Missing the point on the “wages of sin”

Ryan Avent seeks to rebut Matt Klein on the issue of whether a popped real estate bubble must have adverse consequences on the economy as a whole. Afterall, as Avent points out the houses are built and in the worst case we can just let them rot and turn our efforts to gainful production. He “dreams of a day when the only people who suffer from money-losing investments are the money-losing investors.”

The problem with our reaction to the real estate bubble is that the “money-losing investors” haven’t lost their money (yet). The houses were built on debt and there are vast losses on that debt that have not yet been realized.  There’s no issue of morality here.  Someone has to take the losses.  It should have been the banks (who had vast exposure on second liens) and the mortgage investors. Instead, we’ve been protecting the financial sector by convincing people to continue making payments at bubble prices on their houses.  That’s the point of HAMP, the government modification program.

The “wages of sin” language is unfortunate, but the point that nothing good can come of prolonging the financial sector’s realization of its losses over a decade or more remains. The nature of debt means that losses must be realized — and this truth remains with or without moralistic framing.

Vast numbers of mortgagees still owe twice as much as their homes are worth are are continuing to make payments (in December 2012 30% of mortgagees in the crisis states were underwater, 4.7% of all mortgagees owed twice as much as their homes were worth) — in part because the payments have been temporarily reduced through HAMP and HAMP-like mods. These payments are going to support the banks and mortgage investors, who are currently accounting for these loans as though there are no losses (i.e. because payments are current). Instead of these individuals’ income being freed to circulate in the economy productively, this income is spent on preventing the realization of losses in the financial sector.

People who know economics generally assume that what is happening can’t happen, because it doesn’t make sense.  Any rational homeowner would walk away from a mortgage that’s the double the value of the home — and indeed sometime over the course of the 40 to 50 years that this debt is to be paid most likely the homeowners will choose to walk away. However, currently large chunks of U.S. income are being spent on preventing the realization of financial sector losses. I would say that it’s no coincidence that the overall economy is simultaneously remarkably weak.

Given how poorly our financial system is functioning when it comes to simply recognizing losses and moving on, Matt Klein may be right to ask: “Wouldn’t it be ironic if our unwillingness to punish reckless lenders for their sins crippled our economy for a generation?”

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The Real Problem with the Revolving Door: A Monoculture of Thought

Finance and economics are difficult.  Understanding how and why the financial system or the economy works are deeply impenetrable questions that are best answered by healthy, aggressive debate, not by a consensus that we know what the answers are. In my view financial regulation will only be successful when we have competing schools of thought that are constantly pushing back against each other.

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.

A lesson from history: the safety of government debt depends on private sector liquidity

Narayana Kocherlakota brings up the safe asset meme: “The demand for safe financial assets has grown greatly since 2007. … At the same time, the supply of the assets perceived to be safe has shrunk over the past six years.” This he argues has reduced the market-clearing interest rate.

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.


[1] The sense in which it is true that this debt is risk-free is that the government in the model also issues money, so the government can never be forced into default. Of course once one adds multiple governments with multiple inflation rates to the model, the meaning of the term “risk-free debt” suddenly becomes so constrained that it effectively loses all meaning.
* I don’t mean to be too hard on Caballero here. He is wise enough to acknowledge the structural weaknesses in the DSGE framework and also that government guarantees won’t work if the government is viewed as risky.  My main difference with Caballero is my view that the government can easily be made risky by offering liquidity to financial markets.  The point here is that liquidity is a fine tuned public-private mechanism that will be destroyed by counting on one side to act as a liquidity provider.
[2] Andreades (1966). History of the Bank of England 1640 to 1903 reprint of 1909 edition, Augustus M. Kelley, New York, p. 198. Clapham,(1945).The Bank of England: A History, volume I, Cambridge University Press, Cambridge, pp. 271-2.
[3] Grigby v. Oakes, 126 E.R. 1420, 1421 (C.C.P. 1801). Cited in Horsefield (1944) “The Duties of a Banker II: the effects of inconvertibility,” Economica, p. 20-21.

The link between interest rates and financial instability is asymmetric information

Mike Konczal, Nick Rowe, and Brad DeLong are deeply disturbed by FOMC members who are concerned that low interest rates feed financial instability. Mike Konczal concludes his analysis of the arguments in favor of raising interest rates:

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.

How the 2005 bankruptcy reforms guarantee unfair returns to derivatives counterparties (and our largest banks)

The effects of the derivatives safe harbors in bankruptcy that protect financially sophisticated creditors at the expense of the bankrupt company’s other creditors (and were greatly expanded by the no-derivative-left-behind act of 2005 — a.k.a. BAPCPA) are demonstrated by this Lehman Brothers lawsuit.

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.