn their way out of insolvency, and engaging in large scale fiscal policy to avoid a debt-deflation spiral.

Fortunately, in the current situation, this turns out to be a remarkably easy question to answer; we've got Zombie everything.  Banks that don't want to lend, private equity companies that borrowed a lot and are now the only ones with an appetite for more borrowing (which unfortunately just goes to prop them up), and consumers that just want to pay off their debt. 

Zombies of the world unite!  You have nothing to lose but your brains!

Thursday, February 26, 2009

They send us a toe ...

... we're supposed to shit ourselves with fear? This is not a stress test. These guys couldn't find reverse on a soviet tank.
Yesterday, as part of the stress test program, I've heard that the Fed issued two highly classified, double top secret documents for examiners and banks titled: "Template for Supervisory Capital Assessment" and "Supervisory Capital Assessment Program, Frequently Asked Questions: Participating Financial Institutions". These guidelines apparently specify how stress tests should be conducted and how to estimate loss rates under both scenarios (baseline and more severe).

What if I told you - not that I would know what is in these documents because my Q and TS clearances have expired - that these document suggests that under the more adverse scenario examiners should use a cumulative loss rate over the next two years below 30% for subprime first lien mortgages? Compare that to the Moody's updated estimate of 28% to 32% for their current baseline case.
Check out the charts in the first link as well. Then hunker down in your bunker and cover yourself in leaves -- it's going to be a long, cold lost decade.

Wednesday, February 25, 2009

Now we have a game show about a casino ...

"When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done." -- John Maynard Keynes

At least we have had some progress since the last Great Depression:





Couldn't have said it better myself

Calculated Risk reads my mind.

From Bloomberg: U.S. Will Take Bank 'Ownership' Stakes Only as Losses Climb (ht Anthony)

Federal Reserve Chairman Ben S. Bernanke said the ... Treasury will buy convertible preferred stock as needed in the 19 largest U.S. banks after stress tests to determine how much capital is needed to address losses in a "worse" case scenario, Bernanke told lawmakers at a Senate Banking Committee hearing today. The shares will be converted to common only as the extraordinary losses happen, he said.

"It doesn't have an ownership implication until such time as those losses which are forecast in the bad scenario actually occur," the Fed chief said. Bernanke also said that the so- called stress tests that regulators will run on the 19 banks will look at potential losses over a two-year horizon if the economy worsens.
If the banks are seriously insolvent, this sounds like the zombie bank approach and rewards existing shareholders at the expense of taxpayers. If the banks are not seriously insolvent, this is a reasonable approach. But how does Bernanke know the solution before the data is available from the stress tests?

Would you be very convinced by a doctor who said, "Sir, we would like to test you to prove that you don't have cancer"?

Tuesday, February 24, 2009

Halleleujiah

Somebody had to say it:
I note with consternation Europeans’ obsession with regulating hedge funds and tax havens. Did they cause this crisis? No. Europeans also call for regulation of all markets, products and participants, without exception. This is like calling for research into radar while the Titanic sinks. Do they realise that the systemically significant banks at the heart of this crisis are the most regulated institutions we possess? Let us not be diverted from today’s priorities.
Our problem was emphatically not too much regulation, but bad regulation. We may have seen some hedge funds blow up last year, and we may see much of private equity disintegrate in 2009, but we should try to remember that while those guys may not have been regulated, the folks that stuffed them full of leverage were.

This is not my fault

Monday, February 23, 2009

Sunday, February 22, 2009

Returning Depression Economics

I was expecting big things from Paul Krugman's extraordinarily well-timed reprint of his 1999 book The Return of Depression Economics.  After all, this guy was a very welcome voice of sanity (both economically and politically) during the Bush years, he writes well and has an ability to distill economic jargon into easy to understand examples, and he just gave a great Nobel Prize lecture.  Positive auguries all.

So why was this book only so-so?  First, to be fair, I am not really his intended audience.  This is a book written for the public at large, for people who may need a footnote clarifying what it means to go short a stock, and not for an economist or anyone working in the financial markets.  It never really rises to indepth analysis, and mostly contents itself with telling the story of various snafus and panics in recent financial history -- he touches briefly (almost incoherently briefly) on the Latin American debt crises of the 80's and their resolution with the Brady bonds, and then goes on to discuss more substantively the collapse of the Japanese bubble in the late 80's, the breaking of the bank of England in 92, the Mexican Tequila crisis of 94, the Asian Flu and Russian Default of 98, and the Argentinian currency board fiasco of 2002. 

Fun stories all, and useful history if you haven't already heard it.  All of these incidents of course bear a striking resemblance to the current dilemma that the US faces.  Every single one is a self-fulfilling debt driven liquidity crisis -- that is, at bottom they are a run on the bank.  Sometimes the problem is on the asset side of the balance sheet (Japan) and sometimes it is on the liability side (Argentina) because the debts are denominated in dollars and the central banks involved can only print pesos, but at bottom they are the same asset liability maturity mismatch as ever.  Krugman outlines the history of each of these in folksy fashion, showing you how they worked, making occasional (though really somewhat less than totally effective) use of an analogy with a baby-sitting cooperative, to illustrate his point, and extracting the general lesson that with international financial markets, as with banks, confidence matters. 

The mystery though doesn't lie in the dynamic of these liquidity events, but in why printing more money doesn't always serve to solve them.  In other words these crises all led, for varying lengths of time, to those economies functioning below full capacity and employment.  The mystery is why problems in the financial markets, which, after all, are just a bunch of numbers representing our relative rank in the pecking order, should lead to perfectly good factories sitting around empty and perfectly good workers going hungry.  And on this mystery Krugman really kinda falls down. 

I don't mean that he doesn't do some useful analysis or make any suggestions.  In fact, just recounting these vignettes of financial history so that you can see that they are all related is worthwhile.  And he also does say useful things about why Thailand, Malaysia, Indonesia, South Korea, Russia, and Brazil were in a no-win situation because a bank run is fundamentally a crisis of confidence, and because the fiscal austerity required to restore confidence is naturally at odds with the expansiveness required to get through a liquidity crisis.  So he does isolate why these countries, at least, weren't able to solve their problem by simply printing more money -- the IMF didn't really let them until it was too late.  To further this conclusion, he puts forward Soros breaking the BOE as arguably quite a positive thing for England -- they were going to devalue eventually anyway, and Soros just made it quick and definitive.

And he also does explain how you could get a run on banks in the US even though the deposits are insured, and the Fed is there as a backstop, which you would think eliminated the possibility of a self-fulfilling crisis of confidence.  The 'shadow banking system' made up of the investment banks, hedge funds, etc ... that has grown up over the past 20 years is (was) now huge, highly leveraged, and every man for himself.  Undeniably though, this is a useful thing to know if you haven't been following the bouncing political ball of the last several years.

But I think his tendency to simply describe these crises lets the more important point slip away unnoticed.  Of course we know what a  pure bank run liquidity crisis looks like.  And of course, we know that they can start over a rumor about a rumor.  But we also know that they rarely do.  And there's really not a single example in those he gives that is a pure liquidity crisis, with no element of solvency crisis.  These things always start because there is a real concern that some over indebted nation or bank is not going to be able to pay, and, frankly, the market is usually right about this.  Perhaps this is not always true, but just as the markets can panic and stampede towards the exits, they often stampede into some promising new area as well, making huge loans on idiotic terms, and setting up the very real insolvency that they only later wake up to.

Take the case of the US currently.  I think at this point, no one is claiming that this is purely a liquidity crisis that will blow over as soon as we get the prozac levels in the financial district water supply back up.  The US as a whole borrowed too much.  And we spent it giving each other back rubs in our McMansions.  Now, I'm sure a good back rub will do wonders for your productivity, but that McMansion is just dead weight.  So whoever loaned you the money to buy it should be worried at this point.  And if the guy that made you this loan has a lot of others like it, he should be worried about paying off his debts.

So the fact that he really just discusses all of these cases as liquidity crises strikes me as fundamentally flawed.  The real thing that catapults you into serious and long-lasting Depression Economics seems to be how the solvency question stands at the point that the liquidity crisis starts.  After all, for all their ferocity, the crises in Asia, Russia, and Argentina were all quite brief.  They all involved a devaluation, followed by one to two years of sharply lower output.  But they all were over after that, and the snap back was pretty spectacular in most cases.  Krugman has a point when he says that there's really no reason for people to stop producing things for any length of time, but in these economies it didn't take long for things to reset to a lower level and start growing again quite rapidly. 

It seems to me that there are two possible (and not mutually exclusive) explanations for this.  First, exports.  If the rest of the world is growing and you have just suffered a huge devaluation, you can at least use your idle productive capacity to sell stuff to the US.  Second, when you devalue your currency, you also get the chance to default on your foreign currency denominated bonds, so you get to restructure your debt.  Chapter 11 is pretty useful for reviving your economy.  For a while of course, no one wants to loan you any more money, but pretty soon they tend to forget all about the nasty default, and you can start borrowing again because after the big bath write-offs, you balance sheet doesn't look so bad.  Or maybe, during the recovery, instead of the government borrowing abroad, companies do it directly.  Either way, devaluation and default in the context of the ability to restructure your balance sheet and start exporting can work out all right.  There is someone to borrow (export oriented companies) someone to lend (dumb bankers back for round two, or the IMF) and someone to demand the shit your make (the guy building his McMansion). 

But what if you can't default?  What if you can't or won't restructure your debt? You just sit there groaning under it, trying to get out of your liquidity crisis by printing money that nobody wants to lend and nobody wants to spend.  I think this is the root of the solvency crisis that Japan experienced in the 90's and the US in the 30's.  It was not just a liquidity crisis that was curable by printing enough money.  Both sides of the credit system were broken in those cases (as they may be in the US now), so no creditor was willing to loan the money and no debtor to take it, because everyone was up to their gills in un-restructured debt. 

The standard response to this impasse is well known and Krugman mentions it, trying as best he can to only slip the name Keynes into the final chapter of the book so that it will not prematurely raise the ideological hackles of the average economical illiterate.  The response is that the government should transfer the bad debts to itself, and then it should print up money and spend it directly, completely disintermediating the banks and private businesses in the normal credit system. 

The Keynesian solution has a lot of merit.  If your economy were closed (that is, if you were neither a net debtor nor a net creditor nation) it seems to me that this solution would be foolproof, so long as you were willing to bring all loans into the government coffers, and so long as you were willing to spend alot.  After all, in a closed system, credits and debts are just a matter of the internal distribution of wealth.  In that case, you could always get the economy moving again just by coming out one morning and saying, "okay, all debt is forgiven".  This would have no net effect.  It would indeed transfer wealth from the spendthrift to the profligate, but aside from this moral objection, I don't see how this collective restructuring wouldn't leave everyone's balance sheet in perfect shape.  And once this great netting out were performed, there would be no reason for one group to force another to liquidate its perfectly good factory unnecessarily, and any new money that the government prints up would be spent rather than simply hoarded by debtors to pay off debt or hoarded by creditors for fear that debtors won't pay them off. 

I don't know that Keynes actually mentioned the banking system as part of this problem, but the more I think about it, the more I see it as a crucial, and as what makes Krugman's book ring hollow to me.  It's not just a matter of expansionary fiscal policy that borrows from taxpayers and spends on bridge to nowhere.  You also have to have some form of debt restructuring that leads to a functional banking system so that the money spent by the state doesn't just go to the very gradual netting out of debts (again, assuming a closed economy).  The new spending doesn't happen in a vacuum, it happens in the context of previously existing balance sheets that set one part of society off against another part. 

So Krugman's book as whole ends up assuming that no matter how indebted we are, we can always print up the money we need to get more indebted, and always convince people to borrow it.  The only way to do this in lieu of a mass forgiveness of debts would be to create inflation, but the Japanese experience has proven that once the system gets stuck in the over-indebted state, it is very difficult to get inflation to take.  As far back as 1933, Irving Fisher realized that the key to stopping this whole debt-deflation mess was raising the price level, and then Keynesian fiscal policy came along as a plausible way to do this, but probably neither of them counted on the levels of debt involved today and on the stubborn resistance people have to letting the government shuffle the deck chairs.  Maybe that level of solidarity, and that ability to simply confiscate the income of the creditors, can only happen in a war?


P.S. The worst part is that being a net debtor nation makes this even worse.  In that case, even after any netting out, you will still owe others money.  You will still be in the hole and having to produce more than you consume for a while in order to pay them off.  This is tough if no one else wants your stuff because you are the one that they usually sell to.  This suggests that we might be lucky to end up like Japan.

A gate not a lever

... I've had this piece from Steve Keen's Debt Watch stuck in my head for a couple of weeks now.  It's long and complicated, and I'm not sure I completely understand it (I certainly don't understand it well enough to tell you whether I think it proves we cannot get inflation unless it is hyperinflation, which is one of the actionable claims it makes -- ie. don't buy gold, buy options on gold) but I do think there is something important here that I don't want to lose track of. 

The basic point seems to be that the Fed's control of the money supply is more like a gate than a lever.  Normally, we think of the Fed printing money as a lever that pushes on other parts of the mechanism down the line, which directly and causally influences the level of lending and prices.  Keen suggests that this is in error, and that the government sanctioned money supply just works like a gate -- they can open the gate more or shut the gate more, but they don't control the flow through it.  This is almost the same thing as saying that they control the total amount of money, but not its velocity.  On this view, the private banks are the ones who actually create money in the first instance, and the Fed simply ratifies the decision or vetoes it. 

If this is right it would explain a few things, like how you can get stuck in a liquidity trap where nobody wants to lend and nobody wants to borrow despite the gate being wide open (zero interest rates), as well as how you can fall asleep at the wheel and leave the gate open too long (sorry about the mixed metaphor) and then cause all hell to break loose when you shut the thing, resulting in the implicit veto of all those lending decisions by not printing enough money to fulfill them. 

It also goes some way towards the recuperation of Marx that has been percolating through by brain ever since reading The Main Currents of Marxism.  If the inevitable ratchet-like logic that Marx had in mind was a feature of capitalism rather than of markets, a feature of a system where capital makes more capital because the winners manage to re-write the rules and the business interests to capture the government -- well, then he makes a lot more sense.  Fundamentally, Marx may not have been criticizing free markets at all, but government involvement in free markets that creates feedback loops in an otherwise equilibrium tending system. 

One of the basic things we have placed in the hands of the government in the last 70 years is the control of the money supply.  Would it be so surprising if certain business interests managed to capture the lever/gate mechanism for their own self-sustaining benefit?  If they did mange to, even once, what would stop them from continuing to exploit it?  Revolution?


Saturday, February 21, 2009

Whither debt?

Having thought a bit about why debt exists in the first place, both from the individual perspectives of the creditor and debtor, I've found myself wondering about the further systemic implications of a debt economy. 

It seems clear to me now that the problem debt creates is inherent in the reason for its existence; capital with a maturity is simultaneously the only way to guarantee that you can get your money back when you want to spend it, and the only way you can get a cycle of forced liquidation of productive assets.  So it's no accident that a debt economy will repeatedly have credit crunch liquidity crises like the one we see now.   If the music stops playing and everyone wants to sit down at once, the massive liquidation is a problem because many of the assets being liquidated cannot themselves be consumed, and are only worth something as ongoing productive concerns.  You can't eat a factory today, something I learned from this Brad DeLong presentation.

But this just explains the bust side of the instability.  It shows you how the system can go from a sort of dynamic equilibrium where debt is continuously rolling over to a static equilibrium where everything is liquidated and there are no more capital assets.  You would think that the guys who invented debt realized that this was a problem from the outset and used it sparingly, but of course, for each creditor individually, it makes sense to plan out all of your expenses in advance and meet those exactly with the timing of the maturity of your debt.  The problem is one of systemic coordination of course, and leads directly to the logic of the modern central bank as a creditor of last resort that prevents the bust by temporarily printing enough money to redeem the claims of creditors without resorting to mass liquidation.

But our little toy credit economy also lets you see how the boom is produced as well.  Because some economic value is being left on the table when a creditor is satisfied with just getting a little bit of interest along with his principal back.  Someone is walking off with the excess gains that the debt holder is trading for the certainty of timing of his cash flows.  The leveraged entrepreneur is asymmetrically incented to shoot for the moon, and he is more incented the more leveraged he becomes (the less equity of his own that he puts up), and short of the threat of bankruptcy, he certainly never has any incentive to reduce his leverage and lose some of the extra economic value the debt holder is giving up.  The only thing regulating this level of leverage will be the willingness of the creditor to extend more credit, which is of course vastly increased by the comforting presence of an entity whose express purpose is to make good on these claims in times of crisis. 

Wake up and smell the inevitability of moral hazard. 

So the logic of debt, which at an individual level serves to dampen volatility, serves to create the possibility of both boom and bust at a systemic level.  And insofar as there is a creditor of last resort, you can see how this whole process is a sort of ratchet mechanism that lets creditors recover all of what they give up in the boom by taking back ownership during the bust.  One group goes for broke, and then another forces them to go broke for its profit.  Click-click, economic value has been ratcheted out of the hands of equity and into the hands of debt.  So much for progress. 

Now tell me, as a debt-holder, that your fundamental priority in a system like this will not be taking control of and assuring the continued functioning of the creditor of last resort.  Controlling the government is the key to making this whole ratchet system go in just one direction.  This is yet another reason to smash the state; the common conception that the state redistributes income is accurate.  The error lies in believing that the net redistribution is from rich to poor -- in point of fact, it goes in the other direction.





Friday, February 20, 2009

Cannabis Bonds

So, in true stoner fashion, let's just put two and two and two together and get four.
  1. Pot is illegal and hence highly profitable.
  2. The profitability of pot (etc ...) leads more capital to be devoted to its cultivation.
  3. Given the illegality, the growing excess profitability of pot production is captured by criminals.
  4. Much high-grade is produced in California.
  5. California spends a lot of money putting people in jail for expressing their entrepreneurial talent via the cultivation of cannabis.
  6. In essence, California is spending money subsidizing the successful cannabis entrepreneurs by creating, via legal stricture, the value that they exploit, while at the same time taxing the poor exploited cannabis consumer to fund the jails that are the strict corollary of his (or her) being forced to overpay for his (or her) Bob Hope.
  7. California is broke.
  8. I shoulda been a politician.
  9. California could a) increase its income b) reduce its expenses and c) have more stoners by simply legalizing and taxing the production of marihuana because this would allow the state to simultaneously c) reduce the total frictional costs in the pot economy (no more need for that expensive hair-trigger shotgun system (or Dick Cheney) to guard your patch) hence lowering the price and spurring demand b)  eliminate the need to feed, water, and iron the orange jumpsuits of the aforementioned failed entrepreneurs and a) capture some of the remaining economic value added of the pot market for itself.
  10. California could capitalize these savings upfront, as so many states have done with the tobacco settlements, by issuing bonds backed by the future cannabis tax revenues, which would of course help a lot with its current brokeness (see 7 above).

Thursday, February 19, 2009

Planet Mars

Greg Mankiw is afraid of Virginia Wolf:

Why are people scared about the idea of nationalization? One reason is that it is a sign of the depth of our problems. A second, more substantive reason is that it seems to point in a bad direction. I certainly do not want the government deciding who deserves credit and who does not, what kind of investments are worthy of financing and what kind are not. That is a big step toward crony capitalism, where the politically connected get the goodies, and economic stagnation awaits the rest of us.

So what exactly does he think has been going on up till now?  I'm sure that crony capitalism can get even worse, but we have already gone a fair ways down this road.  True, so far the cronies have all been in the finance industry, so that the government wasn't directly deciding who got loans and who didn't, and the cronies were basically indifferent to who they lent to, so long as loans were made and a cut taken.  I hardly see how this is much better than nationalisation though.  If we nationalized the banking system, we might get a lot of dumb loans, but will they be any dumber than loans for houses, the single most unproductive asset you can build besides a bomb?

Monday, February 16, 2009

Why Debt

Why does debt exist?  Why don't we throw the money lenders out of the temple once and for all and finance all business ventures with equity? 

An economy modeled on this idea would look appealingly simple -- a few people who have, over some period of time, managed to produce more than they consumed could get together and use the savings to fund a new business.  The legal wonders of private property and modern joint-stock company accounting being in place, they could all take a pro-rata share of the profits of the company based on the amount of savings they invested.  This to me is the very heart of classic liberalism (a la Adam Smith, Milton Friedman, and Noam Chomsky); create the conditions of possibility for non-zero sum games to arise where people can enter into voluntary arrangements of mutual benefit.  Some of us just call it Anarchy for the sake of simplicity.

In this toy economic world, if we both put up equity for a business, we both want to see it do as well as possible.  As equity holders, the only way we can see a return on the investment of our hard-earned capital is for the business to make money and grow, thus paying us out some form of dividend, or for us to sell our ownership interest in it in the secondary market.  Since this secondary market will be inherently forward looking when it establishes the value of the business, again, the original funders and the new owners all will be aligned in wanting to see the business maximally growing and succeeding. 

Why should debt ever enter this picture?  Debt mars the symmetry of mutually beneficial games.   If I merely loan you the money to start a business, I am now no longer especially interested in seeing the business thrive.  Clearly the business must be viable enough to accommodate the repayment of that loan when its ticking time bomb time limit expires, but that minimal definition of success is all I, Creditor care about.  As long as the business generates sufficient cash over the life of the loan to just pay back the interest and principal I will be happy.  In fact, we occasionally see an even more extreme version of this pessimism, where a lender turns an entrepreneur into a sort of sharecropper.  The lender may be happy charging an interest rate high enough that it prevents the business ever paying back the principle.  Then the lender can just roll over the loan when it matures, and keep the company working for him forever (normally we trust in the benefits of competition between lenders to eliminate any such magnificent money making scheme well before the need arises for Jesús to show up in his purple polyester suit and bust up the party).

So when debt enters the thought experiment, we still have a non-zero sum game -- the entrepreneur gets his additional capital, now, and the holder of capital gets to hold some more of it, eventually -- but the incentives of all the providers of capital are no longer identical, and in particular, one owner is strongly incented to make the company do well and one owner doesn't care if the thing stays on eternal life-support, just so long as it doesn't croak.

Given the inelegance of the system, we can ask why the publicly traded bond markets are larger than the equity markets (worldwide) and why they are completely dwarfed by the overall debt markets if you take into account bank's direct lending.  There would appear to be two basic risk reward calculations, one for each side of the transaction:
  1. An entrepreneur accepts the risk that he may have to repay his creditors on a fixed date, and may thus have to liquidate his business, in exchange for not being forced to share its potential success with anyone else. 
  2. A debt holder accepts an extremely limited potential return in exchange for the guarantee that he can get his capital back at a pre-specified date without having to worry about whether the business is a rousing success.
Number 2 here relates to an interesting debate that is at the heart of William Poundstone's book Fortune's Formula.  The book is a fun read for a whole host of reasons from its exposition of how to count cards in blackjack, to its discussion of the applications of information theory to the stock market and its history of the slimy early career of Rudy Guliani.  But the intellectual meat of it centers around a somewhat esoteric debate on how you define the utility of money -- basically, some people just want to have as much of it as possible, and others see it as merely a means to an end, and so prefer to trade some amount they consider superfluous for a greater guarantee that they will satisfy these ends.  In more technical terms, the difference is between people who invest so as to maximize the geometric mean of their returns, and those who pay more attention to the arithmetic mean.  For someone who just wants to have the largest pile of shekels at the end of the day (He Who Dies With The Most Toys Wins) the only important criteria in investing is the compounding annual growth rate over the long term.  This type of investor is willing to stomach any amount of volatility so long as it is associated with a higher return.  On the contrary, for those who just want to have enough money never to have to think about money again, the temptation is to seek investments that pay out the exact amount necessary for each of life's future expenses. 

The book details the nearly theological level to which this debate has been elevated over the years, but to me it seems pretty clear that from a practical perspective there will always be some actors in the market that prefer the higher and more volatile returns of equity to the relatively certain timing of payout that a bond allows.  Investors have different time horizons not because some are smart and some are dumb or because some are greedy and others slothful, but because they really do have differing needs for cash at different times. 

You can see this more clearly if you imagine again our toy world that consists uniquely of equities.  Let's further assume that in this toy world the frictional costs have been dramatically reduced, and one of the behavioral reasons an investor might be tempted to opt or the safety of a bond -- namely, that he doesn't know anything about the company in which he is investing -- has been overcome.  An ideal world of micro-equity, if you will, where every entrepreneurial undertaking is publicly traded with full disclosure of its structure, financial results and prospects.  If I have some capital to invest for the next 50 years, this world is pretty appealing.  I am almost certainly better off partnering with all of these businesses and taking a share of the upside, than I am letting them keep it for themselves after paying me back.  Over time these businesses will presumably grow and become more productive, and hence become more valuable.  And if for some reason I need to get my capital back, or prefer to hold one set of businesses rather than another, the secondary market will generally accommodate this without problems.

But if I plan to take my capital back next month or next year to buy a house or a car or whatever, I might not want to put all of my money in this micro-equity market.  Over a long time, certainly, these businesses will grow, but over shorter horizons they may shrink.  To some extent, I can mitigate this problem by investing in a great many of them, hoping that this diversified portfolio will always contain a preponderance of growing rather than shrinking businesses, and so will always grow steadily as a whole.  But we all know that certain large cycles do sweep over whole national and even global economies, and unless you believe that the very act of eliminating debt from the world (ex hypothesi in this case) will eliminate these cycles, then you may wish to hold some of your funds back from the market to assure that you have the cash ready to purchase you new mobile home. 

Where would you put this money?  Well, a sock works okay, but pays little interest, so you might make a deal with one of these equity-only entrepreneurs such that you give him the money (as equity of course)  to use until you need it, but he agrees to buy your equity back from you (plus maybe a little for your trouble) at a fixed price on some fixed future date.  Witness the birth of the modern repo transaction (I'm oversimplifying, but the idea is close enough).  If the entrepreneur lines up enough of these transactions, he can run a profitable business where he never has to share the profits of whatever he uses the money for, while at the same time fulfilling the public service of roundly outperforming the liquidity management characteristics my sock.

So, in short, debt makes sense from the perspective of the investor, and once we see that there is value to be had by debt existing, its introduction into our economic Eden of equities is as inevitable as Eve eating the ur-etamame. 

Anyhow, back to number 1.  It's easy to understand at first why an entrepreneur would want to fund his business entirely with debt; if it works he's gonna be rich, and it's all for him.  This is why, at first, it seems as if debt is almost progressive.  If there were no debt, new businesses that required capital would have no choice but to share the open ended economic benefits of their innovations.  Of course, there is always the question of the price of the equity, that is, what valuation the company is given before it even has any capital, but it seems reasonable to imagine that outlawing debt would generally tip the competitive dynamic of the capital markets in favor of capital and away from the entrepreneurs. 

But what crazy entrepreneur wants someone to be able to tell him when he has to liquidate his business!?  Funding a business with debt is only superficially rational, at least for most businesses, and certainly for those early on in their life or facing uncertain prospects.  This is common knowledge of course, and more debt is available to fund stable time tested business models backed by assets that do not tend to loose (too much) value upon liquidation -- ie. real estate -- than is available for brilliant, forward-looking, but inherently 'asset-lite' businesses such as housingdefaultswap.com.

In addition, what may appear progressive from an individual perspective (because it serves to distribute greater gains to founders than to capital) may in practice not be so progressive when seen from a systemic perspective.  In other words, what if all the creditors want to buy mobile homes at the same time?  If one debtholder wants to cash in he can always be replaced with another, so long as the business is even marginally healthy.  But if creditors en masse refuse to roll over their obligations they can force a huge chunk of the economy into immediate liquidation, and in fact, can end up owning the lion's share of what is left over after the mayhem.  Just ask J.P. Morgan how it felt in 1907.  When the option is underwater for the entrepreneur, debt may not look so progressive at all.

Where are we at the end of all this rambling?  It seems to me that the simplistic pure equity world suffers from no endogenous instabilities.  Equity capital is permanent capital a company never has to repay, so that even if some systemic event should come along and cause everyone to simultaneously want a winnebago, a shotgun and a bunker full of canned tuna, no functioning businesses need be liquidated as a result.  Prices in the secondary market for equities may collapse, and so it may be difficult to start a new business for a time, but the secondary market has a buyer for every seller, so that while everyone selling stocks may come up short of what they wish they had, the buyers will be setting the stage for a future fortune.  This again is oversimplifying as the secondary equity markets are also important in price signaling and do not simply serve as side-bet and redistribution mechanisms, so that a collapse in share prices can indirectly cause the uncertainty that reduces the future cash flows from a business.  But that's a definite bank shot, theoretically speaking, and I ain't no Keynes.

Then death intervenes in this relatively stable world.  People don't actually have an infinitely long horizon; they buy the farm.  And what's more, they know that they're going to.  And the plan for it.  And lo, and behold, debt comes to be.  This great force of instability in the markets and asymmetry in incentives ironically stems from the primordial desire to secure future expenditures with greater certainty. 

Which is to say that if we all lived forever, it would be in a capitalist paradise.



The Ponz and the Great Moderation

Late in 2007 most of the central bankers of the world were fawning all over themselves in an unseemly attempt to congratulate one another for yet another victory in what they had come to call the Great Moderation. After all, the sub-prime crisis of the summer had been "contained", the price of housing had moderated a bit, but that was probably just part of reaching its own permanently high plateau, and the juggernaut of the US economy looked to be very gradually slowing, which was anticipated to ease the inflationary pressures which seemed to be everyone's only major worry.

So, it occurred to me today that this was the very best sign one could have wanted that the whole thing was about to explode. Why? Well, I've put together a little graphic novel showing the logic. First, you have the Great Moderation, which is the precipitous decline in the volatility of GDP since the early 80's. The Fed paper cited above explores a few explanations of what might have caused this, but I think that privately the keeps of the money trust were pretty sure it was their beneficent wisdom and foresight.


What the Fed paper does not seem to explore is the fact that there was coincidentally an explosion of debt at the national, corporate, and household level over precisely this same period. So this chart shows you aggregate US indebtedness as a percentage of GDP.

More than a little curious, no. And so but well, then, what did we do with all this debt anyway? It must have gone to build more stuff, and that can't be such a bad thing, right? Unfortunately, the all this new debt got less and less effective over time, meaning that instead of being invested in some productive asset, it was basically just going straight into consumption. In other words, it's pretty easy for you to buy more stuff if you just go further and further into hock.

Now, you tell me where you think the Great Moderation maybe came from. And what you think it was a sign of. And who you think should be lauded for its wonders.

In fact, we've recently seen another remarkably moderate pattern of increases come to an abrupt end. Here is what happened to your money if you invested with Bernie Madoff:

It's interesting that I have yet to hear anyone apply the same logic to 30 years of American economic growth that they seem to trot out so intuitively when we talk about why Madoff's performance was suspicious -- it was too consistent to be real.

At any rate, I presume that eventually we will fix the jukebox, set the music to playing and the bankers to dancing, and happy days will be here again -- but for now, the age of the Ponz is over.

Busting the money trusting

Adam sends word of a good Bill Moyers interview with Simon Johnson of IMF fame. It is refreshing to see someone of importance and clear intelligence outlining the problem in a way that anyone can understand.

I remember trying to explain to an Argentinian friend a year ago how the US was going to go through the same sort of debt restructuring that has happened to so many emerging markets. He probably understood it better than most Americans can. He was also pretty familiar with the idea that the political apparatus of a country can be captured by the business world in general, and by a subset of that world in particular. So the irony of the head of the IMF getting up there and recommending that the US government nationalize a corrupt banking system and additionally go into debt to provide a counter-cyclical fiscal stimulus would certainly not be lost on him.

In the end, every time I think of these things I find myself coming back to Lawrence Lessig's formulation of the problem: the influence of money on politics is not our only problem, nor is it even our most important problem, but it is our first problem -- if we do not solve it we will not solve any of the other problems, no matter what you think those problems are. Here's his most recent restatement of the issue:

Wednesday, February 11, 2009

Markets vs. Capitalism

So, last night, our culture's gradual abandonment of the printed word afforded me the opportunity to pick up a used copy of the last volume of Fernand Braudel's Capitalism and Civilization series. For reasons I can no longer remember, the first book I read in the series was Volume 2 -- The Wheels of Commerce -- and I found Volume 3 a while back as somebody in in the East Village was having a moving sale, so it was only Volume 1 -- The Structures of Everyday Life -- that I was missing.

No longer.

Being Volume 1, it has a nice introduction to the whole series, which rather efficiently summarizes the message I took away from reading all 600 pages of Volume 2. But before I tell you the punch line, let me preface the introduction by describing Braudel's project a little. Basically, the guy was a French historian (not an economist) who wrote a huge and wildly empirically detailed history of early capitalism, from the 15th to the 18th century. The focus of the volume I read was on Europe, primarily, but the series as a whole, and the third volume in particular, puts the development of Europe in the context of the other parts of the world that, Braudel contends, are essential in understanding what happened there. As you will see from this piece of the introduction, the work is elegantly written, and contains an overwhelming amount of detail about how society and the economy actually functioned in this period, something which anyone who seeks to get beyond our current ideological blinkers will presumably appreciate.

When, in 1952, Lucien Febvre asked me to write this book for the collection World Destinies which he had recently founded, I had no idea what an interminable venture I was embarking upon. The idea was that I should simply provide a summary of the work that had been done on the economic history of pre-industrial Europe. However, not only did I often feel the need to go back to the sources, but I confess that the more research I did, the more disconcerted I became by direct observation of the so-called economic realities, between the fifteenth and the eighteenth centuries. Simply because they did not seem to fit, or even flatly contradicted the classical and traditional theories of what was supposed to have happened: whether the theories in question were Werner Sombart's (1902, and backed up by a wealth of evidence) or Josef Kulischer's (1928); or indeed those of economists themselves , who tend to see the economy as a homogeneous reality which can legitimately be taken out of context and which can, indeed must, be measured on its own, since nothing is intelligible until it has been put into statistics. According to the textbooks, the development of pre-industrial Europe (which was studied quite exclusively of the rest of the world, as if that did not exist) consisted of its gradual progress towards the rational world of the market, the firm, and capitalist investment, until the coming of the Industrial Revolution, which neatly divides human history in two.

In fact, observable reality before the nineteenth century is much more complicated than this would suggest. It is of course quite possible to trace a pattern of evolution, or rather several kinds of evolution, which may rival, assist or at times contradict one another. This amounts to saying that there were not one but several economies. The one most frequently written about is the so-called market economy, in other words the mechanisms of production and exchange linked to rural activities, to small shops and workshops, to banks, exchanges, fairs and (of course) markets. It was on these 'transparent' visible realities, and on the easily observed processes that took place within them that the language of economic science was originally founded. And as a result it was from the start confined within this privileged arena, to the exclusion of any others.

But there is another, shadowy zone, often hard to see for lack of adequate historical documents, lying underneath the market economy: this is that elementary basic activity which went on everywhere an the volume of which is truly fantastic. This rich zone, like a layer covering the earth, I have called for want of a better expression material life or material civilization. These are obviously ambiguous expressions. But I imagine that if my view of what happened in the past is accepted, as it seems to be nowadays by certain economists for what is happening in the present, a proper term will one day be found to describe this infra-economy, the informal other half of economic activity, the world of self-sufficiency and barter of goods and services within a very small radius.

On the other hand, looking up instead of down from the vast plane of the market economy, one finds that active social hierarchies were constructed on top of it: they could manipulate exchange to their advantage and disturb the established order. In their desire to do so -- which was not always consciously expressed -- they created anomalies, 'zones of turbulence' and conducted their affairs in a very individual way. At this exalted level, a few wealthy merchants in eighteenth-century Amsterdam or sixteenth-century Genoa could throw whole sectors of the European or even world economy into confusion, from a distance. Certain groups of privileged actors were engaged in circuits and calculations that ordinary people knew nothing of. Foreign exchange, for example, which was tied to distant trade movements and to the complicated arrangements for credit, was a sophisticated art, open only to a few initiates at most. To me, this second shadowy zone, hovering above the market economy of constituting its upper limit so to speak, represents the favored domain of capitalism, as we shall see. Without this zone, capitalism is unthinkable: this is where it takes up residence and prospers.

This triple division, which I gradually saw forming itself before my eyes, as the elements of observation fell into place almost of themselves, is probably what my readers will find the most controversial aspect of this book. Does it not amount to making too rigid a distinction -- indeed a term by term contrast -- between the market economy and capitalism? I did not myself take up this position hurriedly or without hesitation. But in the end I accepted that the market economy had, between the fifteenth and eighteenth centuries and indeed even earlier, been a restrictive order, and that like all restrictive orders, whether social, political, or cultural, it had created an opposition, counter-forces, both above and below itself.

What I find most encouraging to my view of things is that the same schema can be used ti show easily and clearly the articulations of present-day societies. The market economy still controls the great mass of transactions that show up in the statistics. But free competition, which is the distinctive characteristic of the market, is very far from ruling the present-day economy -- as nobody would deny. Today as in the past, there is a world apart where an exceptional kind of capitalism goes on, the my mind the only real capitalism: today as in the past, it is multinational, a close relation of the capitalism operated by the great Indies Companies, and the monopolies of all sizes, official or unofficial, which existed then and which were exactly analogous in principle to the monopolies of today.Would we not call the Fugger or Welser firms transnational today, since the had interests all over Europe and had representatives both in India and Latin America? And Jaques Coeur's business empire in the fourteenth century was as big as the trading interests of the Netherland in the Levant.

But the coincidences go further than this: in the wake of the economic depression following the 1973-74 crisis, we are beginning to see the development of a modern version of he non-market economy: hardly disguised forms of barter, the direct exchange of services, 'moonlighting' as it is called, plus all the various forms of homeworking and 'odd-jobs'. This layer of activity, lying below or alongside the market, has reached sufficient proportions to attract the attention of several economists: some have estimated that it may represent 30 or 40% of the gross national product, which thus lies outside all official accounting, even in industrialize countries.
... and just imagine what that fraction might be for present-day China.

As you can probably imagine, what I find interesting about Braudel is how he traces back, right to the dawn of capitalism, its most basic feature -- to (continue to) be a capitalist, you have to find some way to avoid competition, some way to avoid the free market. There are many ways to do this, but that is the fundamental task of any system that purports to have capital make more capital. I will avoid belaboring analogies to evolution; let me simply suggest that for the market, profits are dinner, whereas for the capitalist, they are life itself.

For some strange reason we are still surprised by this, and still equate capitalism with the free market, when nothing could be more anti-thetical in fact. The same strange logic induces us to think that Goldman Sachs wouldn't ever try to manipulate the government and that the government, in turn, would never go into business with Goldman Sachs.

Ethics will never defeat mechanism. Ethics is nothing but the cold dead invisible hand of mechanism.

Careful ...

Soon I will be able to sue for you thinking this blog out loud.  Here's the latest complaint about Amazon's new version of the Kindle.
Some publishers and agents expressed concern over a new, experimental feature that reads text aloud with a computer-generated voice.

"They don't have the right to read a book out loud," said Paul Aiken, executive director of the Authors Guild. "That's an audio right, which is derivative under copyright law."


Barry does BARF

Barry Ritholtz has an entirely appropriate comment about the reaction to Geithner's speech yesterday.

I am out of the pocket most of today, but I had to address what I see as a misread of the reaction to the latest Bailout plan.

Both the NYT and the WSJ seemed to focus on the lack of details as the cause for the selloff. But that conclusion is belied by the "sell the news" reaction immediately as Geithner began speaking. No one could have digested anything iin that milli-second.

I have a decidely different take. Wall street was hoping for another multi-billion, no strings attached, taxpayer funded giveaway.
Instead, they got something much tougher than they expected.

Hence, the selloff/tantrum.

They wanted their candy and didn't get it…

This is almost certainly part of the story, as there was a lot of tough talk about protecting taxpayers coming from all sides.  Of course, this wouldn't exactly explain why the rest of the market also fell, and not just the financials, which would have been a continuation of the trend we have seen so far this year.  I also don't know why Ritholtz puts it as an either/or.  The guys who trade the banks were expecting another bailout, and the investors were expecting a real plan, and everybody was disappointed.


BARF it up

Yves collects comments on the new Potemkin Plan as she calls it. She was a critic to begin with, so it would have taken a lot to impress her (and her buddies think similarly) but still, the variety of negative reactions to the non-plan that she adduces is pretty stunning.

Tuesday, February 10, 2009

Reactions to BARF

The new and improved Bad Asset Relief Fund.

Krugman thinks it might be okay, mostly because nothing substantive was said. He calls it the Rorschach Plan, and I don't think he's referring to the Watchmen.

What is in it, in reverse order:

1. Super-TALF: a big expansion of the Fed's quantitative easing, with Treasury backing. I'm OK with that.

2. Private-public purchases of questionable assets; as I understand it, private investors would be the junior partners, so this is probably not a big giveaway (unless there's huge public financing, in which case it amounts to ring-fencing after all). I also suspect it wouldn't accomplish much, but no harm, no foul.

3. Stress test: everything depends on how this is actually implemented. What happens if, or more likely when, a major money center bank is stress-tested and found to have negative net worth? One possibility is that the auditors are told to come up with a different answer; that's a big concern. The other is that the bank is effectively nationalized; as I read the language that could be achieved as part of the public capital injection.

So what is the plan? I really don't know, at least based on what we've seen today. But maybe, maybe, it's a Trojan horse that smuggles the right policy into place.
Since when has Krugman become an optimist about the government? I think his Nobel prize money maybe enabled him to get a better dealer.

Wolf is totally unconvinced. He thinks that these guys still optimistically imagine that what the banks are telling them is true and that everyone is just panicked and the banks aren't insolvent.

... rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a "no brainer".

The new plan seems to make sense if and only if the principal problem is illiquidity. Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers. Indeed, any toxic asset purchase or guarantee programme must be an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions: ineffective, because the government must buy vast amounts of doubtful assets at excessive prices or provide over-generous guarantees, to render insolvent banks solvent; inefficient, because big capital injections or conversion of debt into equity are better ways to recapitalise banks; and inequitable, because big subsidies would go to failed institutions and private buyers of bad assets.

Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing.

The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new "good banks", leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new "bad banks", leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic.

Brad Sester strikes his characteristically measured tone. As always with this stuff, the question hinges around what price to pay for the assets, and how much of the losses the government is going to guarantee.

... the US Treasury will propose a fourth option: providing credit to private investors that are willing to buy the banks toxic assets.

Private investors then would have to figure out the right value of the banks existing toxic assets. In return, they would get all of the upside. They would also take some of the downside. But perhaps not all the downside.

If the government provided credit to private investors who put up cash to buy toxic asses, the private investors would take the first loss. That discourages overpayment. But with a non-recourse loan the government on the hook if the value of the toxic assets fell by too much. The private investors could extinguish its debt by handing the toxic assets it bought over to the government.

This seems like a transaction that requires the government take on additional risk. But that probably isn't totally accurate, as the government already in some sense has most of this risk.

So long as the government is committed to protecting the banking system's creditors – depositors, money market funds and bondholders – from losses, the government already has most of the downside risk on these toxic assets. There isn't much bank equity left. As a result the government is already on the hook it the banks' end up taking additional losses on their toxic assets. If the government provided financing to other actors willing to buy the banks bad assets, the government would have more exposure to those players' toxic assets, but less to the banks' toxic assets.

You can already see how this is shaping up to be a slight of hand that people outside the financial industry are unable to follow. First you set up a structure with a sliver of government equity. You let a bunch of big hedge funds put up more equity and become both limited partners and part owner of the general partner. That is, they put capital at risk, but they also get to charge fees for managing the capital. Next, you use a government backing on this structure to leverage the shit out of it. The hedge funds being invited to the dance will lobby for as much leverage as they can get, because the government is going to back the structure and limit the losses. Now you hold your nose and you go out and buy up toxic waste. There's no reason to be overly careful about the price you pay, no reason to build in any margin of safety, because the deal is structured as an option anyhow. Let's say you buy the assets for 50 cents on the dollar and they turn out to be worth 50 in 5 years. In the meantime you collect the high yield and pay interest at the rate the government (your partner and guarantor) can borrow at, and you make a fortune because you get to take home the fees and your share of the spread, all of this leveraged out the wazoo. If you are lucky and buy the assets below their eventual value, you really hit the ball out of the park. And if you "goof" and overpay for them you still get to milk the spread and fees for a few years while you wait for these things to default. By then, you've gotten back a lot of your capital. So maybe your downside is losing 50% on the investment -- no matter what you pay for the assets -- and your upside is enormous because of the leverage. You bought an option, and the taxpayer is the lucky counterparty.

So, what are the variables in this structure. The price for the assets, the amount of losses the government is going to guarantee, and the leverage. As Krugman points out, if the guaranteed losses are high, this is "ring-fencing" by another name, and just loots the taxpayer. However, if you don't guarantee enough, then the private capital that comes in will drive a hard bargain, and you will low-ball the banks into insolvency, given that current estimates put the forthcoming losses at $1T plus . If the government were willing to buy a lot of bank equity, this would be fine, but this is going to take a whole lot more than the $350 billion of remaining TARP money, even assuming that this time you don't blow nearly a third of it bailing out your buddies.

This brings us the part of the plan where the government kicks the big banks' tires to decide whether they need more equity. Krugman is right here again -- the devil is in the details. If you get the first part of this delicate structure right and guarantee just the right amount of toxicity to attract private capital without encouraging them to simply overpay and recoup everything from milking the fees, you still have the other side of the coin, which is convincing the banks to sell at these prices, which are still below their marks, and could throw them into bankruptcy.

Sester puts it this way:

So long as a bank can rely on the government to prevent a run (thanks to the government's guarantee that creditors of large banks won't take losses; i.e. "no more Lehman's") the banks current owners may prefer to sit on its toxic assets and hope the market recovers.

Finding private buyers doesn't solve this problem. No bank has much incentive to sell its toxic assets at a price that would leave the bank bankrupt. Not selling is one way of gambling for redemption.

Breaking this logjam presumably is the purpose of another reported component of the reported Financial Stability Plan: a review of the balance sheets of large banks and, if needed, additional injections of equity capital into troubled banks.

The fact that you can simply take over the equity of most of the US financial system for around $400 billion (the stocks have gotten crushed) and so avoid dealing with valuing anything at all, suggests that all of these gyrations, as Wolf correctly points out, are due to nothing more than our deathly deathly fear of the N-word. This in turn suggests that the Treasury really, really doesn't want to own and control these banks, which, if the loss estimates are correct and the system is in aggregate insolvent, means either that they are going to fake the solvency of the banks by overpaying for the assets via this hedge fund rope-a-dope structure (a marketing breakthrough that simply makes it look like private capital is on the line thus surmounting the initial resistance to the TARP I overpay) or via some tweaking of the accounting rules so that after the Bad Assets are removed we can pretend the newly zombified banks are not walking corpses.

Anyhow, in sum, while it's not inconceivable, I think you have to be pretty generous to see this as anything but a politically expedient way of bailing out the banking system at taxpayer expense. It is meant to balance not hurting the bondholders, not completely giving away money to the equity holders, and not offending the precious goal of bipartisanship by nationalizing the banking system. Unfortunately, while I might support those goals in theory, I think the combination of forces at work here essentially guarantees a multi-year Japanese style deflationary slump. The only other option would be to devalue the dollar relative to gold and every other currency via inflation, and I've come to believe that this is a much longer term outcome.

UPDATE: Jim Hamilton also has some comments on the plan. The synopsis:
Oh, dear. We obviously don't have clear details of the plan, only the concept, but it sounds to me like the wrong concept. As I've argued before, there basically are five parties who might be asked to absorb the losses on existing assets, namely, stockholders, creditors, managers, employees, and the taxpayers. My favored concept is, we use player 5 to get as much leverage as possible out of the first 4. It appears that the Treasury's concept is instead a continuation of Plan A, namely, hope that if we hold on tight and keep the ship from sinking long enough, everything will turn out OK.

Well and Truly ...

Well, this article basically sums it up; it appears that the government game of three card monte is set to go on indefinitely, and while this will certainly help Geithner secure a position at Goldman Sachs when our depression really gets going, it's unlikely to help the rest of us avoid it.

The leader:

WASHINGTON— The Obama administration's new plan to bail out the nation's banks was fashioned after a spirited internal debate that pitted the Treasury secretary, Timothy F. Geithner, against some of the president's top political hands.

What did he prevail on?

Mr. Geithner, who will announce the broad outlines of the plan on Tuesday, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.Because of the internal debate, some of the most contentious issues remain unresolved.

This, my fellow taxpayer, makes it clear not only what he prevailed on, but who he prevailed upon.  If that doesn't sound promising, wait till you get to the meat of the proposal, which is a puzzle wrapped in an enimga inside a fig newton.

It intends to call for the creation of a joint Treasury and Federal Reserve program, at an initial cost of $250 billion to $500 billion, to encourage investors to acquire soured mortgage-related assets from banks.

The Fed will use its balance sheet to provide the financing, and the Federal Deposit Insurance Corporation might provide guarantees to investors who participate in the program, which some people might call a "bad bank."

A second component of the plan would broadly expand, to $500 billion to $1 trillion, an existing $200 billion program run by the Federal Reserve to try to unfreeze the market for commercial, student, auto and credit card loans. A third component would involve a review of the capital levels of all banks, including projections of future losses, to determine how much additional capital each bank should receive.

Ummm ... so let me get this straight.  We're going to set up a fund so that private investors like myself can do what we all can do now anytime and in any amount we want -- namely buy discounted toxic waste on the open market.  How can this solve the problem?  I would be buying if I could get a good price where I could make some money.  Unfortunately, the banks are not offering this price because they would then have to write the toxic waste down and would be insolvent as a result.  The only way the government is going to induce me to "acquire soured mortgage-related assets from banks" is to lower the rpice or guarantee my losses beyond a certain point.  If they force the banks to lower the price, they then have to recapitalize them.  If they guarantee the assets, I'll buy them at whatever price they want, but then the government will eat the losses if they pay too much for the assets or guarantee too much of the losses.  There is NO WAY AROUND this fundamental problem.  Someone is going to take the losses on these loans that have not been marked to market (an amount estimated at $1 tillion plus right now).  It will either be:
  1. The banks, their bondholders and shareholders.
  2. Private investors who buy these things from the banks at their current book value.
  3. The government, if they buy these things from the banks at current book value.
  4. Some combination of the above.
It's clear that what Geithner wants to do here is pretend that he's not giving money to the banks (not eating their losses) by partnering with private investors so that it looks like the government is buying the assets at a discount.  Then he wants to pull a fast one by using his other hand, the FDIC, to take away all the risk that his first hand will claim these private investors have taken on.  It's a complete and total sham.  There is no other way to look at it. 


Monday, February 9, 2009

The Good Bank

I liked the idea of this proposal when I first read it, and as Buiter points out, it has been floating around in various forms both before and since his original comments. I thinkt he idea of starting from scratch with a good bank funded by the government makes a lot more sense than trying to sort out how to prop up the system we have by creating a bad bank to take over the toxic waste. I mean, from the perspective of the public, all we need is a functioning banking system. This is why the existing banks are too-big-to-fail -- because it is impossible to replace the Ponzi scheme intermediation of the banking system overnight, not because they are somehow magical.

When you look at it from this larger perspective, in which you see banking as a relatively low-risk, public-good, utility-like business that shuttles capital from mom and pop's pocketbook to the guy who wants to build a factory, you wonder why this isn't a perfect opportunity to get into the banking business. The competition has its hands tied dealing with its earlier excess. No one is making loans despite the cost of money being essentially zero. Sounds like easy money, no? And you already do see this, only the government's clumsy lumbering around the sector changing the rules around every five minutes doesn't help. It's already a big undertaking to start a bank, and if you don't have any idea what the landscape will look like in 6 months because you know who the government will bail out or how, you will be reluctant to go into this business. The government could solve all of this in one swell foop by itself going into the banking business in partnership with private capital, which is what Buiter proposes.

The logic is simple. Many (probably most, possibly all but a handful) high-profile, large border-crossing universal banks in the north Atlantic region are dead banks walking - zombie banks kept from formal insolvency only through past, present and anticipated future injections of public money. They have indeterminate but possibly large remaining stocks of toxic - hard or impossible to value - assets on their balance sheets which they cannot or will not come clean on.

This overhang of toxic assets acts like a tax on new lending. Banks are required, by regulators or by market pressures, to hoard capital and liquidity rather than engaging in new lending to the real economy. The public financial support offered in the form of capital injections (in the US mainly through preference shares and other non-voting equity), guarantees for assets and for liabilities (old and new), insurance of toxic assets (as provided to Citigroup by the US sovereign) and possibly in the future through direct purchases by the state of toxic assets (using TARP money in the US) and the creation of one or more publicly owned 'bad banks' has been a complete failure.

The bad bank proposals the Obama administration and other governments are considering are non-starters, for the simple reason that they require the valuation of assets whose true value (even on a hold-to-maturity basis) can only be guessed at. The good bank proposal only requires the valuation of those assets on the balance sheets of the existing banks that are easy to value: transparently valued assets. The toxic stuff is left on the balance sheet of the existing banks, which become the legacy bad banks.

Offering to pay enough to the existing owners of the toxic assets to induce these owners to sell them would require paying over the odds. That might not leave enough fiscal resources to support the new lending activities that are so urgently needed. It would also be an unfair and moral-hazard-maximising bail out of the existing owners and creditors of the banks. Nationalising the dodgy banks (or even the entire cross-border universal banking sector) would only solve the valuation problem of the new owner (the state) after nationalisation. The toxic assets could be transferred into a bad bank at any valuation, including zero. The owner of the bad bank and of the cleansed bank are the same. Nationalising the dodgy banks would not solve the problem of how much to pay for the banks, however, because that would depend in part on the valuation of the toxic assets. The good bank proposal creates new, publicly owned banks which only purchase good assets from the legacy bank. There is no valuation issue involving toxic assets for the tax payer.

...

Two things are systemically important. The first is to restore the operation of key financial markets that have become illiquid. The Fed is doing a reasonable job in that regard. The second is to restore bank lending to the real economy. Neither objective requires that the existing banks be saved, let alone that their existing shareholders and creditors receive any financial support from the state. We can save banking without saving the banks or the bankers. The 'good bank' proposal demonstrates how to do this.

Feliz Salmon objects to this idea, but I don't find what he says terribly convincing.

For one thing, it's far from clear that there's a shortage of "good banks" in the US right now. One of the big differences between the US and Europe is that the US has many more banks; even the huge ones don't have anything like the market share that big European banks do, and there are thousands of small and tiny banks -- not to mention credit unions -- which have really no European counterparts at all. Many of them -- and even many pretty big banks -- are doing fine.

Putting government capital into new "good banks" would create unhelpful competition for the existing good banks, while providing no help whatsoever for the existing bad banks. Remember that the single biggest problem with too-big-to-fail banks is that they can't be allowed to fail. So even if setting up good banks was a good idea, it would be an insufficient idea, since the big bad banks would still need to be rescued: there's simply no way we can afford a big bond default by the likes of Citigroup or Bank of America, let alone even hint that their uninsured depositors might be in danger.

While it's true that there are good banks, they are finding it tremendously difficult to take advantage of the opportunity afforded them because no one trusts and banks at all any longer. The government good bank could also be structured as essentially just a big pool of capital that lets these banks expand dramatically in a short period of time. That is, instead of competing with the existing good banks, the government could be partnering with them in a transparent fashion. This would be precisely the opposite of "unhelpful competition".

As to his second point, we have to really define what we mean by too-big-to-fail. Why can't they fail? What would happen? Yes, their equity would be worthless. And their bondholders would have to try a recoup their money from the bankruptcy, but so what? I see three objections to letting these banks fail:

  1. Depositors get screwed -- There hasn't been a run on these banks by depositors even though their insolvency is pretty common knowledge at this point, and anyway the problem with a run on the banking system is that the money comes out completely and goes into a sock. If the run simply takes the form of moving your deposits to another account, how is this a systemic problem?
  2. They default on their obligations to other institutions -- There is no question that Citibank announcing that they cannot pay a bond would have an impact on the market. But why does this have to have such an impact? Clearly the equity can got to essentially zero without total armegeddon, given that they equity is already at zero, give or take. Whoever holds the bonds would need to write them down in the case of a bankruptcy. But by how much? From a systemic perspective, the problem with a bank going bankrupt is that it has to liquidate its loan portfolio (including the good loans) at fire sale prices, which, if everyone is doing it at the same time, can result in a general deflationary environment that spirals out of control. But what if they didn't have to liquidate in a hurry. What if the government manages the bankruptcy by taking all of the easy to value assets off the books at good prices? No good loans are called in quickly to meet obligations of the bankrupt estate because the new good bank is happy to make these loans. The bondholders can be paid off from the proceeds of selling these good loans. Any losses to the higher unsecured tranches or the quity will be realized over time as in any bankruptcy. What's the big deal?
  3. New loans don't get made -- We still need somone to go out and make loans and roll over existing good loans. That's the whole point of having a new good bank though. It's not like Buiter, Romer or Soros are liquidationists that propose doing nothing. They simply propose to focus entirely on what is systemically important about the banking system so that its insolvency doesn't force us needlessly stop making as much stuff as we are.

Sunday, February 8, 2009

The New Paradigm for Financial Markets

So, George Soros has written an interesting little book that would be easy to dismiss.

I mean, after all, here is a (wildly) successful speculator turned philanthropist and all around do-gooder who admits in the introduction to the book that he really wants to be know as a philosopher. If you follow these things, you will also know that he has written essentially the same book three times in the last 20 years, each time crying wolf and predicting an end to the "super-bubble" of financial capitalism, and has lately has been ceaselessly flogging his "theory of reflexivity" in the dozens of articles and op-eds his success affords him. And to top it all off, Soros is a quite perfectly atrocious writer, though, of course this is but par for the course in finance; the world's most interesting system as analyzed by bunch of over educated but somehow only semi-literate neanderthals in suits.

In short, you would be forgiven for not taking the book completely seriously, intellectually speaking.

And yet, I think Soros actually has something quietly profound to say. Yes, you have to wade through some 50 pages of what only a very generous reader could describe as "philosophy" (Do we really need repeated explanations of how we both think about the world as well as act in it? Does this come as some sort of new philosophical problem? Does Soros do anything new to help us understand it?). But once you get through this, you realize that Soros has actually outlined, in his own ploddingly schizophrenic manner, a theory of feedback loops that makes a lot of sense, particularly in the context of financial markets.

The basic idea is the relatively simple ones that Keynes (who was admittedly stiff competition, verbally speaking) put much more eloquently -- "successful investing is anticipating the anticipation of others". Soros describes this as the "two way interaction of thinking and reality". Reality, of course, is defined as the actual economic fundamentals at any given moment. Things like how many teddy bears are being manufactured, or how much demand there is for gold. Thinking, by contrast, involves the anticipation of changes in these quantities and the calculation of how they fit together. If lots of people want golden teddy bears and there aren't many of them, their price will increase. The prices of assets in financial markets are in this sense thinking about reality.

Typically, of course, financial market prices and economic fundamentals stay rather closely aligned. Companies who say they are going to make less money next year see their stocks fall, and when guy with a towel on his head can't find reverse on a soviet tank, the price of oil goes up. No mystery here. Neither is it news that prices in financial markets influence the future course of the economic fundamentals they currently reflect. After all, neoclassical economics has touted for a long time that one of the fundamental purposes of a market is as a price signalling mechanism that helps us determine what we need to make more or less of. So Soros is utterly in error when he claims that the idea that prices can interact with fundamentals, and that changes in prices (thinking) can cause changes in fundamentals (reality), is in any way a new idea.

What Soros does contribute, however, is a more general theory about the way prices and fundamentals interact. He calls this his "theory of reflexivity". He simply means that prices and fundamentals are involved in a feedback loop, and that they reciprocally impact one another. As I say, classical economics understands this quite well, but assumes that the feedback loop is always a negative feedback loop, the type of feedback loop you find in control systems such as a thermostat that tend to maintain themselves at equilibrium. Usually this is a pretty good assumption. If I see my neighbor charging a fortune for his new housingdefaultswap.com website, I might be tempted to get in on the act and make one for myself. The high price leads to an increased supply which leads to a low price. The system tends towards equilibrium.

Soros simply points out that this negative feedback loop, where random fluctuations tend to damp themselves out, is really a special case (even if it is the more common one). Sometimes prices and fundamentals interact via a positive feedback loop where higher prices lead to even higher prices, or vice versa. Economics doesn't deal with these situations too much for a very good reason -- they lead inherently in the direction of infinity. Infinity, as usual, is a problem. Some days, I think infinity is the only problem, but that's a story for another post. Anyhow, because of the counter-intuitive idea of prices spiraling upwards (or downwards) in a feedback loop, and the mathematical intractability of any system that works like this, we have tended to ignore this possibility. Which is odd, because there is absolutely overwhelming evidence that it happens all the damn time in the real world.

As a thinking person, you can't work in the financial markets for more than five minutes and still believe that they are perfectly rational efficient equilibrium-tending mechanisms. This idea has always been a farce; what Soros does is describe a simple mechanism by which the markets might tend away from equilibrium. Consider the interaction between the price of a house and how much money you are willing to lend against it. As the value of the house increases, a bank will be willing to lend you more money against this more valuable collateral. If you go out and spend this money on remodeling your house, you will complete a feedback loop where an increase in the price of housing causes the bank to lend more, which causes the price of housing to increase further in a runaway loop.

Stop me if you see where this is going.

There are millions of examples like this, and the point Soros wants to make is that these positive feedback loops live alongside the more common negative ones. In the housing example, the rising prices --> rising debt --> rising prices loop lives alongside the more typical rising price --> increased supply --> lower prices loop. Normally, the (dare we call it ecological?) interaction of these forces leads to a more or less stalbe equilibrium, but this result is not guaranteed in advance, and in some cases, for whatever reason, the positive feedback loop runs out of control and we have what people commonly understand as crashes and bubbles.

Why Soros feels the need to bring up Karl Popper, truth, fallibility and naive enlightenment ideas about scientific progress in this context remains a bit of a mystery to me, but, hey ... everybody should have their day to pontificate in the sun. At any rate, the basic idea is quite simple and really pretty important.

Like most people who think they've said something smart, and like pretty much anyone who considers themselves a philosopher, Soros applies his idea to e-v-e-r-y-thing. Fortunately, I think it's actually a pretty profound idea that you can usefully apply to all kinds of things.

It really is a sort of new paradigm for the financial markets, in contrast to the idea that they are efficient. It gives a (somewhat vague, admittedly) framework for thinking about market mechanisms, and separates out their complexity into two basic types, positive and negative feedback loops. As far as its direct usefulness for succesfully trading ... well, I think you probably have to be George Soros to make money off this idea. After all, he's really just pointing out that momentum trading works under certain circumstances. Once a feedback loop catches on, it will keep going until it blows up, one way or another. You should be able to make money if you identify these mechanisms in the early phase, but its anybody's guess how long a fuse these things have.

I also think his application of the theory to politics is not entirely misguided. Soros is a classic liberal, and was a major critic of the Bush administration. In the book he argues that Bush manipulated the media (our thinking) so that it became completely divorced from reality in the same way that prices and fundamentals get divorced in a financial bubble. Here he shades into philosophy when he should be more careful to talk about mechanism (there are clear feedbacks loops in our political system -- campaing finance and media access and regulation, to cite the simplest ones), but seeing the Bush years as a phenomena similar to a financial bubble is interesting. He refers to this idea as his "super-bubble" theory, and it is part political observation and part analysis of the long credit boom that has occurred since Reagan took office.

Now you can start to think about the structure of a system that is really always out of equilibrium, particularly as you increase the scale at which you consider it; start pondering bubbles within bubbles and other larger-scale phenomena, and you quickly do get into really philosophical territory. After all, the industrial revolution, the evolution of talking monkeys, or the consciousness of an ant colony doesn't sound much at all like a system at equilibrium. "Reflexivity" at this level starts to look like a basic way of restating the theory of immanence (there is no vantage point outside the world) and a stab at perhaps the most fundamental classification of algorithms -- ie. some go on and on, and some stop.

Right so enough already. The last thing is that I found that the book combined well with Nassim Taleb's Black Swan ideas. Taleb would love to beleive that he's being more precise and scientific than Soros the philosopher, but in reality all he points out is that the statistics of the market pretty clearly indicate that it is not efficient because the distribution of outcomes has much fatter tails than you would expect if it were. Fine. But it's not like the guy ever proposes a mechanism for how his alternate Black Swan distribution is actually produced. Maybe you have to pay him $50,000 to eat lunch with you in order to find this out. So while Taleb highlights the off-kilter statistics of a chart like this, Soros actually gives you an idea of what mechanism might have produced those numbers: