Marginal Revolution

Regulatory accountability

A handful of the agency’s [Office of Thrift Supervision] officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.

Here is the story, interesting throughout.  One response to this anecdote is to think we simply needed more regulators on the scene and indeed on many other scenes as well.  A different response is to conclude that institutions of many different kinds work less well than we used to think.

What are the remaining pressure points?

Do read up on Arnold Kling before proceeding.  From my outsider's vantage point, it seems that commercial bank failures and consolidations are already being handled (see Alex's recent posts) and of course the investment banks are gone.  Money market funds are now (mostly) insured.  I see three key questions for the next few weeks:

1. Will there be a run on hedge funds?

2. Will the commercial paper market dry up?

3. Will the Fed have to bail out any major foreign banks?

At this point, perhaps the Paulson plan is directed against these contingencies rather than being for the commercial banking sector per se.  From this list, it is least clear how the Paulson plan would handle #2, although you could point to a short-run confidence effect.  Will that last?  #2 is the hardest to handle without implicitly socializing parts of the real economy and if you have good proposals for #2 please let us know.  How much can corporations bypass the commercial paper market altogether? 

"Recapitalization is a public good" is one key phrase for this crisis; "no natural buyers" is another.  So far debate over the plan has focused on the first phrase but not the second.

Addendum: Bruce Bartlett defends the Paulson plan.  So does Kudlow.

Substitute Bridges

Binyamin Appelbaum at the Washington Post should get an award for writing a story so much at odds with the conventional wisdom.

Banks throughout the United States carried on with the business of making loans yesterday even as federal officials warned again that their industry is on the verge of collapse, suggesting that the overheated language on Capitol Hill may not reflect the reality on many Main Streets.

.... many smaller banks said they were actually benefiting from the problems on Wall Street. Deposits are flowing in as customers flee riskier investments, and well-qualified borrowers are lining up for loans.

"We collect money from local savers, and we lend it in the local community," said William Dunkelberg, chairman of Liberty Bell Bank in Cherry Hill, N.J. "We're doing fine. There are 9,000 financial institutions out there, and most of them are small and most of them are doing fine."

Dunkelberg, a professor of economics at Temple University and chief economist for the National Federation of Independent Business, added that a recent survey of that group's members found that only 2 percent said getting a bank loan was the great challenge facing their businesses.

Even some of the nation's largest banks, which have pushed hard for a federal bailout, deny that the current situation is forcing them to reduce lending. "The strength of our core businesses, capital and liquidity are enabling us to continue to support our customers," Bank of America, the nation's largest bank, said in a statement. It added, however, that the bailout plan would allow more lending.

The most recent Federal Reserve data show that the volume of outstanding bank loans declined 0.5 percent from the last week of August to the second week of September, though it was up more than 6 percent from the corresponding time last year.

The article goes on to discuss some of the real problems in the industry and do bear in mind that the majority of deposits are in big banks.  Nevertheless, I found the perspective valuable.  As I have argued, we should be paying more attention to the institutions that are doing well and can serve as substitute bridges to keep credit flowing to firms with valuable projects.  I have also advocated increasing savings with a temporary savings stimulus package - this could involve expanding and making contributions to Roth IRAs tax deductible or something like promising no taxes on CD investments of 1 year maturity or longer that are made in the next year .

Is a Potential Bailout Making Things Worse?

Ken Rogoff says yes.  Elizabeth Warren at Credit Slips summarizes Rogoff's discussion at a Harvard Roundtable (video):

Any liquidity crisis is caused by the promise of a government bailout. Ken said [Actually this was Greg Mankiw, AT] that his many friends in investment banking said that there is plenty of money to invest in financial services, but right now it is "sitting on the sidelines."  Why?  Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity).  As he put it, why do business with Warren Buffett who will negotiate a tough deal, if you believe that the government will ride in soon with cheaper cash? 

Ken [this is correct, AT] also talked about the need to shrink the financial services sector. He thinks it is good that the investment banking houses are failing and many people on Wall Street are losing their jobs because, in his view, we have an oversupply in that sector and our economy just can't support it.   

Ken's background with the IMF and on the Board of the Federal Reserve add a certain credibility to his assessment of conditions on Wall Street.  If he is right, the $700 bailout is saving some investment bankers' jobs in the short term, but overall it is just making the financial system worse.

In a related point Felix Salmon suggests that the Ted Spread may not be a valid measure of distress when the Fed is providing lots of liqudity.

...if you're a bank, you really neither want nor need three-month interbank funding right now. Global central banks, led by the Federal Reserve, have flooded the system with so much overnight liquidity that you can get as much cash as you need, at a much lower interest rate, directly from your central bank, overnight. The choice between that and locking in a high interest rate for three months is a no-brainer.

The WaMu Speed Bankruptcy

The Washington Mutual "speed bankruptcy" seems like a good model for the rest of the industry.  The FDIC took over the bank, wiped out the shareholders, and immediately auctioned it off to JP Morgan who paid $1.9 billion. Depositors are secure.

Notice that to do the deal, JP Morgan raised $10 billion in the equity markets and their shares rose.  Moreover, the issue was oversubscribed so they may go back for more.  All this illustrates that at least some of the substitute bridges from savers to investors that I have talked about continue to work (on the latter point see also Arnold Kling and Steve Landsburg). 

Hat tip to Garrett Jones.

Sentences to ponder

Call it the biggest carry trade in history.

Here is more.

It's a bird, it's a plane, it's Jetman

What we need today is a superhero.  Thus, I give you Jetman.

Swiss adventurer Yves Rossy flew from England to France Friday propelled by a jetpack strapped to his back -- the first person to cross the English Channel in such a way.

Rossy, a pilot who normally flies an Airbus airliner, crossed the 22 miles between Calais and Dover at speeds of up to 120 mph in 13 minutes, his spokesman said.

Quoted here.  More pictures here.

What do the Republicans want?

Under the alternative Republican plan, the government would set up an expanded insurance system, financed by the banks, that would rescue individual home mortgages. The government would not have to buy up the toxic mortgage-backed assets that are weighing down financial institutions.

Here is the story.  Is this the Jeffrey Ely plan (you heard it here first!)?  Do any of you have more information?  Does the Paulson-Bernanke rejection of this plan count as a very bad signal about the immediate solvency of major banks?

Another modest proposal

This one is even more modest than the last.

Let's say you have ten banks and two of them are insolvent.  But you don't yet know which two.  So the credit market is messed up for all ten because at some sufficiently high level of risk credit just shuts down.  The goal then is to reveal which two of the ten banks are insolvent.

I've been thinking of all those old puzzles where a bunch of guys enter the room and only so many of them have smudges on their foreheads and you have to find the algorithm to reveal that information.

What can be done?  Temporarily allow insider trading, with short selling of course?  (Bryan Caplan's idea)  Make executives either resign or post personal bonds, where default of the bond follows if the bank ends up insolvent?  Change laws and make banks exhibit their books to the public and let traders sort it out?

I don't know.  But maybe sorting out the bad banks is one alternative to finding and isolating the toxic assets.  Because once all the remaining banks are good and known to be good, the problem of toxic assets no longer seems so paralyzing.

I'm still not sure that the Treasury buying bank assets is to best way to make this sorting, and that's leaving aside the price tag.  In fact maybe Treasury buying postpones this revelation of information.

Of course if eight of the ten banks are bad, maybe we don't even have the luxury of asking these questions.

What really caused the financial crisis?

Kashyap, Rajan, and Stein have lots of explanation but here is the initial bottom line:

The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept
on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing.

In other words, one problem was not enough (!) securitization.  They also call for counter-cyclical capital requirements.  They like mandatory capital insurance -- with payments triggered by capital disasters -- even better.  My main worry, of course, is how we should regulate (or not) the entities which offer this insurance.  Will they too engage in liquidity transformation and if so who ensures them?

And, going back to banks, part of the governance problem was this:

...it is very hard, especially in the case of new products, to tell whether a financial manager is generating true excess returns adjusting for risk, or whether the current returns are simply compensation for a risk that has not yet shown itself but that will eventually materialize.

Their phrase "recapitalization as a public good" should not soon be forgotten.  And it is leverage which is dangerous, a lesson becoming clearer every day.

This paper is essential reading for anyone following the crisis and it makes more sense than just about anything else I've read on the topic.  I thank David L., a loyal MR reader, for the pointer.

Who should make this decision come January 20?

Israel gave serious thought this spring to launching a military strike on Iran's nuclear sites but was told by President George W Bush that he would not support it and did not expect to revise that view for the rest of his presidency, senior European diplomatic sources have told the Guardian.

Here is the story, from The Guardian.  I hope you all have given this matter some thought...

Greg Mankiw defends the Paulson plan (from a distance)

Read the whole thing, which is full of economics.  I think the bottom line is this part:

...that's [capital injection] a complement to an asset purchase plan, not a substitute -- and it's one allowed by the Treasury proposal and indeed envisaged in some cases. But that will take much longer to implement than an asset purchase. That's why it's a complement not a substitute -- Treasury needs to act now.

In other words, we are going to get both the Paulson plan and the Dodd plan, or some modified versions thereof.  It was never either/or.  Note that if Greg's arguments are correct things are very bad indeed.  The outstanding open question is why markets don't now, pre-plan, successfully trade the toxic assets in sufficient quantities.  But they don't.

WaMu fact of the day

With $310 billion in assets (hat tip Nemo), WaMu would be the biggest bank failure in history - in fact it would be larger than the previous top ten added together (although maybe not in inflation adjusted terms).

Here is the link.

Quotable quotes

Mercedes scoffs at such notions. "It is really, really difficult to harm a horse with massage, especially if all you're using is your hands."

Here is the story and that is from The Washington Post.  Apparently it is legal to give a human a massage in Maryland, and legal to shoe a horse in Maryland, but not legal to give a horse a massage in Maryland unless you own that horse.  And there is no way to get the appropriate license.  The Institute for Justice is taking up the case.

New York Times economics blog

There is a new one, find it here.  The writers include David Leonhardt and Catherine Rampell.  Hat tip to Tim Harford.

A Supply Side Approach to the Crisis

Yesterday I pointed out that credit is still robust.  Growth rates are declining, however, and many people say the real crunch is around the corner.  Thus, today I want to suggest a new approach to dealing with the crisis that will have benefits regardless of how the crisis unfolds.

I see the key issue as follows: Banks bridge the gap between savers and firms.  We want to keep capital flowing to firms even when some of the bridges collapse.  One approach tries to prop up the collapsed bridges, a second approach tries to route funds across substitute bridges.  A third approach is to increase the flow pressure - in other words, I suggest a temporary but large stimulus to savings.

I suggest that for the next 12 months contributions to an IRA account will never be taxed.  We can modify this in various ways to cap contributions at a certain level etc.  We can even make the proposal progressive - for the next 12 months contributions to an IRA account will never be taxed and the government will match $1 for every $10 saved for anyone with income below a certain threshold.  The main idea is to increase savings.

The increase in savings will help deal with our current problems by offsetting any credit crunch.  (Some of the savings will also help to recapitalize banks.)  In addition, the U.S. needs a higher savings rate regardless.  During the 1990s as measured savings rates declined to zero commentators argued that rising asset values compensated.  Well asset values are now falling so true savings are negative - thus we need to increased savings.

A big benefit of this proposal - lower taxes, higher savings and a savings bonus to those with lower incomes - is that it should appeal to both the right and the left.

Questions that are rarely asked

Was September 2008 the month of greatest increase in United States Wealth in History?

Doesn't the long term economic impact of 5-10 trillion dollars of offshore oil overwhelm the trillion dollars from the bailout?

That's from Andrew, a loyal MR reader.  He sends along this link.  I have not myself done any calculations of the fiscal benefits from such oil (which are distinct from the price effect, which is likely small).  Does anyone know a number?

At first I thought he was going to mention the recent decline in the price of oil, which on average you can expect to be permanent.  The real lesson, I would say, is how much coordination (or lack thereof) matters and how badly representative agent models perform in explaining the most important economic changes.

Interest rate swaps

The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005.

That's from Wikipedia. You'll see other estimates as well, although they fall within a few hundred trillion of this number.  If it makes you feel any better, swap numbers usually measure the total liabilities in the market, not the size of the swapped payments.  So you could argue that "the real number" is maybe 1/20th of this or so, with error margins of only trillions remaining.

Oddly economists don't have a clear explanation for swaps.  In a classic "plain vanilla" swap you trade a fixed rate interest payment for a floating rate payment and of course the swaps occur across currencies as well.  So here's a typical story: Bank A takes out a floating rate loan in terms of Swiss francs (from C) and Bank B takes out a fixed rate loan in terms of Japanese yen (from D).  Bank A and Bank B then decide they each would rather have each others' liabilities and so they swap interest payments.  That's called the comparative advantage theory.

But why didn't Bank A borrow in yen from D to begin with?  And why didn't Bank B borrow in Swiss Francs from C to begin with?  OK, they "changed their minds."  Is that how you get to all those trillions?

Or maybe lender D didn't trust Bank borrower A in the first place and would have charged an excess risk premium.  But then why does Bank B trust Bank A so much? 

Is there a regulatory arbitrage argument here?  Under Basel I, a bank might prefer to get a non-risky loan off its books to avoid the associated capital requirements.  Clearly that drives some of the market but regulators have been working on remedying that problem and no one was expecting the swaps market to disappear as a result.  Furthermore the interest rate swaps predated the Basel agreements.  Another regulatory arbitrage argument cites the difference between the U.S. and Eurodollar markets.

Here is one survey of explanations for interest rate swaps.  The explanations mostly seem lame and question-begging to me.  Here is another survey of potential explanations of interest rate swaps.  Good luck and I hope you have JSTOR access.  Here is a useful non-gated summary.

It is a shame that economists have devoted so little attention to understanding interest rate swaps.  It's hard to get the data for doing first-rate quantitative finance work, so the topic tends to be ignored.  Right now it would be nice to know how much of this market is real gains from trade and how much is a zero- or even negative-sum game of some kind.  I believe that practitioners have a better sense of this than do the academics, myself included.

The bright side is that -- as far as we've been told -- this massive, unregulated interest rate swaps market has not been a major driver for troublesome counterparty risk.  The credit default swaps have been the culprit there, in part because those latter markets are based on large, discrete default events, which kick in quickly and require very large surprise payments.

Betting markets in everything

Will Congress approve a bail-out package for banks before September 30?  Right now the contract is selling at about 79, which usually translates roughly into a 79 percent chance of approval. 

Note however that the marginal utility of money here does differ across worldstates.  Assume that the marginal utility of money is higher (people are poorer) with no bail-out.  That makes some people want to bet against the bail-out as a form of insurance, thereby raising the price of the "no bail-out" contract.  (Addendum: that was bad phrasing -- no one has to intend insurance as long as the MUs of money differ across the world-states.)  In other words, the real implied chance of a bail-out is higher than 79 percent.

Jeffrey Ely's mortgage proposal

We all need more creative thinking and Jeff is one of the best people to supply it:

True just sending money is not incentive compatible. But there is no reason to bail out homeowners. Just intervene in any mortgage default. Seize the property and continue making the mortgage payments. In the short run rent the property back to the homeowner.

This is what I have been advocating to my colleagues. I don't know why it is not under discussion. Before going with the arbitrary implememtation that Paulson is proposing now there should be some convincing argument that it's more efficient than this alternative. It is clearly the most direct approach and therefore should be the default (so to speak.)

Thoughts?  Unlike Tyler (and some others), Jeff is not obsessed with Jonathan Swift.

Can the subsidy be redirected?

Claire asks me:

If one is going to throw a huge pot of money at solving the crisis, is there any way to give it to anybody ‘lower’ in the chain?

Ideally we could send money to anyone about to default.  The obvious problem is that everyone would then pretend to be in that position. 

So I have a modest proposal.  The Fed/Treasury can identify those parts of the country with the most foreclosures.  They can buy or confiscate empty homes in those areas and destroy them.  That will raise the price of the remaining homes.  Anyone who is otherwise about to default could then sell the home at a high enough price (fingers crossed) to get out of the deal alive.  This would stop home prices from falling and it would limit the number of future defaults.

Buying the current already-foreclosed homes also would recapitalize the banking system but if you wanted to punish banks (not my goal) you could just seize the homes.  Of course the elasticities may not work out in such a way for this plan to forestall financial disaster but I've heard worse ideas.

And if you want to save the homes from outright destruction, you could offer 20-year, no-resale residencies in the homes to some group that won't otherwise be buying an American home.  Alex suggests offering the homes to potential immigrants ("have I got a deal for you...") or how about giving away the homes to current low-asset recipients of Medicaid?  Dealing the homes away in the right manner could win back some money for the government or help out others in a very humane way.

Where is the Credit Crunch?

Back in February I pointed out that despite all the talk of a credit crunch commercial and industrial loans were at an all-time high and increasing.  At the time, Paul Krugman and others responded that this was just temporary as firms drew on previously existing lines of credit.  Well here we are in September and bank credit continues to look very robust.  As Robert Higgs points out consumer loans are up, commercial and industrial loans are up, even real estate loans are up.  Overall, total  bank credit is up with just a slight sign of leveling off in recent weeks.  So where is the credit crunch?

A credit crunch does exist in the sector of the market based on short-term, asset backed securities.  In addition, interbank lending is unusually risky.  But in light of what I have just said the "credit crunch" takes on a new meaning and potential new solutions are suggested.  The first question I have is this.  Investment banks were selling these securities and using the money to lend to whom?  I do not know the answer.  But let's suppose that the money being raised in these markets was being lent to productive businesses.  If so, then any solution should focus on feeding those businesses that are starved for credit.

I look at the situation as follows.  Banks are bridges between savers and investors.  Some of these bridges have collapsed.  But altogether too much attention is being placed on fixing the collapsed bridges.  Instead we should be thinking about how to route more savings across the bridges that have not collapsed.  Government lending may be one way of doing this but why lend to prop up the broken bridges?  Instead, why not lend directly to the investors who are in need of funds?  After all, if these investors exist and have valuable projects that's where the money is!  Let the broken bridges collapse, taking the shoddy builders with them.  Instead focus on the finding and rescuing the victims of any credit crunch, the investors who need funds.

Now here is a hypothesis.  It may be that there just aren't that many firms in need of funds.  First, one reason that bank lending is up may be that firms with good projects have already turned to the substitute bridge of ordinary bank loans.  Second, I wonder how much real lending was actually being generated by asset backed securities.  Could it not be that most of the funds generated were used to buy more asset backed securities?  (The growth in these securities is certainly suggestive of that possibility).  If that is the case then it explains why the real economy has been remarkably resilient to the "credit crunch."

Now perhaps I am wrong about all this.  Bernanke has access to a lot more data than I do and he seems very worried.  I'd still like to know, however, which credit-worthy firms are credit starved.  And I'd suggest that we ought to think more about alternative bridges that will connect credit-starved firms with savers.    

Paulson plan vs. Dodd plan: my email to Eric Posner

I thought the original Paulson plan was terrible with regard to rule of law, and in that sense I thought the equity stake idea of Dodd was better.  A modified Paulson plan might be as good, it is hard to say.

[Eric now blogs that the Dodd plan gives the Treasury more power than current versions of the Paulson plan.  His post is very important.]

In reality I expect that either the Paulson or the Dodd plan would have to move quickly to incorporate some aspects of the other.  We'll likely get some version of both loan-buying and equity shares, in any case.

The key factor is what kind of institutions are set up for making the next round of decisions.  That's not getting much attention but of course there is no reason to think this is the final step or the final change in conditions.

Think of a barrel of apples, some good, some less good.  To oversimplify, the Paulson plan has the government buy some of the bad apples.  The Dodd plan has the government buy a 20 percent share in the barrel.  In both cases government buys something.

My intuitive rule of thumb is to want the government to be doing its buying in the better organized, more liquid market.  They are less likely to screw that up.  That tends to favor the Dodd plan in my view.

I like one other feature of the Dodd plan.  Our government loves cash revenue.  Furthermore the U.S. economy is set up so the "public choice" advantage of the government owning banks for the long haul is not so obvious.  We don't have "insider-based" capital markets, for instance, so owning a bank wouldn't give a politician so much chance to dole out loan favors.  I believe our government would be in a hurry to reprivatize those banks in return for the cash.  The Paulson plan, as I understand it, does not have an equally clear end game.

I may put this email of mine, or an edited version of it, on MR, check there for reader comments...

Tyler

Night thoughts: How or whether do equity holdings give the government "upside" in eventual bank recovery?  Holding equity yields nothing if the banks never recover.  If the banks will recover, you would think a loan from the Fed would suffice.  But we've already tried that.  So what exactly are the assumptions here?  Somehow it is the Fed/Treasury actions which *cause* the banks to recover.  How does that happen?  They overpay for the loans at mysterious prices?  That just puts the Dodd plan back into all the problems of the Paulson plan.  If the government ends up overpaying for loans in the Dodd plan, and then someday gets 20 percent of that overpayment back through its equity share, is not a huge positive advertisement.  (Isn't simply "knowing when to stop the subsidies" the best way to protect the taxpayers?)  And in the meantime, what kind of credit guarantees is the government offering these banks and their creditors?

Don't forget Mark Thoma's good analysis: "So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization."

It is easy to say that the Paulson plan is worse.  (Oddly I think the Paulson plan makes most sense in Paul Krugman's multiple equilibria model for asset values.)  But you shouldn't think that the Dodd plan is very good.  Most of the Dodd plan boosterism I've seen doesn't look very closely at how it actually going to work.  There's lots of talk about justice and the taxpayers getting upside and then a reference to the RFC from the New Deal.

Finally, in my view the Paulson plan makes (partial) sense if a) the major banks are in much worse shape than anyone is letting on, and b) you believe in multiple equilibria confidence models for these underlying asset markets.  I'm not saying those assumptions are true, but it would be nice to start by confronting the exact assumptions under which each plan might prove better than the other.

Economists Speak

An excellent Open Letter on the Bailout signed by many economists.  Hat tip to Justin Wolfers.

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses.  Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If  taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects.  If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity.  Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come. 

How does socioeconomic status cause health?

Probably most of you know the familiar result that social status is one of the best predictors of personal health, even when adjusting for other measurable variables.  David Cutler, Adriana Lleras-Muny and Tom Vogl have looked at the evidence more carefully and come up with the following:

This paper reviews the evidence on the well-known positive association between socioeconomic status and health. We focus on four dimensions of socioeconomic status -- education, financial resources, rank, and race and ethnicity -- paying particular attention to how the mechanisms linking health to each of these dimensions diverge and coincide. The extent to which socioeconomic advantage causes good health varies, both across these four dimensions and across the phases of the lifecycle. Circumstances in early life play a crucial role in determining the co-evolution of socioeconomic status and health throughout adulthood. In adulthood, a considerable part of the association runs from health to socioeconomic status, at least in the case of wealth. The diversity of pathways casts doubt upon theories that treat socioeconomic status as a unified concept.

In other words, "we don't know."  My simplistic view has long been that high status simply helps "keep the juices flowing," in Roissy-like fashion, and that's good for you all over.

Can any of you high-status people find an ungated copy?

In case you had forgotten

SOX [Sarbanes-Oxley] was sold as the way to prevent future market bubbles and crashes.

That's Larry Ribstein reminding us.  And here is Arnold Kling reminding us:

A Central Banker should stand up to fear-mongering.  Even when it comes from a Treasury Secretary.

And here is Robin Hanson reminding us of his favorite lessons:

Medicine isn't about Health
Consulting isn't about Advice
School isn't about Learning
Research isn't about Progress
Politics isn't about Policy

Fairfax County fact of the day

In Fairfax County, about half of the homes for sale are bank-owned properties...

Fairfax County, of course, is one of the wealthiest (and stable) counties in the United States.  Here is the story, which shows Fairfax is one of the few places with a rebounding housing market.

The Lehman gift that keeps on giving

DonorsChoose is one of more than 200 nonprofits that Lehman aids each year. Through corporate contributions and grants from its U.S. and European foundations, it [Lehman Foundation] distributed $39 million in the 12 months ended in November 2007, according to Lehman's Web site.    

Melissa Berman, chief executive of Rockefeller Philanthropy Advisors, which advises individuals and corporations about giving away money, said the [Lehman] foundation must close -- eventually -- because it no longer has a corporation sustaining it. Yet its assets are protected from creditors, she said.   

Here is the story.  Here is a story on the Lehman art collection.  Here are articles about how Lehman has several times won the Credit Derivatives House of the Year Award, including the Asia version of the award in 2008.

Credit default swap fact of the day

...the CDS [credit default swap] positions of large US banks during 2001–06 grew at an average compounding annual rate of over 80%.

That's from a very good paper by Darrell Duffie.  There is more:

Of all 5,700 banks reporting to the US Federal Reserve System, however, only about 40 showed CDS trading activity and three banks – JP Morgan Chase, Citigroup and Bank of America – accounted for most of that activity.

The net transfer of credit risk away from banks is estimated to account for 30 percent of the market.  Furthermore a bank may go short on the credit risk of a company it is lending to.  A CDS is then a substitute for selling or securitizing the loan.  If you think securitization is overdone, CDS has this benefit namely that it is a potential substitute. 

A bank also can short the credit risk of a company by dealing in its bonds and other securities.  But these other security markets are regulated and replete with restrictions on short sales and the like.  The CDS markets don't have comparable restrictions.  You can think of the CDS market as, in part, an attempt to circumvent regulations and trading costs in other securities markets.

Here is the single best paper on CDS that I know.  Enjoy.

Ike Brannon, where is my talk?

My Wednesday evening, 6:30 p.m., Washington, D.C. talk on the financial crisis.  Both I and some MR readers would like to know, so please leave the answer in the comments.  If you know Ike, could you please forward this inquiry to him?  My email for him isn't working and tomorrow I am on the road.

And for those of you wondering about my Bloggingheads.TV with Robin Hanson, Robin had a cold and we will reschedule it.

Arnold Kling's alternative: lower capital requirements

My alternative is to encourage new lending by lowering capital requirements at the margin. Tell banks that loans issued after September 1, 2009, require half the capital of similar loans issued before September 1. Some banks are in such bad shape that even with those lower capital standards they will not be able to make new loans. Fine. You don't want those banks to grow. But other banks have room to grow, and you want them to grow more than they would under the existing regulations.

As with changing accounting rules, lowering capital requirements ultimately exposes the government funds that insure banks to more risk. That is the flaw in the idea. However, there has to be some risk exposure to tax payers for any policy that encourages bank lending.

Here is more.  One question I have is how to calculate the existing capital for the very worst, most insolvent, and most corrupt banks.  You don't want them making loans to their uncles, so to speak.  Would requiring 1/2 capital discriminate usefully against such banks or would it in fact select for their relative expansion?  Or do we have this problem in any case?

Via Brad DeLong, here is a summary of the Dodd plan.  It sounds like an improvement over the Paulson plan.

Paul Krugman on why the liquidity trap really matters

Read his latest post, which outlines many key but usually unstated assumptions behind monetary theory and policy.  It is one of the most instructive econ posts to appear in some time. 

That said, on the policy issue I think one of Krugman's earlier posts (I can't find it) is closer to the mark.  With or without a liquidity trap, monetary policy can't fix negative real shocks and -- here is now the earlier Krugman -- monetary policy can't make insolvent (or potentially insolvent) banks whole.  That's my take on why the Fed is relatively powerless, not because of a liquidity trap.  If you believe, as a Keynesian would, that insufficient aggregate demand is the problem in the first place, you will be relatively worried about liquidity traps.  If you believe, as a neo-Austrian would, that malinvestments and coordination problems are the key issues, you will look toward other factors which limit the power of central banks to restore order. 

In my view sometimes the Keynesian perspective is relevant, but not so much today.  As the contraction of credit spreads through the Fed-regulated banking sector, however, and the broader money supply aggregates come under stronger negative pressure, the Keynesian perspective is likely to become more relevant.  That is in fact my major medium-term worry and we probably should be pessimistic in this regard.

There is a separate and very important liquidity issue about restoring the markets and valuations for bank loans, but this is not a liquidity issue in the sense of Keynes's portfolio theory or the traditional liquidity trap.

Addendum: Brad DeLong adds comment.  Another way of putting my point is this: in the situations where a liquidity trap might be binding, there is usually some even worse constraint which is more binding, thereby making the potential liquidity trap not so much a problem at the relevant margin.

Markets in everything, India electoral fact of the day edition

According to the study...almost one in two voters in Karnataka, where assembly elections were held in May, had taken money for voting or not voting.

However, the share of voters is higher among the voters in the so-called below the poverty line, or BPL, category: 73% in Karnataka while the national average is 37%.

And the price?

“The bribe money varies from state to state. It may be Rs100-150 (a voter) in some states and it can go up to Rs1,000 in some constituencies,” said Rao, adding that the CMS study refers to only cash bribes, not the value of liquor or other material inducements being doled out during election campaigns.

The exchange rate is about 45 to 1.  Here is the full story.  It is estimated that one-fifth of the Indian electorate sells its vote in some manner.  I thank Deane Jayamanne for the pointer.

Won't Get Fooled Again

The regulation of derivatives

Be wary when you hear talk of "derivatives" without further qualification.  They fall into three quite distinct categories: exchange-traded, over the counter (OTC), and swaps.  Here is the best overall paper I know on that division.  Wikipedia is useful as well.

I'll cover swaps in a separate post soon, so for now let's set those aside.

Exchange-traded derivatives include the instruments traded at the Chicago Mercantile Exchange and The New York Stock Exchange.  Their regulation has overall gone well and no one serious has alleged that they are responsible for our current financial problems.  That said, a single regulator is preferable to our current dual SEC-CFTC structure.

Most but not all OTC derivatives are interest rate derivatives.  Equity derivatives fit this category as well and so do credit default swaps (even though they are called "swaps" they do not here fit into the swaps category). 

These instruments are OTC because no clearinghouse in the middle guarantees the deal.  That means more credit risk and that no single middleman is tracking net positions on a more or less real time basis.  Ideally we would like to make OTC derivatives more like exchange-traded derivatives and we should consider regulation toward that end.  (Do note that private swaps regulators have already done quite a bit to clear up the issue of hanging and unconfirmed transactions.)  At the margin the social benefits of such homogenization are higher than what the private swaps regulators will bring on their own accord.  In essence homogenization and trading through a clearinghouse limits the leverage issue to a single, easily-regulated institution and therefore it limits the problem of counterparty risk.

The cost of such additional regulation will be higher transactions costs for the trades themselves and also greater contract homogeneity, which is a requirement for exchange trading, netting, and clearing.  We need to make this move wisely and carefully, otherwise OTC derivatives could move to even wilder and less well regulated markets.  Simply trying to shut down the OTC markets, even if that were the economically ideal vision (unlikely), would in terms of risk prove counterproductive.  But the strong market positions of New York and London do make some effective regulatory action possible for OTC derivatives, especially if done in concert.

The lack of sufficient offset and netting and the inefficient spread of counterparty risk across a large number of institutions is an important issue behind current crises and it does not receive enough attention in most blogosphere discussions.

How about Europe?  The 2006 Markets in Financial Instruments Directive extends traditional European financial regulation to OTC derivatives.  Here is one source: "MiFID expands the definitions of financial instruments to include other frequently-traded instruments, including contracts for difference (CFDs) and other types of derivatives such as credit, commodity, weather and freight derivatives."  Here is one overview of MiFID. 

Implementation and enforcement is on a country-by-country basis and of course the UK is the big player.  Read pp.27-29 in the very first link above and you'll see that overall the UK has a looser regulatory approach than does the United States, though not on every single matter.  For instance the UK is stricter on regulating hedge funds in OTC derivatives markets.

The more important point is that no country uses regulation of the derivatives market as its major line of defense against financial crises.  Rather countries regulate their financial institutions, their risk, their leverage, and their accounting directly, of course with more or less success.  Regulating the derivatives market, as opposed to regulating the institutions, and their possible participation in those markets, simply isn't a very effective instrument.

To sum up: a) we should regulate OTC derivatives more, b) those regulations should aim toward establishing netting and well-capitalized clearinghouses, not micro-management of those markets, which would prove both impossible and counterproductive, and c) regulating OTC derivatives is only a weak substitute for regulating the institutions which trade in them.

The U.S. passed the Commodity Futures Modernization Act of 2000, which, among other things, limited the ability of the federal government to regulate OTC derivatives.  I'll cover that Act in a separate post and yes I do think it should be amended.  But I'll start by saying that most blogosphere critics of the act simply do not know or understand much of the above.

A defence of the Paulson plan

It's always worth hearing from both sides, in this case Nadav Manham:

This [the purchases of the Paulson plan] has the effect of modestly increasing the stated book value of these financial institutions.  More importantly, with the toxic waste off the books, it improves the likelihood that an outside investor--Treasury itself, a sovereign wealth fund, even our man in Omaha--now feels able to value the enterprise.  Hold your nose and admit it:  the relatively few franchises that manage the capital raising and M&A activities of Corporate America are worth a lot.

3) Said outside investors collectively have enough capital to recapitalize the major Wall Street insitutions via injections of new equity.  Here comes the tricky part: In exchange for their largesse, both the outside investors and Treasury (e.g. via warrants struck at the same price as the outside investor) must be allowed to invest on very favorable terms.  In a perfect world existing equity holders and stock options would be essentially wiped out, a la AIG.  In an even more perfect world, existing debt holders (i.e. unsecured lenders to Morgan Stanley, Merrill, etc.) would also take a big haircut, just as they usually do when corporations declare bankruptcy. 

4)  Both liquidity and solvency are restored, credit starts to flow again, and the downward spiral of asset sales is prevented, allowing whatever pain will occur to occur over time, and to be spread widely.

...as far as I can tell, the plan does not specify when Treasury is obligated to buy toxic assets, nor does it prevent Treasury from doing another AIG.  Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets.  Or it could continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself.

There is more at the link.  A key assumption here is that jump-starting liquidity for bank assets is a big part of the cure; having the government dilute bank equity, as the Elmendorf plan suggests, does not on its own achieve this end.  I do find this a reasonable view, though as Paul Krugman points out it is unlikely that it is only a liquidity issue.  The implicit belief here is that resolving the liquidity issue is needed to make progress on the solvency issue.  Maybe.  But still I do not like the Paulson plan.  It reminds me of everything I dread about unchecked power and the administration's score on this question is very, very bad.

Assorted links

1. Jose Saramago starts blogging; here in Portuguese, here in Spanish.

2. The world's most expensive hotel rooms; via Craig Newmark

3. Milton Friedman YouTube video, from way back when with Milton at his peak.  Black and white, and thanks to Yana for the pointer.

4. 9-minute video of Julian Simon.

5. Frank Partnoy, financial prophet.

Matt Yglesias, drunk

The plan is bad. But bad policies get enacted all the time. But we’re at a point now where congress is, allegedly, in the hands of progressive leadership. Simply put, if congressional Democrats manage to acquiesce in a plan that spends $700 billion on a bailout while doing nothing for average working people and giving the taxpayer virtually no upside in a way that guarantees that even electoral victory would give an Obama administration no resources with which to implement a progressive domestic agenda in 2009 then everyone’s going to have to give serious consideration to becoming a pretty hard-core libertarian.

It’d be one thing for a bunch of conservative politicians to ram a terrible policy through. Then we could say “well, if some progressives win the next election things will be different.” But if this comes through an allegedly progressive congress then the whole enterprise starts looking pretty hollow.

Here is the link.  Personally, I don't get drunk, but there are a number of enterprises -- not just Matt's -- which are looking pretty hollow these days.  And I don't just mean banks.  You can blame lots of the crisis on government -- more than most people think -- but at the end of the day it is hard to escape the conclusion that markets simply have performed horribly in a number of important regards.

As one of Matt's commentators indicates, it is time for both candidates to show up in Washington and start...um...acting like Senators.

Addendum: Via Greg Mankiw, here is a chilling analysis of the bail-out.  Get this line:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Second addendum: Also via Matt, here is a round-up of critical commentary on the Paulson plan.  Count me in too, among those screaming "no!"  Yet it seems it's going to happen.

And Now for Something Completely Different

• Philosopher Saul Smilansky says his work is a cross between Kant and Monty Python. I'm not sure I'd go that far but I enjoyed hearing Smilansky and Will Wilkinson on blogginheadstv.  I discussed Smilansky's paradox of retirement argument earlier.  He is now out with a book, Ten Moral Paradoxes.

• Pictures from the most alien place on earth.  Worth a look (scroll down). Hat tip to Craig Newmark.

• The Sarah Connor Chronicles doesn't get any respect but I thought the first season was great in an action-packed, edge-of-your seat, thrill-seeking sort of way.  The second season has just begun.  Summer Glau plays the Spock/Data learning-to-be-human cyborg that John Connor can't admit he wants to interface with.

How big was the Nazi premium?

Every now and then I like to post about history:

Firms connected with the Nazi party outperformed unaffiliated firms massively. Their share prices rose by 7.2% between January and March 1933 (43% annualised), compared to 0.2% (1.2% annualised) for unaffiliated firms. The politically induced change was equivalent to 5.8% of total market capitalisation. This is a high number by international standards. Johnson and Mitton (2003) estimate that revaluation of political connections in Malaysia during the East Asian crisis wiped 5.8% of share values. While comparable in magnitude, it took 12 months for this change to occur.

Here is more, interesting throughout.