It is most entertaining to talk about health care with intelligent people. The differences in beliefs, and in philosophical orientation, are just amazing. Some of the difference in belief can be eliminated with data. The philosophical differences are harder to get rid of.
A starting point is that many many people think that our current health care system is a disaster and delivers terrible quality at very high cost.
I would suggest looking at a couple of these items:
1. The book, The Business of Health, by Ohsfeldt and Schneider. Among other things, these two economists show that if you take out the impact of high rates of murder and accidental (especially highway) deaths from the US life expectancy, the US ends up number one in life expectancy. Now how can you possibly say that our high rates of murder are due to failings of the health care system?
2. Read the paper by June and David O'Neill, "Health Status, Health Care and Inequality: Canada vs the US," NBER Working paper13429. They document the failings of comparing health care systems by metrics such as infant mortality and, similar to point number one above, life expectancy. On infant mortality, they show how much of a role low birth weight plays in infant mortality -- and how low birth weight is greatest for teenage mothers. Of course, the US has many more teenage mothers than Canada. Shall we blame teenage pregnancy on the health care system?
3. And the paper by Hall and Jones, "The Value of Life and the Rise in Health Spending," Quarterly Journal of Economics, Feb 2007. These economists argue that optimal health care spending in the US is not inconsistent with utility maximization and that as we grow richer we should expect the percentage of GDP spent on health to rise much higher. This is a great point, and they back it up with great theory. In fact a colleague of mine was recently lamenting how he could not spend as much as he would like on health care, because he cannot hire a doctor on a consulting basis as easily as he would like. This is true: the practices and institutional rules in place do restrict us from buying some health care that many of us would purchase if we could.
4. The paper by my Dartmouth colleague Jon Skinner, and Alan Garber, "Is American Health Care Uniquely Inefficient?," Journal of Economic Perspectives, American Economic Association, vol. 22(4), pages 27-50, Fall. In particular, note the very neat argument how heterogeneity in demand for health care in different regions of a country might make it look like that country is inefficient in producing health care.
And here are some interesting questions to ask folks and ponder their responses:
-- should insurance pay for routine expenses like eye exams, and teeth cleanings?
-- should insurance pay for annual doctor checkups?
-- Why do we assume that people can take their cars in for oil changes, understanding that regular oil changes increase the life of the car, but we cannot trust people to go see the doctor?
Thursday, August 20, 2009
Thursday, August 13, 2009
Health Care Incentives
One of my main worries about the health care proposals is that I don't see them doing anything significant to reduce costs -- and even that the whole mindset is misguided on the cost issue. (On this latter point, the correct measure of welfare is clearly not cost, but overall surplus. Even more spending on health care may well be welfare enhancing.)
But if we want to assume that there is spending beyond the point where marginal cost equals marginal benefit, and we want to reduce the total spending, the question is how to do it.
To that end, I would present the case of Dartmouth College. Like many reasonably sized institutions and businesses, the College self-insures in regard to the health expenses of its employees. So while we all think we have Blue Cross Blue Shield insurance, in fact that organization simply manages the administration of the College's health benefits to its employees. The College actually ends up paying all the bills. Of course this would be true even if we did buy true insurance, as over time the premium we would pay would have to equal costs.
My point here is simply that the College, since it bears all of its employees' health costs, has tremendous incentive to reduce those costs through whatever means it can. It can find the most efficient administrative entity to handle all the paperwork -- and it can find this administrator through a competitive process. I have to assume that Anthem BC/BS must offer the best overall package of service and cost. The College can also tell this administrator how to structure the different policies offered to employees, including deductibles, coninsurance, incentives for good behavior, etc. In fact we have a relatively active committee consisting of faculty, staff and administrators who work together to determine the policy options that will be offered each year. I think the overall incentives and ability to manage health care costs are quite high.
Even with these incentives and ability for an institution like Dartmouth to manage health care costs, we still see cost increases very similar to those of the rest of the nation. And I think our overall costs, in an absolute sense, are close to average as well. As a very rough calculation, the cost for a single person to buy health insurance from the College is around $6500. If I take that and multiply by the 300 million population of the US, and divide by US GDP of about 13.8 trillion dollars, I get around 14%, roughly our national expenditures on health care.
So I don't think that the College does any better in reducing costs than the rest of the country.
And this is even with the incentives and ability noted above -- and even with the Dartmouth Institute on campus, the folks who the Obama administration seem to think have the magic wand to show where waste is and how to eliminate it!
So here is the question: to the extent that the health care proposals shift the center of cost controls and incentives away from institutions like Dartmouth and towards the US government, why should we assume there will be better management of health care spending?
But if we want to assume that there is spending beyond the point where marginal cost equals marginal benefit, and we want to reduce the total spending, the question is how to do it.
To that end, I would present the case of Dartmouth College. Like many reasonably sized institutions and businesses, the College self-insures in regard to the health expenses of its employees. So while we all think we have Blue Cross Blue Shield insurance, in fact that organization simply manages the administration of the College's health benefits to its employees. The College actually ends up paying all the bills. Of course this would be true even if we did buy true insurance, as over time the premium we would pay would have to equal costs.
My point here is simply that the College, since it bears all of its employees' health costs, has tremendous incentive to reduce those costs through whatever means it can. It can find the most efficient administrative entity to handle all the paperwork -- and it can find this administrator through a competitive process. I have to assume that Anthem BC/BS must offer the best overall package of service and cost. The College can also tell this administrator how to structure the different policies offered to employees, including deductibles, coninsurance, incentives for good behavior, etc. In fact we have a relatively active committee consisting of faculty, staff and administrators who work together to determine the policy options that will be offered each year. I think the overall incentives and ability to manage health care costs are quite high.
Even with these incentives and ability for an institution like Dartmouth to manage health care costs, we still see cost increases very similar to those of the rest of the nation. And I think our overall costs, in an absolute sense, are close to average as well. As a very rough calculation, the cost for a single person to buy health insurance from the College is around $6500. If I take that and multiply by the 300 million population of the US, and divide by US GDP of about 13.8 trillion dollars, I get around 14%, roughly our national expenditures on health care.
So I don't think that the College does any better in reducing costs than the rest of the country.
And this is even with the incentives and ability noted above -- and even with the Dartmouth Institute on campus, the folks who the Obama administration seem to think have the magic wand to show where waste is and how to eliminate it!
So here is the question: to the extent that the health care proposals shift the center of cost controls and incentives away from institutions like Dartmouth and towards the US government, why should we assume there will be better management of health care spending?
Sunday, August 09, 2009
Review of the Health Care Proposals: Predation by Government Enterprises?
It is costly to stay up-to-date on the status of the health care bill specifics, but the broad picture seems pretty well agreed. The Kaiser Foundation provides good summaries, see here. As I read the proposals, I see these as the key features:
1. A mandate for all citizens to have health insurance (punishable with fines).
2. A mandate for all employers (except "small" businesses) to provide health insurance to employees.
3. Provide individuals with subsidies to buy insurance.
4. Provide "small" businesses with subsidies to provide insurance to employees.
5. Create "gateways" or "exchanges" through which individuals and certain employers would buy insurance.
Here are my issues, with the last one being the most serious.
First, if a key objective is to provide health care insurance to the currently uninsured and needy, the proposal will likely fail. The system is too complex. The people that I want to be covered by health insurance are likely to be excluded by this proposal simply because they will still not know what to do or how to get coverage.
Second, the proposal does not cut the tie between health insurance and the employer, in fact it increases the strength of that tie. If you want to increase portability of insurance, get rid of the employer-based nature of our current coverage. That would be a great move in the right direction. Do our employers buy car insurance for us? No. Not even life insurance, at least not most of it. Then why health insurance?
Third, the proposal is economic/social engineering at its worst. The proposal has a bunch of subsidies, the most insidious being those for "small" businesses. Now, I like small business as much as everyone, but I like big business too. Why should our health policy have built into it an advantage for some kind of businesses? Can you imagine how this will be manipulated in years to come? (As an aside, the proposals should be viewed in that light -- as living documents. Don't just take the current policy as the end of the road, but anticipate how it will change with political winds in the future.)
Fourth, and most serious I think, are the "gateways" or "exchanges" that will be created. Think of this gateway idea as a government-overseen consortium of insurers, all of who can offer different health policies to the individuals and employers who qualify to buy insurance through the gateway (a set that even in the current bill is set to expand over time, letting more and more employers and individuals opt into the gateway if they desire). At least in the House bill, there is a provision to ensure that there is a "public" or "community health insurance" option in the gateway. This public option will compete with private insurers. The problem is that the public option is likely to have a huge cost advantage over the private insurers, with the cost advantage arising from the likelihood that the public option will pay service providers (doctors, hospitals, pharma companies) a much lower rate than private insurers can. The version of the House bill that I just read clearly specifies that the public option will pay suppliers prices based off Medicare rates (that are very low compared to what private insurers pay). More on this issue below.
To the extent that the public option has a cost advantage, it is the stealth bomb of the health care proposal. We should expect the public option to be increasingly chosen. As that happens, suppliers will raise prices to the private insurers even more, making their cost disadvantage even worse, and the market share of the public option will increase even more. Sounds to me like a vicious cycle leading to a public monopoly -- hence my reference to predation by government enterprise. Give a government entity a cost advantage, and it will drive private business out.
I recognize there is a vigorous debate over this issue of the public option, and I do have some questions about the theory above. Why can the public option just piggyback on Medicare prices, while private insurers cannot? This is an interesting question. How can Medicare get such low rates today, while private insurers pay more? I suspect there are two factors, one being the sheer size of Medicare and the second being that health providers do not want to turn down Medicare patients for political reasons. These effects will apply just as strongly to the public option described above. Steven Pearlstein, whose editorials I normally find enormously enlightening, has one in the Washington Post today that seems to me to rather shrill and downright wrong. He says that Republicans are "propagating falsehoods" about the proposal, with his main point illustrated with this quote:
Now my analysis above might be wrong, and maybe Pearlstein's assurances about House leaders ruling out "piggybacking off Medicare" might turn out correct, but to say that I am being disengenous or being a "political terrorist" by making the argument, well, that is just the kind of discussion around this major policy proposal that we do not need. Lighten up, Pearlstein. You just lost a bunch of credibility from this reader.
I can support a health care proposal that would provide base insurance for the currently uninsured. I suspect many would support that. Why not just create something that did that, and leave the rest alone? And, be honest about what the effect will be: the more people we provide with free health care (free to them), the bigger will be the national bill for health care. This is NOT going to reduce costs.
1. A mandate for all citizens to have health insurance (punishable with fines).
2. A mandate for all employers (except "small" businesses) to provide health insurance to employees.
3. Provide individuals with subsidies to buy insurance.
4. Provide "small" businesses with subsidies to provide insurance to employees.
5. Create "gateways" or "exchanges" through which individuals and certain employers would buy insurance.
Here are my issues, with the last one being the most serious.
First, if a key objective is to provide health care insurance to the currently uninsured and needy, the proposal will likely fail. The system is too complex. The people that I want to be covered by health insurance are likely to be excluded by this proposal simply because they will still not know what to do or how to get coverage.
Second, the proposal does not cut the tie between health insurance and the employer, in fact it increases the strength of that tie. If you want to increase portability of insurance, get rid of the employer-based nature of our current coverage. That would be a great move in the right direction. Do our employers buy car insurance for us? No. Not even life insurance, at least not most of it. Then why health insurance?
Third, the proposal is economic/social engineering at its worst. The proposal has a bunch of subsidies, the most insidious being those for "small" businesses. Now, I like small business as much as everyone, but I like big business too. Why should our health policy have built into it an advantage for some kind of businesses? Can you imagine how this will be manipulated in years to come? (As an aside, the proposals should be viewed in that light -- as living documents. Don't just take the current policy as the end of the road, but anticipate how it will change with political winds in the future.)
Fourth, and most serious I think, are the "gateways" or "exchanges" that will be created. Think of this gateway idea as a government-overseen consortium of insurers, all of who can offer different health policies to the individuals and employers who qualify to buy insurance through the gateway (a set that even in the current bill is set to expand over time, letting more and more employers and individuals opt into the gateway if they desire). At least in the House bill, there is a provision to ensure that there is a "public" or "community health insurance" option in the gateway. This public option will compete with private insurers. The problem is that the public option is likely to have a huge cost advantage over the private insurers, with the cost advantage arising from the likelihood that the public option will pay service providers (doctors, hospitals, pharma companies) a much lower rate than private insurers can. The version of the House bill that I just read clearly specifies that the public option will pay suppliers prices based off Medicare rates (that are very low compared to what private insurers pay). More on this issue below.
To the extent that the public option has a cost advantage, it is the stealth bomb of the health care proposal. We should expect the public option to be increasingly chosen. As that happens, suppliers will raise prices to the private insurers even more, making their cost disadvantage even worse, and the market share of the public option will increase even more. Sounds to me like a vicious cycle leading to a public monopoly -- hence my reference to predation by government enterprise. Give a government entity a cost advantage, and it will drive private business out.
I recognize there is a vigorous debate over this issue of the public option, and I do have some questions about the theory above. Why can the public option just piggyback on Medicare prices, while private insurers cannot? This is an interesting question. How can Medicare get such low rates today, while private insurers pay more? I suspect there are two factors, one being the sheer size of Medicare and the second being that health providers do not want to turn down Medicare patients for political reasons. These effects will apply just as strongly to the public option described above. Steven Pearlstein, whose editorials I normally find enormously enlightening, has one in the Washington Post today that seems to me to rather shrill and downright wrong. He says that Republicans are "propagating falsehoods" about the proposal, with his main point illustrated with this quote:
But there is no credible way to look at what has been proposed by the president or any congressional committee and conclude that these will result in a government takeover of the health-care system. That is a flat-out lie whose only purpose is to scare the public and stop political conversation.
Now my analysis above might be wrong, and maybe Pearlstein's assurances about House leaders ruling out "piggybacking off Medicare" might turn out correct, but to say that I am being disengenous or being a "political terrorist" by making the argument, well, that is just the kind of discussion around this major policy proposal that we do not need. Lighten up, Pearlstein. You just lost a bunch of credibility from this reader.
I can support a health care proposal that would provide base insurance for the currently uninsured. I suspect many would support that. Why not just create something that did that, and leave the rest alone? And, be honest about what the effect will be: the more people we provide with free health care (free to them), the bigger will be the national bill for health care. This is NOT going to reduce costs.
Thursday, July 02, 2009
Health Care Cost Savings from Less Paperwork
Much has been written about the waste in the US health care system from excess paperwork. One estimate -- here, from Physicians for a National Health Program, puts the total cost of "administrative expenses" at 31% of total health care expenditures. That is more, it appears, than in countries with a single payer system. The idea is that if we cut out all the paperwork -- tracking of expenses by patient -- for doctors, hospitals, and insurance companies, we could save a bundle.
As I was working at school the other day, I heard some of our hourly employees talking about getting their timesheets in, so that they would get paid on time. It made me remember when I worked at Wahlstrom's restaurant in Harvey, MI and had to punch the time clock.
Think of all that time spent filling out timesheets, I thought. Not just at Tuck, but across the entire country. There must be tens of millions of hourly workers filling out timesheets, then a bookkeeper needs to record those hours, and paychecks need to be cut. I bet we could save millions of dollars by cutting that out.
And why stop there? In the Wall Street Journal was an article about the THOUSANDS of patents that Toyota has filed for the Prius hybrid. My gosh, think of all the paperwork and administrative cost associated with our patent system! Not just the filling out of forms and the government Patent Office, but all the lawyers involved! Cut that out and we would be talking real money.
But we can go even further. Just think, if everyone was just paid the same yearly salary -- kind of like if everyone had the same health plan -- then we could get rid of all kinds of things, in particular the entire income tax code. Since everyone would owe the same tax, we could just take it out of their pay up front. Think of the savings if we abolished the IRS! All those hours spent filling out forms, and dealing with audits, etc.
Maybe we need to just think for a minute: Why do we have folks fill out timesheets?
As I was working at school the other day, I heard some of our hourly employees talking about getting their timesheets in, so that they would get paid on time. It made me remember when I worked at Wahlstrom's restaurant in Harvey, MI and had to punch the time clock.
Think of all that time spent filling out timesheets, I thought. Not just at Tuck, but across the entire country. There must be tens of millions of hourly workers filling out timesheets, then a bookkeeper needs to record those hours, and paychecks need to be cut. I bet we could save millions of dollars by cutting that out.
And why stop there? In the Wall Street Journal was an article about the THOUSANDS of patents that Toyota has filed for the Prius hybrid. My gosh, think of all the paperwork and administrative cost associated with our patent system! Not just the filling out of forms and the government Patent Office, but all the lawyers involved! Cut that out and we would be talking real money.
But we can go even further. Just think, if everyone was just paid the same yearly salary -- kind of like if everyone had the same health plan -- then we could get rid of all kinds of things, in particular the entire income tax code. Since everyone would owe the same tax, we could just take it out of their pay up front. Think of the savings if we abolished the IRS! All those hours spent filling out forms, and dealing with audits, etc.
Maybe we need to just think for a minute: Why do we have folks fill out timesheets?
Thursday, June 25, 2009
Apple iPhone Price Elasticity
The market intelligence firm iSuppli has estimated the cost of the new iPhone 3G S to be $178.96 -- $172.46 of components and manufacturing expense of $6.50. I am not sure how accurate these are, but let's take them to be an estimate of Apple's marginal cost of production. They are probably pretty close.
From price theory, we know that optimal pricing implies the following markup relationship:
(price - MC)/price = 1/elasticity
or in words, the markup of price over marginal cost should be inversely related to elasticity.
Estimates of price are in the vicinity of $600: this is not what consumers pay, but what ATT likely pays for the phone. Using the $600 price and the above formula implies an elasticity of demand of 1.43. Probably not a bad estimate.
There are some interesting questions to think about in regard to what price one should actually use and how the impact of ATT's service revenues affect things. But I think that the above formula has to be based on the price Apple actually receives, and that would be the $600 figure.
From price theory, we know that optimal pricing implies the following markup relationship:
(price - MC)/price = 1/elasticity
or in words, the markup of price over marginal cost should be inversely related to elasticity.
Estimates of price are in the vicinity of $600: this is not what consumers pay, but what ATT likely pays for the phone. Using the $600 price and the above formula implies an elasticity of demand of 1.43. Probably not a bad estimate.
There are some interesting questions to think about in regard to what price one should actually use and how the impact of ATT's service revenues affect things. But I think that the above formula has to be based on the price Apple actually receives, and that would be the $600 figure.
A Dangerous Profession?
News reports this morning are of 70 university professors in Iran being arrested, whereabouts unknown, after meeting with former prime minister and opposition leader Mousavi.
Events in Iran could be some of the more significant in the Middle East since the Iraq War, maybe even more so.
It is striking to see these kind of crackdowns in 2009. Imagine what would be the case in any Western country if text messaging and cell phones were cut off, the internet restricted, and professors were arrested for meeting someone.
Can the current leaders of Iran pull this off? Can a government in this day and age be so intolerant, restrictive and oppressive and get away with it? The bulk of evidence leans toward "no" but China/Tiananmen Square shows it can happen.
My guess is that the current regime will get through the current crisis but that the genie is indeed out of the bottle and things will not be the same. How significant will be the changes and how long they will take are the questions.
Events in Iran could be some of the more significant in the Middle East since the Iraq War, maybe even more so.
It is striking to see these kind of crackdowns in 2009. Imagine what would be the case in any Western country if text messaging and cell phones were cut off, the internet restricted, and professors were arrested for meeting someone.
Can the current leaders of Iran pull this off? Can a government in this day and age be so intolerant, restrictive and oppressive and get away with it? The bulk of evidence leans toward "no" but China/Tiananmen Square shows it can happen.
My guess is that the current regime will get through the current crisis but that the genie is indeed out of the bottle and things will not be the same. How significant will be the changes and how long they will take are the questions.
Saturday, June 20, 2009
The Market for Human Organs
So Steve Jobs, CEO of Apple, had a liver transplant -- see story here.
Interestingly, he had it in Tennessee, not the state that first comes to mind when speaking of the forefront of medicine.
But if your criteria is length of time to wait on the liver transplant list, Tennessee comes up with the shortest wait.
Interesting. Someone with enough money can relocate to a different area, get on the local list, and get a needed transplant before someone with less wealth.
Is that wrong? Should Steve Jobs be on the same timetable as everyone else?
Why do we accept wealth as enabling people to get an advantage in so many things, even many that are life-preserving (a new Mercedes is certainly safer than a used Chevy), but when it comes to things like organ transplants we balk?
Would it be OK if Mr. Jobs could offer cash to a live donor to spare half of their liver (all that is generally needed for a "live" liver transplant)? Is that OK if that person would never have considered donating part of their liver if not for the money? Is it not obvious that offering cash for livers would dramatically increase the supply? Aren't we really interested in saving lives, after all?
Interestingly, he had it in Tennessee, not the state that first comes to mind when speaking of the forefront of medicine.
But if your criteria is length of time to wait on the liver transplant list, Tennessee comes up with the shortest wait.
Interesting. Someone with enough money can relocate to a different area, get on the local list, and get a needed transplant before someone with less wealth.
Is that wrong? Should Steve Jobs be on the same timetable as everyone else?
Why do we accept wealth as enabling people to get an advantage in so many things, even many that are life-preserving (a new Mercedes is certainly safer than a used Chevy), but when it comes to things like organ transplants we balk?
Would it be OK if Mr. Jobs could offer cash to a live donor to spare half of their liver (all that is generally needed for a "live" liver transplant)? Is that OK if that person would never have considered donating part of their liver if not for the money? Is it not obvious that offering cash for livers would dramatically increase the supply? Aren't we really interested in saving lives, after all?
Wednesday, May 20, 2009
Credit Card Charges
The credit card bill is headed for the President's desk, where it is sure to be signed.
Among the more significant items are: teaser rates must last at least six months; payments get applied to the lowest interest rate balance first; and consumers cannot be charged for overlimit fees unless they have asked for permission to go overlimit.
These are significant changes, and there are other ones as well. Some of them I find not entirely disagreeable. Disclosure of terms has not been wonderful, and I think there is the capability of banks to exercise market power on the basis of locked-in consumers: once your credit record gets scarred, you effectively cannot switch banks and your existing lender has you at their mercy.
This said, there will be negative consequences -- many consumers will not get offers of credit that they otherwise would have. That will mean that folks who get into trouble and use credit cards to weather the storm (how many of us have not been there) will have to forego more purchases. Let's not immediately think of alcohol and cigarettes, but how about food and medicine??
What bothers me most about the discussion is the naivety that commentators display in talking about the ramifications of the changes. The view that some people have of business is just amazing. Read this New York Time story,especially this quote:
So the thinking is that a business basically has these various faucets, out of which profits flow. If one faucet slows down -- in this case because of regulation -- well, you just turn up the other one. After all, business has to maintain its profitability, right?
If only it were so easy.
If some set of credit card users are currently unprofitable, why are they not already eliminated? Or if the banks could increase profits by changing terms on the "sterling" users, why wouldn't they already have done that?
The answer is, of course, that those free lunches simply do not exist. All faucets are already optimized, producing as much profit as they can. If one slows down, turning the other ones will only reduce profit.
There are some more complicated theories of how some deals will be cut back. Basically the idea is that I might offer things like frequent flyer miles to all users even if I do not make money from charges per se. What I am hoping is that some consumers will take the card for the miles and then end up paying me interest. If the interest rate gets capped by regulation, the whole scheme gets less profitable so I might stop offering the deal.
Understanding the why of things is rather critical.
Among the more significant items are: teaser rates must last at least six months; payments get applied to the lowest interest rate balance first; and consumers cannot be charged for overlimit fees unless they have asked for permission to go overlimit.
These are significant changes, and there are other ones as well. Some of them I find not entirely disagreeable. Disclosure of terms has not been wonderful, and I think there is the capability of banks to exercise market power on the basis of locked-in consumers: once your credit record gets scarred, you effectively cannot switch banks and your existing lender has you at their mercy.
This said, there will be negative consequences -- many consumers will not get offers of credit that they otherwise would have. That will mean that folks who get into trouble and use credit cards to weather the storm (how many of us have not been there) will have to forego more purchases. Let's not immediately think of alcohol and cigarettes, but how about food and medicine??
What bothers me most about the discussion is the naivety that commentators display in talking about the ramifications of the changes. The view that some people have of business is just amazing. Read this New York Time story,especially this quote:
And to make up for lost income, the card companies are going after those people with sterling credit.
So the thinking is that a business basically has these various faucets, out of which profits flow. If one faucet slows down -- in this case because of regulation -- well, you just turn up the other one. After all, business has to maintain its profitability, right?
If only it were so easy.
If some set of credit card users are currently unprofitable, why are they not already eliminated? Or if the banks could increase profits by changing terms on the "sterling" users, why wouldn't they already have done that?
The answer is, of course, that those free lunches simply do not exist. All faucets are already optimized, producing as much profit as they can. If one slows down, turning the other ones will only reduce profit.
There are some more complicated theories of how some deals will be cut back. Basically the idea is that I might offer things like frequent flyer miles to all users even if I do not make money from charges per se. What I am hoping is that some consumers will take the card for the miles and then end up paying me interest. If the interest rate gets capped by regulation, the whole scheme gets less profitable so I might stop offering the deal.
Understanding the why of things is rather critical.
Saturday, May 16, 2009
How Does Closing Dealers Help the Auto Companies?
Can someone explain this one to me? The dealers are independent, and buy cars from the manufacturers at a wholesale price. Yes, there are some volume-based rebates and so on, but nothing that would seem to change my basic view of things.
For any given wholesale price, the manufacturers want to sell as many cars as possible. Or, to put it differently, for any wholesale price, the manufacturers want the final retail price to the customer as low as possible.
This calls for as much competition among the dealers as possible.
Closing dealers reduces competition among dealers and for a given wholesale price causes a larger wedge between that wholesale price and the final retail price.
If there were things that the dealers were doing such as providing information or extra services, then there is a valid reason for the manufacturer to want to limit price competition -- to avoid some dealers from free-riding on other dealers' provision of services.
But in the modern auto world, I don't know what services are being free-ridden on. Consumers can find most information online. All that dealers need to do is to have some cars on the lot for people to drive. The manufacturers can easily require that and even pay for the cost.
Many people get the basic economics here wrong, even people who are pretty smart. They somehow think that competition between dealers on price reduces the price that the manufacturer gets. This is clearly wrong. Or they think that the manufacturers are paying for the dealers' costs. That also is not right.
I cannot believe that the manufacturers and their consultants are getting this wrong. There must be some other contractual obligation that I am unaware of, or there is some freeriding issue that is not obvious to me.
For any given wholesale price, the manufacturers want to sell as many cars as possible. Or, to put it differently, for any wholesale price, the manufacturers want the final retail price to the customer as low as possible.
This calls for as much competition among the dealers as possible.
Closing dealers reduces competition among dealers and for a given wholesale price causes a larger wedge between that wholesale price and the final retail price.
If there were things that the dealers were doing such as providing information or extra services, then there is a valid reason for the manufacturer to want to limit price competition -- to avoid some dealers from free-riding on other dealers' provision of services.
But in the modern auto world, I don't know what services are being free-ridden on. Consumers can find most information online. All that dealers need to do is to have some cars on the lot for people to drive. The manufacturers can easily require that and even pay for the cost.
Many people get the basic economics here wrong, even people who are pretty smart. They somehow think that competition between dealers on price reduces the price that the manufacturer gets. This is clearly wrong. Or they think that the manufacturers are paying for the dealers' costs. That also is not right.
I cannot believe that the manufacturers and their consultants are getting this wrong. There must be some other contractual obligation that I am unaware of, or there is some freeriding issue that is not obvious to me.
Monday, March 23, 2009
AIG and "Payment in Full"
Some press stories note that the Fed is paying holders of AIG credit default swaps full face value. I am not really sure what that means. My understanding of the CDSs is that when issued, they were structured to have a zero value, with the premium being paid just sufficient to cover the insurance liability. If the likelihood of default on the underlying security went up, then there would be a premium paid for that contract. So to say that the Fed (I take this to be the Maiden Lane funds that were set up) is paying full face value is kind of nonsensical. I suspect what is happening is that the Fed is buying a portfolio of underlying securities and the related CDS/insurance for full face value of the underlying security. That makes sense, for a holder of both the security and the CDS would essentially have a guarantee of full payment (so long as the seller of the insurance was going to pay). If this is the case, there is nothing that I see wrong in paying 100% of face value of the underlying security and in fact that makes sense. The transaction eliminates a liability from AIG’s balance sheet and eliminates a need for them to post collateral – and these are the reasons the Fed bailed out AIG in the first place.
AIG and the House of Thugs
The US House of Representatives actually caved in to the rising clamor of populist rhetoric and passed some kind of bill that would ostensibly tax AIG bonuses at 90%.
I only hope that the world sees this as the grandstanding which it is, not as a true willingness to use the United States Tax Code not just as a tool of social policy but as a device to enforce the Members’/Thugs’ code of ethical behavior.
The AIG bonuses do upset anyone, me included, at first hearing. But calmer people think about it a bit and reflect on why they perhaps make sense. There is also a long history -- well, several months -- of Fed and/or Treasury employees dealing with this issue. Our President and his Treasury Secretary would be well advised to stop fueling the populist fires.
Let’s see if the Senate can put the damper on this craziness. If not, Obama’s chickens will have come home to roost.
I only hope that the world sees this as the grandstanding which it is, not as a true willingness to use the United States Tax Code not just as a tool of social policy but as a device to enforce the Members’/Thugs’ code of ethical behavior.
The AIG bonuses do upset anyone, me included, at first hearing. But calmer people think about it a bit and reflect on why they perhaps make sense. There is also a long history -- well, several months -- of Fed and/or Treasury employees dealing with this issue. Our President and his Treasury Secretary would be well advised to stop fueling the populist fires.
Let’s see if the Senate can put the damper on this craziness. If not, Obama’s chickens will have come home to roost.
Wednesday, March 11, 2009
The Meaning of Leadership
President Obama signed an omnibus spending bill today that included 9,000 earmarks worth over $8 billion (yes, that is real money). Several news sources have noted that he signed the bill outside the range of cameras, but he did come out to make comments on the bill and earmarks. Here is part of what he said:
Ah yes, the old Prisoner's Dilemma. Hey, if everyone is feeding at the trough, I am an idiot for starving my constituents.
What a leader would do is eliminate the incentives for everyone to behave like a pig instead of complaining about how legislators act in their own self interest.
President Obama added: "Now, let me be clear: Done right, earmarks give legislators the opportunity to direct federal money to worthy projects that benefit people in their district, and that's why I have opposed their outright elimination. I also find it ironic that some of those who railed the loudest against this bill because of earmarks actually inserted earmarks of their own -- and will tout them in their own states and districts.
Ah yes, the old Prisoner's Dilemma. Hey, if everyone is feeding at the trough, I am an idiot for starving my constituents.
What a leader would do is eliminate the incentives for everyone to behave like a pig instead of complaining about how legislators act in their own self interest.
On Hiring Foreign MBAs
The WSJ today printed an editorial from my colleagues and fellow deans Matt Slaughter and Paul Danos, and me.
The topic is the Employ American Workers Act, which restricts hiring practices of US companies that accepted stimulus and/or TARP funds. Like I said in my NYT post -- see here -- once you accept Federal money, you better be prepared to have them tell you what to do.
In this case, the government's restrictions are especially pernicious. Besides the economic illogic of it, pitting US citizens and foreign citizens against one another is not the way to go. A colleague sent me an email with the words from the Statue of Liberty, and they say it better than anything else:
Some people want to close that golden door -- and they accuse the bankers of being selfish!
The topic is the Employ American Workers Act, which restricts hiring practices of US companies that accepted stimulus and/or TARP funds. Like I said in my NYT post -- see here -- once you accept Federal money, you better be prepared to have them tell you what to do.
In this case, the government's restrictions are especially pernicious. Besides the economic illogic of it, pitting US citizens and foreign citizens against one another is not the way to go. A colleague sent me an email with the words from the Statue of Liberty, and they say it better than anything else:
"Give me your tired, your poor,
Your huddled masses yearning to breathe free,
The wretched refuse of your teeming shore.
Send these, the homeless, tempest-tost to me,
I lift my lamp beside the golden door!"
Some people want to close that golden door -- and they accuse the bankers of being selfish!
Tuesday, March 10, 2009
Mark to Market: Gains to come
The mark-to-market, fair value debate is a rich one, with the two sides both having support. In principle, of course, mark to market is great -- market prices impound all relevant information, so they should be used in financial statements and in regulation as well. The issue today is not even how informative prices are (I could argue they are not) but how informative mark to model results are. Without knowing all the parameters that were used to fairly value assets, in the absence of relevant market prices, I think I might prefer just full disclosure of holdings and let me do the valuations (of course, we don't have full disclosure either, so we are really choosing from imperfect choices).
But nonetheless, my belief is that for banks, most securities and derivatives have been marked down to levels that are, at worst, not too much above any sense of true value. Thus, there is a tremendous upside for mark-ups once asset prices begin to rise (and they will). If we repeal mark to market now, banks will be able to take some write-ups, which will of course get reported as profits, just as the writedowns were taken as losses. If we don't repeal mark to market, I expect the gains will come a bit later, as valuation models won't change immediately. The total gains to be reported will be the same, but the timing may well be different. If one believes in some market psychology, I suppose that there could be a differential effect. I am not one to bet on such things, but I could see an argument for keeping mark to model for now and letting the writeups occur with a big bang all at once -- hopefully sometime soon. Since in principle I think mark to market is what we want, we might as well stick to our principles and hold out for what could be some massive writeups.
But nonetheless, my belief is that for banks, most securities and derivatives have been marked down to levels that are, at worst, not too much above any sense of true value. Thus, there is a tremendous upside for mark-ups once asset prices begin to rise (and they will). If we repeal mark to market now, banks will be able to take some write-ups, which will of course get reported as profits, just as the writedowns were taken as losses. If we don't repeal mark to market, I expect the gains will come a bit later, as valuation models won't change immediately. The total gains to be reported will be the same, but the timing may well be different. If one believes in some market psychology, I suppose that there could be a differential effect. I am not one to bet on such things, but I could see an argument for keeping mark to model for now and letting the writeups occur with a big bang all at once -- hopefully sometime soon. Since in principle I think mark to market is what we want, we might as well stick to our principles and hold out for what could be some massive writeups.
Thursday, March 05, 2009
Layoffs, Across the Board Wage Cuts, and Elections
We had our local school budget vote in Hanover on March 3 -- one of the great things about NH that is taken for granted is that we still have significant local control over school issues that matter (like the budget).
On the ballot was a special item: a single ballot measure that asked for an appropriation of around $80,000 to keep one elementary school teacher position. This was over and above the vote on the overall budget. If this single item did not pass, a teacher would lose his/her job and class sizes, especially for the third grade, would increase slightly.
I voted for it, and I usually vote for resources for our schools. I don't have any children in the elementary or middle schools any longer, and just one senior in high school. I do have an interest as a Tuck professor in making sure that our schools are excellent, for faculty recruiting purposes. So that is my disclosure.
One would think, in these times, and with all the outcry for people to take salary cuts to allow others to keep their jobs, that something like this would win by a landslide. At a cost of $17 on average per household (increased property taxes) one could let a teacher keep their job, and at the same time improve the quality of education at the elementary school. Think about it -- this is not a "redundant" position we are eliminating, like many layoffs where the work just no longer needs to be done or even can be done. This is a teacher's position, which if eliminated means more students for the other teachers to deal with.
It barely passed. By 20 votes on a total vote cast of around 1,000.
Now maybe it is my viewpoint, but I see this as interesting commentary on those calls for working people to take salary cuts to maintain the jobs of others. And I don't take it as positive, even though the item passed. What is striking is that so few people were willing to cough up a few more dollars to keep a teacher!
In another post to come, I will lay out why I think the push for wage cuts to preserve jobs is generally ill-advised.
On the ballot was a special item: a single ballot measure that asked for an appropriation of around $80,000 to keep one elementary school teacher position. This was over and above the vote on the overall budget. If this single item did not pass, a teacher would lose his/her job and class sizes, especially for the third grade, would increase slightly.
I voted for it, and I usually vote for resources for our schools. I don't have any children in the elementary or middle schools any longer, and just one senior in high school. I do have an interest as a Tuck professor in making sure that our schools are excellent, for faculty recruiting purposes. So that is my disclosure.
One would think, in these times, and with all the outcry for people to take salary cuts to allow others to keep their jobs, that something like this would win by a landslide. At a cost of $17 on average per household (increased property taxes) one could let a teacher keep their job, and at the same time improve the quality of education at the elementary school. Think about it -- this is not a "redundant" position we are eliminating, like many layoffs where the work just no longer needs to be done or even can be done. This is a teacher's position, which if eliminated means more students for the other teachers to deal with.
It barely passed. By 20 votes on a total vote cast of around 1,000.
Now maybe it is my viewpoint, but I see this as interesting commentary on those calls for working people to take salary cuts to maintain the jobs of others. And I don't take it as positive, even though the item passed. What is striking is that so few people were willing to cough up a few more dollars to keep a teacher!
In another post to come, I will lay out why I think the push for wage cuts to preserve jobs is generally ill-advised.
Gore on the Warming Debate (Oops, I'm sorry, there is no debate)
Al Gore had a great little exchange with Bjorn Lomborg, as reported in the Wall Street Journal:
Right, climate change is not a matter of theory. Then what exactly is it? Empirical evidence without any theory to tell us how to interpret the data?
I don't know what the political system of the Maldives is, but if the NH legislature were to pass a bill saying that we needed to build a coastal defense against sea rise, I would not give it a minute of thought (but it would be amusing).
And, even if there is a significant human element to climate change, does it automatically follow that resources should be devoted to climate change rather than to other problems?
You should be wary when people move to close off debate. How many "certain" things in economics and finance have been challenged successfully after having been broadly accepted? Several for sure (the CAPM being perhaps the number one example).
But he was challenged by Mr. Lomborg, the Danish skeptical environmentalist who thinks the world would be better off spending more money on health and education issues than curbing carbon emissions.
“I don’t mean to corner you, or maybe I do mean to corner you, but would you be willing to have a debate with me on that point?” asked the polo-shirt wearing Dane.
“I want to be polite to you,” Mr. Gore responded. But, no. “The scientific community has gone through this chapter and verse. We have long since passed the time when we should pretend this is a ‘on the one hand, on the other hand’ issue,” he said. “It’s not a matter of theory or conjecture, for goodness sake,” he added.
As an example, he pointed to a new addition to the budget for the island nation of the Maldives: “Funds to buy a new nation.”
Right, climate change is not a matter of theory. Then what exactly is it? Empirical evidence without any theory to tell us how to interpret the data?
I don't know what the political system of the Maldives is, but if the NH legislature were to pass a bill saying that we needed to build a coastal defense against sea rise, I would not give it a minute of thought (but it would be amusing).
And, even if there is a significant human element to climate change, does it automatically follow that resources should be devoted to climate change rather than to other problems?
You should be wary when people move to close off debate. How many "certain" things in economics and finance have been challenged successfully after having been broadly accepted? Several for sure (the CAPM being perhaps the number one example).
Tuesday, March 03, 2009
Lloyd Blankfein's Views
For those who have not seen it, Lloyd Blankfein, CEO of Goldman Sachs, gives a nice overview of lessons learned in the Financial Times. See here.
I cannot agree more on his point that the financial services industry has destroyed a lot of trust. I am not sure what they have destroyed more of -- trust or wealth.
The thing that bothers me most is the destruction of trust in markets generally. There will be a wholesale shift to the public sector. It won't surprise me to see some Eastern European countries shifting seriously back to a communistic mentality, thinking that they were actually better off back then. I for one think that is very wrong.
One source of optimism is that sales of Atlas Shrugged have been soaring. The Economist had the original story, but here is a link from another paper.
I cannot agree more on his point that the financial services industry has destroyed a lot of trust. I am not sure what they have destroyed more of -- trust or wealth.
The thing that bothers me most is the destruction of trust in markets generally. There will be a wholesale shift to the public sector. It won't surprise me to see some Eastern European countries shifting seriously back to a communistic mentality, thinking that they were actually better off back then. I for one think that is very wrong.
One source of optimism is that sales of Atlas Shrugged have been soaring. The Economist had the original story, but here is a link from another paper.
Saturday, February 28, 2009
AIG, Maiden Lane, and Buying CDOs
I have another question concerning AIG and CDOs that maybe someone can help with. The Fed set up Maiden Lane II and III as special purpose vehicles to assist in the bailout of AIG. These funds buy the underlying CDOs that AIG wrote insurance on. Once the funds own the underlying CDOs, they can extinguish the CDS written on them (thus saving AIG from collateral calls and further writedowns). So here is the question: If one of the big problems with TARP was how to buy mortgage backed securities from the banks, how is the Fed managing to buy tens of billions of mortgage backed securities to bail out AIG? It would seem a particularly difficult transaction since the holder may own the CDO as well as the CDS, ie,, the insurance. So does the Fed just have to pay 100% on the dollar? Well, that would explain how they can get the deals done.
AIG, Foreign Banks, and the Role of Regulation
There is an underlying story in the AIG fiasco that does not get adequate attention. See, for instance, Joe Nocera's generally excellent piece in the NYT today, or for a piece from last September that makes my point really well, see this article in International Financial Law Review.
AIG was engaged in a big way in regulatory and ratings arbitrage. Many commentators fault the regulatory system for failing to monitor and control AIG, even though there were regulators sitting in AIG's US headquarters continuously. Perhaps part of the problem was that the Financial Products Group was based in London. It is probably a lot harder to regulate things offshore.
And why was the FPG in London? Well, I cannot find figures on it, but there is certainly a lot of qualitative evidence that European banks (French, German) were very big buyers of AIG's credit default swaps (read: insurance). Why? Because Basel II, the international banking regulatory accord, specified the amount of capital required to be held against different classes of assets. If you could get a AAA rating on assets (insurance, I think, was actually the key), then the amount of capital you needed was much lower (doesn't this sound like the issue with the US investment banks and leverage -- indeed it is). So how can we get a AAA rating on some of our subprime assets? In steps AIG, with their credit default swaps.
So the banking regulatory system, set up to a great extent by the Europeans, created a demand for the insurance that AIG was more than willing to sell.
What is to blame? The regulation that created the demand, or the lack of regulation that allowed AIG to persist? Not clear to me. Some of both, no doubt -- and some serious lack of oversight at AIG themselves.
Perhaps it does come back to what more and more people tell me: you need the overall leverage restrictions on the banking system. If you start parsing risk and saying these kinds of assets need x% capital, and another kind of asset only y%, you are asking for regulatory and ratings arbitrage. And just like with illegal drugs, once the demand is created, it is very hard to restrict supply.
I wonder how much European banks really are benefitting from the US taxpayer's bailout of AIG. Why is Treasury and the Fed so willing to do this? Are they extracting something from the European banks? How long will it take before we hear about the sorry state of European banks (of course some of that has come out already, but I suspect not nearly all of it).
AIG was engaged in a big way in regulatory and ratings arbitrage. Many commentators fault the regulatory system for failing to monitor and control AIG, even though there were regulators sitting in AIG's US headquarters continuously. Perhaps part of the problem was that the Financial Products Group was based in London. It is probably a lot harder to regulate things offshore.
And why was the FPG in London? Well, I cannot find figures on it, but there is certainly a lot of qualitative evidence that European banks (French, German) were very big buyers of AIG's credit default swaps (read: insurance). Why? Because Basel II, the international banking regulatory accord, specified the amount of capital required to be held against different classes of assets. If you could get a AAA rating on assets (insurance, I think, was actually the key), then the amount of capital you needed was much lower (doesn't this sound like the issue with the US investment banks and leverage -- indeed it is). So how can we get a AAA rating on some of our subprime assets? In steps AIG, with their credit default swaps.
So the banking regulatory system, set up to a great extent by the Europeans, created a demand for the insurance that AIG was more than willing to sell.
What is to blame? The regulation that created the demand, or the lack of regulation that allowed AIG to persist? Not clear to me. Some of both, no doubt -- and some serious lack of oversight at AIG themselves.
Perhaps it does come back to what more and more people tell me: you need the overall leverage restrictions on the banking system. If you start parsing risk and saying these kinds of assets need x% capital, and another kind of asset only y%, you are asking for regulatory and ratings arbitrage. And just like with illegal drugs, once the demand is created, it is very hard to restrict supply.
I wonder how much European banks really are benefitting from the US taxpayer's bailout of AIG. Why is Treasury and the Fed so willing to do this? Are they extracting something from the European banks? How long will it take before we hear about the sorry state of European banks (of course some of that has come out already, but I suspect not nearly all of it).
Friday, February 27, 2009
Back from Behind Enemy Lines: Redistribution Logic
See my post immediately below about my venture onto the New York Times' blog, Room for Debate.
I am really surprised, and somewhat dismayed, at the vitriol heaped on my comments, and on me personally. Wow. Several lessons to be learned there, mostly concerning the nature of the NYT readership and the curious trust that liberals give the Federal government on some issues (the wisdom of the stimulus bill) but not on others.
But one set of comments in particular stood out and showed me the redistributionist, entitlement mentality that is now quite prevalent. Look at these quotes:
Let's leave aside the fact that in 2006, the top 1% of the taxpayers in this country paid 40% of the personal income taxes while earning 20% of the income.
The more important issue here is the tone in the above quote: The other 99% MUST share in only 80%...the remaining 99% of us...have ONLY A CHANCE TO EARN FAR LESS THAN 1% APIECE...
No, sorry, that is not the way this country or any market economy works. Actually, everyone has the chance to get into that top 1%. It might take some effort. You are not going to get there from complaining. It might take several generations -- of parents sacrificing for their children, who then move up, and give the next generation an even better chance. I come across loads of people like that who are in the top earning categories.
It may have been forgotten by many, but the beauty of this country is indeed that everyone has opportunity to become great, and to get respect and wealth.
I am really surprised, and somewhat dismayed, at the vitriol heaped on my comments, and on me personally. Wow. Several lessons to be learned there, mostly concerning the nature of the NYT readership and the curious trust that liberals give the Federal government on some issues (the wisdom of the stimulus bill) but not on others.
But one set of comments in particular stood out and showed me the redistributionist, entitlement mentality that is now quite prevalent. Look at these quotes:
The result is that 1% of America’s wealthiest families take home 20% of the nations earnings.
Think about that. Does that seem fair to you?
The other 99% of Americans must share in only 80% of our country’s earnings. While 1% of the wealthiest Americans enjoy 20% of our nation’s earnings, the
remaining 99% of us, on average, have only a chance to earn far less than 1% apiece of the money our nation produces every year.
Let's leave aside the fact that in 2006, the top 1% of the taxpayers in this country paid 40% of the personal income taxes while earning 20% of the income.
The more important issue here is the tone in the above quote: The other 99% MUST share in only 80%...the remaining 99% of us...have ONLY A CHANCE TO EARN FAR LESS THAN 1% APIECE...
No, sorry, that is not the way this country or any market economy works. Actually, everyone has the chance to get into that top 1%. It might take some effort. You are not going to get there from complaining. It might take several generations -- of parents sacrificing for their children, who then move up, and give the next generation an even better chance. I come across loads of people like that who are in the top earning categories.
It may have been forgotten by many, but the beauty of this country is indeed that everyone has opportunity to become great, and to get respect and wealth.
Thursday, February 26, 2009
Republican Governors Rejecting Fed Money?
I did a guest post on a New York Times blog tonight; they asked me to comment on why some governors might reject Federal stimulus money. Seems to me that they don't want to get caught in the Federal bear hug, but I doubt that they will actually go through with their threat to turn down the money.
At any rate, I seem to have riled up a few NYT readers.
Check it out here: http://roomfordebate.blogs.nytimes.com/2009/02/26/when-to-take-a-federal-hand-out/
At any rate, I seem to have riled up a few NYT readers.
Check it out here: http://roomfordebate.blogs.nytimes.com/2009/02/26/when-to-take-a-federal-hand-out/
Thursday, February 19, 2009
The Obama Mortgage Plan
I understand the desire to help those homeowners who have problems with their mortgages.
But I also believe there is a need to get mortgage-related assets off the books of the banks and into the hands of less risk-averse investors. This must be the biggest potentially mutually beneficial exchange since...well, the Resolution Trust Corporation.
The new mortgage plan has a mixed set of consequences, some unintended. I fear that it throws a lot more uncertainty into the valuation process. It will also take some of the more clearly profitable mortgages out of the pools -- which could be a plus. On the first point, uncertainty, it would seem to make the valuation of mortgages and mortgage backed securities even more difficult. Who is now going to be in default? How do we assess likely default rates if the feds are encouraging the lowering of interest payments? How does all this work within the confines of contract law in the context of mortgage backed securities? Senior tranches may prefer foreclosure and liquidation to stretching things out and accepting lower payments - if they can even be forced to accept lower payments. But more to my point, who is going to bid a reasonable price to buy senior MBS from banks with this kind of uncertainty? Have we made the valuation problem easier or more difficult?
On the second point, taking out the most profitable mortgages, the plan makes it easier for mortgagees to refinance at lower rates. Great for them, and this gets full payment of principal into the hands of the trusts holding the mortgages, which will in turn pay off the senior tranches according to priority. That is good, for as those tranches are repaid, the securities are retired and the holders can book what is likely to be a profit. What is left, however, is truly the most toxic -- mortgages that cannot qualify even for these generous (moral hazard-inducing!) restructuring terms. What this implies for the valuation of the remaining lower tranches is probably not pretty.
But I also believe there is a need to get mortgage-related assets off the books of the banks and into the hands of less risk-averse investors. This must be the biggest potentially mutually beneficial exchange since...well, the Resolution Trust Corporation.
The new mortgage plan has a mixed set of consequences, some unintended. I fear that it throws a lot more uncertainty into the valuation process. It will also take some of the more clearly profitable mortgages out of the pools -- which could be a plus. On the first point, uncertainty, it would seem to make the valuation of mortgages and mortgage backed securities even more difficult. Who is now going to be in default? How do we assess likely default rates if the feds are encouraging the lowering of interest payments? How does all this work within the confines of contract law in the context of mortgage backed securities? Senior tranches may prefer foreclosure and liquidation to stretching things out and accepting lower payments - if they can even be forced to accept lower payments. But more to my point, who is going to bid a reasonable price to buy senior MBS from banks with this kind of uncertainty? Have we made the valuation problem easier or more difficult?
On the second point, taking out the most profitable mortgages, the plan makes it easier for mortgagees to refinance at lower rates. Great for them, and this gets full payment of principal into the hands of the trusts holding the mortgages, which will in turn pay off the senior tranches according to priority. That is good, for as those tranches are repaid, the securities are retired and the holders can book what is likely to be a profit. What is left, however, is truly the most toxic -- mortgages that cannot qualify even for these generous (moral hazard-inducing!) restructuring terms. What this implies for the valuation of the remaining lower tranches is probably not pretty.
The 2004 Leverage Regulation
I did have the chance to ask a retired risk officer from a major bank his views on the 2004 leverage regulation change.
To brazenly and hopefully honestly summarize, he definitely lays a fair amount of blame on that change. Not everything, of course, and there are some caveats. Somehow he was even able to pick the firms that he thought would have shown the biggest response to it, and his predictions pretty well matched up with the Wikipedia graph noted in earlier posts and comments.
It still surprises me that the binding constraint on risk was a government regulation. I would have thought that the folks whose livelihood depended on survival of the firms, as well as counterparties, would have induced a more conservative stance than the loose regulations allowed. Lesson learned.
To brazenly and hopefully honestly summarize, he definitely lays a fair amount of blame on that change. Not everything, of course, and there are some caveats. Somehow he was even able to pick the firms that he thought would have shown the biggest response to it, and his predictions pretty well matched up with the Wikipedia graph noted in earlier posts and comments.
It still surprises me that the binding constraint on risk was a government regulation. I would have thought that the folks whose livelihood depended on survival of the firms, as well as counterparties, would have induced a more conservative stance than the loose regulations allowed. Lesson learned.
Tuesday, February 17, 2009
Heated Arguments over Crowding Out
Will the fiscal stimulus work -- will the increase in government spending cause GDP to increase and unemployment to decrease?
One of the key issues is what economists call "crowding out". I hate to give just a simple explanation of it, because as you will see, economists have been attacking one another over simplistic (and some not too simplistic) explanations. But anyway, crowding out refers to the possibility that an increase in government spending will cause spending by other agents (especially businesses) to spend less. If that were to occur, then there might be no overall increase in aggregate demand, and no stimulus.
See here for a piece by John Cochrane at Chicago titled "Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?" Gene Fama gives his own thoughts in a new blog feature on the DFA website. See here and here for some rather testy responses by DeLong and Krugman.
It is enlightening to read the comments on either the DeLong or Krugman sites to get a sense for who is reading those blogs.
At any rate, when I was in graduate school at UCLA in the early 80s, crowding out was a huge question. You can address it pretty well by the old IS/LM model. I am not a macroeconomist, but my casual observation from the later 80s and 90s is that the crowding out argument did pretty well, and the standard Keynesian "government spending will increase GDP" result was relegated to the "tired models" shelf, to be brought down in honor only in extreme times. Well, it certainly has come back with a vengeance.
With governments worldwide heading to the capital markets in a real big way, I don't see how we won't get some crowding out. Yes, there is another equilibrium with higher world income and higher consumption, government spending, and higher private investment too -- that is the rosy view with little crowding out and big multiplier. There is a less rosy view, with just slightly higher world income, much higher government spending, and less consumption and investment.
One of the key issues is what economists call "crowding out". I hate to give just a simple explanation of it, because as you will see, economists have been attacking one another over simplistic (and some not too simplistic) explanations. But anyway, crowding out refers to the possibility that an increase in government spending will cause spending by other agents (especially businesses) to spend less. If that were to occur, then there might be no overall increase in aggregate demand, and no stimulus.
See here for a piece by John Cochrane at Chicago titled "Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?" Gene Fama gives his own thoughts in a new blog feature on the DFA website. See here and here for some rather testy responses by DeLong and Krugman.
It is enlightening to read the comments on either the DeLong or Krugman sites to get a sense for who is reading those blogs.
At any rate, when I was in graduate school at UCLA in the early 80s, crowding out was a huge question. You can address it pretty well by the old IS/LM model. I am not a macroeconomist, but my casual observation from the later 80s and 90s is that the crowding out argument did pretty well, and the standard Keynesian "government spending will increase GDP" result was relegated to the "tired models" shelf, to be brought down in honor only in extreme times. Well, it certainly has come back with a vengeance.
With governments worldwide heading to the capital markets in a real big way, I don't see how we won't get some crowding out. Yes, there is another equilibrium with higher world income and higher consumption, government spending, and higher private investment too -- that is the rosy view with little crowding out and big multiplier. There is a less rosy view, with just slightly higher world income, much higher government spending, and less consumption and investment.
Sunday, February 15, 2009
Information from the NYT
Concerning my post below, The 2004 Banking Leverage Rule Change, there was an interesting comment from an anonymous poster.
I had noted a NYT article titled,"Agency's '04 Rule Let Banks Pile Up New Debt" and pointed out, first, that a quick check of Bear Stearns leverage ratios did not support the story, and second, that it would have been nice for the NYT to do a bit more work and provide the data to support or reject their hypothesis.
"Anonymous" found a very nice post on Wikipedia that gives a graph of five banks' (gross) leverage from 2003 to 2007. I will leave readers to look at the graph and make their own conclusion (my response to the comment might help). I think the graph supports my first point above, which is that the 2004 change in leverage regulation is no smoking gun.
"Anonymous" concludes with, annoyingly I have to say, "I think that I'm gonna get my info from the NYT going forward..."
Well, no. Look how easy it was for you to find that quite nice chart on Wikipedia, with (clickable!) references. Or for me to find the original data in the Bear annual report.
I think the right conclusion is: Wikipedia 1, NYT 0.
I had noted a NYT article titled,"Agency's '04 Rule Let Banks Pile Up New Debt" and pointed out, first, that a quick check of Bear Stearns leverage ratios did not support the story, and second, that it would have been nice for the NYT to do a bit more work and provide the data to support or reject their hypothesis.
"Anonymous" found a very nice post on Wikipedia that gives a graph of five banks' (gross) leverage from 2003 to 2007. I will leave readers to look at the graph and make their own conclusion (my response to the comment might help). I think the graph supports my first point above, which is that the 2004 change in leverage regulation is no smoking gun.
"Anonymous" concludes with, annoyingly I have to say, "I think that I'm gonna get my info from the NYT going forward..."
Well, no. Look how easy it was for you to find that quite nice chart on Wikipedia, with (clickable!) references. Or for me to find the original data in the Bear annual report.
I think the right conclusion is: Wikipedia 1, NYT 0.
More Biased Climate Change Reporting
With a dearth of serious science showing that climate change is accelerating (indeed, even keeping pace with model predictions), it should not surprise us to see the media overstretching to attempt to maintain the momentum on public funding and policy intiatives.
Google News this morning had this article from the Washington Post: "Scientists: Pace of Climate Change Exceeds Estimates." The body of the article is essentially arguing that the pace of climate change might be stronger because carbon emissions have continued to increase and some additional positive feedbacks in the climate cycle have been identified. But unless we include the mere concentration of carbon dioxide in the atmosphere to constitute climate change, then the headline is certainly misleading.
Does anyone else want to suggest that the search for positive climate feedbacks is heavily favored over negative feedbacks? Bad science, when most effort is spent trying to confirm a theory rather than reject it.
The Climate Science site picked up on these headlines as well: "An Egregious Example Of Biased News Reporting."
Google News this morning had this article from the Washington Post: "Scientists: Pace of Climate Change Exceeds Estimates." The body of the article is essentially arguing that the pace of climate change might be stronger because carbon emissions have continued to increase and some additional positive feedbacks in the climate cycle have been identified. But unless we include the mere concentration of carbon dioxide in the atmosphere to constitute climate change, then the headline is certainly misleading.
Does anyone else want to suggest that the search for positive climate feedbacks is heavily favored over negative feedbacks? Bad science, when most effort is spent trying to confirm a theory rather than reject it.
The Climate Science site picked up on these headlines as well: "An Egregious Example Of Biased News Reporting."
Saturday, February 14, 2009
The End of Responsibility
All signs point to the end of individual responsibility. I just read an article by Rebecca Solnit for the Los Angeles Times on the Icelandic financial crisis.
Here is perhaps the most worrisome quote: "It's official. Capitalism is monstrous. Try talking about the benefits of free markets and you will be treated like someone promoting the benefits of rape."
Capitalism is monstrous? Just because the citizens of Iceland were given some very attractive prices at which to borrow, and they blindly took a bit too much advantage of those prices?
So much of the Western world is now looking for government actions to not only save us from this recession (has nobody lived through a recession before, by the way?) but to prevent us from ever making such mistakes again.
I will give the "monstrous" label to something, but it is not to capitalism, which is nothing but the flourishing of individual liberty. Monstrous is this $787 billion "stimulus" plan and the whole process by which the new politics of fear got it passed. If that process and the result is indicative of how government is going to save us from ourselves, I am afraid we have taken a turn onto the road to serfdom.
Here is perhaps the most worrisome quote: "It's official. Capitalism is monstrous. Try talking about the benefits of free markets and you will be treated like someone promoting the benefits of rape."
Capitalism is monstrous? Just because the citizens of Iceland were given some very attractive prices at which to borrow, and they blindly took a bit too much advantage of those prices?
So much of the Western world is now looking for government actions to not only save us from this recession (has nobody lived through a recession before, by the way?) but to prevent us from ever making such mistakes again.
I will give the "monstrous" label to something, but it is not to capitalism, which is nothing but the flourishing of individual liberty. Monstrous is this $787 billion "stimulus" plan and the whole process by which the new politics of fear got it passed. If that process and the result is indicative of how government is going to save us from ourselves, I am afraid we have taken a turn onto the road to serfdom.
Tuesday, February 10, 2009
Welcome to the Treasury Amateur Hour
So our new Treasury Secretary comes out after having plenty of time to work out some details, and what do we get?
More uncertainty. Just what the markets and the economy need.
There is a beast in the room, and nobody wants to move because they don't know which way the beast will run. The beast of course is the Federal Government, doing their best to avoid the laws of unintended consequences.
A few quotes from the Wall Street Journal's story are very illuminating:
"But critical details of the plan remained unanswered, despite the weeks of planning leading up to Tuesday's announcement."
"Mr. Geithner said the plan to stem foreclosures would be announced in coming weeks."
"He also provided few details of the asset-purchase plan, which is designed to be done in partnership with the private sector."
"The absence of detail speaks to the thorny issues that lie at the heart of the financial crisis: how to value the toxic assets causing banks to report losses and how to shuffle aid to homeowners and stem the rise of foreclosures."
OK, these are not new issues.
The Government has two choices: One, come up with a credible and specific plan to buy toxic assets from financial institutions and support the ones that become insolvent as a result of having to take losses on the sales. Or two, step aside, and let natural market forces restore equilibrium.
Right now, the Government is effectively blocking mutually beneficial trades from taking place. Who wants to argue that financial institutions are the natural holders of these risky mortgage assets right now, instead of private investors? They never should have had such a concentration in the first place, so let's get on with the business of transferring that risk to those who are most willing and able to bear it.
UPDATE: I have to add this additional quote from Geithner's actual speech; it is just so perfect: "We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it."
Beautiful. How about you have the President ask some of those poor folks in Elkhart Indiana who "have no idea what to do or who to turn to."
More uncertainty. Just what the markets and the economy need.
There is a beast in the room, and nobody wants to move because they don't know which way the beast will run. The beast of course is the Federal Government, doing their best to avoid the laws of unintended consequences.
A few quotes from the Wall Street Journal's story are very illuminating:
"But critical details of the plan remained unanswered, despite the weeks of planning leading up to Tuesday's announcement."
"Mr. Geithner said the plan to stem foreclosures would be announced in coming weeks."
"He also provided few details of the asset-purchase plan, which is designed to be done in partnership with the private sector."
"The absence of detail speaks to the thorny issues that lie at the heart of the financial crisis: how to value the toxic assets causing banks to report losses and how to shuffle aid to homeowners and stem the rise of foreclosures."
OK, these are not new issues.
The Government has two choices: One, come up with a credible and specific plan to buy toxic assets from financial institutions and support the ones that become insolvent as a result of having to take losses on the sales. Or two, step aside, and let natural market forces restore equilibrium.
Right now, the Government is effectively blocking mutually beneficial trades from taking place. Who wants to argue that financial institutions are the natural holders of these risky mortgage assets right now, instead of private investors? They never should have had such a concentration in the first place, so let's get on with the business of transferring that risk to those who are most willing and able to bear it.
UPDATE: I have to add this additional quote from Geithner's actual speech; it is just so perfect: "We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it."
Beautiful. How about you have the President ask some of those poor folks in Elkhart Indiana who "have no idea what to do or who to turn to."
Monday, February 09, 2009
The 2004 Banking Leverage Rule Change
We can expect a lot of revisionist history in the next several months, as policymakers and pundits attempt to spin the historical record to fit their interests.
We had a speaker at Tuck today who mentioned the SEC's 2004 rule change, which eliminated some leverage restrictions on investment banks in favor of capital requirements by type of asset as well as more reliance on self-regulation and reporting to the SEC. A good reference for a similar story is here in the NYT.
I have been meaning to look into this "smoking gun" for some time as it did sound intriguing. Of course, the headline is usually something like the NYT's: "Agency's '04 Rule Let Banks Pile Up New Debt." The subheading is, naturally, that we need more regulation not less and that the Bush administration was at fault.
Now there might be some issues about regulation of the banks, and I myself am very surprised at how poorly market forces seemed to enforce reasonable behavior on the part of the banks. Like Alan Greenspan, I have I guess a nostalgic view of how self-regulation should work (well).
But as to the story on the 2004 deregulation -- it simply does not hold water. I pulled out the Bear Stearns 2003 and 2006 annual reports -- before and after the regulatory change, but before falling asset prices caused an endogenous increase in liquidity.
In 2003, Bear had an overall leverage ratio of 26.4, and a net adjusted leverage ratio of 12.4. In 2006, the respective numbers were 26.5 and 13.6.
Do you think the NYT reporter could have looked that up and told us as well?
We had a speaker at Tuck today who mentioned the SEC's 2004 rule change, which eliminated some leverage restrictions on investment banks in favor of capital requirements by type of asset as well as more reliance on self-regulation and reporting to the SEC. A good reference for a similar story is here in the NYT.
I have been meaning to look into this "smoking gun" for some time as it did sound intriguing. Of course, the headline is usually something like the NYT's: "Agency's '04 Rule Let Banks Pile Up New Debt." The subheading is, naturally, that we need more regulation not less and that the Bush administration was at fault.
Now there might be some issues about regulation of the banks, and I myself am very surprised at how poorly market forces seemed to enforce reasonable behavior on the part of the banks. Like Alan Greenspan, I have I guess a nostalgic view of how self-regulation should work (well).
But as to the story on the 2004 deregulation -- it simply does not hold water. I pulled out the Bear Stearns 2003 and 2006 annual reports -- before and after the regulatory change, but before falling asset prices caused an endogenous increase in liquidity.
In 2003, Bear had an overall leverage ratio of 26.4, and a net adjusted leverage ratio of 12.4. In 2006, the respective numbers were 26.5 and 13.6.
Do you think the NYT reporter could have looked that up and told us as well?
Wednesday, January 21, 2009
Caroline Kennedy Calls it Quits
Late word tonight is that Caroline Kennedy has told Gov. Patterson that she cannot accept the Senate seat of Hillary Clinton.
The supposed reason? That she has to care for her uncle, Ted Kennedy, who collapsed during the inauguration.
Now if I had been Gov. Paterson, the way I might have handled this is to get word to Mrs. Kennedy that if she withdraws for her own personal reasons, then I would not have to choose someone else over her. Which outcome do you prefer -- or need that be said?
The supposed reason? That she has to care for her uncle, Ted Kennedy, who collapsed during the inauguration.
Now if I had been Gov. Paterson, the way I might have handled this is to get word to Mrs. Kennedy that if she withdraws for her own personal reasons, then I would not have to choose someone else over her. Which outcome do you prefer -- or need that be said?
TARP: Take Two (Hopefully in Earnest This Time!)
It appears that the core of the original TARP idea is being resurrected: buying bad assets and securities from banks and putting them into a government-controlled vehicle with the intent of reselling at a later point. From the WSJ over the weekend:
"The U.S. government, recognizing that the banking crisis is far larger than originally thought, is laying the groundwork for a second phase of its rescue attempt, with plans to purge bad assets that are paralyzing the financial system.
Officials at the Treasury, Federal Reserve and Federal Deposit Insurance Corp., in consultation with the incoming Obama administration, are discussing a plan to create a government bank that would buy up the bad investments and loans that are behind the huge losses that U.S. banks continue to report, say government officials."
How is this different from the first incarnation of TARP? Well, even less detail on how the bad assets would be acquired -- at least Paulson had the idea of using an auction -- and also now there is talk of creating a government bank.
So leaving out talk of an auction and introducing the sketchy idea of a "government bank" makes things better (does a government bank take deposits from anyone other than the Fed?)
The allure of injecting equity was the idea of leverage: if we put $100 of equity into a bank, and they are leveraged 10 to 1, then we will get $1,000 of new loans made. Ah, but where does that $900 of capital to lend out come from? With toxic assets on the balance sheet, no new lenders want to throw new funds into the pot that will just go to protect all the existing creditors and equity holders. Indeed, judging from the last few months, the equity injections by themselves have done very little to create more lending.
The balance sheets of the banks have to get purged of the assets that are currently so hard to value. That was the genius behind TARP, and could still be implemented. I bet that we will soon see something very similar to the Resolution Trust Corporation. Hopefully we will not have to wait for banks to actually fail to get assets into the new institution. Talk to some auction theorists and get those auctions moving to buy assets from solvent but illiquid banks, put them into a new RTC, re-securitize them (this time with only one class of pass-through certificates) and return the profits to the taxpayer.
"The U.S. government, recognizing that the banking crisis is far larger than originally thought, is laying the groundwork for a second phase of its rescue attempt, with plans to purge bad assets that are paralyzing the financial system.
Officials at the Treasury, Federal Reserve and Federal Deposit Insurance Corp., in consultation with the incoming Obama administration, are discussing a plan to create a government bank that would buy up the bad investments and loans that are behind the huge losses that U.S. banks continue to report, say government officials."
How is this different from the first incarnation of TARP? Well, even less detail on how the bad assets would be acquired -- at least Paulson had the idea of using an auction -- and also now there is talk of creating a government bank.
So leaving out talk of an auction and introducing the sketchy idea of a "government bank" makes things better (does a government bank take deposits from anyone other than the Fed?)
The allure of injecting equity was the idea of leverage: if we put $100 of equity into a bank, and they are leveraged 10 to 1, then we will get $1,000 of new loans made. Ah, but where does that $900 of capital to lend out come from? With toxic assets on the balance sheet, no new lenders want to throw new funds into the pot that will just go to protect all the existing creditors and equity holders. Indeed, judging from the last few months, the equity injections by themselves have done very little to create more lending.
The balance sheets of the banks have to get purged of the assets that are currently so hard to value. That was the genius behind TARP, and could still be implemented. I bet that we will soon see something very similar to the Resolution Trust Corporation. Hopefully we will not have to wait for banks to actually fail to get assets into the new institution. Talk to some auction theorists and get those auctions moving to buy assets from solvent but illiquid banks, put them into a new RTC, re-securitize them (this time with only one class of pass-through certificates) and return the profits to the taxpayer.
Geithner Should Not be Confirmed
Timothy Geithner is on path to be Treasury Secretary of the United States, with among other duties oversight of the IRS.
On his own failure to pay the employer portion of Social Security tax on his IMF earnings: "As I look back at all the documents that I provided the committee . . . both in the initial documents the IMF staff gave me to explain the way the IMF system works, in the quarterly statements I received from the IMF, in the annual tax forms I received -- in all those documents, looking back, it was very clear," Geithner said.
Yes, it is actually one of the simpler parts of our terrible personal income tax code.
And on his failure to pay the taxes owed for mistakes in 2001, 2002 when the IRS only audited 2003 and 2004:
"Sen. Jon Kyl (R-Ariz.) asked Geithner pointedly whether he choose not to pay the earlier taxes because they were beyond the IRS's three-year statute of limitations.
Geithner replied that he simply did not think about the issue.
"If I thought about it more at the time, I would have asked a lot more questions. I would have handled it differently and I regret not having done so," Geithner said. "This is my mistake, and it's my responsibility."
He simply did not think about the issue. Social Security, one of the burning issues of our time, for a Treasury Secretary to worry about -- and he simply did not think about the issue of paying his own fair share??
Sorry, but this is definitely an exclusionary mistake. Do not pass go, do not collect $200. Worse than not paying taxes on a nanny, which has disqualified certain female nominees. There are two critical issues: One, he was actually paid by the IMF for the taxes that he was supposed to pay; and two, he did not 'fess up and pay the early year taxes after caught for the later mistakes. If that does not disqualify you for the post of Treasury Secretary, then we are in trouble.
I have already heard from people who feel that they do not need to pay their credit card bills since some banks are not paying their creditors, and since the Treasury nominee does not pay his taxes. Where is the tipping point, where the vast majority stop being law-abiding because they feel like suckers?
Where are the Republican backbenchers on this one?
On his own failure to pay the employer portion of Social Security tax on his IMF earnings: "As I look back at all the documents that I provided the committee . . . both in the initial documents the IMF staff gave me to explain the way the IMF system works, in the quarterly statements I received from the IMF, in the annual tax forms I received -- in all those documents, looking back, it was very clear," Geithner said.
Yes, it is actually one of the simpler parts of our terrible personal income tax code.
And on his failure to pay the taxes owed for mistakes in 2001, 2002 when the IRS only audited 2003 and 2004:
"Sen. Jon Kyl (R-Ariz.) asked Geithner pointedly whether he choose not to pay the earlier taxes because they were beyond the IRS's three-year statute of limitations.
Geithner replied that he simply did not think about the issue.
"If I thought about it more at the time, I would have asked a lot more questions. I would have handled it differently and I regret not having done so," Geithner said. "This is my mistake, and it's my responsibility."
He simply did not think about the issue. Social Security, one of the burning issues of our time, for a Treasury Secretary to worry about -- and he simply did not think about the issue of paying his own fair share??
Sorry, but this is definitely an exclusionary mistake. Do not pass go, do not collect $200. Worse than not paying taxes on a nanny, which has disqualified certain female nominees. There are two critical issues: One, he was actually paid by the IMF for the taxes that he was supposed to pay; and two, he did not 'fess up and pay the early year taxes after caught for the later mistakes. If that does not disqualify you for the post of Treasury Secretary, then we are in trouble.
I have already heard from people who feel that they do not need to pay their credit card bills since some banks are not paying their creditors, and since the Treasury nominee does not pay his taxes. Where is the tipping point, where the vast majority stop being law-abiding because they feel like suckers?
Where are the Republican backbenchers on this one?
Wednesday, December 10, 2008
Crazy Prices?
Oil for January 2009 delivery is priced at $43.80. For January 2010 delivery, it is $56.21, or 28% higher. That 28% has to cover my cost of financing and storing oil for one year. Could that be? Short term interest rates are very very low -- if a bank would lend me money on a sure bet! How much could the cost of storage be? Hmmm....
And NOMINAL interest rates on US Treasury bills went negative. In the US Treasury's auction of bills, the yield was ZERO. People are willing to lend US Treasury money at no cost. Gosh, I hope the Treasury locks in as much money as they can at these "deal of the century rates." I am going to wait just a bit longer, then lock in as much long term mortgage money as I can at 4.5 to 5% (I hope).
And NOMINAL interest rates on US Treasury bills went negative. In the US Treasury's auction of bills, the yield was ZERO. People are willing to lend US Treasury money at no cost. Gosh, I hope the Treasury locks in as much money as they can at these "deal of the century rates." I am going to wait just a bit longer, then lock in as much long term mortgage money as I can at 4.5 to 5% (I hope).
Tuesday, December 09, 2008
The Cold Blast is Coming
We hit close to zero degrees Fahrenheit in Hanover the last two nights.
Southern California is due for some cold as well: "Rare 50 year Arctic Blast Sets Sights On Southern California."
And 2008 will go down as the coldest year of the decade at least.
And the US Congress has seen it wise to take money from a fund dedicated to helping Detroit produce environmentally friendly cars and use the money for keeping the Big Three out of Chapter 11 (or 7). I vote for "none of the above."
Southern California is due for some cold as well: "Rare 50 year Arctic Blast Sets Sights On Southern California."
And 2008 will go down as the coldest year of the decade at least.
And the US Congress has seen it wise to take money from a fund dedicated to helping Detroit produce environmentally friendly cars and use the money for keeping the Big Three out of Chapter 11 (or 7). I vote for "none of the above."
Selling to the Highest Bidder!
On a day that I covered auction theory in my class, it was heartening to see that Governor Blagojevich of Illinois was (allegedly) running an auction of his own. According to the New York Times Blagojevich took to heart at least the most basic auction lesson, that of selling to the highest bidder:
"CHICAGO — Gov. Rod R. Blagojevich of Illinois was arrested by federal authorities on Tuesday morning on corruption charges, including an allegation that he conspired to effectively sell President-elect Barack Obama’s seat in the United States Senate to the highest bidder."
It sounds like his wife added some nice quips on the wiretaps.
"CHICAGO — Gov. Rod R. Blagojevich of Illinois was arrested by federal authorities on Tuesday morning on corruption charges, including an allegation that he conspired to effectively sell President-elect Barack Obama’s seat in the United States Senate to the highest bidder."
It sounds like his wife added some nice quips on the wiretaps.
Thursday, November 13, 2008
Sears Brings Back the Layaway
You know that credit has really dried up when stores like Sears are again offering layaway plans!
Ask your children if they know what layaway means.
Ask your children if they know what layaway means.
Hilarious Motley Fool Column
This is a great spoof on the Paulson about-face, from the Motley Fool.
Just one quote pulled here, but read the whole thing because it is worth it:
"Paulson acknowledged that there had been criticism of the TARP's actual strategy, which quickly became one of injecting capital directly into banks, though without demanding control in the form of board representation, or cuts in dividends, or any of the other limitations used in successful bank bailout schemes in countries such as Finland and Sweden. But he said there was good reason for handing out money with no strings attached.
"America is not Finland, and it is not Sweden," Paulson explained. "I don't see any of you eating lutefisk or swatting your sweaty bodies with a birch switch."
The assembled journalists laughed, looked at one another, and admitted that America certainly isn't Finland or Sweden. "That is silly," said Barney Field of the New York Examiner/Picayune."
Just one quote pulled here, but read the whole thing because it is worth it:
"Paulson acknowledged that there had been criticism of the TARP's actual strategy, which quickly became one of injecting capital directly into banks, though without demanding control in the form of board representation, or cuts in dividends, or any of the other limitations used in successful bank bailout schemes in countries such as Finland and Sweden. But he said there was good reason for handing out money with no strings attached.
"America is not Finland, and it is not Sweden," Paulson explained. "I don't see any of you eating lutefisk or swatting your sweaty bodies with a birch switch."
The assembled journalists laughed, looked at one another, and admitted that America certainly isn't Finland or Sweden. "That is silly," said Barney Field of the New York Examiner/Picayune."
Wednesday, November 12, 2008
YouTube Institutes Google-Like Ad Auctions
YouTube is finding new ways to generate revenue off its site. The last time I visited, I was surprised at how "pure" the experience was, surprising for a company that was bought for billions.
The new revenue model uses auctions like Google's search-word mechanism. When a YouTube user types in a search phrase, sponsored links appear. As in Google, the highest placed link is from the advertiser who bid the most for that phrase. The second highest link bid the second highest amount, and so on. And I am assuming it is a "second-price" auction, with the amount that the high bidder wins being the second highest bid, and so on.
Now I wonder what they will do to make sure that there is no copyrighted material being illegally displayed by any of the advertisers. That will create a revenue link that I think would weaken Google's defense in its copyright infringement case with Viacom.
The new revenue model uses auctions like Google's search-word mechanism. When a YouTube user types in a search phrase, sponsored links appear. As in Google, the highest placed link is from the advertiser who bid the most for that phrase. The second highest link bid the second highest amount, and so on. And I am assuming it is a "second-price" auction, with the amount that the high bidder wins being the second highest bid, and so on.
Now I wonder what they will do to make sure that there is no copyrighted material being illegally displayed by any of the advertisers. That will create a revenue link that I think would weaken Google's defense in its copyright infringement case with Viacom.
Bye, Bye TARP
Has Hank Paulson lost all or merely most of his credibility?
Quotes from his statement today:
"Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets. Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets."
OK, so TARP is not going to work out as planned, in the form of buying the mortgage-backed securities that were at the heart of the initial problem. I am on record as saying that success of this program would be measured by how much MBS they had bought 3-4 weeks into the program. As the answer, up until the AIG purchase announced this week, was ZERO, we can assess the program as pretty much of a failure. But fine. Lots of people thought it was going to be hard to figure out ways to effectively buy those MBS.
But, Paulson and Treasury have been standing by TARP for the last few weeks. Saying they were still moving forward, just taking time to work out the plans. All of a sudden...Change of plans.
Come on, at least a little more explanation than saying it "is not the most effective way to use TARP funds..." would be nice. Congress signed a bill for $700 billion of expenditure on the basis of a plan that is now not going to be implemented, and that is all the explanation we get????
But Paulson and Treasury still have $700 billion -- no, wait, $700 b. less what they have spent becoming owners of some banks and AIG -- and that spare change is obviously burning a hole in their pocket. Plus Nancy Pelosi has her sights on Michigan and the auto industry, so she is putting some pressure on them as well (TARP obviously applies to all troubled assets, and if the auto industry does not have troubled assets, who does?).
So another quote by Paulson:
"Second, we are examining strategies to support consumer access to credit outside the banking system. To date, Fed, FDIC and Treasury programs have been targeted at our banking system, and the non-bank consumer finance sector continues to face difficult funding issues. Specifically, the asset-backed securitization market has played a critical role for many years in lowering the cost and increasing the availability of consumer finance. This market is currently in distress, costs of funding have skyrocketed and new issue activity has come to a halt. Today, the illiquidity in this sector is raising the cost and reducing the availability of car loans, student loans and credit cards. This is creating a heavy burden on the American people and reducing the number of jobs in our economy. With the Federal Reserve we are exploring the development of a potential liquidity facility for highly-rated AAA asset-backed securities."
Ah. Illiquidity in the credit card receivables market is beckoning for government intervention. Because, if consumers can't borrow, obviously they can't buy anything and the economy will tank.
TARP is slipping rapidly from a program aimed at preventing systemic financial system failure as evidenced by the failure or near failure of major financial institutions to an almost Keynesian-like stimulation of the economy. Surely Paulson sees a difference between the failure of Lehman Bros., and the threat of runs on banks and near-banks like money market funds; versus "raising the cost and reducing the availability of car loans, student loans and credit cards." When the US financial system appeared to be on the brink of ceasing to function in most important ways, that was a time for major and innovative intervention, such as TARP and, maybe most important, the support by Treasury and the Fed of the commercial paper market (which money market funds rely on). But are we now just shifting to supporting credit cards and car loans so that we don't reduce the number of jobs in the economy?
Is anyone surprised that the market fell over 400 points today?
Quotes from his statement today:
"Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets. Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets."
OK, so TARP is not going to work out as planned, in the form of buying the mortgage-backed securities that were at the heart of the initial problem. I am on record as saying that success of this program would be measured by how much MBS they had bought 3-4 weeks into the program. As the answer, up until the AIG purchase announced this week, was ZERO, we can assess the program as pretty much of a failure. But fine. Lots of people thought it was going to be hard to figure out ways to effectively buy those MBS.
But, Paulson and Treasury have been standing by TARP for the last few weeks. Saying they were still moving forward, just taking time to work out the plans. All of a sudden...Change of plans.
Come on, at least a little more explanation than saying it "is not the most effective way to use TARP funds..." would be nice. Congress signed a bill for $700 billion of expenditure on the basis of a plan that is now not going to be implemented, and that is all the explanation we get????
But Paulson and Treasury still have $700 billion -- no, wait, $700 b. less what they have spent becoming owners of some banks and AIG -- and that spare change is obviously burning a hole in their pocket. Plus Nancy Pelosi has her sights on Michigan and the auto industry, so she is putting some pressure on them as well (TARP obviously applies to all troubled assets, and if the auto industry does not have troubled assets, who does?).
So another quote by Paulson:
"Second, we are examining strategies to support consumer access to credit outside the banking system. To date, Fed, FDIC and Treasury programs have been targeted at our banking system, and the non-bank consumer finance sector continues to face difficult funding issues. Specifically, the asset-backed securitization market has played a critical role for many years in lowering the cost and increasing the availability of consumer finance. This market is currently in distress, costs of funding have skyrocketed and new issue activity has come to a halt. Today, the illiquidity in this sector is raising the cost and reducing the availability of car loans, student loans and credit cards. This is creating a heavy burden on the American people and reducing the number of jobs in our economy. With the Federal Reserve we are exploring the development of a potential liquidity facility for highly-rated AAA asset-backed securities."
Ah. Illiquidity in the credit card receivables market is beckoning for government intervention. Because, if consumers can't borrow, obviously they can't buy anything and the economy will tank.
TARP is slipping rapidly from a program aimed at preventing systemic financial system failure as evidenced by the failure or near failure of major financial institutions to an almost Keynesian-like stimulation of the economy. Surely Paulson sees a difference between the failure of Lehman Bros., and the threat of runs on banks and near-banks like money market funds; versus "raising the cost and reducing the availability of car loans, student loans and credit cards." When the US financial system appeared to be on the brink of ceasing to function in most important ways, that was a time for major and innovative intervention, such as TARP and, maybe most important, the support by Treasury and the Fed of the commercial paper market (which money market funds rely on). But are we now just shifting to supporting credit cards and car loans so that we don't reduce the number of jobs in the economy?
Is anyone surprised that the market fell over 400 points today?
Monday, November 10, 2008
American Express Becomes a Bank
AMEX, issuer of my favorite credit card, has been approved by the Fed to become a bank holding company. AMEX follows Morgan Stanley and Goldman Sachs on this road -- supposedly the road to a lower cost and more stabele source of funding.
I have heard several people say that one of the causes of the current crisis was the repeal of the Glass Steagall Act that prohibited commercial and investment banking being done in the same firm.
So let's see: Bear Stearns, Merrill, and Lehman, the three firms that fell, were pure investment banks (no commercial bank status). Citigroup and JP Morgan (Chase) are firms that combined investment and commercial banking and did not fail.
And now we have two of the remaining investment banks taking advantage of an open window to becoming banks, and even AMEX doing the same. They seem to think that stability comes from combining both activities.
Hmmm.....
I have heard several people say that one of the causes of the current crisis was the repeal of the Glass Steagall Act that prohibited commercial and investment banking being done in the same firm.
So let's see: Bear Stearns, Merrill, and Lehman, the three firms that fell, were pure investment banks (no commercial bank status). Citigroup and JP Morgan (Chase) are firms that combined investment and commercial banking and did not fail.
And now we have two of the remaining investment banks taking advantage of an open window to becoming banks, and even AMEX doing the same. They seem to think that stability comes from combining both activities.
Hmmm.....
Where Does Obama Stand on Vouchers?
The Obama family is checking out private schools in Washington, DC for their children. Most of us who could afford to send our children to private schools would do the same. The Clintons did so. Probably the vast bulk of Congress' kids who live in the DC area go to private schools.
The problem is that many of those same politicians will not support voucher programs that would allow middle- and lower-income families to take advantage of the better private schools. If you want to empower people, what could be stronger than letting them decide where to send their kids to school (without having to pay twice that is, once in state and local taxes and once in tuition).
Where does Obama stand on this? At one point, he seemed to be more open than the typical Democrat. Later reports suggest that the Democratic NEA establishment has gotten to him. Too bad. This would be a great chance to show some real change.
The problem is that many of those same politicians will not support voucher programs that would allow middle- and lower-income families to take advantage of the better private schools. If you want to empower people, what could be stronger than letting them decide where to send their kids to school (without having to pay twice that is, once in state and local taxes and once in tuition).
Where does Obama stand on this? At one point, he seemed to be more open than the typical Democrat. Later reports suggest that the Democratic NEA establishment has gotten to him. Too bad. This would be a great chance to show some real change.
Wednesday, November 05, 2008
Another Cause for Celebration
Massachusetts decriminalized marijuana possession! Finally some comon sense prevails. How about legalization, with a nice alcohol/tobacco type tax? Think of the revenues, and the stimulus to agriculture in states like California and Washington!
Congratulations Obama! (And the Dartmouth Reaction)
Well, it is indeed an historic moment. The passing of an administration that has been in charge for 8 years, a whole new agenda coming in, and of course the first African American President. One cannot help but be somewhat amazed and certainly excited.
I think for young people the election of Obama is really meaningful. Here is a story I heard this morning that really makes me reflect on the great side of this election.
At around 1230 am this morning, a Hanover resident heard a loud roar coming from town. He got on his bike (!) and rode in, to find several hundred Dartmouth students outside President Wright's house, celebrating. President Wright came out and gave an impromptu few words. The students went on to the Green, where they continued their joyous celebration by singing the national anthem.
That story should inspire anyone!
Obama has a great opportunity. He has great leadership capability, and he has a pretty strong mandate for change, winning more than 50% of the vote. With any luck at all, we are at the bottom of the financial crisis and while unemployment will be creeping up for some time to come, the economy should turn around well before the midpoint of Obama's first term. The US should be able to exit Iraq, with honor and leaving a country that has good economic and political prospects.
I only hope that he and his advisors take advantage of these events to make the country stronger, economically, socially and politically. I would love to see a major revision of the tax code, especially a fix to the AMT. I suspect someone should take a hard look at military expenditures and especially our intelligence services. How about some sense to the nation's drug laws? Energy policy could certainly be improved, but let's not do it by economic engineering, e.g., having folks in Washington decide which alternative energy sources should get subsidies.
I think for young people the election of Obama is really meaningful. Here is a story I heard this morning that really makes me reflect on the great side of this election.
At around 1230 am this morning, a Hanover resident heard a loud roar coming from town. He got on his bike (!) and rode in, to find several hundred Dartmouth students outside President Wright's house, celebrating. President Wright came out and gave an impromptu few words. The students went on to the Green, where they continued their joyous celebration by singing the national anthem.
That story should inspire anyone!
Obama has a great opportunity. He has great leadership capability, and he has a pretty strong mandate for change, winning more than 50% of the vote. With any luck at all, we are at the bottom of the financial crisis and while unemployment will be creeping up for some time to come, the economy should turn around well before the midpoint of Obama's first term. The US should be able to exit Iraq, with honor and leaving a country that has good economic and political prospects.
I only hope that he and his advisors take advantage of these events to make the country stronger, economically, socially and politically. I would love to see a major revision of the tax code, especially a fix to the AMT. I suspect someone should take a hard look at military expenditures and especially our intelligence services. How about some sense to the nation's drug laws? Energy policy could certainly be improved, but let's not do it by economic engineering, e.g., having folks in Washington decide which alternative energy sources should get subsidies.
Friday, October 31, 2008
Mortgage Servicer Proposal
There is no shortage of proposals by thoughtful people on how to get out of this financial/economic mess the world finds itself in. I do hope that we see the Treasury moving forward on its original plan to buy up a good chunk of the mortgage backed securities. I want to see the Treasury make some money in this market!
John Geanakoplos and Susan Koniak have an interesting oped in the New York Times today, addressing the role of the master servicer in mortgage pools.
I have been saying for some time that the incentives of the servicing organizations are key to how homeowners in default are treated. And that the terms of the mortgage trust that bought the mortgages, appointed the servicer, and sold the mortgage backed securities are the determining factors. The NYT piece argues, albeit with a lack of specificity, that the servicers are loath to renegotiate with homeowners in arrears as it will benefit some MBS owners and hurt others. I wish they had given some examples of how that would happen. If there had been only one class/tranche of MBS created, then the incentives of all would be aligned: renegotiation might make sense, say by lowering the interest rate in return for a higher likelihood of principal repayment. But with differing classes of security holders, conflicts will exist. The higher tranches won’t want to lower interest rates for a higher likelihood of repayment of principal, as they are first in line for both interest and principal. Also, there were triggering events in a lot of these pools that will benefit the higher tranches if they occur – so avoiding those events might not be in the higher tranches’ interests.
I am not sure I agree with the authors’ proposal for government-appointed trustees. No, wait, I am SURE I don’t like that proposal. What I could see working would be some legislation to change the terms of the mortgage pool contracts, or at least to give the servicers some indemnification from lawsuits.
John Geanakoplos and Susan Koniak have an interesting oped in the New York Times today, addressing the role of the master servicer in mortgage pools.
I have been saying for some time that the incentives of the servicing organizations are key to how homeowners in default are treated. And that the terms of the mortgage trust that bought the mortgages, appointed the servicer, and sold the mortgage backed securities are the determining factors. The NYT piece argues, albeit with a lack of specificity, that the servicers are loath to renegotiate with homeowners in arrears as it will benefit some MBS owners and hurt others. I wish they had given some examples of how that would happen. If there had been only one class/tranche of MBS created, then the incentives of all would be aligned: renegotiation might make sense, say by lowering the interest rate in return for a higher likelihood of principal repayment. But with differing classes of security holders, conflicts will exist. The higher tranches won’t want to lower interest rates for a higher likelihood of repayment of principal, as they are first in line for both interest and principal. Also, there were triggering events in a lot of these pools that will benefit the higher tranches if they occur – so avoiding those events might not be in the higher tranches’ interests.
I am not sure I agree with the authors’ proposal for government-appointed trustees. No, wait, I am SURE I don’t like that proposal. What I could see working would be some legislation to change the terms of the mortgage pool contracts, or at least to give the servicers some indemnification from lawsuits.
A Republican Halloween?
I was afraid that the signs in my front yard would deter trick or treaters, but that doesn't seem to be the case -- all kinds of little munchkins showing up right now! I also wonder if the signs will make it through the night. Last election, I did have my Bush signs thrown in the bushes.
One little girl was dressed up as Palin, an amazing costume. Very cute.
Saturday, October 25, 2008
Oil Demand Elasticity
Some data on oil price elasticity are starting to arrive.
Gasoline demand in the US has fallen relative to year-earlier numbers for 26 consecutive weeks, with demand last week being 6.4% below the same week last year.
According to the EIA, and as reported by Forbes, US petroleum product demand fell in the last four-week period by 8.5% relative to the same four-week period last year.
Not sure what percent change in price to use to calculate a rough elasticity. If we use a 100% change in price, which is excessive, we get an elasticity of -.085 which is not too bad. I have always thought that an elasticity of -.20 was reasonable for a period of 2-3 years. I expect we are to see more "demand destruction" even though prices have come way down -- and many of these changes will be irreversible.
Some people might say that we are not observing price elasticity but income elasticity -- as the economy slows, oil demand drops. To some extent this is true -- to the extent that the slowing economy is due to non-oil factors. But we should expect some of the demand reductions to show up as GDP decreases. That is, some economic activity is no longer undertaken at high oil prices, and that shows up as a reduction in GDP. The decline in demand for oil should be attributed in that case to price increases, not to income falling.
Gasoline demand in the US has fallen relative to year-earlier numbers for 26 consecutive weeks, with demand last week being 6.4% below the same week last year.
According to the EIA, and as reported by Forbes, US petroleum product demand fell in the last four-week period by 8.5% relative to the same four-week period last year.
Not sure what percent change in price to use to calculate a rough elasticity. If we use a 100% change in price, which is excessive, we get an elasticity of -.085 which is not too bad. I have always thought that an elasticity of -.20 was reasonable for a period of 2-3 years. I expect we are to see more "demand destruction" even though prices have come way down -- and many of these changes will be irreversible.
Some people might say that we are not observing price elasticity but income elasticity -- as the economy slows, oil demand drops. To some extent this is true -- to the extent that the slowing economy is due to non-oil factors. But we should expect some of the demand reductions to show up as GDP decreases. That is, some economic activity is no longer undertaken at high oil prices, and that shows up as a reduction in GDP. The decline in demand for oil should be attributed in that case to price increases, not to income falling.
Simply Incredible Price Volatility
Oil was at $147 per barrel in July of this summer. On Friday, about three months later, it was at $64.
The Canadian dollar, one year ago, bought more than one US dollar. On Friday, the US dollar bought 1.28 loonies.
This is incredible volatility, and to be honest, is quite hard to explain on the basis of fundamentals.
I was predicting for a long time that oil prices were too high, and that the economic forces of demand cutbacks and supply increases would bring us back from the skyhigh levels we were seeing. But the price went much higher than I would have anticipated, and it took a long time for the price to peak and start falling. Then once it started falling, it just has not stopped.
Either the price significantly overshot in the last year or it is now seriously undershooting -- or, very possibly, both.
Could it be that investment flows from hedge funds and general investors caused this incredible volatility? Or is it just that given the uncertainties in the world at this time, value is so hard to pin down? It is still true that oil demand and supply are both very inelastic, so in a sense you can have prices move a lot and not be too far away from equilibrium in regard to quantity.
Whatever the reasons, it is hard to make investments in alternative energy, or in oil production, given the volatility. As with the credit crisis, financial market turmoil has real effects.
The Canadian dollar, one year ago, bought more than one US dollar. On Friday, the US dollar bought 1.28 loonies.
This is incredible volatility, and to be honest, is quite hard to explain on the basis of fundamentals.
I was predicting for a long time that oil prices were too high, and that the economic forces of demand cutbacks and supply increases would bring us back from the skyhigh levels we were seeing. But the price went much higher than I would have anticipated, and it took a long time for the price to peak and start falling. Then once it started falling, it just has not stopped.
Either the price significantly overshot in the last year or it is now seriously undershooting -- or, very possibly, both.
Could it be that investment flows from hedge funds and general investors caused this incredible volatility? Or is it just that given the uncertainties in the world at this time, value is so hard to pin down? It is still true that oil demand and supply are both very inelastic, so in a sense you can have prices move a lot and not be too far away from equilibrium in regard to quantity.
Whatever the reasons, it is hard to make investments in alternative energy, or in oil production, given the volatility. As with the credit crisis, financial market turmoil has real effects.
Wednesday, October 15, 2008
That Great Cooling Sound
Listen carefully, and you will hear the sound of the mainstream media reporting on record cold temperatures and Alaskan glaciers growing for the first time in 200 years.
Hmmm......
On second thought, maybe you won't hear anything at all.
No, the recent data do not fall into line with accepted wisdom, so don't expect to hear about it.
Hmmm......
On second thought, maybe you won't hear anything at all.
No, the recent data do not fall into line with accepted wisdom, so don't expect to hear about it.
Monday, October 13, 2008
Moral Hazard
With McCain and Obama fighting to come up with the best plan for giving homeowners relief, especially in the form of forbearance on defaults, I wonder why anyone rational would keep up their mortgage payements?
Equity Stakes vs. Buying Bad Assets
There are a lot of policy options being considered, but the two big alternatives are buying equity stakes in banks vs. the original idea of buying bad assets from the banks, predominantly mortgage-backed securities.
Judging from the huge increase in stock prices today, it seems that the market prefers the equity injection (if there was any news today, it was about that -- and the Morgan Stanley deal).
I understand the basic rationale there, that with the normal 10 to 1 leverage of banks, an injection of $100 of equity can support $1000 of new loans.
But will that additional equity be used for new lending, or will it go to just shore up cash on the balance sheet and/or pay off some existing debt? Given the risk aversion of banks right now, who is to say that they won't just buy more Treasury bills with the new cash?
I still like the buying of mortgage assets for four main reasons:
1. It goes to the heart of the original problem, which is uncertain value of banks' assets, and that has caused interbank lending to fall off.
2. It directly removes risk from the banks' balance sheets and thereby stands a good chance of increasing lending.
3. If done by auctions, it will establish prices for all assets in the same class, creating a spillover benefit that helps us sort out good banks from bad banks, even for banks that do not sell any assets.
4. And it still gets cash onto banks' balance sheets, that can be used for new loans.
Of course, these two options are only mutually exclusive in that the Treasury only has $700 billion to play with. Perhaps they will do some of both.
Judging from the huge increase in stock prices today, it seems that the market prefers the equity injection (if there was any news today, it was about that -- and the Morgan Stanley deal).
I understand the basic rationale there, that with the normal 10 to 1 leverage of banks, an injection of $100 of equity can support $1000 of new loans.
But will that additional equity be used for new lending, or will it go to just shore up cash on the balance sheet and/or pay off some existing debt? Given the risk aversion of banks right now, who is to say that they won't just buy more Treasury bills with the new cash?
I still like the buying of mortgage assets for four main reasons:
1. It goes to the heart of the original problem, which is uncertain value of banks' assets, and that has caused interbank lending to fall off.
2. It directly removes risk from the banks' balance sheets and thereby stands a good chance of increasing lending.
3. If done by auctions, it will establish prices for all assets in the same class, creating a spillover benefit that helps us sort out good banks from bad banks, even for banks that do not sell any assets.
4. And it still gets cash onto banks' balance sheets, that can be used for new loans.
Of course, these two options are only mutually exclusive in that the Treasury only has $700 billion to play with. Perhaps they will do some of both.
Saturday, October 11, 2008
The Fundamentals of Value
The Dow is off about 33% in one year, with 20% of that coming in the last couple weeks.
I've been looking around for evidence that we have lost a third of our labor force, but that doesn't seem to have happened (in fact, labor supply has now increased tremendously, as some of our most productive workers decide they can't retire quite yet). And I looked to see if a hurricane or some kind of natural disaster destroyed a third of our capital base. Nope, nothing like that either. Not even a bad Supreme Court decision that would impact our still-strong legal regime of markets and private property.
Folks tell me that stock valuations are down because of fear that corporate earnings will be low.
Anyone who has done a discounted cash flow valuation of a company should be deeply disturbed by what is going on. In a typical valuation, with say 5 years of explicitly forecasted cash flows and then a perpetuity at the end, upwards of 75% of the total value will derive from the perpetuity value. Said differently, the first five years of cash flow make up only 1/4 of the total value of the company.
As an example: Suppose we have a very simple company that produces $10 of cash per year forever, and that the appropriate discount rate is 10%. The value of the company is then $100. Note this is a weird company, with no growth at all -- more like a bond than a company. Suppose a nasty recession next year is forecast to take the first year of cash flow away entirely. Wow -- the value of the company falls to $91. An even nastier recession is forecast, with no cash flows for two whole years -- and value falls to $83.
And bear in mind that in our real world, we are not looking at losing even one year of earnings, just lower earnings.
Folks also say that capital constraints will prevent companies from taking advantage of growth opportunities. That might be true for the short run. But are these growth opportunities going to disappear entirely? Doubtful. They will wait for capital constraints to release.
There have to be some real good deals out there right now. For instance, you could buy GM for about $3 billion. That's right, you can own all of General Motors for the low price of 3 billion dollars. One of the two largest auto manufacturers in the world, with a franchise in Europe that is to die for, and a great stake in Asia as well. And not exactly chopped liver in the US, especially if you get off the two coasts and get into the good old heartland, where folks still like to drive Chevys.
What a sale that is! KKR could write a check for $3 billion without even checking to make sure they have that much in their checkbook.
Sure, GM has some liabilities, and they have a lot of debt outstanding. But just think of the option value on that equity.
I've been looking around for evidence that we have lost a third of our labor force, but that doesn't seem to have happened (in fact, labor supply has now increased tremendously, as some of our most productive workers decide they can't retire quite yet). And I looked to see if a hurricane or some kind of natural disaster destroyed a third of our capital base. Nope, nothing like that either. Not even a bad Supreme Court decision that would impact our still-strong legal regime of markets and private property.
Folks tell me that stock valuations are down because of fear that corporate earnings will be low.
Anyone who has done a discounted cash flow valuation of a company should be deeply disturbed by what is going on. In a typical valuation, with say 5 years of explicitly forecasted cash flows and then a perpetuity at the end, upwards of 75% of the total value will derive from the perpetuity value. Said differently, the first five years of cash flow make up only 1/4 of the total value of the company.
As an example: Suppose we have a very simple company that produces $10 of cash per year forever, and that the appropriate discount rate is 10%. The value of the company is then $100. Note this is a weird company, with no growth at all -- more like a bond than a company. Suppose a nasty recession next year is forecast to take the first year of cash flow away entirely. Wow -- the value of the company falls to $91. An even nastier recession is forecast, with no cash flows for two whole years -- and value falls to $83.
And bear in mind that in our real world, we are not looking at losing even one year of earnings, just lower earnings.
Folks also say that capital constraints will prevent companies from taking advantage of growth opportunities. That might be true for the short run. But are these growth opportunities going to disappear entirely? Doubtful. They will wait for capital constraints to release.
There have to be some real good deals out there right now. For instance, you could buy GM for about $3 billion. That's right, you can own all of General Motors for the low price of 3 billion dollars. One of the two largest auto manufacturers in the world, with a franchise in Europe that is to die for, and a great stake in Asia as well. And not exactly chopped liver in the US, especially if you get off the two coasts and get into the good old heartland, where folks still like to drive Chevys.
What a sale that is! KKR could write a check for $3 billion without even checking to make sure they have that much in their checkbook.
Sure, GM has some liabilities, and they have a lot of debt outstanding. But just think of the option value on that equity.
Wednesday, October 08, 2008
Two Paradoxes: Interbank Lending, Commercial Paper
The talk is that the interbank lending market has frozen. Rates for overnight borrowing are around 5.4%, much higher than the Federal Reserve's discount rate, which is at 1.75%. Paradox: why would anyone borrow in the private market rather than from the Fed?
Second paradox is commercial paper, another market that is supposedly freezing up. Volume is down signficantly, true, you can see that in Federal Reserve data. But rates are not very high, say 3% for 3 month paper. Those data seem more consistent with a drop in supply of commercial paper rather than a drop in demand to hold. If demand to hold paper were low, then volume would go down but rates would go up.
There is a theory to reconcile these paradoxes, I think. And it reinforces the general idea that incomplete and asymmetric information is driving a lot of the patterns in all the markets.
Let me use loosely, as we sometimes do in our models, the idea of "good" banks and "bad" banks.
In the interbank market, the good banks -- those who know they are solvent -- will borrow from the Fed. The bad banks don't want to undergo the examination that I believe they will get from the Fed if they show up at the discount window. So they go to the interbank market and get charged an appropriate risk adjusted rate. And there is not much lending going on in that market, with credit being rationed on the basis of knowing that a counterparty is of decent risk.
A similar idea explains the commercial paper market -- essentially a credit rationing story. Only the best credit risks can sell their commercial paper. And they get a reasonable rate charged -- around 3%. The worse risks just cannot sell any paper at all. So the rate we see in this market is low, but that is because we are seeing only the best risks using the market.
So the Fed is stepping in to both markets, trying to get reserves to even the bad banks, and letting the marginal borrowers still access the commercial paper market.
Second paradox is commercial paper, another market that is supposedly freezing up. Volume is down signficantly, true, you can see that in Federal Reserve data. But rates are not very high, say 3% for 3 month paper. Those data seem more consistent with a drop in supply of commercial paper rather than a drop in demand to hold. If demand to hold paper were low, then volume would go down but rates would go up.
There is a theory to reconcile these paradoxes, I think. And it reinforces the general idea that incomplete and asymmetric information is driving a lot of the patterns in all the markets.
Let me use loosely, as we sometimes do in our models, the idea of "good" banks and "bad" banks.
In the interbank market, the good banks -- those who know they are solvent -- will borrow from the Fed. The bad banks don't want to undergo the examination that I believe they will get from the Fed if they show up at the discount window. So they go to the interbank market and get charged an appropriate risk adjusted rate. And there is not much lending going on in that market, with credit being rationed on the basis of knowing that a counterparty is of decent risk.
A similar idea explains the commercial paper market -- essentially a credit rationing story. Only the best credit risks can sell their commercial paper. And they get a reasonable rate charged -- around 3%. The worse risks just cannot sell any paper at all. So the rate we see in this market is low, but that is because we are seeing only the best risks using the market.
So the Fed is stepping in to both markets, trying to get reserves to even the bad banks, and letting the marginal borrowers still access the commercial paper market.
Now Jean-Claude Trichet Speaks Out
Jean-Claude Trichet, head of the European Central Bank, has urged financial market participants to "collect themselves."
The scary thing is that he may have a point.
The scary thing is that he may have a point.
Tuesday, October 07, 2008
Gary Becker Speaks Out
Professor Gary Becker of Chicago has an excellent column in the WSJ today.
Here is one particularly good section:
"The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system. That is, insufficient appreciation of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such limitations, it is difficult to propose long-term reforms. Still, a few reforms seem reasonably likely to reduce the probability of future financial crises."
I think this does hit one nail on the head -- that participants did not know how the system as a whole would behave when under stress.
The best analogy is that of soldiers marching over a bridge. The longstanding rule is to break cadence, or there is a risk that the frequency of the march will hit the natural frequency of the bridge and cause a positively reinforcing, amplifying force that can cause the bridge to collapse. In differential equations courses, this film of the Tacoma Narrows collapse is often used to illustrate the concept.
In the mortgage backed securities markets, participants were in some sense walking in step and did not realize it. One place where I really see this is in the complexity of all the MBS, which given the point we are in now, really exacerbates the problems of valuation. A little less tranching and fewer bells, whistles and triggers on these securities would be really nice right about now.
Here is one particularly good section:
"The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system. That is, insufficient appreciation of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such limitations, it is difficult to propose long-term reforms. Still, a few reforms seem reasonably likely to reduce the probability of future financial crises."
I think this does hit one nail on the head -- that participants did not know how the system as a whole would behave when under stress.
The best analogy is that of soldiers marching over a bridge. The longstanding rule is to break cadence, or there is a risk that the frequency of the march will hit the natural frequency of the bridge and cause a positively reinforcing, amplifying force that can cause the bridge to collapse. In differential equations courses, this film of the Tacoma Narrows collapse is often used to illustrate the concept.
In the mortgage backed securities markets, participants were in some sense walking in step and did not realize it. One place where I really see this is in the complexity of all the MBS, which given the point we are in now, really exacerbates the problems of valuation. A little less tranching and fewer bells, whistles and triggers on these securities would be really nice right about now.
Monday, October 06, 2008
The "How To" Questions of Reverse Auctions
The Treasury plan is to buy mortgage backed securities (MBS), instead of purely whole loans (the mortgages themselves). They have the authority to buy the underlying mortgages, but I am not sure there is $750 billion of those available. Most of the mortgages went into pools, on which the MBS are defined over. And then some of the MBS went into secondary pools, on which collateralized debt obligations (CDOs) were created. What a mess.
So how will Treasury buy the MBS? It is easy to just say, well, by reverse auction. Current owners of the MBS submit offers to sell (price and quantity specified). The government accumulates the bids, from lowest price to highest price, and keeps track of cumulative volume offered. When that dollar volume hits what the government has agreed to buy in that auction, the price associated with the last accepted offer (or first not accepted offer)becomes the price that all offers are paid. That would be a nondiscriminatory auction. An alternative would be a discriminatory auction, whereby all accepted offers get the price they offered their MBS at. For several reasons I won't elaborate on here, I think the nondiscriminatory auction is the way to go.
But this begs the question of: what is being offered? Not all MBS are the same! If we were buying, say, shares of GM from different holders, there would be no problem, one share of GM being equivalent to another.
So the big issue is how to define the characteristics of MBS that will be accepted in any given auction. There is even the simple matter of different coupon rates, so that you cannot even say that $100 of face value is the same across different MBS even if credit issues are equivalent. But credit issues are the real big one.
I still think that the way to go will be to define ranges of credit characteristics that will enable a MBS to qualify for an auction. Prime candidates for the qualifying characteristics: Date of mortgage issuance, original rating of MBS, degree of subordination in pool (ie what tranche), prepayment history of pool, current default rates, etc. Just the kinds of things that the rating agencies would use to give a rating -- hey, maybe that will be some more work for our friends the rating agencies!
My colleague Bob Aliber has a neat idea, which I think has some merit. He suggests having sellers put all their MBS into a new pool, and define new securities with equal claims to the cash flows from that pool. Then the sellers offer these new securities to the government.
Note that this is essentially creating new CDOs out of the MBS. Neat. Put all the MBS into a pool, and define just one class of collateralized mortgage obligation on that pool. This is in fact essentially what CDOs did, and you can now see why maybe they made original sense -- to pool a bunch of disparate risks together. (Of course, the original CDOs then created multiple tranches on those secondary pools, which in Aliber's plan would not happen.) What this plan also may help to solve is the risk of getting just the absolute worst "lemons" from the sellers. If they have to pool everything together, they can't cherry pick and keep the best.
My thinking has been that Treasury will buy the MBS using pooling techniques of some kind, and then will pool all the MBS and create new securities, ie, CDOs, on that new pool and sell off those claims.
We shall see. It does look like Paulson is moving fast. Given the market turmoil today, that would be good.
So how will Treasury buy the MBS? It is easy to just say, well, by reverse auction. Current owners of the MBS submit offers to sell (price and quantity specified). The government accumulates the bids, from lowest price to highest price, and keeps track of cumulative volume offered. When that dollar volume hits what the government has agreed to buy in that auction, the price associated with the last accepted offer (or first not accepted offer)becomes the price that all offers are paid. That would be a nondiscriminatory auction. An alternative would be a discriminatory auction, whereby all accepted offers get the price they offered their MBS at. For several reasons I won't elaborate on here, I think the nondiscriminatory auction is the way to go.
But this begs the question of: what is being offered? Not all MBS are the same! If we were buying, say, shares of GM from different holders, there would be no problem, one share of GM being equivalent to another.
So the big issue is how to define the characteristics of MBS that will be accepted in any given auction. There is even the simple matter of different coupon rates, so that you cannot even say that $100 of face value is the same across different MBS even if credit issues are equivalent. But credit issues are the real big one.
I still think that the way to go will be to define ranges of credit characteristics that will enable a MBS to qualify for an auction. Prime candidates for the qualifying characteristics: Date of mortgage issuance, original rating of MBS, degree of subordination in pool (ie what tranche), prepayment history of pool, current default rates, etc. Just the kinds of things that the rating agencies would use to give a rating -- hey, maybe that will be some more work for our friends the rating agencies!
My colleague Bob Aliber has a neat idea, which I think has some merit. He suggests having sellers put all their MBS into a new pool, and define new securities with equal claims to the cash flows from that pool. Then the sellers offer these new securities to the government.
Note that this is essentially creating new CDOs out of the MBS. Neat. Put all the MBS into a pool, and define just one class of collateralized mortgage obligation on that pool. This is in fact essentially what CDOs did, and you can now see why maybe they made original sense -- to pool a bunch of disparate risks together. (Of course, the original CDOs then created multiple tranches on those secondary pools, which in Aliber's plan would not happen.) What this plan also may help to solve is the risk of getting just the absolute worst "lemons" from the sellers. If they have to pool everything together, they can't cherry pick and keep the best.
My thinking has been that Treasury will buy the MBS using pooling techniques of some kind, and then will pool all the MBS and create new securities, ie, CDOs, on that new pool and sell off those claims.
We shall see. It does look like Paulson is moving fast. Given the market turmoil today, that would be good.
Whew, What a Day
Nice quote in this story on CNBC:
"We'd actually like to see a little more panic," said Matt Cheslock, a senior specialist at Cohen Specialists.
"We'd actually like to see a little more panic," said Matt Cheslock, a senior specialist at Cohen Specialists.
Saturday, October 04, 2008
The Government's Significant Role in the Causes
I wish we had more people in the media documenting the negative role of government interventions in the housing and mortgage industry and in particular the supportive role that government actors played in creating this whole mess. Right now, populist opinion is heavily weighing against the greed and predation of private enterprise and thinking that government regulation will be our saving grace. Please let's not let that pendulum swing too far.
Tom Sowell had a nice piece today, "Do Facts Matter?" where he points out the role of Fannie and Freddie in buying subprime and Alt-A mortgages, and the strong lobbying by various politicians for easy credit.
Fannie and Freddie did indeed buy hundreds of billions of MBS created from subprime and alt-A trusts. Without the easy money from these government-sponsored entities, with their clear US taxpayer guarantee and subsidy, the housing market would definitely have been less heated. I won't lay all the blame on their doorstep, but they share in it heavily, and this should make rational people remember that while markets are not perfect neither are political regulatory mechanisms. We still await that legendary benevolent dictator -- and it appears that Paulson will not have his chance at the job!
Tom Sowell had a nice piece today, "Do Facts Matter?" where he points out the role of Fannie and Freddie in buying subprime and Alt-A mortgages, and the strong lobbying by various politicians for easy credit.
Fannie and Freddie did indeed buy hundreds of billions of MBS created from subprime and alt-A trusts. Without the easy money from these government-sponsored entities, with their clear US taxpayer guarantee and subsidy, the housing market would definitely have been less heated. I won't lay all the blame on their doorstep, but they share in it heavily, and this should make rational people remember that while markets are not perfect neither are political regulatory mechanisms. We still await that legendary benevolent dictator -- and it appears that Paulson will not have his chance at the job!
Some of the Pork
Besides the tax break for children's arrows, here is another good one:
"Representative Mike Thompson, Democrat of California, said he switched his vote to support the bill in order to help the economy. He would not say whether the insertion of a measure to give tax breaks for auto racing tracks, which he had previously tried to get passed, played a role in his decision. One such race track is in Thompson's district. The addition of such sweeteners was criticized by some who said the bailout bill was being loaded with wasteful earmarks."
Full article, which is not focused just on the pork, is from the Boston Globe.
"Representative Mike Thompson, Democrat of California, said he switched his vote to support the bill in order to help the economy. He would not say whether the insertion of a measure to give tax breaks for auto racing tracks, which he had previously tried to get passed, played a role in his decision. One such race track is in Thompson's district. The addition of such sweeteners was criticized by some who said the bailout bill was being loaded with wasteful earmarks."
Full article, which is not focused just on the pork, is from the Boston Globe.
Friday, October 03, 2008
Deep Disappointment
On the part of Democrats, that is. Palin not only did not fall on her face, but she did a fine job. Do I wish she had more at-hand knowledge of policy issues -- of course. But she has certain qualities that are very important. Anyone who can get up on that stage against Senator Biden and hold her own the way she did -- well, I give her credit for having some real sisu (look it up, Finnish word that has no clear translation to English, but very roughly it means I WILL GET THE JOB DONE.)
David Brooks of the NYT has a very fair evaluation.
David Brooks of the NYT has a very fair evaluation.
Thursday, October 02, 2008
The Behemoth Bailout Bill
I wonder if the function
y = f(t)
where y = dollar amount of non-credit market tax breaks and subsidies
and t = days that Congress has to write the emergency stabilization bill (aka as the bailout)
converges to a positive number or if it goes to infinity. I suspect the latter.
A good story on the "children's bow and arrow" tax break is here. CNBC almost makes it sound like it is a reasonable thing to include in the bill.
My question: If the arrow tax is such a bad thing, why not get it taken care of in a bill that is at least somewhat related to taxes?
Why can't our elected congresspeople have the courage to put this bill to a straightforward up or down vote? Can it really be that these pork barrel items are needed to get support? Someone is opposed to the bill in principle but will vote for it if a business in their area gets some kind of break? Please give me a break.
And, where is dear John McCain, he of principled opposition to earmarks and government waste? How can he ever again rail against earmarks if he is not willing to take a stand right now?
y = f(t)
where y = dollar amount of non-credit market tax breaks and subsidies
and t = days that Congress has to write the emergency stabilization bill (aka as the bailout)
converges to a positive number or if it goes to infinity. I suspect the latter.
A good story on the "children's bow and arrow" tax break is here. CNBC almost makes it sound like it is a reasonable thing to include in the bill.
My question: If the arrow tax is such a bad thing, why not get it taken care of in a bill that is at least somewhat related to taxes?
Why can't our elected congresspeople have the courage to put this bill to a straightforward up or down vote? Can it really be that these pork barrel items are needed to get support? Someone is opposed to the bill in principle but will vote for it if a business in their area gets some kind of break? Please give me a break.
And, where is dear John McCain, he of principled opposition to earmarks and government waste? How can he ever again rail against earmarks if he is not willing to take a stand right now?
Wednesday, October 01, 2008
A Mortgage Backed Mystery
As I review some of the terms of mortgage backed securities, I am really struck by the complexity that the designers of these securities created. Too clever by half, I am afraid.
A $1 billion pool of mortgages went into a trust, and out came 20 tranches of different securiies. The top few were called A level, as they got first dibs on any payments. Then the middle 15 or so were "mezzanine" and they got second dibs on payments, but of course in order of M1, M2, M3.....
Then at the very bottom were the equity and unrated tranches who were last to be paid and first to incur losses.
But this was not the only complexity. There was a lock out period which meant that principal payments went only to the A tranches initially. There was something called overcollateralization, meaning that the face value of the MBS sold was less than the principal value of the mortgages. Overcollateralization was enhanced by capturing excess spread, the difference between the average interest rate on the mortgages vs. the average rate paid on the MBS. Then there were triggers that would be evaluated a couple years into the pool performance that would determine if this over-collateralization would be released to benefit the equity or the higher rated tranches.
Plus there was an interest rate swap on the whole pool, converting a fixed payment by the mortgage trust to a LIBOR payment from the swap counterparty.
Very complicated.
There is simply no way that anyone can value such a complex scheme. No way. You've got default risk, prepayment risk, 20 different tranches, the triggering events, ....
But here is the real mystery. Why all this complexity? If you look at how Fannie Mae creates MBS, they throw everything into a pool and create just one class of MBS pass-through security out of it. Of course, it is easy for them, because they guarantee the payments, so everything is highly rated.
Therein lies the secret to what was going on. The creators of the subprime MBS were optimizing the tradeoff between the A rated MBS versus the lower-rated tranches. They were facing prices of MBS that were higher for high rated securities than for lower rated ones. And the relationship between price and rating was nonlinear, in that as rating went up, price went up by even more. This is what made it feasible to essentially put more risk on the lower class MBS, and less risk on the higher rated ones. If the relationship between price and rating was linear, then you cannot benefit from trading risk between the classes.
I can imagine that the underwriters would go to the rating agency and show them the deal, and the raters would say something like: "No, to get AAA you have to give the top tranches more security." Thereby came all the bells and whistles: reduce the size of the AAA tranche, increase the overcollateralization, create some trigger events that would benefit the AAA.
As I put this issue to one of my finance colleagues, he brought up what we call the Modigliani-Miller Theorem: that the value of the firm cannot be increased by moving claims to that fixed value between the debt and equity holders.
The application of that concept to MBS is simply that this trading of risk between the different tranches could not have created any value. What one tranche gained, another lost.
So why was it done, and to such an extent? Good question, and we are living with the complex consequences.
I think it was essentially taking advantage of errors in ratings and errors by the capital markets in pricing securities rated by the agencies.
A $1 billion pool of mortgages went into a trust, and out came 20 tranches of different securiies. The top few were called A level, as they got first dibs on any payments. Then the middle 15 or so were "mezzanine" and they got second dibs on payments, but of course in order of M1, M2, M3.....
Then at the very bottom were the equity and unrated tranches who were last to be paid and first to incur losses.
But this was not the only complexity. There was a lock out period which meant that principal payments went only to the A tranches initially. There was something called overcollateralization, meaning that the face value of the MBS sold was less than the principal value of the mortgages. Overcollateralization was enhanced by capturing excess spread, the difference between the average interest rate on the mortgages vs. the average rate paid on the MBS. Then there were triggers that would be evaluated a couple years into the pool performance that would determine if this over-collateralization would be released to benefit the equity or the higher rated tranches.
Plus there was an interest rate swap on the whole pool, converting a fixed payment by the mortgage trust to a LIBOR payment from the swap counterparty.
Very complicated.
There is simply no way that anyone can value such a complex scheme. No way. You've got default risk, prepayment risk, 20 different tranches, the triggering events, ....
But here is the real mystery. Why all this complexity? If you look at how Fannie Mae creates MBS, they throw everything into a pool and create just one class of MBS pass-through security out of it. Of course, it is easy for them, because they guarantee the payments, so everything is highly rated.
Therein lies the secret to what was going on. The creators of the subprime MBS were optimizing the tradeoff between the A rated MBS versus the lower-rated tranches. They were facing prices of MBS that were higher for high rated securities than for lower rated ones. And the relationship between price and rating was nonlinear, in that as rating went up, price went up by even more. This is what made it feasible to essentially put more risk on the lower class MBS, and less risk on the higher rated ones. If the relationship between price and rating was linear, then you cannot benefit from trading risk between the classes.
I can imagine that the underwriters would go to the rating agency and show them the deal, and the raters would say something like: "No, to get AAA you have to give the top tranches more security." Thereby came all the bells and whistles: reduce the size of the AAA tranche, increase the overcollateralization, create some trigger events that would benefit the AAA.
As I put this issue to one of my finance colleagues, he brought up what we call the Modigliani-Miller Theorem: that the value of the firm cannot be increased by moving claims to that fixed value between the debt and equity holders.
The application of that concept to MBS is simply that this trading of risk between the different tranches could not have created any value. What one tranche gained, another lost.
So why was it done, and to such an extent? Good question, and we are living with the complex consequences.
I think it was essentially taking advantage of errors in ratings and errors by the capital markets in pricing securities rated by the agencies.
The Senate Bailout Monstrosity
We have gone from a nice clean three page bill that was short on oversight to a 450 page monstrosity.
Do we need any more evidence on why Congress deserves its abysmally low approval rating -- 18% according to RealClearPolitics?
A bunch of tax provisions and special benefits to buy votes have made their way in. From the article cited in the above link:
"And tucked away in the tax provisions is a landmark health care provision demanding that insurance companies provide coverage for mental health treatment—such as hospitalization—on parity with physical illnesses.
Really a bill onto itself, the mental health parity measure has been a bipartisan priority for top lawmakers in both chambers but has stalled because of disagreements again over how to pay for its estimated $3.8 billion five-year cost. In the current climate, that seems to be no longer a stumbling block, and if the Treasury plan becomes law, it will also."
Right. Nice work, guys. A true hat trick: many can say they voted against the original bill but then voted for a better one, and they can brag to certain special groups that they got their bacon as well.
Do we need any more evidence on why Congress deserves its abysmally low approval rating -- 18% according to RealClearPolitics?
A bunch of tax provisions and special benefits to buy votes have made their way in. From the article cited in the above link:
"And tucked away in the tax provisions is a landmark health care provision demanding that insurance companies provide coverage for mental health treatment—such as hospitalization—on parity with physical illnesses.
Really a bill onto itself, the mental health parity measure has been a bipartisan priority for top lawmakers in both chambers but has stalled because of disagreements again over how to pay for its estimated $3.8 billion five-year cost. In the current climate, that seems to be no longer a stumbling block, and if the Treasury plan becomes law, it will also."
Right. Nice work, guys. A true hat trick: many can say they voted against the original bill but then voted for a better one, and they can brag to certain special groups that they got their bacon as well.
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