Transcript "Financial Crisis" Presentation

Michael C. Munger
Director, Philosophy, Politics, and
Economics Program
Duke University
A TRAP BAITED WITH 3 KINDS
O’TASTY CHEESE:
REAL CAUSES OF PANIC 2008
Why have private financial
corporations in the first
place?
 Liquidity
 Prices
 Intermediation --
transactions costs
A Question
Should we bail out
firms that are too big
to fail?
The Question
Should we bail out
firms that are too big
to fail?
The Question
Should we bail out
firms that are too big
to fail?
The Question
Should we bail out
firms that are too big
to fail?
The Question
Should we bail out
firms that are too big
to fail?
Greenspan's Mea Culpa (10/23/08)
"Those of us who have looked to the
self-interest of lending institutions to
protect shareholder's equity–myself
especially–are in a state of shocked
disbelief... I still do not fully understand
why it happened and obviously to the
extent that I figure where it happened
and why, I will change my views. If the
facts change, I will change."
Why was Greenspan Wrong?
 The only reason we need a policy of bailing
out losers is that we have a policy of
bailing out losers.
 Greenspan assumed a limited kind of
rationality. A "rational" investor would
recognize that bailouts allow large losers
to play with house money.
Why was Greenspan Wrong?
 Merton's distinction:
Investors vs. Customers.
 FDIC and FSLIC: "bail out" customers of bad
banks. Liquidity crisis protection
 Moral hazard (I look for high returns, don't
care if bank is solvent) is real, but
manageable.
Why was Greenspan Wrong?
 Merton's distinction needs to be expanded:
Investor/Owners vs. Customers vs.
CUSTOMERS.
 The bailout in 2008-9 was a bailout of
investors…in other firms that were major
counterparties in exotic products
(derivatives, CDS, CDO). Unlike moral
hazard for traditional depositors, this moral
hazard problem is not manageable, but
unlimited.
Some definitions
 Bailout: The use of taxpayer funds
either to buy assets, or to guarantee
the value of assets, of insolvent firms.
Definitions:
TBTF
 Systemically Important Financial
Institutions
 SIFIs will always be bailed out
 Two features:
Solvency/Size
External effects of failure
Problem
Systemically Important Financial Institutions:
Externality more important than solvency
SIFI status is therefore endogenous. Yes,
investors lose, but competitive advantage in
selling to CUSTOMERS
My choices to select extra risk, and more
leverage, make it more likely that my
counterparties will be bailed out. Larger
insolvency makes bailout MORE likely
Problem
The “SIFI” designation is found in the Dodd-Frank legislation, and the
language in that law says:
(a) Liquidation required--All financial companies put into receivership
under this subchapter shall be liquidated. No taxpayer funds shall be
used to prevent the liquidation of any financial company under this
subchapter.
(b) Recovery of funds--All funds expended in the liquidation of a
financial company under this subchapter shall be recovered from the
disposition of assets of such financial company, or shall be the
responsibility of the financial sector, through assessments.
(c) No losses to taxpayers--Taxpayers shall bear no losses from the
exercise of any authority under this subchapter.
Problem
Mutual benefit: Exists a contract, or
agreement, under which everyone would
be better off. Looks like this:
 Governments will not bail out firms
 Therefore, firms choose best guess
risk/leverage for portfolios
 Insolvency reflects bad production
choices, prices allocate scarce resources
accurately
Problem
 The Problem?
 That agreement, on previous page, is
unenforceable, because the incentives
facing the enforcer (the state) are timeinconsistent
 But we tried. Set up the Fed as a
Lender of Last Resort
 Bagehot (1897), Lombard Street.
Bagehot's Lender of Last Resort
Bail out only for liquidity crises, not
equity. LLR Regs do 3 things:
• Lend as much money as necessary
directly to troubled banks
• At a penalty rate
• And only for good collateral (the
institution must be technically solvent)
Problem III
Lender of last resort Bagehot (1897). But
our standard is different: externalities!
The size of the externality has (at best)
nothing to do with solvency, and may (at
worst) be correlated with externality
In other words, using size of externality
causes larger externalities
Problem is Time Inconsistency
"what to do once there is a crisis?"
Answer: there would be no crises if we
could credibly commit to a policy of no
bailouts.
(Might or might not be true, need
empirical cases)
Ann is right, of course, in 2008-9. But
what now?
Here is Circe’s dire warning to Odysseus (Chapman
2000: Chap. XII, lines 56-89; emphasis added):
First to the Sirens ye shall come, that taint
The minds of all men, whom they can acquaint
With their attractions. Whomsoever shall,
For want of knowledge moved, but hear thcall
Of any Siren, he will so despise
Both wife and children, for their sorceries,
That never home turns his affection's stream,
Nor they take joy in him, nor he in them.
The Sirens will so soften with their song
(Shrill, and in sensual appetite so strong)
His loose affections, that he gives them head.
And then observe: They sit amidst a mead,
And round about it runs a hedge or wall
Of dead men's bones, their wither'd skins and all
Hung all along upon it; and these men
Were such as they had fawn'd into their fen,And
then their skins hung on their hedge of bones.
Sail by them therefore, thy companions
Beforehand causing to stop every ear
With sweet soft wax, so close that none may hear
A note of all their charmings. Yet may you,
If you affect it, open ear allow
To try their motion; but presume not so
To trust your judgment, when your senses go
So loose about you, but give straight command
To all your men, to bind you foot and hand
Sure to the mast, that you may safe approve
How strong in instigation to their love
Their rapting tunes are. If so much they move,
That, spite of all your reason, your will stands
To be enfranchised both of feet and hands,
Charge all your men before to slight your charge,
And rest so far from fearing to enlarge
That much more sure they bind you.
.
Federal Trade
Commission,
Washington, DC
But…Did That Big Horse Get
Loose, and Pull Us Off a Cliff?
 You’ve heard it: Worst economic downturn since




the Great Depression (not remotely true, not even
as bad as ‘73, or ‘81, in terms of GDP decline.)
Huge financial losses, bankruptcies of hundreds of
companies
Government bailouts (unprecedented!)
Record postwar unemployment (okay, THAT’s
true)
WHY a crisis? Prices…No Prices, No Liquidity
Document Problem: House Prices
Stock Prices & Volume, ‘04-’09
Unemployment Rates, end 2008
Unemployment Rates, end 2011
Unemployment Rates, 11/07–4/09
2009
Three Deficits
 Federal
 Consumer
 Trade
US Federal Debt/capita (‘07$)
110% is the Worry Line
Consumer Debt
Student Loan Debt (US Gov’t)
Trade Deficit
Fiscal Deficit and Trade
Deficit are CONNECTED
Competing Diagnoses
1. Greed, Especially Predatory Lending
2. Too Much Government Interference in Housing
Markets
3. Too Little Government Regulation of Financial Markets
4. Too Much Debt, Not Enough Saving
5. Death Throes of a Dying Capitalist / Consumerist Order
6. Space Aliens (The “Cordato Thesis”)
7. Normal fluctuations of business cycle, exacerbated by
policy mistakes. Inherent in capitalism
The Answer (correct in all
unimportant respects…)
Problem: Too much leverage, too little margin for
error in investment and real estate markets.
To take an example, a company with a net worth of US$ 25
billion borrowed 26 times its net worth and creates
leveraged funds of US$ 650 billion to invest or lend them.
When a small portion of the company's investments turns
bad, as is the norm for the industry, the company's capital
is under threat. To put things in perspective a 3.8 percent
misjudgment in their books was enough to wipe out their
shareholders' capital of $ US 25 billion.
And leverage ratios of 40, or 50, to 1 were not uncommon.
Prudence? No more than 2 to 1. (May not be comparable,
since derivatives seem different from borrowing outright)
The Answer (correct in all
unimportant respects…)
The reason this is correct in “all
unimportant respects” is that it makes us
want to ask: “WHY? WHY DID IDIOTS
DO THAT? LET’S KILL THEM ALL!”
Well, even in the U.S. being an idiot is not a
capital crime. In fact, if you are a BIG
idiot, the government will bail you out!
My View: A Trap Set by the US
Government, and Baited with three
types of tasty Cheese
For the first time in history, you could
be trapped even if you never leave the
house. Just a computer was enough…
Effective? Unfortunately…
Each trap could catch many!
Hard Not to Feel Sorry for
those poor mice….
 But blaming markets for the financial crisis is
a lot like blaming the CHEESE!
 The Bush Administration, and Clinton
Administrations, did not realize they were
setting a trap.
 But they were. This is a crisis where markets
ran wild, and where government did nothing
to control the problem. Government actually
made things much worse than was necessary.
To Repeat: A Trap Set by the US
Government, and Baited with three
types of tasty Cheese
Many Traps--Three
Kinds of Cheese,
No Waiting!!!!!
1.Equity Purchase Subsidies
2.Artificially Low Interest Rates
3.Guarantee of Permanent Price
Increases
1. Equity Purchase
Subsidies: Homes
Home ownership policy of Bush, also Clinton: Pay
low-income people to make a risky investment that
they would otherwise rationally avoid.
Mortgage Agencies treated like “public utilities”
(Bernanke, Paulson).
Banks/financial entities both threatened, and bribed,
to make loans that could not possibly be paid back.
Community Development Block Grants: subsidize the
down payment.
1. Equity Purchase
Subsidies: Homes
PROBLEM: Behavioral economics--people
overestimate their prospects, poor people
shouldn't take too much risk, because they have
little to fall back on. The natural market
tendency is too much home ownership, not too
little.
BACKGROUND: US Federal Reserve Bank Study
on the dangers of Home Ownership Subsidies,
(Published August of 2008!)
http://www.richmondfed.org/publications/research/region_focus/2008/fall/pdf/cover_story.pdf
1. Equity Purchase
Subsidies: Homes
Two New York Times Articles:
I. “Fannie Mae Eases Credit To Aid Mortgage Lending,” By
STEVEN A. HOLMES, September 30, 1999:
“In a move that could help increase home ownership rates among
minorities and low-income consumers, the Fannie Mae Corporation is
easing the credit requirements on loans that it will purchase from banks
and other lenders…. In moving, even tentatively, into this new area of
lending, Fannie Mae is taking on significantly more risk, which may not
pose any difficulties during flush economic times. But the governmentsubsidized corporation may run into trouble in an economic downturn,
prompting a government rescue similar to that of the savings and loan
industry in the 1980's.”
Why do it? Clinton Admin and House Democrats…..
1. Equity Purchase
Subsidies: Homes
Two New York Times Articles:
II. “New Agency Proposed to Oversee Freddie Mac and Fannie
Mae,“ By STEPHEN LABATON, September 11, 2003
The Bush administration today recommended the most significant
regulatory overhaul in the housing finance industry since the savings
and loan crisis a decade ago...The plan is an acknowledgment by the
administration that oversight of Fannie Mae and Freddie Mac -- which
together have issued more than $1.5 trillion in outstanding debt -- is
broken.... (Oxley): ''The current regulator does not have the tools, or
the mandate, to adequately regulate these enterprises. We have seen
in recent months that mismanagement and questionable accounting
practices went largely unnoticed by the Office of Federal Housing
Enterprise Oversight,'' the independent agency that now regulates the
companies. (CONTINUED ON NEXT SLIDE)
1. Equity Purchase
Subsidies: Homes
Two New York Times Articles:
II. “New Agency Proposed to Oversee Freddie Mac and Fannie Mae,“ By
STEPHEN LABATON, September 11, 2003
Among the groups denouncing the proposal today were the National
Association of Home Builders and Congressional Democrats who fear that
tighter regulation of the companies could sharply reduce their commitment
to financing low-income and affordable housing.
''These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind
of financial crisis,'' said Representative Barney Frank of Massachusetts,
the ranking Democrat on the Financial Services Committee. ''The more
people exaggerate these problems, the more pressure there is on these
companies, the less we will see in terms of affordable housing.''
Representative Melvin L. Watt, Democrat of North Carolina, agreed.
''I don't see much other than a shell game going on here, moving something
from one agency to another and in the process weakening the bargaining
power of poorer families and their ability to get affordable housing,'' Mr.
Watt said.
1. Equity Purchase
Subsidies
Government-guaranteed home mortgages, especially when a negligible
down payment or no down payment whatever is required, inevitably
mean more bad loans than otherwise. They force the general
taxpayer to subsidize the bad risks and to defray the losses. They
encourage people to “buy” houses that they cannot really afford.
They tend eventually to bring about an oversupply of houses as
compared with other things. They temporarily overstimulate building,
raise the cost of building for everybody (including the buyers of the
homes with the guaranteed mortgages), and may mislead the
building industry into an eventually costly overexpansion. In brief, in
they long run they do not increase overall national production but
encourage malinvestment. (my emphasis)
~From Chapter VI "Credit Diverts Production" in Henry
Hazlitt's "Economics in One Lesson," first published in 1946
Artificially Low Interest Rates
Another Way of Computing It…
Artificially Low Interest Rates
Why would this matter? Reasons:
1. Subsidy to long term borrowing
2.Subsidize risk-taking, lender of
last resort
3. ARMs and Balloons: Nonstandard loans, because money
was free
Guarantee of Permanent
Price Increases
If there is no risk, people take too many risks.
Buy a house, zero down, 4 year lock-in of 4%
interest, then balloon payment or ARM
If house was $200,000, and it appreciates at 5%
per year, that’s more than $40,000 capital
gain. You can refinance, with a $40,000 down
payment and a standard fixed rate mortgage.
It’s all free!
And so housing prices went up forever…
Guarantee of Permanent
Price Increases
Example: Interview with Henry Paulson (T-Sec,
2006-Jan 2009), in 2007:
Paulson: “I think what we’re doing is avoiding a market failure that
would have forced housing values down in a way that was not in the
investors’ interest, and in a way that the market wasn’t intended to
work.”
Interviewer: “How can you force values down? Why aren’t values
finding their natural level?”
Paulson: “The way values would go down is, as I’ve said, you’d have
market failure.” [After Treasury Department intervention ] “we
won’t have housing prices driven down in ways that distort the
market.”
The Guarantee: Government SHOULD, and CAN,
maintain orderly permanent increases in housing
prices.
History:
Four Influences
How did it actually happen?
I have said that the trap was baited with
 Equity purchase subsidies
 Artificially low interest rates
 Government guarantee of intervention to prevent
“market failure” of housing price decline
But how did the trap close? How did it actually happen?
This is as simple as I can make it. Like any simple
account, it leaves out a lot of important details.
But, it captures the primary moving parts of the crisis.
History: 4 Influences, 4 Slides
1. SECURITIZED DEBT
Fannie Mae (1938) and Freddy Mac (1970) set up to
“rationalize” the mortgage market—”Securitize.”
At first, worked pretty well. Repackaged and
commoditized mortgages, so that people with
money could loan to people who wanted to borrow
money. Didn’t need banks, except as intermediaries.
Home ownership is highly illiquid debt; more extensive
loan market, with reselling, allowed for increased
liquidity among both borrowers and lenders.
Reduced transactions costs, lower rates for
borrowers, higher rates for lenders.
Problems: Risk status endogenous, increase asymmetric
information about repayment rates
History: 4 Influences, 4 Slides
2. INCREASE HOME OWNERSHIP, CONFIDENCE IN
MANAGEMENT OF ECONOMY
It seemed home ownership was the stairway to the
American dream. Encourage home ownership
through (a) tax subsidies, (b) explicit subsidies, (c)
pressure banks and regulatory agencies to certify
“subprime” loans as “conforming.” Conforming loans
require 20% downpayment and 30% cap on monthly
income. Both relaxed by regulators, 1994-1997.
Problems: None, as long as home prices go up. But
investors either didn’t know, or didn’t care, that
regulators were expanding the definition of
“conforming” loans. Appeared to be good loans,
certified by government agencies as being
investment grade assets.
US Homeownership Rates
The new loan products are known as the combo / ballon loan,
and have lower down payment requirements. Combo loans are
the contract of choice for nearly 40% of new loans, explaining
much of the increase in homeownership rate since 1994.
Longer Term…Home Owner Rates
At the same point in time, 1997, housing prices started to skyrocket in real terms.
Before, housing had been a hedge against inflation, but wealth was built through
accumulating equity. Now, with the new loan regime from the Congress and the
Clinton administration, and Fred and Fan helping, there was a huge rush of cash
chasing houses.
US Homeownership Rates
“Real” Housing Prices
Housing Prices vs. CPI
Overall, Shiller Index
Not hard to
figure out…
1997
Buying vs. Renting
History: 4 Influences, 4 Slides
3. COLLATERALIZED DEBT OBLIGATIONS
Collaterlized Debt Obligations (CDO)—90% repayment
rate means an accurate price for bundles, even if no
one security could be priced accurately.
Problems: 90% repayment rate is endogenous, assumed
old regulatory structure. And assumed steady
increase in home prices. When repayment rates
plummeted, no idea how to price these very complex
assets. Imagine what the bankers thought; they must
have been incredulous! “We can certify these lousy
risks as investment grade, and then we can sell them
in bundles at full price to FM/FM, and then bear NO
responsibility for anything that happens later?
COOOOOL!”
Billions $
History: 4 Influences, 4 Slides
History: 4 Influences, 4 Slides
4. DERIVATIVES, especially Credit Default Swaps
Similar to other “hedging” derivatives. “Invented” by JP
Morgan analysts in 1997, in 2000 became exempt
from most regulation. (Pres. Clinton supported). Like
insurance, but NOT insurance. Needn’t own asset,
not regulated, and no requirements for reserves or
structures of hedged risk layoffs.
Problems: “Insurance” aspect of these derivatives meant
that no one cared about the underlying assets, and
no one investigated repayment rates. And AIG (with
its physicists) made huge amounts of money writing
these contracts. But like a one-sided betting shop:
did not hedge the risk. For many companies, their
only assets were these swap contracts after the
primary assets defaulted.
Credit Default Swaps
Now, Just One Slide:
Cause?
Bad regulation: Focus on identities rather than instruments.
Market failure, government at least negligent, possibly
complicit. CDS’s are NOT insurance.
Really, really bad regulation: Government caused the crisis, by
subsidizing housing prices, and using government prestige to
hoodwink small investors. Certified junk as conforming, allowed
fast resale at full price, facilitated by Freddy and Fanny.
“Investment houses” turned into “Animal Houses.”
The dilemma: Bad regulation can be worse than no regulation.
But good regulation is better still. Test: When you say,
“Government should regulate markets,” take out the word
“Government” and substitute “Politicians.” You sure you still
believe that?
Confidence, Transparency, Liquidity required for
accurate pricing and functioning markets
What Has Obama Administration Done?
 TARP (carried over from Bush Administration): 3+






Trillions of $?
Porkulus (Stimulus for Reelecting Congressmen):
Again, 3+ Trillion $ (If not temporary)
He is NOT George Bush, a positive worldwide
Proposed new regulations of executive compensation
“Stress tests,” not a bad idea, because they finesse
“mark to market” valuation
Takeovers of large manufacturers, directing bankruptcy
Proposed “Financial Product Safety Commission”
What SHOULD have been done?
1. The George W. Bush presidency was not an era of
deregulation, but overregulation and failed
financial supervision. Sarbanes-Oxley, “10,000
Commandments,” attempts to prop up housing
prices. So, Republicans were primary cause.
2. Don’t bail out! At most, offer lender of last resort
function for banks, and liquidity of last resort
function for CDOs. 40 cents on the dollar, take it or
leave it. Bailing out AIG was just pouring money
down a rat hole. Now, again for PIGS? Amazing.
What SHOULD have been done?
3. Stop changing things. Why is unemployment so
high? Why won’t banks lend? It’s because no one
knows what is going to happen to taxes, regulations,
or health care.
Regime Uncertainty: regime uncertainty pertains to the likelihood
that investors’ private property rights in their capital and the income
it yields will be attenuated further by government action. Such
attenuations can arise from many sources, ranging from simple taxrate increases, to the imposition of new kinds of taxes, to outright
confiscation of private property. Many intermediate threats can arise
from various sorts of regulation, for instance, of securities markets,
labor markets, and product markets. In any event, the security of
private property rights rests not so much on the letter of the law as
on the character of the government that enforces, or threatens,
presumptive rights. (Higgs, 1997, Independent Review)
What SHOULD have been done?
4. Depend on greed and information to get us
out of this. If banks are self-interested, not
necessary to bribe them to make loans.
5. Stop politically motivated industry takeovers. Buying debt may be justified (though
I’m skeptical.) But buying debt is WAY better
than buying, or seizing, equity shares.
6. Announce freeze on new regulations, and
end constant threats of new taxes on profits.
What Will Happen Now?
US
Securities based on risky mortgages are what toppled
financial institutions but it was the government that made
the mortgages risky in the first place, by making homeownership statistics the holy grail, for which everything
else was to be sacrificed, including commonsense
standards for making home loans.
Politicians and bureaucrats micro-managing the mortgage
sector of the economy is precisely how today's economic
disaster began. Why anyone would think that their micromanaging the automobile industry, or executive pay across
a wide sweep of other industries, is likely to make things
better in the economy is a mystery.
THOMAS SOWELL, “Cheap Political Theater,”
http://townhall.com/columnists/ThomasSowell/2009/03/24/cheap_political_theater