Marginal Revolution

Markets in everything

Kiwi song videos about chess boxing.  The interviews produce several remarks of interest plus some nice accents.

Over the last year a few of you sent me links about chess boxing.  I thank you all but I rejected your mainstream taste to hold out for something quirky.

Prophets of Accountancy

Here is Franklin Allen and Elena Carletti, circa 2006:

When liquidity plays an important role as in times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. We show that a shock in the insurance sector can cause the current value of banks’ assets to be less than the current value of their liabilities so the banks are insolvent. In contrast, if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities. Mark-to-market accounting can thus lead to contagion where none would occur with historic cost accounting.

Here is a comment on that same paper.  I thank Scott Cunningham for the pointer.

The Economic Consensus v. Politics

The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.  Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself.  Krugman would prefer a recapitalization in the form of nationalization.  In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.)  In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways. 

The consensus policy of economists would put most of the burden of adjustment on politically powerful holders of equity and bonds.

There is also a consensus among economists that the bailout bill is not the right policy.  None of the above economists, for example, is enthusiastic about the bailout.  My bet is that all of us think that the bailout has a substantial likelihood of failing.  The support that exists is born out of hope and fear not judgment and experience.  Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.   

Addendum: Lynne Kiesling draws the Olsonian conclusion.

Concise Encyclopedia of Economics

It is now on-line.  Contributors include Armen Alchian, Gary Becker, Avinash Dixit, Claudia Goldin, Greg Mankiw, Paul Romer, Pete Boettke, Tyler Cowen, Bryan Caplan, Russ Roberts and many others.

On another topic, from elsewhere, here is Arnold Kling on net worth certificates.  And here is Russ Roberts on home prices.  Here is Bill Easterly's Op-Ed on development and the crash.

How did the credit rating agencies misfire?

A second view is that because the methodologies used for rating CDOs are complex, arbitrary, and opaque, they create opportunities for parties to create a ratings “arbitrage” opportunity without adding any actual value. It is difficult to test this view, too, although there are reasons to find it persuasive. Essentially, the argument is that once the rating agencies fix a given set of formulas and variables for rating CDOs, financial market participants will be able to find a set of fixed income assets that, when run through the relevant models, generate a CDO whose tranches are more valuable than the underlying assets. Such a result might be due to errors in rating the assets themselves (that is, the assets are cheap relative to their ratings), errors in calculating the relationship between those assets and the tranche payouts (that is, the correlation and expected payout of the assets appear to be higher and therefore support higher ratings of tranches), or errors in rating the individual CDO tranches (that is, the tranches receive a higher rating than they deserve, given the ratings of the underlying assets). These arguments are complex and subtle...

That is from a very interesting paper by Frank Partnoy.  The paper is not always easy reading but so far it is the best piece on its topic I have found.  This was another good section:

If the mathematical models have serious limitations, how could they support a $5 trillion market? Some experts have suggested that CDO structurers manipulate models and the underlying portfolio in order to generate the most attractive ratings profile for a CDO. For example, parties included the bonds of General Motors and Ford in CDOs before they were downgraded because they were cheap relative to their (then high) ratings.67 The primary reason that the downgrades of those companies had an unexpectedly large market impact was that they were held by so many CDOs.

Thus, with respect to structured finance, credit rating agencies have been functioning more like “gate openers” rather than gatekeepers. The agencies are engaged in a business, the rating of CDOs, which is radically different from the core business of other gatekeepers. No other gatekeeper has created a dysfunctional multi-trillion dollar market, built on its own errors and limitations.

There is also a good discussion of how the ratings agencies have claimed First Amendment protection for their activities, more or less successfully.  p.96 offers some good policy conclusions.