It’s normal for people who work together to settle into a consensus view, in part because it’s stressful to be butting heads on a daily basis, so it’s common for people who feel that their views cannot be expressed without generating conflict or ridicule to go elsewhere. In the best working environments everybody’s view is given weight, so the consensus view is something of a truce — as long as you frame your view in this way, I won’t challenge you.  In other working environments, a single group or even individual manages to define the consensus, largely because of that entity’s reaction to other views.

It’s also normal for any industry to develop a consensus view that’s conducive to its interests.  While there will certainly be sub-cultures within the industry, the variation is likely to lie within a very narrow range, because the interests within industry will tend to be aligned.

Thus, it seems to me that the principal source of the counterweight that’s necessary to promote healthy debate about the nature of the financial system and the economy is the regulators. We need these regulators to have their own view of how finance and the economy work that should look bat-shit insane when viewed from the perspective of industry. When the regulators take industry to court, it should be common for a war of ideas to be taking place.

Thus, the problem with the revolving door is really one of cultural cross-contamination. If industry and the regulators together settle into a single consensus view of how finance and the economy function, then the result will be destabilizing, because whatever flaws exist in that consensus view will become deeply entrenched in the way finance and the economy function.

We don’t our regulators to agree with industry on what is a prosecutable offense.  We don’t want our regulators to agree with industry on the most efficient microstructure of exchanges. We don’t want our regulators to agree with industry on when financial innovation is good.

We do want our regulators to have their own view of the financial system, of the economy, and of what constitutes legal behavior that should be so different from the industry view, that they appear to be generated by people born on different planets. Thus, the real problem with the revolving door is that a collegial consensus on how the financial system and economy function and on what financiers can and cannot legally do is destablizing to the financial system and the economy.

What is missing from his analysis is the fact that both the increase in demand and the decrease in supply are caused by deep seated dysfunction in the financial system, which is no longer performing its prime duty: creating safe assets by lending to credit-worthy borrowers. (In fact, after the 2008 crisis there is good reason to doubt that banking system still fosters the development of the underwriting skills that are essential to the issue of safe assets.) Let me explain this view in three steps.

As J.P. Koning pointed out the first problem with the “safe asset” meme is one of definition: What is a “safe asset”? The answer I think is that the “safe asset” argument is derived from individuals with economics training confusing their idealized economic models with reality.  In an economic model, the asset that has a “risk-free” rate is government debt, so it’s obvious that a safe asset is government debt.[1]  Tipping their hats to reality, these economists will quickly concede that not just any government debt qualifies, but that issued by the U.S., Germany and a few other countries surely qualifies.

The next problem is that the evidence points to the fact that the safe asset shortage is in no small part created by the collateral demands of our largest financial institutions. That is, our banks – more often than not prodded by their regulators (see here p. 59 ff.) — no longer have enough confidence in the financial system to lend to each other on an unsecured basis. Unsecured short-term paper issued by our largest banks should be part of the “safe asset” supply – and this should be true not because of government support, but because of the unquestionable quality of our largest banks’ balance sheets and the knowledge within the industry that they are well-managed institutions. Given our modern financial structure, this obvious source of “safe” private sector assets has been thrown into doubt.

This leads into the real problem with the “safe assets” meme: people who cut their teeth on models where government (which is equivalent to a hybrid of the central bank and treasury) is modeled as a benevolent social planner that enables the economy to function perfectly, end up holding a deep-seated belief that is founded on little more than an assumption in the models they use, that a central bank cum treasury actually is a deus ex machina that can solve all our problems. Thus, their policy prescriptions rely in an entirely unrealistic manner on government-backing of the financial system.*

An understanding of our financial system that is founded on history, not economic models would recognize that the development of “safe” privately issued assets (e.g. the bill of exchange) precedes the issuance of “safe” government debt by centuries. The classic example of the ability of a democratic government to bear a heavy debt burden is Napoleonic Britain when facing the threat of Napoleon. The ability of the government in late 18th century Britain to issue trusted government debt depended on the support of British merchants and bankers, who literally convened and signed a resolution agreeing to accept Bank of England notes when the Bank went off the gold standard in 1797.[2] No such resolution was signed with respect to English country bank notes (which relied heavily on the London market and Bank of England notes for finalizing payment), and the courts acknowledged that country bank creditors had the legal right to demand gold in payment.  As the Lord Chief Justice remarked in his decision: “Thank God few such creditors as the present plaintiff have been found since the passing of the [Bank Restriction] Act!”[3] (Does anyone doubt that if Goldman Sachs and J.P. Morgan Chase could be transported to 1800s England, they would definitely demand to receive the gold that they are “due”.)

In short, just as public sector liquidity in the form of central bank loans is necessary to support private debt in times of crisis, private sector liquidity is necessary to support public sector debt in times of crisis. Unlike the idealized world of economic models where the government is the ultimate source of liquidity, liquidity in the real world is a two way street that is sustainable in the long-run only if there is a source of private sector “safe” assets that is willing and able to support the government in times of trouble. Thus to the degree that there is a “safe” asset shortage, the question is what is preventing the private sector from issuing safe assets.  Until the structural problems in the private-sector financial system that prevent it from generating safe assets endogenously are addressed, there is little hope that the liquidity of assets to which we, in the United States, have become accustomed can be maintained in the long run.

It’s hard not to read the financial stability arguments as saying “look, we can’t trust the financial sector to accomplish its most basic goals.” If true, that’s a very significant problem that should cause everyone a lot of concern. It should make us ask why we even have a financial system if we can’t expect it to function, or function only by put the entire economy at risk.

Well, precisely. What did the crises of 2007-08 mean if not that our financial structure is fundamentally flawed.

Theoretically raising interest rates can have two effects (and a range of combinations between them that I won’t address). In the absence of asymmetric information, raising interest rates allows fewer projects to be funded (that is, fewer projects have positive expected returns given the higher cost of borrowing) and this reduces economic activity and employment. (I think this story is consistent with Nick Rowe’s view of monetary policy as acting through spending, though he would include a multiplier effect.)  In the presence of asymmetric information, however, we can have a very different outcome due to adverse selection.  An increase in interest rates can result in an increase in the number of projects funded, as “bad” borrowers prefer to get money that there is a high probability that they won’t be able to pay back now and incur the likely costs of default later. Of course, in a world with perfect information the lenders wouldn’t participate in this scheme, so we need an environment where lenders are misinformed. Theoretically, when lenders realize how bad loan origination methods are, the whole market can collapse. This is the “lemons” problem.

It is also arguably what happened in 2008. From mid-2004 to mid-2006, interest rates were rising – and the origination of adjustable rate mortgages – where the initial rate is very sensitive to short term interest rates was rising. (see here page 17)  Not coincidentally, the issuance of private-label MBS was also increasing over this time.

In 2008, the market recognized it’s origination failures and was at the edge of collapse just as the theory predicts, but the Fed prevented the collapse by lowering interest rates and making it easy to roll over many of the negative-present-value projects that had been funded, giving banks the opportunity to terminate them over time, instead of experiencing an immediate huge hit to their balance sheets. (Through a variety of mostly off-balance sheet guarantees, the banking sector had significant exposure to the private label mortgage markets.)

It is far from clear that that our banks retain the underwriting skills necessary to distinguish between positive and negative present value loans. (They may have switched to automated systems and now have a deficiency of underwriting experience.)  The other crucial question is whether the banks have taken advantage of this prolonged period of low interest rates to bury their dead bodies, or whether they remain hidden under the carpet. (This is clearly related to the idea that bankers are “gambling for job tenure” or “reaching for yield.”) The test of this will be what happens when we raise interest rates.

In some sense, one of the major problems with prolonged zero-interest rates is that they are very effective at hiding deep-seated problems in our financial system and, thus, are very likely to be interfering with the process of financial reform, and with the basic economic principle that failing businesses and projects should be allowed to fail.

In my view the appropriate policy response in this situation is to slowly raise interest rates, while simultaneously engaging in aggressive fiscal expansion, targeted towards the individuals who will be most adversely affected by the increase in interest rates. Given that the unconstrained optimal policy is politically impossible, I am willing to assume that the Federal Reserve’s current policy is a constrained optimum (especially given that I know the Fed has studied the problem much more carefully than I have).  In any event, critics of the Federal Reserve should probably include discussions of asymmetric information in their analyses.

The former purpose of the bankruptcy process was to guarantee that all creditors receive no more than they are due under the law given that the bankrupt debtor is unable to meet all of its obligations.  The modern bankruptcy process allows derivative and repo counterparties to foreclose on any collateral posted to them. While theoretically they must demonstrate that the collateral they have taken was no more than was owed to them, the imprecision inherent in the process of marking complex assets to market clearly gives these counterparties the upper hand. In the event that discussion fails to result in the return of improperly seized collateral, the bankrupt debtor must sue the counterparty to get what is due the other creditors, as the Lehman lawsuit aptly illustrates.

It is a trivial matter to show using economic analysis that the costs to the bankrupt debtor of suing will guarantee that the vast majority of derivative and repo counterparties will be able to keep more collateral than they are due (unless they were undercollateralized at the date of default). In short the bankruptcy process now favors financially sophisticated creditors over trade creditors and debt-holders, not only because the financially sophisticated are able to negotiate more favorable contracts before bankruptcy, but also because they are able to take more than they are due under the law once a company enters bankruptcy.

Update 5-8-13: Matt Levine has done the yeoman’s job of reading some Lehman-related legal complaints and appears to reach similar conclusions.

Update 5-15-13: This article leaves the impression that that best targets for a lawsuit regarding the closing of a derivative contract are those who can’t afford expensive legal advice.

The biggest problem with data analysis is that it limits the discourse to things about which we have data series. Important questions are not addressed, because like the drunk looking for his keys, researchers are disincentivized from spending their time on them in the absence of good data.

The Reinhart Rogoff kerfluffle focuses attention on a secondary problem with data analysis: that it’s all about the underlying model, and typically represents a very narrow test built on very strong assumptions.  Of course, the best data analysts understand this and some work genuinely addresses these concerns.  However, the way data analysis is consumed and the approaches taken by average data analysts often fail to reflect how very little we learn from data analysis — in no small part because an argument is always more convincing if you deflect attention from its weaknesses rather than exposing those weaknesses to open debate.

For example, there’s nothing wrong with treating each high debt episode as a single event whether it comprises 19 years or 1, after all data analysis is all about heroic assumptions. There is, however, arguably an issue with doing this and not making it crystal clear — at least in a footnote or appendix — what your heroic assumptions are.  (Reinhart and Rogoff’s critics allege that they failed to do this.) Afterall, understanding the heroic assumptions is essential to interpreting the research.

If it is the norm — and I don’t read enough of this literature carefully to know — to hide heroic assumptions and force other researchers to learn about them by reviewing your data set, then the idea that any conclusions drawn from any of this literature analyzing data are worth paying attention to is thrown into doubt.

Data analysis is a useful tool, but should be considered a secondary backup to broader, more nuanced historical analysis that goes far beyond the inherently simplistic nature of data analysis. Narrative historical approaches are currently undervalued, and it is often argued that their weakness that they are not disciplined by formal models. It is time to recognize, first, that this is also the strength of historical analysis and, second, that the fact that data analysis is disciplined by formal models is also a weakness.

In recent years the Fed has relied on asset price bubbles to support the economy — and keep unemployment down

Over the past few decades a shrinking fraction of economic gains has gone to labor (and a greater fraction to capital)

This was the era of the subprime loan (p. 13ff in link), where lenders put increasing value on the opportunity to take back the underlying asset and less on the borrower’s income stream

Query:

Is Federal Reserve asset price support distorting the fundamental structure of economic contracts by undervaluing labor and overvaluing capital?

Which raises another question: should the objective of monetary policy focus not on low inflation and low unemployment, but on a slowly increasing median wage and low unemployment?

SIGTARP is concerned that the number of homeowners who have redefaulted on a HAMP permanent mortgage modification is increasing at an alarming rate. Treasury’s data shows that the longer a homeowner remains in HAMP, the more likely he or she is to redefault out of the program. As of March 31, 2013, the oldest HAMP permanent modifications, from the third and fourth quarter of 2009, are redefaulting at a rate of 46.1% and 39.1%. HAMP permanent modifications from 2010 also had high redefault rates, ranging from 28.9% to 37.6%.

But, of course, redefaults (at least in the absence of a flourishing economic recovery that raises incomes by 3% a year) are built into the HAMP modification program, because payments, that were deliberately set at the outer limit of affordability, increase in each of the sixth, seventh, and often eighth years by 8-9%. While the first HAMP payment increases will not kick in until 2014, borrowers who know their payments are going to go up unsustainably in a matter of months (and remember every single one of them has been through this before) are incentivized to default today.

SIGTARP failed to do its homework on HAMP if it’s only realizing now that large numbers of redefaults will be a result of HAMP modifications. Why were redefaults built in to the program? Presumably because any other policy would have had too harsh an effect on investors and the banks for them to be willing to participate voluntarily in the program.  Like a subprime mortgage the HAMP program has payment increases that induce default and give the lenders the option (p. 13 ff. in link) of taking the house or refinancing the mortgage depending on the relative performance of the economy and the housing market.

For those who don’t understand how HAMP is structured, this is the (Tier 1) program:

Calculate 31% of the borrower’s monthly income.  This is the target monthly mortgage payment or TMMP and under almost no circumstances should the monthly payment in a HAMP modification fall below this amount.

A step 1 modification:  (Applies mostly to borrowers who fell behind due to temporary misfortune.)  Capitalize any delinquent amounts and fees into the principal of the loan (=the new balance) and apply the existing interest rate and loan terms to the new balance.  If this requires a payment in excess of TMMP go to step 2.  (Less than 4% of permanent mods. See MHA report p. 6)

A step 2 modification:  Determine the interest rate at which the new balance can be amortized given payments of TMMP over the existing term of the loan.  If the interest rate is 2% or higher, offer a HAMP loan with an initial interest rate at that level to the borrower.  If not go to step three.  (Approximately 35% of permanent mods.)

A step 3 modification:  Determine the number of months over which payments of TMMP will amortize the new balance at 2% interest.  If this is less than 480 months, extend the maturity of the loan to that length and offer a HAMP increasing payment loan with an initial interest rate of 2%.  If not, go to step 4. (Approximately 29% of permanent mods.)

A step 4 modification:  Calculate the principal amount of a 2% fixed rate loan amortizing over 480 months that the borrower can afford given TMMP.  Subtract this amount from the new balance.  Do a net present value analysis to determine whether adding the remainder as a balloon payment due at the end of the 40 year loan is more valuable to the lender than foreclosing.  (32.6% of permanent mods.)

The terms of the HAMP loan for the borrower:

HAMP step 3 and step 4 (and to a lesser degree step 2) loans have interest rates that are fixed only for 5 years.  (According to SIGTARP: “Treasury designed the program so that homeowners could keep their modifications for up to five years.” p. 179.) The interest rate then climbs by 1% a year until it reaches the market rate for a fixed rate loan at the date the modification was made.  As a result 2009 vintage HAMP loans have interest rates that increase to 5%.  More recent HAMP mods have interest rates that increase to as little as 3.5%.

Thus in the sixth year for the majority of HAMP mods the interest rate at which the principal balance (excluding the step 4 balloon) is amortized increases by 1%, so the payment increases.  Most HAMP mods have another increase in the seventh year and the earliest HAMP mods have an increase in the eighth year.  In the sixth year the payment increases by more than 9%, in the seventh year most payments increase by almost 9% and there are many loans that have payments that increase by 8% in the eighth year.  The total payment increase from the end of the fifth year to the start of the eighth year for early vintage HAMP loans is 29%.

Given that most early vintage HAMP loans have a built in payment increase of 29%, it is far from clear how anyone who understands the nature of the HAMP program can fail to predict increasing redefaults as the program progresses.

Update 4-26-13: In case anybody thinks it’s a mistake to analyze HAMP in nominal terms and implicitly argues that a 3% nominal growth rate for income was a reasonable assumption for Treasury to make in 2009, I have to say that it’s precisely this assumption that I find so outrageous. HAMP appears to have been built on the view that a recovery was just around the corner and a rejection of the endogeneity of government policy to economic performance.

Using census data we find that nominal median income increased from 2001 to 2008 by 2.4% per annum.  In 2009, it was completely unreasonable to imagine that this performance was likely to continue over the next few years.  A financial crisis had taken place, aggressively addressing it by resolving our largest banks was likely to cause greater economic distress in the short run and failing to address it was all but certain to cause economic stagnation for years. Furthermore, in order to set HAMP up to succeed it was incumbent on the decision makers to make a conservative prediction about future economic performance.  In fact, nominal median income increased by 0.3% from 2009 to 2011 and I believe that the likelihood of such weak performance should have been built into the HAMP program.

What we do know is that Dodd-Frank gave federal regulators numerous and wide-ranging powers to tame too big to fail institutions. … Obviously, for any of this to work the regulators must translate these “words on paper” into tough, sensible rules, and then they must enforce them fairly and consistently.

Examiners have to be on top of what’s happening inside these systemically important firms and pounce when something goes awry.

I realize that’s a big unknown. Everyone — including the regulators — realizes the agencies missed the 2008 financial crisis. They overlooked gaping risk management holes because firms were booking massive profits.

And it’s fair to question how well the agencies are implementing Dodd-Frank so far.

Personally I’m disappointed that no one in power — say, Geithner or Fed Chairman Ben Bernanke — has made it his mission to expand the corps of examiners dedicated to the largest banks. This people should be better trained and better paid.

But when push comes to shove, the regulators will act.

This is a very romantic view of how regulation works and why we should be optimistic about regulation after the financial crisis.  When Ms. Rehm writes that the regulators “overlooked gaping risk management holes because firms were booking massive profits,” she is in fact obscuring what actually happened.

The regulators often understood that the banks’ profits were derived from regulatory arbitrage with the result that insufficient capital was held against the risks held on — or as was frequently the case off — their balance sheets.  They even promulgated regulations that were designed to severely curtail the growth of the asset-backed commercial paper market in 2004 precisely because the banks were not holding sufficient capital against the guarantees they were providing to commercial paper conduits.

For reasons that remain entirely unclear, at the request of the banking industry the joint bank regulators chose via guidance interpreting the regulation not to implement the regulation as it was written.  It is hard to imagine that this interpretation would stand up to judicial review — if there were a path to judicial review for that guidance.  (For more details on this issue, see Section II.A et seq. of this paper.)

While I would like to believe that “this time is different,” the evidence indicates that just because regulators know they have to act doesn’t mean they will be capable of effectively exercising their authority to do so.

El-Erian repeats the mantra that “central banks succeeded in their overwhelming priority of avoiding economic depression.”  But this is precisely what they have not done, because a central bank’s toolkit does not enable it to address structural problems with the balance of trade.  Those must be addressed by policy makers – and thus policy makers are the only ones with the tools to avoid forced, sudden adjustments in such imbalances and economic depression.  Central banks can buy policy makers the time in which to act – but they can do no more than that.

By analogy with the Great Depression, we are currently somewhere in the late ’20s.  In 1925, after the Dawes plan had stabilized the European balance of payments situation via American lending to Germany, the central bankers got together and decided to work together to help Britain return to its pre-World War I peg to gold – expecting or hoping that policy makers would cooperate in this endeavor and facilitate the global rebalancing that needed to take place.  Instead French policy decisions, for example, ensured a steady inflow of gold, and capital flows were overall driven by disequilibrium exchange rates until in 1931 the system broke:  Britain finally acknowledged that the peg to gold could not be maintained and the international economy tumbled into Depression (though the move helped Britain put an end to a decade of stagnation).

Thus 2008 looks very like 1925.  Our efforts to muddle through may have been more effective than in the late twenties, because many understand that the underlying problem of trade and capital flow imbalances must be addressed.  On the other hand, policy makers’ actions have definitely been insufficient to date and there is good reason to fear that the vast challenge of international policy coordination will prove too great and that our system too will break under the stress of ongoing imbalances sometime over the next decade.

This concern was clearly expressed by El-Erian.  But he chose not to call it by its name.  What El-Erian is worried about is a second Great Depression.  And, as he states clearly, the only people with the tools to stave off such a crisis are the policy makers.  The question is whether they will fail as their 20th century forebears did before them.

Shiller writes:

Finance is substantially about controlling risk. If risk management is suitably democratized, and if its sophisticated tools are better dispersed throughout society, it could help reduce social inequality. …

The essence of finance is that contracts should benefit all parties.

This last sentence hints at a fundamental aspect of finance that Shiller left out of his New York Times essay:  asymmetric information.  Financiers — in the process of gaining the information necessary to “manage risk” — have access to information that is essential to pricing assets that trade for millions — and even billions — of dollars every day.  You and I don’t.  If we want the financiers to do their jobs in the public interest — however we choose to define that — we will have to compensate them for not abusing their privileged position.  Even when banks acted mostly as utilities, the 3-6-3 banking rule was a clear indicator that bankers were well-compensated for behaving themselves.

What worries me about seeking to “democratize Wall Street” is that the goal of democratization has been pursued for decades.  And most of the laws passed with this goal seem to just make Wall Street richer.  There was a time (before most of us were born) when stock brokers earned incomes like bankers.  The charged a relatively high fee for every trade and mostly worked for a small well-to-do clientele.

In 1969 Time Magazine asked “Should brokerage firms be allowed to sell their own stock to the public, thereby letting the ordinary investor in on Wall Street’s enormously profitable business?”  And as we all know the answer was yes.  The NYSE let member firms go public.  Access to the vast capital of public markets allow newcomers to reduce the commissions paid on stock trade dramatically — this too democratized access to the markets.

More or less at the same time, the NYSE ended its unofficial policy of protecting the customers of member firms from losses due to a member firm bankruptcy.  (cf. Ira Haupt & Co. 1963 and Dupont-Homsey & Co. 1960).  The SIPC was founded in 1970, backed not only by member contributions, but also by a line of credit from the Treasury.  That is, hand-in-hand with “democratization” of stock trading came government insurance against tail risk.

Stocks are now cheap to trade and within the financial reach of many Americans.  But it’s far from clear that democratization of the gains from trading in the stock market have accompanied this change.  From the “spinning” of IPOs to the growth of hedge funds and the movement of significant financial activity to “over-the-counter” derivatives markets, the rich and connected still have better ways of making money from the markets than the rest of us.   And it’s far from clear that you can write a law that will prevent financiers with access to information the rest of us don’t have from reaping the gains of the information in one way or another.

Maybe we should give up trying to democratize finance and turn our focus to reining in its excesses — while recognizing that a good share of the profits from finance will always end up flowing to the financiers.