Finance – Page 3 – Donald Marron

Will September Bring Another Banking Crisis?

Over at the Economist, Greg Ip points us to a new IMF working paper that surveys all the systemic banking crises–147 in all–since 1970. As Greg notes, one of Luc Laeven and Fabian Valencia’s most striking findings is that banking crises disproportionately begin in the second half of the year, with a particular spike in September:

So let’s enjoy what few days of June remain.

P.S. Theories to explain this pattern are appreciated. Or maybe it’s a spurious correlation, at Tyler Cowen hints.

Update: Joshua Hedlund at PostLibertarian crunches the underlying data and finds that (a) the authors provided a date for only 63 of the crises and (b) that 22 of the 25 in September happened in 2008. ht: Tyler Cowen

Soros: The European Union is a Bubble

My Twitter feed lit up yesterday with folks recommending a speech by George Soros about Europe. [Link subsequently stopped working, but now it’s back.] They were right. Whether you love him or hate him, he provides a fascinating perspective on Europe’s past, present, and future and, in so doing, provides a particularly clear presentation of his critique of (what he views as) mainstream economics.

The whole speech is worth a read. Here are some excerpts describing his view that the European Union is a bubble:

Among other things, I developed a model of a boom-bust process or bubble which is endogenous to financial markets, not the result of external shocks. According to my theory, financial bubbles are not a purely psychological phenomenon. They have two components: a trend that prevails in reality and a misinterpretation of that trend. A bubble can develop when the feedback is initially positive in the sense that both the trend and its biased interpretation are mutually reinforced. Eventually the gap between the trend and its biased interpretation grows so wide that it becomes unsustainable. After a twilight period both the bias and the trend are reversed and reinforce each other in the opposite direction. Bubbles are usually asymmetric in shape: booms develop slowly but the bust tends to be sudden and devastating. That is due to the use of leverage: price declines precipitate the forced liquidation of leveraged positions.

…

I contend that the European Union itself is like a bubble. In the boom phase the EU was what the psychoanalyst David Tuckett calls a “fantastic object” – unreal but immensely attractive. The EU was the embodiment of an open society –an association of nations founded on the principles of democracy, human rights, and rule of law in which no nation or nationality would have a dominant position.

The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble. That is how the Coal and Steel Community was gradually transformed into the European Union, step by step.

Germany used to be in the forefront of the effort. When the Soviet empire started to disintegrate, Germany’s leaders realized that reunification was possible only in the context of a more united Europe and they were willing to make considerable sacrifices to achieve it. When it came to bargaining they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to assert that Germany has no independent foreign policy, only a European one.

The process culminated with the Maastricht Treaty and the introduction of the euro. It was followed by a period of stagnation which, after the crash of 2008, turned into a process of disintegration. The first step was taken by Germany when, after the bankruptcy of Lehman Brothers, Angela Merkel declared that the virtual guarantee extended to other financial institutions should come from each country acting separately, not by Europe acting jointly. It took financial markets more than a year to realize the implication of that declaration, showing that they are not perfect.

The Maastricht Treaty was fundamentally flawed, demonstrating the fallibility of the authorities. Its main weakness was well known to its architects: it established a monetary union without a political union. The architects believed however, that when the need arose the political will could be generated to take the necessary steps towards a political union.

But the euro also had some other defects of which the architects were unaware and which are not fully understood even today. In retrospect it is now clear that the main source of trouble is that the member states of the euro have surrendered to the European Central Bank their rights to create fiat money. … Due to the divergence in economic performance Europe became divided between creditor and debtor countries. This is having far reaching political implications … .

Is Incentive Compensation a Giant FIB?

Harvard Business School professor Mihir Desai believes American companies and investment firms have erred–horribly–by linking manager compensation so tightly to financial market performance. In the current Harvard Business Review, he identifies this as a giant FIB, a Financial Incentive Bubble:

American capitalism has been transformed over the past three decades by the idea that financial markets are suited to measuring performance and structuring compensation. Stock-based pay for corporate executives and high-powered incentive contracts for investment managers have dramatically altered incentives on both sides of the capital market. Unfortunately, the idea of compensation based on financial markets is both remarkably alluring and deeply flawed: It seems to link pay more closely to performance, but it actually rewards luck and can incentivize dangerous risk-taking. This system has contributed significantly to the twin crises of modern American capitalism: governance failures that cast doubt on the stewardship abilities of U.S. managers and investors, and rising income inequality.

Mihir has nothing against well-functioning financial markets. He emphasizes that they “play a vital role in economic growth by ensuring the most efficient allocations of capital,” and he believes that capable managers and investors should be “richly rewarded” when their talents are truly evident.

The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck. In finance-speak, managers and investors often get rewarded for taking on beta, when their pay really ought to be linked to alpha. In practice, luck gets rewarded with undeserved windfalls (that are by no means offset by negative windfalls for the unlucky). And that, he argues, results in an important “misallocation of financial, real, and human capital.”

Well worth a read.

Financial Answers Made Simple

For the past year, I have been advising a start-up, FedWise LLC, that is working to improve American’s financial literacy. (Full disclosure: I have a small interest in the company.)

FedWise’s vision is simple: to provide helpful, unbiased, reliable information to consumers about financial products and services like mortgages and credit cards.

The company recently launched its first two products.

One is a public website, FinFAQs, where visitors can get answers to specific questions. For example, “What are points?” or “What questions can creditors not legally ask me?“. If you are interested, please try it out. FinFAQs is still young, and the team welcomes feedback on the questions, answers, and interface.

The second, the FedWise Answer Engine, allows financial institutions to offer the Qs and As to consumers on their own websites while receiving sales leads and market intelligence. Several banks and credit unions have already signed up for subscriptions. Perhaps needless to say, FedWise is happy to talk to other institutions that might be interested in offering the service to their customers. For more info, click here.

The Most Important Economic Chart of the Year

Ezra Klein surveyed 18 economists for their charts of the year. Here’s my candidate, courtesy of Spiegel Online:

This chart illustrates the end of euro complacency. Investors once acted as though the euro eliminated not just currency risk but sovereign credit risk. All nations–from Greece to Germany–could borrow at the same low rates. No longer. As the financial crisis enters its fifth year, markets are again distinguishing between strong nations and weak.

I subsequently discovered that I am not alone in choosing this chart. The BBC has a version of this as the first entry in its survey of top graphs of the year (with commentary by Vicky Pryce of FTI Consulting), and Desmond Lachman of the American Enterprise Institute included it in Derek Thompson’s survey of top graphs over at the Atlantic.

P.S. For the United States, I think Brad DeLong is right: behold the shortfall in nominal U.S. GDP.

How Fast Does the Stock Market Forget False News? About Seven Days

The New York Federal Reserve just posted an entertaining analysis of an “Internet blooper” that struck UAL, the parent company of United Airlines a few years ago. As authors Carlos Carvalho, Nicholas Klagge, and Emanuel Moench note in a blog post:

On September 8, 2008, a six-year-old article about the 2002 bankruptcy of United Airlines’ parent company resurfaced on the Internet and was mistakenly believed to be reporting a new bankruptcy filing by the company. This episode caused the company’s stock price to drop by as much as 76 percent in just a few minutes, before NASDAQ halted trading. After the “news” had been identified as false, the stock price rebounded, but still ended the day 11.2 percent below the previous close. Trading volumes skyrocketed during these extreme price movements. In subsequent days, the stock traded as much as 17 percent below its September 8 closing price, and on September 15 it finally traded above the price level seen just before the false news impacted the market.

In short, it took a week for the stock market to flush the “blooper” out of its system.

They then confirm that result using much more sophisticated techniques that allow them to estimate what UAL’s stock price would have been absent the false news:

For bonus points, they also find that similar, but smaller effects on the stock prices of other major airlines.

ht: Paul Kedrosky.

S&P’s $2 Trillion Error

In the final hours before Friday’s historic downgrade, Standard & Poors gave Treasury an advance copy of its report. Amazingly, that report contained a $2 trillion error in its calculations of U.S. deficits and debt over the next decade. Here are four things you should know about it.

1. Treasury hoped that S&P would change its decision in light of the error, but S&P shrugged it off as not material.

In a blog post, Acting Assistant Secretary for Economic Policy John Bellows described what happened when the error was discovered:

After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.

On Saturday morning, S&P issued a clarification / rebuttal acknowledging the error, but downplaying its importance:

The primary focus [of our analysis] remained on the current level of debt, the trajectory of debt as a share of the economy, and the lack of apparent willingness of elected officials as a group to deal with the U.S. medium term fiscal outlook. None of these key factors was meaningfully affected by the assumption revisions to the assumed growth of discretionary outlays and thus had no impact on the rating decision.

2. Despite S&P’s claim, $2 trillion would “meaningfully affect” “the trajectory of debt as a share of the economy.”

It’s own revised calculations show net general government debt hitting 85% of gross domestic product in 2021 instead of 93%. That’s a big difference.

The 85% figure is still uncomfortably high and may well not deserve a AAA rating. But S&P was too dismissive in its clarification.

3. The error is understandable but remarkably sloppy for such an important analysis.

The source of the error is painfully familiar to anyone who deals with U.S. budget projections. S&P’s analysts didn’t use the right measuring stick — i.e., the right budget baseline — when analyzing the effects of the recently-enacted Budget Control Act.

In one sense, it’s easy to see how this error happened. Budget discussions are now hopelessly confused by a profusion of different baseline projections of what spending and revenues will look like in the future. Indeed, I have devoted multiple posts to clarifying how different revenue baselines fit together (e.g., here and here). I’ve even used Johnny Depp to highlight the challenge.

A similar challenge exists with discretionary spending. Official budget baselines assume that annual appropriations (the defense and non-defense spending Congress fights over every year) grow with inflation unless subject to an explicit cap. That was the basis, for example, for the official baseline that the Congressional Budget Office used in evaluating the impacts of the Budget Control Act.

Before the BCA, there were no discretionary spending caps, so annual budget authority was assumed to grow with inflation from the most recent appropriated levels. The BCA then generated $917 billion in budget savings by setting annual spending caps below those levels.

S&P messed up because it based its analysis on another baseline. That “alternative fiscal scenario” assumes that discretionary spending grows at the same pace as the overall economy, not just with inflation. That baseline implies much more spending and debt over the next decade — $2 trillion more, in fact — than the official baseline.

So, again, it’s easy to see mechanically how this error happened. But it’s still remarkably sloppy. Budget experts are well-aware of the problem of multiple baselines. Indeed, we all pepper our conversations and analysis with the question “what baseline are you using?” It’s stunning that S&P didn’t have multiple analysts asking the same question to make sure their original numbers were right.

4. S&P’s response to the error further demonstrates that its primary concern about the United States is political not numerical.

As S&P said in Friday’s report:

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers. In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging.

In short, S&P worries that America won’t get its act together in time.

Five Things You Should Know About the S&P Downgrade

On Friday night, Standard and Poors announced that it was downgrading U.S. long-term sovereign debt from AAA to AA+, the first such downgrade in U.S. history.

Here are five things you should know about the downgrade — four important, one trivia.

1. S&P downgraded U.S. debt not only because of the deteriorating fiscal outlook, but also because of concerns about America’s ability to govern itself. It said:

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

2. Moody’s and Fitch recently reaffirmed their AAA ratings on U.S. sovereign debt. On Tuesday, Moody’s reaffirmed its Aaa rating, but assigned a negative outlook given the risk that the U.S. might flinch from further fiscal tightening, borrowing costs might rise, and the economy might weaken. Fitch similarly reiterated its AAA rating on Tuesday, but noted that it would have a fuller reassessment by the end of August. Fitch also emphasized the need for further fiscal adjustments.

One issue (on which I haven’t seen much discussion) is how the impact of a downgrade would increase if it spreads from just one rating agency to two or three.

3. In the past thirty years, five nations — Australia, Canada, Denmark, Finland, and Sweden– have regained a AAA rating after losing it. See, for example, this nice chart from BusinessWeek:

America still has much to learn from other nations that fixed their economies and budgets after financial crises. Sweden, for example, did a remarkable job addressing the fiscal challenges that followed its financial crisis in the early 1990s.

4. This downgrade may set off a cascade of further downgrades for other U.S. debt. The federal government provides an implicit or explicit backstop for many other debt securities. For example, the federal government stands behind trillions of dollars of debt and guarantees issued by Fannie Mae and Freddie Mac, GNMA securities, and securities backed by guaranteed student loans. It implicitly stands behind systemically important financial institutions. And it provides substantial support to state and local governments. S&P did not specifically address these other credits in Friday’s report, but did say that:

On Monday, we will issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.

S&P did reaffirm its highest, A-1+ rating on U.S. short-term debt, which should limit impacts on money market funds and other short-term lending markets.

5. S&P was not the first rating agency to downgrade U.S. sovereign debt. In the category of trivia, China’s Dagong credit rating agency downgraded U.S. credit to A with a negative outlook earlier this week. Dagong had initiated U.S. coverage with a AA rating about a year ago, which was lowered to A+ last November. Dagong apparently views the United States as a greater risk than China. Despite all of America’s problems, that seems a stretch.

Update: In addition, Egan-Jones, a U.S. rating agency, cut the U.S. to AA+ in mid-July. Egan-Jones thus wins the prize as first U.S.-based agency to downgrade. Writing in the Financial Times, Michael Mackenzie noted:

Egan-Jones was officially recognised in 2008 by the Securities and Exchange Commission and, unlike its larger rivals, generates revenue from institutional investors and not from issuers of debt. During the past decade it downgraded US carmakers and structured credit products before similar decisions by the big rating agencies.

Thanks to reader Dan Diamond for pointing out the Egan-Jones downgrade.

Playing with Fire with the Debt Limit

My latest column in the Christian Science Monitor:

America sometimes takes its exceptionalism too far.

Case in point: We are the only major economy that talks openly of default.

Government debt has ballooned throughout the developed world in the aftermath of the Great Recession. France and Britain are as deep in debt as the United States, for example, and Japan is much further in the hole.

But their leaders never mention the possibility of default. Why would they? If you have the ability to pay your bills, there’s no reason to scare your creditors.

But that’s exactly what we do in America. Treasury Secretary Timothy Geithner has been warning about the risks of default since January.

If we don’t increase the debt limit by early August, he tells us, default becomes a real possibility. And that could pose grievous risks to our already weak economy.

Many Republicans play down that risk. Echoing famed investor Stanley Druckenmiller, some argue that a temporary default would be acceptable if it’s part of a larger political strategy that brings future deficits under control.

But that is a dangerous game.

Large swaths of America’s financial infrastructure have been built on the assumption that US Treasuries pay on time. And financial markets would likely punish the US with higher interest rates if we defaulted. That’s what happened in 1979, for example, when back office snafus caused Treasury to unintentionally miss payments to some investors.

This time, Fitch, Moody’s, and Standard & Poors are threatening to cut the US credit rating if we choose to default. Given the risks, most observers recognize that default is not, and should not be, an option. The US is not a deadbeat nation.

But does that mean the debt limit has to go up in early August? Some Republicans say no because of a simple fact: Every month, the federal government collects more in taxes than it pays in interest. With careful cash management (which would likely have to start before the August deadline), Mr. Geithner should be able to prioritize debt payments and thus avoid debt default.

As best as I can tell, that argument is correct, but it’s hardly a reason for complacency. America is currently spending about $100 billion more each month than it collects in revenues. If we hit the debt limit, we won’t be able to pay everyone who is rightly expecting to be paid.

Geithner can and should ensure that our debtholders get paid.

But someone – perhaps millions of someones – won’t be paid on time. Contractors, federal workers, program beneficiaries, or state and local governments will suddenly find themselves short on their cash flow.

That won’t be good for the economy. Even though it’s not as bad as debt default, it still would paint the US as a deadbeat.

The US faces severe fiscal challenges in the years ahead. It’s perfectly reasonable that lawmakers want to combine an increase in the debt limit with efforts to rein in future deficits.

But that worthy goal should not weaken our commitment to paying – on time and in full – the obligations that we have already incurred.

As the debt limit draws near, our leaders should stop playing with fire and craft instead a plan to rein in future deficits without threatening our struggling recovery.

That’s a difficult balancing act, requiring tough compromises across the political spectrum. But as everybody knows on Capitol Hill and beyond, it would be the best step for the nation and our fragile economy.

It would also be exceptional.

Treasury Offers Some Good Ideas on Mortgage Finance

Today was a big one for housing finance. Treasury kicked things off with its much awaited report to Congress on “Reforming America’s Housing Finance Market.” And then the Brookings Institution hosted a full day conference on “Reforming the U.S. Mortgage Market.”

Both Treasury’s report and the conference showed that there’s still important debate about the potential merits and demerits of a continued government backstop in the prime mortgage market. Treasury’s three options, for example, run the gamut from no guarantee to a backstop guarantee that kicks in during bad times to a permanent, broad-based guarantee. I’ll have more to say on these options in the future.

For now, I’d like to highlight several other aspects of the Treasury report and the discussion at Brookings that I found encouraging. Based on what I heard (and what I read between the lines of the Treasury report), there appears to be near-consensus on five important issues:

The multi-trillion dollar investment portfolios of Fannie Mae and Freddie Mac were a mistake. As the Treasury report puts it: “Fannie Mae and Freddie Mac were allowed to behave like government-backed hedge funds, managing large investment portfolios for the profit of their shareholders with the risk ultimately falling largely on taxpayers.” Such government-backed portfolios have no place in our future mortgage finance system.
Any future government assistance must be better targeted. For example, the conforming loan limit (and its FHA counterpart) need to come down.
If there are any future government guarantees for prime mortgages, they must be protected by greater private capital.
If there are any future government guarantees for prime mortgages, they must be explicit, and financial firms must pay at least actuarially fair rates to purchase them.
Affordable housing programs should be transparent and on budget, rather than embedded in regulatory requirements on Fannie Mae, Freddie Mac, or any successors.

Each of these would be a substantial improvement from the old GSE system.