Finance – Page 9 – Donald Marron

Yuppie 911 and the Financial Crisis

If you make an activity safer, people will take more risk. The inventions of seat belts, air bags, and anti-lock brakes, for example, have all inspired people to drive more aggressively. And if you put drivers in SUVs, rather than regular cars, they are more likely to hit the road during a snow storm.

In recent days, several media outlets have noted a similar phenomenon: if you make it easier to call for help, more hikers will get themselves in trouble. As noted over at MSNBC (ht Tyler Cowen):

Technology has made calling for help instantaneous even in the most remote places. Because would-be adventurers can send GPS coordinates to rescuers with the touch of a button, some are exploring terrain they do not have the experience, knowledge or endurance to tackle.

Rescue officials are deciding whether to start keeping statistics on the problem, but the incidents have become so frequent that the head of California’s Search and Rescue operation has a name for the devices: Yuppie 911.

“Now you can go into the back country and take a risk you might not normally have taken,” says Matt Scharper, who coordinates a rescue every day in a state with wilderness so rugged even crashed planes can take decades to find. “With the Yuppie 911, you send a message to a satellite and the government pulls your butt out of something you shouldn’t have been in in the first place.”

So what does this have to do with the financial crisis? Well, it’s not merely that the government has been forced to save financial firms from things that they shouldn’t have been doing in the first place.

The broader idea is that people take more risks when they feel more comfortable. In the pre-crisis days, it appeared that business cycle fluctuations had gotten smaller. Because of this “Great Moderation”, firms and investors felt that they faced smaller macroeconomic risks when taking on new investments. Improvements in risk management had a similar effect, as firms and investors got better at managing pesky things like interest rate risk. These advances made it appear that risks were smaller and more manageable and, as a result, firms and investors felt more comfortable taking on more leverage and larger investment risks.

P.S. For additional coverage of Yuppie 911, see NPR.

More TIPS to Finance Our Growing Debt?

As you may noticed, the U.S. needs to borrow vast amounts of money. Which raises an interesting question: how should we finance that debt?

The Government Accountability Office (GAO) has taken note of this question and has begun a series of reports on debt management. In its first report, released today, the GAO provides a ringing endorsement of inflation-indexed bonds, aka TIPS (Treasury Inflation Protected Securities). The title of the report pretty much summarizes its conclusions: “Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges.”

The report provides a nice history of the TIPS program, which dates back to 1997, and the challenges it has faced. The number one challenge? Liquidity. Regular Treasury securities are the most liquid in the world and, as a result, investors are willing to pay a premium to own them. U.S. taxpayers thus benefit from the low interest rates our government has to pay on its debt. Unfortunately, TIPS are much less liquid and thus don’t enjoy the same benefit. GAO thus suggests that actions to improve liquidity (e.g., more frequent auctions) could help bring down interest costs.

GAO also recommends that longer-dated TIPS be issued as the U.S. moves to lengthen the maturity of its debt. As noted in the following chart, the current maturity structure of U.S. debt is heavily skewed to short maturities:

GAO - Debt Issuance

More than $3 trillion of U.S. debt will come due by the end of 2010 alone.

The reliance on short-term debt makes sense when near-term interest rates are incredibly low, as they have been lately. But interest rates will rise again one day (perhaps sooner than many anticipate according to a recent op-ed by Fed Governor Kevin Warsh), and the government should therefore be evaluating how it will lengthen maturities. GAO believes that TIPS should be part of that.

IMF: The Lasting Effects of Financial Crises

Earlier this week, the IMF released a key chapter from the upcoming World Economic Outlook: Chapter 4: What’s the Damage? Medium-Term Output Dynamics After Financial Crises. As noted in the much pithier summary, the report concludes that:

The global financial crisis is likely to leave long-lasting scars on the world economy, but governments can act to stimulate a quicker revival and counter output losses … . The study finds that banking crises typically have a long-lasting impact on the level of output, although growth eventually recovers. Lower employment, investment, and productivity all contribute to sustained output losses.

Those conclusions are based on their review of financial crises around the world since the early 1970s. As shown in the following graph, the key finding is that after a financial crisis economic output remains below trend for years:

The blue line shows, for example, that in the average country, output seven years after the crisis was about 10% below what would it would have been if the pre-crisis growth rate had continued.

The dotted red lines, however, highlight the enormous range of outcomes. At least one-quarter of the countries eventually had output that was above the level implied by the earlier trend; while another quarter eventually fell at least 25% below the prior trend.

The study slices and dices this result in numerous ways, trying to identify the factors that lead to better or worse outcomes. Some are bad news for the United States.

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Lessons from the Fall of Lehman

As you have undoubtedly noticed, this week marks the one-year anniversary of the fall of Lehman Brothers–the moment at which the financial crisis became a severe economic crisis.

I did an interview on Fox Business on Tuesday to discuss some of the lessons learned. (My wife’s comment on the interview: “You need to straighten your collar next time.”)

Going in, I had two basic points I wanted to make:

First, the fall of Lehman Brothers was the moment that the abstract threat of “systemic risk” became tangible to many policy makers and the public. As we progressed from propping up Bear Stearns to taking over Fannie Mae and Freddie Mac, many observers began to suffer from policy fatigue, and, in some circles, there was concern that the scale of the government actions might be disproportionate to the alleged, but little-seen, risk of a systemic crisis. That changed when Lehman fell, and the dominoes started toppling.

Second, we still have our work cut out for us. The major items on our to do list include:

(1) Taking steps to avoid such enormous shocks in the future (e.g., by increasing capital requirements and reducing allowed leverage for financial firms).

(2) Fixing the problem of too-big-to-fail (or, if you prefer, too-interconnected-to-fail). Unfortunately, this problem has worsened, in many ways, since the crisis began. Some gigantic firms have grown even larger. And the necessary interventions to prop up the financial sector have reinforced the idea that the government will prevent these firms from failing in the future.

(3) Disentangling the government from private firms, so that it can again act as a referee, not as a player. That will take time given the enormous investment portfolio that the government has amassed in financial firms and the auto companies. It is heartening, however, that even Citigroup is beginning to ponder how to raise outside capital and reduce the government stake.

The Simple Economics of Student Loan Crises

Yesterday, my students heard my second lecture on supply and demand. You know, the one in which we examined how government policies like rent control and the minimum wage can affect market outcomes. Those are important examples, and I dutifully discussed both of them. But I must admit they also feel a smidgen stale – how many millions of students have seen a lecture on rent control and the minimum wage?

To spice things up, I threw in a third example of government intervention: the market for guaranteed student loans. As I mentioned a few weeks ago, the government has a major program in which it provides guarantees for private student loans. Under the program, lenders are protected against the risk of future defaults by the student borrowers. In return for providing these loans, the lenders receive interest payments that are limited by a formula that is specified in law. (These payments are determined completely separately from the amounts that are charged to students which, for simplicity, I will ignore in what follows.)

This program is currently the focus of a major political battle: the Obama administration has proposed eliminating the program and replacing it with direct loans from the government (which currently account for a much smaller portion of the market). But I didn’t get into that larger debate in class. Instead, the reason I focused on this program is that it has experienced two crises in recent years:

In 2006 and 2007, the crisis was kickbacks. In their enthusiasm to win more business, private lenders were offering “inducements” to schools and student loan officers in order to get preferred access to students who wanted loans.

In 2008, the crisis was a lack of lending. In large part because of the financial crisis, private lenders had no enthusiasm whatsoever for making loans. As a result, there was a real risk that students might not be able to get loans.

As I told my students, I think both of these crises had the same root cause: the fact that the government, rather than market forces, determined how much lenders were paid for making guaranteed student loans. In both cases, the government got the payment levels wrong, and the crises followed soon thereafter.

Continue reading “The Simple Economics of Student Loan Crises”

Wall Street Goes to Washington

A front page story in today’s Washington Post (“In Shift, Wall Street Goes to Washington“) documents the Capital’s rising importance in the financial world:

J.P. Morgan Chase for the first time convened its board in Washington this summer, calling the directors to a meeting at the downtown Hay-Adams hotel, then dispatching them to Capitol Hill for meet-and-greets.

Last month, a firm run by the billionaire investor Wilbur Ross hired the head of Washington’s top mortgage regulator to pick through the wreckage of the housing bust looking for bargains.

And the world’s largest bond fund, Pimco, which has traditionally assessed the risk of any new investment according to five financial criteria, recently added one more: the impact of any change in federal policy.

…

“In the old days, Washington was refereeing from the sideline,” said Mohamed A. el-Erian, chief executive officer of Pimco. “In the new world we’re going toward, not only is Washington refereeing from the field, but it is also in some respects a player as well. . . . And that changes the dynamics significantly.”

The Ross example doesn’t tell us much — the financial world has always recruited government officials. The J.P. Morgan and Pimco examples, however, highlight how much the playing field has changed over the past two years. Washington is not just a more aggressive regulator. Given the stresses on the system, it has become a serial intervener — stepping in to prop up specific firms or credit channels that appear too important to fail. And it is now a major investor, with a burgeoning portfolio of investments in financial firms, auto companies, and mortgage backed securities.

As we commemorate the first anniversary of the fall of Lehman, it appears that the worst of the financial and economic crisis is behind us. And the policy conversation should increasingly focus on exit strategies. Not just the narrow question of how the Federal Reserve eventually unwinds the extraordinary expansion of its programs. But also how the Treasury eventually unwinds it TARP investments. How the FDIC walks back from offering guarantees on bank debt. How the government restructures Fannie Mae and Freddie Mac.

And, perhaps most importantly, how policymakers recalibrate their relationship with financial markets. To paraphrase Mohamed A. el-Arian: can Washington return to being a referee on the sidelines or will it continue to be a player?

The Fannie and Freddie Anomaly

Can anyone explain the stock prices of Fannie Mae and Freddie Mac, the two government-sponsored enterprises that are supporting our mortgage market?

On Friday, Fannie’s common stock closed at $2.04 per share, up 250% since the start of August. That values the company–to be precise, the privately-owned common shares in the company–at more than $2 billion.

Freddie Mac’s common shares closed at $2.40 per share, up almost 300% since the start of August. That values Freddie’s privately-owned common shares at more than $1.5 billion.

Collectively, then, the common stock of these two wards of the state totals almost $4 billion.

This seems a trifle high, however, since most observers think their common stock is worthless (see, for example, this AP story).

I think those observers are right.

Continue reading “The Fannie and Freddie Anomaly”

OMB’s 2009 Deficit Estimate Is Likely Too High

As expected, the new budget projections from the Office of Management and Budget show an estimated deficit of $1.58 trillion in the current year (which ends on September 30).

In their coverage of the dueling budget releases, many members of the media are noting that this estimate is almost identical to the $1.59 trillion estimate released by the Congressional Budget Office. Thus, it may appear that OMB and CBO reached similar conclusions about this year’s deficit.

That is not correct.

OMB and CBO use different accounting for a growing part of the budget — the federal take-over of Fannie Mae and Freddie Mac. If you adjust for those accounting differences, an apples-to-apples comparison shows that OMB’s projection of a $1.58 trillion deficit should be compared to a CBO estimate of $1.41 trillion. (For details, see the table on p. 2 and the box on pp. 8-9 of CBO’s report.)

In other words, using identical accounting, CBO is projecting a deficit that is almost $200 billion less than projected by OMB.

Here’s how it works:

Continue reading “OMB’s 2009 Deficit Estimate Is Likely Too High”

How to Manage $3 Trillion

Shawn Tully at Fortune has a fun article recounting the rapid rise of Blackrock, which will soon be the largest asset manager in the world.

He contrasts the firm’s fixed-income investment strategy with other firms (e.g., Pimco) as follows:

BlackRock does not invest by forecasting which way interest rates are headed. Instead BlackRock wonkishly focuses on the other factors that drive bond values: prepayments and default risk. As a result, BlackRock was better equipped to analyze the complex mortgage securities that came to dominate the fixed-income markets and that caused so much havoc last year.

BlackRock’s approach works like this: Say mortgage bonds are selling at a big discount because rates recently rose. BlackRock’s models are expert at judging if those bonds are “rich” or “cheap” based on its technology for predicting prepayment trends and defaults. If the model predicts, for example, that prepayments will be higher than most investors expect, BlackRock can garner extra returns because homeowners will pay off their loans at full value, and the fund can reinvest the proceeds at higher rates.

The firm’s analytical modeling gets so granular that BlackRock found that people living near IBM offices prepay frequently because IBM executives are often dispatched to new cities.

I find that IBM tidbit very telling. It’s a great example of the information-processing that can, in principle, allow investors to earn super-normal returns (alpha, in the lingo). And if enough investors do it, market prices could approach the efficiency that finance theory often predicts. On the other hand, the need to get that “granular” suggests just how difficult it is for normal investors to value these kinds of securities. (Of course, experience has shown that many investors in mortgage-backed securities made much more basic errors — like trusting the ratings granted by the credit rating agencies — but that’s a topic for another day.)

P.S. For those too young to remember, the old joke is that IBM stands for “I’ve Been Moved.”

The Charming World of Las Vegas Real Estate

Over at Time Magazine, Joel Stein has an amusing / troubling article (“Less Vegas: The Casino Town Bets on a Comeback“) about the perils of Las Vegas real estate (ht Anne Canfield).

The juiciest part of the article recounts how real estate agent Brooke Boemio advises clients to exploit the realities of the collapsed housing market:

Boemio specializes in short selling, in a particularly Vegas way. Basically, she finds clients who owe more on their house than the house is worth (and that’s about 60% of homeowners in Las Vegas) and sells them a new house similar to the one they’ve been living in at half the price they paid for their old house. Then she tells them to stop paying the mortgage on their old place until the bank becomes so fed up that it’s willing to let the owner sell the house at a huge loss rather than dragging everyone through foreclosure. Since that takes about nine months, many of the owners even rent out their old house in the interim, pocketing a profit.

In short, homo economicus is again stalking the Vegas housing market.

Stein notes that the renters often suffer from this ploy, since they can be evicted when a foreclosed property finally changes hands. In a nice illustration of how markets work, he then describes how renters are adjusting to this reality:

People are now paying a premium to live [i.e., rent] in apartment buildings, which in Vegas are almost always owned by a corporation.

Klein’s story has lots of other fun anecdotes from the front line of real estate crisis, including this immortal line from casino mogul Sheldon Adelson, whose wealth has reportedly declined by more than $35 billion:

A billion dollars doesn’t buy what it used to. So it’s not as tragic as one would assume.”