Regulation – Donald Marron

Conservative Principles for Environmental Reform

Case Western Law Professor Jonathan Adler just released an interesting paper setting out a conservative case for environmental protection. Here’s his abstract:

The existing environmental regulatory architecture, largely erected in the 1970s, is outdated and ill-suited to address contemporary environmental concerns. Any debate on the future of environmental protection, if it is to be meaningful, must span the political spectrum. Yet there is little engagement in the substance of environmental policy from the political right. Conservatives have largely failed to consider how the nation’s environmental goals may be best achieved. Perhaps as a consequence, the general premises underlying existing environmental laws have gone unchallenged and few meaningful reforms have proposed, let alone adopted. This essay, prepared for the Duke Law School conference on “Conservative Visions of Our Environmental Future,” represents a small effort to fill this void. Specifically, this essay briefly outlines a conservative alternative to the conventional environmental paradigm. After surveying contemporary conservative approaches to environmental policies, it briefly sketches some problems with the conventional environmental paradigm, particularly its emphasis on prescriptive regulation and the centralization of regulatory authority in the hands of the federal government. The essay then concludes with a summary of several environmental principles that could provide the basis for a conservative alternative to conventional environmental policies.

One example of what he thinks ought to be a conservative approach to resource protection: property rights in fisheries (footnotes omitted):

The benefits of property rights at promoting both economic efficiency and environmental stewardship can be seen in the context of fisheries. For decades, fishery economists have argued that the creation of property rights in ocean fisheries, such as through the recognition of “catch-shares,” would eliminate the tragedy of the commons and avoid the pathologies of traditional fishery regulation. The imposition of limits on entry, gear, total catches, or fishing seasons has not proven particularly effective. Property-based management systems, on the other hand, have been shown to increase the efficiency and sustainability of the fisheries by aligning the interests of fishers with the underlying resource. A recent study in Science, for example, looked at over 11,000 fisheries over a fifty-year period and found clear evidence that the adoption of property-based management regimes prevents fishery collapse. Other research has confirmed both the economic and ecological benefits of property-based fishery management. The recognition of property rights in marine resources can also make it easier to adopt additional conservation measures. For instance, the adoption of catch-shares can reduce the incremental burden from the imposition of by-catch limits or the creation of marine reserves. A shift to catch-shares would have fiscal benefits as well. Yet in recent years, the greatest opposition to the adoption of such property-based management regimes has not come from progressive environmentalist groups, but from Republicans in Congress.

He also endorses a carbon tax, which combines responsibility (the polluter pays principle) with a move toward consumption taxation.

Regulatory Uncertainty and Our Weak Economy

Over at the Economist’s Free Exchange blog, Grep Ip offers an excellent, balanced analysis of regulatory uncertainty and our weak economy. Here’s a short excerpt:

How much of our economic malaise can be blamed on regulatory uncertainty? Conservatives argue that a wave of Obama administration regulations and the threat of more to come are the primary hindrance to business confidence and hiring. Liberals say that the weak economy is far more important and that any regulations being enacted more than pay for themselves in economic terms.

I’ve been struggling with this question for months and have found the debate frustrating: the terminology is wrong and the subject poorly framed, the evidence fragmentary and unhelpful, and generalisations are rampant. So what follows are a few thoughts that I think clarify the debate, though without necessarily resolving it.

First, it is not “uncertainty” per se that bothers business. Whether uncertainty is unwelcome depends entirely on what’s at stake. What would you prefer: 100% probability of dying next year, or 50%? Most of us would choose the latter. Similarly, business would prefer zero probability of a burdensome new rule, but if that’s not possible, would certainly take 50% probability over 100%. The administration’s decision to delay implementation of a new ozone standard perpetuates uncertainty. Business welcomed it nonetheless because now they do not have to spend money to meet it for at least two years, and perhaps forever if in the interim a new president chooses never to implement it. Does the Federal Reserve create some uncertainty when it undertakes quantitative easing? Probably, but in the process it makes the stability of inflation around 2% much more certain, and that, most businesses would say, is a reasonable trade-off.

Second, “regulation” doesn’t capture the breadth of government activity that affects business confidence, investment and hiring. The threat that America might default must surely have been one of the most toxic sources of uncertainty America’s political classes have yet inflicted on the economy, something you’ll see mentioned in the Federal Reserve’s latest beige book. This speaks to a more deep-rooted alienation between business and Washington.

Read the whole thing, it’s the best treatment I’ve seen.

Taxi Medallions in DC: Who Would Win and Lose?

Today’s lesson in political economy: the looming battle over Washington’s cab market.

Three members of DC’s City Council (Marion Barry, Harry Thomas, Jr., and Michael Brown) want to require every taxi to have a medallion. The number of medallions would be much smaller than the number of cabs on the streets today.

As I noted a few months ago, this proposal would harm consumers more than it would help drivers. With fewer cabs on the road, it would be harder for passengers to find a ride and easier for drivers to turn down what they perceive as undesirable fares. If medallion prices rise, it may also make it easier for taxi drivers to lobby for higher fares in the future. All of that adds up to fewer cab trips.

The sponsors reportedly have close ties to some taxi drivers, so it isn’t surprising they favor drivers over consumers. What is interesting, however, is how they would favor some drivers over others.

The favored? Drivers with two or three decades on the road who are DC residents. In short, long-time incumbents who can vote.

The disfavored? Drivers with less experience or who live outside the district. In short, entrants and those who can’t vote.

This favoritism shows up in several ways in the proposed legislation:

Medallion prices. Under the proposal, initial medallion prices would vary by a factor of ten. A DC resident with 30+ years experience could buy a Class 1 unrestricted medallion for $500. A DC resident with 20+ years experience would pay $1,000. A non-resident with 20+ years would pay $4,000. Other qualifying drivers – if I am reading the proposal right, these would be DC residents who have filed DC income taxes for at least five years – would pay $5,000.

Right to purchase medallions. DC residents have priority over non-residents for most medallions, and priority further depends on seniority.

Property rights. Under the proposal, most medallions would become the buyer’s property and could be assigned or sold in the future. That means the driver would get the benefit of any price appreciation in the future. But that isn’t true for one category: Class 5 medallions that would be created for non-resident drivers who don’t get Class 1 through 4 medallions. Those medallions are not property and cannot be transferred; once the driver stops using them, they would be gone, and the number of taxis would decline further. (By the way, the price of Class 5 medallions is not specified in the legislation; instead it is left up to the Taxicab Commission.)

Bottom line: The proposal is a classic illustration of how the regulatory system might be used to favor (a) an organized group (taxi drivers) over a non-organized one (consumers), (b) incumbents over entrants, and (c) residents over non-residents.

CBO Weighs in on Fannie and Freddie

Yesterday, the Congressional Budget Office released its long-awaited report on the future of Fannie Mae and Freddie Mac. Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market (written by Deborah Lucas and David Torregrosa, with input from a cast of dozens — including, full disclosure, me as an outside reviewer) provides an outstanding overview of Fannie and Freddie’s history, the arguments for and against a government role in the secondary mortgage market, the flaws of the precrisis structure of Fannie and Freddie, and the pros and cons of possible reform models.

Readers may recall that last spring Phill Swagel and I proposed a reform in which Fannie and Freddie would be privatized, the government would sell guarantees on mortgage-backed securities composed of conforming loans, and that this guarantee would be available not only to Fannie and Freddie but also to qualified new entrants. (Here’s the blog version; here’s the full paper.)

CBO provides a thoughtful overview of such hybrid models:

A Hybrid Public/Private Model

Many proposals for the secondary mortgage market involve a hybrid approach with a combination of private for-profit or nonprofit entities and federal guarantees on qualifying MBSs. At its core, the hybrid public/private approach would preserve many features of the way in which Fannie Mae and Freddie Mac have operated, with federal guarantees (combined with private capital and private mortgage insurance) protecting investors against credit risk on qualifying mortgages. However, most hybrid proposals would differ from the precrisis operations of Fannie Mae and Freddie Mac in several important ways: A possibly different set of private intermediaries would participate in securitizing mortgages backed by federal credit guarantees, the guarantees would be explicit rather than implicit, and their subsidy cost would be recorded in the federal budget.14 As the public-utility and competitive market-maker models illustrate, a hybrid approach could be implemented in a way that involved more or less federal regulation of participants in the secondary market and a smaller or larger number of competitors in that market.

Advantages of a Hybrid Approach

Regardless of its exact design, a hybrid model with explicit federal backing for qualifying privately issued MBSs would have several advantages over the precrisis model, as well as over either a fully federal agency or complete privatization (approaches that are discussed below). An explicit federal guarantee would help maintain liquidity in the secondary mortgage market, in normal times and particularly in times of stress, and could retain the standardization of products offered to investors that Fannie Mae and Freddie Mac bring to that market. Compared with the precrisis model, imposing guarantee fees would ensure that taxpayers received some compensation for the risks they were assuming.

Compared with a fully federal agency, a hybrid approach would lessen the problem of putting a large portion of the capital market under government control, encourage the inflow of private capital to the secondary market, and limit the costs and risks to taxpayers by having private capital absorb some or most losses. Putting private capital at risk would also provide incentives for prudent management and pricing of risk.

Compared with a fully private market, hybrid proposals would give the government more ongoing influence over the secondary market and an explicit liability in the case of large mortgage losses that would be reflected in the budget. That arrangement might have the advantage of leading to a more orderly handling of crisis situations.

Disadvantages of a Hybrid Approach

Relative to other approaches, a public/private model has a number of potential drawbacks, the importance of which differs depending in part on the specific design chosen. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices for guarantees and probably would shift some risks to taxpayers. A hybrid approach also might not eliminate the tensions that exist—with regard to risk management and pursuit of affordable housing goals—between serving private shareholders and carrying out public missions.

Another concern is that over time, the secondary-market entities might push for broader guarantees of their product lines and attempt to reestablish themselves as too-big-to-fail institutions backed by implicit federal guarantees. Consequently, regulators would need to be vigilant to control risks to the financial system and avoid regulatory capture, while also being open to market innovations.

DC’s New Mayor Should Say No to Taxi Medallions

I love taxi medallions.

As an example for my microeconomics students, not as policy.

Just last week, I used New York City’s medallion system to show how an entry barrier — the requirement that each yellow taxi have one of a limited number of medallions — could create profits in an otherwise viciously competitive industry.

How much profit? Well, according to the most recent data from the city’s Taxi and Limousine Commission medallions for independent cab drivers traded at between $610,000 and $620,000 in October. If you figure 8% as a reasonable rate of return of this asset, that translates into almost $50,000 in pure profit each year from driving a cab, thanks to the entry barrier.

Good exam question: Who gets that profit? Hint: It isn’t the cab driver, who either has to lay out $600,000+ for a medallion or lease one at perhaps $50,000 per year.

Of course that profit comes at the expense of taxi riders, who face a double whammy: they pay more for the cab rides they can get, and they end up taking fewer cab rides (the latter effect is known as a deadweight loss – society loses the benefit of the cab rides that would have happened without the medallion system).

Given that background, I was horrified to learn from Matt Yglesias that taxi drivers in Washington DC are lobbying Vincent Gray, the city’s new mayor, to introduce a medallion system. Yglesias quotes Alan Suderman of the Washington City Paper thusly:

Derje Mamo, a taxi driver who helped run transportation for the mayor-elect’s campaign, said cabdrivers already are pushing Gray to reshape the Taxicab Commission and allow for the creation of a medallion system. A medallion or certification system would limit the number of cabs operating in the city. Proponents of such a system argue that too many taxis are flooding D.C. streets. ‘He’s got one year, that’s it,’ Mamo said.”

As Yglesias notes, this is a really bad idea. There’s no reason to believe that there are too many cabs on DC streets (except, of course, from the view of cab drivers who hate the competition), and in some neighborhoods there may well be too few. A more plausible concern, as some commenters on his blog note (but I can’t link to because of some glitch), is that current taxi fares might be a bit too low. Taxi fares are still a new thing in DC–until 2008 the city had a zone system that many passengers, myself included, found bewildering–and it may be that the initial levels weren’t set exactly right. If Mayor Gray wants to do something for the cabdrivers, he should ask the Taxicab Commission to ponder whether some upward tweaks to fares might induce some extra supply that passengers would value.

Update: For further discussion, please see this later post.

Positive Feedback and the Flash Crash

The CFTC and SEC staffs are out with their analysis of the May 6 “flash crash.”

Short version: A large trader (identified by the media as Waddell & Reed) initiated a large sell order to be executed based on volume, not time or price. The initial selling boosted trading volumes which prompted the algorithm to sell even faster. That positive feedback then spawned the short-lived crash.

The whole report is worth a skim for the details about market functioning, but if you are pressed for time here’s the key part of the Executive Summary (with my emphasis added and footnotes deleted):

At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex]) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.

…

This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.

The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year (from January 1, 2010 through May 6, 2010). Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6. When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume. On that occasion it took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell program.

However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes.

This sell pressure was initially absorbed by:

• high frequency traders (“HFTs”) and other intermediaries in the futures market;

• fundamental buyers in the futures market; and

• cross-market arbitrageurs who transferred this sell pressure to the equities markets by opportunistically buying E-Mini contracts and simultaneously selling products like SPY, or selling individual equities in the S&P 500 Index.

HFTs and intermediaries were the likely buyers of the initial batch of orders submitted by the Sell Algorithm, and, as a result, these buyers built up temporary long positions. Specifically, HFTs accumulated a net long position of about 3,300 contracts. However, between 2:41 p.m. and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their temporary long positions. At the same time, HFTs traded nearly 140,000 E-Mini contracts or over 33% of the total trading volume. This is consistent with the HFTs’ typical practice of trading a very large number of contracts, but not accumulating an aggregate inventory beyond three to four thousand contracts in either direction.

The Sell Algorithm used by the large trader responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs. In fact, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.

What happened next is best described in terms of two liquidity crises – one at the broad index level in the E-Mini, the other with respect to individual stocks.

For more, click on over to the report.

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.