The End of Cap and Trade?

No, not for carbon. For sulfur dioxide.

As noted by Mark Peters at the Wall Street Journal:

The original U.S. cap-and-trade market, which succeeded in slashing the power-plant emissions that cause acid rain, is in disarray following the issuance of new federal pollution rules.

The collapse in the pioneering market where power producers trade permits that allow them to emit sulfur dioxide and other pollutants that cause acid rain comes as policy makers seek to establish a similar market to curb the emissions of carbon, a cause of climate change.

The SO2 market has been one of the great successes of economic engineering, using market forces to drive down the cost of cleaning the environment. After almost twenty years of trading, however, the market ran into what may be an insurmountable hurdle: increased regulatory concern about the location of SO2 emissions.

The SO2 marketplace is national in scope, which has been great for establishing liquid trading and allowing emitters to find the cheapest way of reducing emissions. But it also meant that some SO2 emissions would end up in particularly unwelcome spots, e.g., upwind of cities, states, or entire regions that are having trouble meeting air quality standards.

Over the past couple of years, court rulings and new regulatory efforts by the Environmental Protection Agency have increased the emphasis of the location of emissions. And that means that the national market may be coming to an end.

That’s certainly what it looks like in the allowance marketplace, where prices have fallen from more than $600 per ton in mid-2007 to $5 or less today:

The price decline has been particularly sharp because utilities had been polluting less than allowed in recent years. That allowed them to build up an inventory of allowances to use in the future. With prices so low today, however, utilities have essentially no incentive to avoid sulfur emissions and no incentive to hold allowance inventories. As Gabriel Nelson puts it over at the New York Times:

With SO2 allowances trading at about $5 per ton, and little prospect of carrying over the permits into the new program, utilities have little incentive to bank allowances or add emissions controls for the time being, traders say. Because those controls have upkeep costs beyond the original investment, some plants might even find it more cost-effective to use allowances than to turn on scrubbers that have already been installed, traders said.

Fannie & Freddie Reform Gets a Boost from the Washington Post

Sunday’s Washington Post has an encouraging editorial about the Fannie Mae and Freddie Mac reform proposal that Phill Swagel and I recently put forward. An excerpt:

[Their plan would] abolish the most toxic features of the old “government-sponsored enterprise” model. In particular, the plan would get Fannie and Freddie out of the business of directly purchasing mortgage-backed securities, which was highly profitable to them in large part because their implicit government guarantee enabled them to fund a large portfolio at artificially low rates. Their existing $5 trillion pile of securities and guarantees would be wound down or sold off to the private sector.

But Mr. Marron and Mr. Swagel would keep a government role in Fannie and Freddie’s other business: securitizing conventional, moderately sized “conforming loans,” which is both necessary to mortgage liquidity and relatively less risky. And instead of a non-transparent, implicit government guarantee, the new securities would carry an explicit one, for which the securitizers would pay a fee. Accumulated fees, in turn, would cover losses, thus shielding taxpayers. To promote innovation and competition, this business would be open not only to Fannie and Freddie but to any other well-capitalized financial institution capable of taking it on.

What Should We Do with Fannie and Freddie?

The past few years have demonstrated that Fannie Mae and Freddie Mac, the two mortgage giants, were built on a flawed business model. One that paired private profit in good times with taxpayer burdens in bad times; created systemic risks to the world financial system; concealed the degree of federal involvement in mortgage markets; and directed many of the benefits of government assistance to shareholders and management, rather than homeowners.

The folks at e21 asked Phill Swagel and me to ponder how Fannie and Freddie ought to be restructured when they emerge from government conservatorship.

Our proposal, “Whither Fannie and Freddie: A Proposal for Reforming the Housing GSEs” has just been released.

Here’s the gist:

The two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.

Our proposal would also free Fannie and Freddie from regulatory requirements that promote affordable housing. As worthy as those efforts can be, we believe they should not be run through these reformed organizations with their narrower missions (and no investment portfolios). If policymakers think that the conforming mortgage market should help finance those efforts, that can be done through a tax on the MBS guarantees, above-and-beyond the actuarially-fair fee for the government insurance. The resulting revenue can then be directed to affordable housing programs through usual budget channels.

How did we come to this proposal? Well, we were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit  easing). In addition, we felt that some backstop role for the government is inevitable as a matter of political economics and that it ought to be explicit at the outset.

P.S. For a nice overview of the Fannie & Freddie situation, see this article by Nick Timiraos in the Wall Street Journal; it includes a brief mention of our plan.

Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.

A Useful Primer on Derivatives Regulation

Bob Litan of the Brookings Institution recently penned an excellent overview of the issues surrounding derivatives regulation, with a particular focus on credit default swaps (CDS). “The Derivative Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, and Other Interested Parties,” is really two pieces in one: a primer on derivatives policy and a warning about the power that a few firms now exercise over CDS markets.

Bob’s recommendations for reform (which I have numbered for convenience) are:

1. Induce or require “standardized” derivatives to be “cleared” on central clearinghouses rather than handled by dealers, acting on behalf of each of the parties (the buyer and seller) to these contracts.

2. Establish the conditions that will induce derivatives that are centrally cleared to be traded on exchanges or an equivalent transparent platform, as is now the case generally with stocks and futures contracts.

3. Ensure that adequate reserves – in the form of capital or margin – are held against all trades that are not centrally cleared.

4. Require the margin or collateral backing derivatives positions to be held either in segregated accounts or by third parties (such as a central clearinghouse) so that these funds cannot be co-mingled with other assets of dealers.

5. For derivatives that are both centrally cleared and traded on exchanges, regulators should ensure that the transaction prices and volumes of derivatives transactions are posted promptly on the equivalent of a “ticker” (post-trade transparency), while also ensuring that the prices at which buyers are willing to trade (the “bids”) and sellers willing to sell (the “asks”) are made public so that all parties, not just the dealers, know the state of the market at any given time (pre-trade transparency). I believe that a price ticker, or something close to it, should be in place even without central clearing and/or exchange trading.

Of course, much of the heavy lifting will be deciding which derivatives are “standardized.”

Mythical Budget Savings from Cutting TARP

The TARP news continues fast and furious. This afternoon’s installment involves the House’s financial regulation bill, officially known as H.R. 4173, the Wall Street Reform and Consumer Protection Act of 2009. That bill would make many changes to financial regulation, one of which – enhanced dissolution authority for financial firms that run into severe trouble – would cost about $10 billion over the next five years, according to the Congressional Budget Office.

In order to pay for those costs, the bill would reduce TARP authority by $20.8 billion. Consistent with previous scoring decisions, CBO estimates that this provision would result in budget savings of $10.4 billion (because CBO assumes, for scoring purposes, that each dollar of reduced TARP authority translates into 50 cents of reduced outlays; for more explanation, see this earlier post.)

Why is this important? Because the alleged savings are mythical.

Earlier today, Secretary Geithner predicted that the maximum draw on TARP would be $550 billion out of the $699 billion currently authorized. Reducing TARP authority from $699 billion to $678 billion, as the bill would do, would thus have no effect on spending or the deficit.

Under congressional budget rules, CBO is required to score the House bill relative to the budget baseline developed back in March. That was during the depths of the financial crisis so CBO assumed that all TARP authority would eventually be used. Happily, conditions have since improved, and that assumption is no longer realistic. But it is still used in congressional scoring.

The “savings” attributed to the House bill thus exist because the financial world has improved, not because the House bill is actually doing anything new to pay for its costs.

I hasten to add that this isn’t just my opinion. CBO itself highlights this issue in its cost estimate for the House bill, saying (in its more measured tones):

That reduction in spending relative to the March baseline might occur even in the absence of this legislation because financial conditions have improved considerably since March. Indeed, the Secretary of the Treasury noted in his December 9, 2009, letter to the Congress that “beyond these limited new commitments, we will not use remaining [TARP] funds unless necessary to respond to an immediate and substantial threat to the economy stemming from financial instability.” Thus, if CBO were to estimate the impact of the TARP provision in this legislation taking into account current financial conditions, the agency would not expect that the TARP’s ceiling on outstanding investment would be fully utilized. Therefore, the savings estimated relative to the budget resolution baseline may be attributable to the improvement in financial conditions rather than enactment of H.R. 4173. (emphasis added)

P.S. I should emphasize that there are good reasons for the current congressional budget rules. Developing legislation takes time, and it would be disruptive if CBO were constantly updating cost estimates to reflect changes in the economy. Fixing a baseline in March, however, does open up the possibility of budget game playing, particularly in budget categories that are volatile (TARP spending is one; royalties on oil and gas leases are another).  The hard question is when Congress should decide to deviate from the March baseline to reflect new realities.

John Smith: “I Made $1 Million Reading”*

*Results not typical.

Over at Managerial Econ, Luke Froeb highlights a new FTC initiative to crack down on testimonial advertising. Its target? Ads that highlight extreme results (“I lost 100 pounds eating Wonder chocolate”), without revealing what typical results look like. The FTC won’t forbid firms from highlighting extreme results, but if they do, they will also have to report typical results:

Under the revised Guides, advertisements that feature a consumer and convey his or her experience with a product or service as typical when that is not the case will be required to clearly disclose the results that consumers can generally expect. In contrast to the 1980 version of the Guides – which allowed advertisers to describe unusual results in a testimonial as long as they included a disclaimer such as “results not typical” – the revised Guides no longer contain this safe harbor.

The FTC’s goal is to protect consumers from misleading ads, a worthy goal.  But Luke (who was the FTC’s top economist for several years) believes that the new rule may have some side-effects. In particular, he wonders whether this policy will also make life more difficult for firms with legitimate products, since they would have to invest in studies to document the experience of typical consumers before they could highlight the experience of individual successes.

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?

Bending the Curve: Redefining Health Insurance

Over the past few months, a politically-diverse group of health policy experts has been pondering a key question: what are the “specific, feasible steps” that policymakers could use to reduce the growth of health spending? In short, how can we bend the curve?

The fruits of their labor were published by the Brookings Institution on Tuesday as Bending the Curve: Effective Steps to Reduce Long-Term Health Care Spending Growth.

I encourage everyone interested in health policy to give it a close look.

The report’s recommendations for fixing health insurance particularly caught my eye:

Governments should ensure proper incentives for non-group and small-group health insurance markets to focus on competition based on cost and quality rather than selection. Achieving this requires near-universal coverage and insurance exchanges to pool risk outside of employment, augment choice, and align premium differences with differences in plan costs.

[Therefore, these insurance markets should be restructured to] focus insurer competition on cost and quality through requirements for guaranteed issue without — or with very limited — pre-existing condition exclusions; limited health rating, such as those related to age and behaviors only; and full risk-adjustment of premiums across insurers based on enrollees’ risk. For market stability, these reforms must be undertaken in the context of an enforced mandate that individuals maintain continuous, creditable basic coverage.

In short, the report recommends a combination of an individual mandate and reforms that eliminate both the ability of and the incentive for insurance companies to try to enroll only the healthy and low-cost.

Continue reading “Bending the Curve: Redefining Health Insurance”

Follow-up: Defense, Mortgage Modifications, and Yahoo/Microsoft

This morning’s headlines include some important follow-ups to recent posts:

Bing Bounces Onto Yahoo

Yesterday’s deal between Microsoft and Yahoo is a big boost for Bing. Microsoft’s new engine will power search on Yahoo, raising its visibility and, perhaps, eating into Google’s market leadership.

If the stock market is any guide, Microsoft is getting the better of the deal. As Techcrunch notes, Yahoo’s stock fell 12% on the day, lopping almost $3 billion off its market cap:


Microsoft , on the other hand, was up  about 1.4%  — boosting its market cap by about $3 billion.

The real question, of course, is how the deal will affect Google. GOOG was down about 0.8% (around $1 billion in market cap), a bit more than the decline in the Dow or the Nasdaq. That suggests that Google investors respect the MSFT-YHOO deal, but aren’t running scared just yet.

The logic of the deal seems impeccable. Yahoo is an also-ran in the search space, while Microsoft’s Bing is an exciting new entrant. Just how far Yahoo has trailed in search was driven home for me when I reviewed my posts about the search market (here is a list). Google gets the most attention in those posts, of course, but I also discussed competitors Bing, Wolfram Alpha, and Cuil. But it never occurred to me to mention Yahoo. That oversight is vindicated by today’s deal.

Personally, I am looking forward to having Bing on the Yahoo home page. I’ve spent far too much effort avoiding Yahoo’s search engine (e.g., by uninstalling the annoying Yahoo toolbar that various services foist on you when you get new software). Perhaps now I will have reason to let Yahoo take up a bit more valuable screen space.

Disclosure: I don’t own stock in any of these companies.