Unwinding Freddie and Fannie

This article in Time makes clear that reforming Fannie and Freddie should be at the heart of any reform proposal, and yet we don't plan on dealing with it till next year. An excerpt:

"What I have seen is that government insurance programs are high-risk," said Lockhart. "It is often difficult in a political environment to calculate or charge an actuarially fair price." It is essentially a moral-hazard argument. Lockhart believes that the government will never be able to accurately price the guarantees that Fannie and Freddie offer mortgage lenders and investors. And as long as the government is offering that insurance too cheap, banks will be encouraged to make loans they shouldn't. And that will lead to more losses for Fannie and Freddie down the road.

Option A: Start unwinding Fannie and Freddie sometime next year, and watch the life get sucked out of the nascent housing recovery.

Option B: Kick the can down the road, and watch the federal government lose its AAA bond rating causing borrowing costs to increase and the now more politically dependent Fed to monetize the debt and destroy the dollar.

I'd go with option A, but I'm thinking the politicians will go with option B.

The big shift

The latest in California:

California Controller John Chiang, a Democrat, warned last week that the state was "less than 50 days away from a meltdown of state government."

While that's music to my ears in many ways, I wonder just how culpable California is in all this. Or for that matter the auto industry, the financial industry, and the housing industry. What if they are all ultimately caused by a fundamental shift in consumer preferences, i.e. a real business cycle? I think we are all aware of the shift in living patterns that has occured over the last decade or two. Sometime in the mid to late 1990s, the seemingly inexorable pattern of rich folks leaving the city for the suburbs started to reverse.

Understandably, this was not widely predicted, indeed it appears unprecendented at least in the US and Brittain. The car companies, domestic and foreign, lost this bet. Suburban homeowners and the suburban housing industry lost this bet. The financial industry, by facilitating these bets, also lost. States with a disproportionate share of suburban development, i.e. the sun belt states, lost this bet. Ultimately, this may the explain the downfall of the US as a car centric economy. Although non-car centric Europe has suffered just as much in the initial crash and aftermath, it remains to be seen who will emerge stronger.

Addendum: Offsetting this trend to some extent is politics. Many southern states, particularly Texas, are growing despite their car-centric infrastucture, because they have lower taxes and regulation.

Bubbles and banks, the never ending story

Tyler has a new paper in which he deflects blame for the financial crisis away from central banks and towards behavioral biases such as herd behavior and over confidence. See my comments there, but basically I'm wondering why we can't blame both. My dissertation is about trying to sort out the relationship between these factors. I intend to test in the lab and with simulations the idea that free banking better mitigates bubbles, including those arising initially from behavioral biases (what other kind is there?).

Hard to imagine a worse way to spend $40 billion

Read it and weep:

The filing also disclosed that GM will not repay the loans it has already received from the government or any additional federal aid it will get as part of the bankruptcy. When all is said and done, total assistance to GM is expected to reach nearly $40 billion.

Instead, the government will convert that debt into a 72.5% stake in the new company. This means that for taxpayers to make back any of the money loaned to GM, it will have to be because shares of the new GM increase in value following an exit from bankruptcy.

I would rather the government spend it on a national toilet paper reserve.  Why this is so much worse than similar bank deals is that GM is not likely to recover any time soon, and everyone knows that.  Banks suffered from a sudden lack of market confidence, which government replaced to some extent with its explicit backing.  GM suffered from a chronic quality problem, and there is no reason to think this will be fixed with government backing.  You can make the same kind of argument with banks, and I do think to so some extent it is a matter of degree.  But fundamentally, the government is good at providing liquidity but bad at providing quality.  Nevertheless, I'm not betting on GM or the banks. 

Too big to jail

While it's not the first best solution (get rid of federal deposit insurance and bailouts), I think we can call it a second best:

The agency [FDIC] traditionally collected a percentage of the deposits held by each bank, adjusted for the health of the institution. It now further adjusts to reflect the likely cost of a bank's failure, based on its business model.

The latest assessment goes one step further, moving away from the deposit model. Instead, the FDIC will collect 0.05 percent of each bank's assets, the amount of money loaned, invested or otherwise committed to customers. Smaller banks tend to have roughly the same amount of assets and deposits, because they lend to borrowers what they collect from depositors. But larger banks also lend money from other sources, such as borrowed money -- and as a result they now face larger assessments.

To limit the impact, the FDIC charged only the bare minimum required to keep the fund from dwindling to nothing, based on its projections of future bank failures. It backed away from a plan to collect a larger amount now, but officials said a second special assessment was likely at the end of the year.

I'm assuming, hoping, that the asset model involves adjusting for the health, i.e. risk, of the assets.

Gary Gorton on the shadow banking system

Tyler Cowen and Arnold Kling comment on Gary Gorton's new paper.  Here's the main idea:

Periodic banking panics have been the norm in U.S. history. But the panics appeared to end in the U.S. when deposit insurance was legislated in 1934. Combined with valuable bank charters and oversight by bank examiners, the Quiet Period was created. What changed? Bank charter values eroded under competition. Securitization is a more efficient way to finance loans. The growth of derivative securities caused an enormous demand for collateral. Over twenty-five years the shadow banking system evolved to meet the needs of this modern economy. Unfortunately, the vulnerability to panic was also produced.

Gary has an incredible knack for details and more than anyone else I've read he seems to be abreast of how the modern banking system is evolving.  But I don't get why he doesn't apply the same rigour to understanding the pre-Fed era.  Here's my comment on Tyler's post:

I don't understand how Gorton can honestly review the history of pre-Fed banking in the US and conclude that the frequent panics were all market failures and that federal deposit insurance finally saved the day in 1934. Does he know anything about the experience of free banking in Scotland or Canada or Australia? Panics occurred in the pre-Fed US precisely because of severe regulatory restrictions on branch and interstate banking and the bond-deposit requirement for bank note issuance. These regs didn't exist in Scotland, Canada, or Australia in the 19th century and things worked out great. Gorton's whole analysis stems from this assumption, so naturally he thinks federal deposit insurance should be extended to the shadow banking system. Instead, I think it's more likely that the shadow banking system, as the name implies, has evolved to avoid the regulations and the regulators and will continue to do so with each new regulation.

Interview with George Selgin

By the Richmond Fed.  It's an excellent overview of free banking.  This is my favorite part:

Freedom to issue notes is important too. When banks can’t issue their own notes, well, they need a lender of last resort to supply them with notes. If we told companies that manufacture shoes that henceforth they could only make shoes for left feet, lo and behold, there would be a need for an “emergency” source of shoes for right feet, which could be created by establishing a new government agency for the purpose. Eventually people would say, “Thank goodness for the Government Shoe Agency. How would anyone be able to walk otherwise?”

By the way, I have the privledge of working with George on my dissertation, which involves using laboratory methods to explore the macro and business cycle implications of free banking versus central banking.

(HT to Tyler Cowen and Arnold Kling)

Vernon Smith explains Austrian Business Cycle Theory, without using the word Austrian

Don't know how I missed his article in the WSJ two weeks ago, but as always it's right on the money, so to speak:

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

The graphs comparing the last three real estate bubbles and the fed funds rate are compelling evidence that the Fed cannot escape blame.  

While I've always been a little skeptical of Austrian Business Cycle Theory, i.e. bubbles are created by the Fed's easy money policies, I've never been able to make much sense of the critiques.  Tullock, Cowen, and Krugman start and end with, what to me are absurd, neo-classical rationalist assumptions, namely that a) investors but not consumers are effected by interest rates, b) these two types are easily distinguished and do not effect each other, and c) investors are but a small minority of the economy.  They believe too much in the models.  Here's Tullock:

The end result of all of this is that we would anticipate that in an Austrian-style depression, there would be a good deal of unemployment in the capital goods industries, but this is, after all, a small part of the total industrial picture. Of course, such industries would not be able to buy as much in the way of consumer goods as they would otherwise, and this would add to the fall in prices which would have to be absorbed by other industries. Indeed, it would increase the bankruptcy rate. Because of the size of the capital goods industries compared to the rest of the economy, however, the forcing down of prices in other industries made necessary by this unemployment would once again cause bankruptcies but not unemployment. 

You're telling me the capital goods industries do not to some significant degree include or effect home owners or stock owners, or that either group constitutes a minority in the US?

Here is additional support for the Austrians. 

FDIC or Louis Sullivan

This is the tradeoff, according to Scott Sumner:

Just imagine how fortunate the residents of Owatonna, Minnesota are, as they get to walk by this pre-FDIC bank building everyday (also see here.)  I’m not saying that modestly reducing the FDIC coverage will revive the architectural fashions of the early 1900s, but if it produces buildings even 1/10th as beautiful as Sullivan’s masterpiece, then it will have been worthwhile.

Why be modest?

The revolution is here

Class War, an anarchist newspaper, has produced a special edition to promote the protest with an image of former Royal Bank of Scotland Group Plc CEO Fred Goodwin, whose house was vandalized this week, on a guillotine under the headline “Ready to Riot.” Another shows people dancing around a fire with the slogan “How to keep warm in the credit crunch -- Burn a Banker!” Public anger erupted at Goodwin’s 703,000 pounds annual pension after RBS was bailed out by the government.

The English Revolution culminated with the beheading of Charles I in 1649, ending the so-called divine right of kings in England. Today’s protesters say they draw inspiration from 17th century radicalism.

Four marches will converge on the Bank of England at midday on April 1 for a protest the organizers call “Financial Fools Day.” At the same time, there are plans for a blockade of the European Climate Exchange, in Bishopsgate, to protest against the market in carbon emissions.

It is appropriate that it begin at the birthplace of central banking: 

The Bank of England, founded in 1694, has been the target of demonstrators before, according to the Bank’s Web site. In 1780 the bank, known as the Old Lady of Threadneedle Street, was provided with a military guard after it was threatened by a mob during anti-government riots. This was only discontinued in 1973.

Read the rest here.

Gee, I hope Tim Geithner is a nice guy...

Because he just threw out the rule of law:

It would give the Treasury the power to restructure troubled companies to avoid economy-wide risks that would fall from either a bankruptcy or taxpayer-funded bailout. The government would either seize the company in a conservatorship, which would keep the company going while it is restructured, or in a receivership, which would break up the company and sell its assets.

Unlike in a bankruptcy that gives precedence to creditors, the Treasury plan would allow the government to unwind the company in the best interests of the economy as a whole.

If the government took control of a financial company, existing shareholders, management and creditors could lose everything. Existing contracts could be renegotiated or repudiated.

"Had the government possessed the authorities contained in the proposed legislation, it could have resolved AIG in an orderly manner that shared losses among equity and debt holders in a way that maintained confidence in the institution's ability to fulfill its obligations to insurance policyholders and other systemically important customers [my emphasis]," the Treasury said.

Who needs the courts when Tim Geithner and his pals can figure it out. Right. I'm afraid "systemically important customers" will mean those who lobby and bribe the most, which actually isn't too far from the way it was.

Read the rest here.

AIG, when does it stop?

From Reuters:

The payments to AIG counterparties include the provision of collateral to back up credit default swaps, a form of financial insurance that AIG's London office was writing; the purchase of the collateralized default obligations, a type of complex debt security that underlay that insurance; and payments to counterparties of a securities lending program.

Through three separate types of transactions, Goldman received an aggregate $12.9 billion. Among European banks, SocGen was the biggest recipient at $11.9 billion, Deutsche got $11.8 billion and Barclays was paid $8.5 billion.

The AIG disclosures are still incomplete in that they do not include payments to the banks since December 31.

The list of counterparties was made public by AIG amid growing pressure on the insurer to come clean about the true beneficiaries of the bailout ahead of a congressional hearing on Wednesday at which AIG chief executive Edward Liddy is slated to testify.

Democratic Congressman Paul Kanjorski, whose committee will quiz Liddy, said the counterparties and bonuses would both be topics for investigation at the hearing.

Summers -- speaking before the payments to banks were made public -- called the AIG bonuses "outrageous" but said contracts must be honored, even though Treasury Secretary Timothy Geithner had "negotiated very forcefully" with AIG and done all that was "legally permissible" to limit the payments.

"We're not a country where contacts just get abrogated willy nilly," Summers, a former treasury secretary, said on CBS's "Face the Nation" program. "What the lesson is, is this: We don't really have a satisfactory regulatory regime in place."

Yes we do, it's called bankruptcy.  Yes, it would be calamitous.  How else do you propose ending this gross corporate welfare?

Addendum: James Hamilton agrees.

Time for a world currency?

KAZAKH President Nursultan Nazarbayev has won backing for his plan for a single world currency from an intellectual architect of the euro currency, Nobel-prize winner Professor Robert Mundell.

That's from The Australian.  As Mundell has argued, little countries stand to benefit most from a world currency.  Consider this:

In a world of big international banks and multinational corporations, there is not much scope in practice for the monetary independence of any except a few large countries.

Mundell's argument hinges on economies of scale in convenience, information, policy, and insulation from international monetary shocks.  Ultimately, he seems most concerned about inflation, and he believes inflation can be minimized by minimizing the number of currency issuers.  I don't believe that.  As he says, from 1949 to 1973 there was a de facto world currency, the US dollar, since nearly everyone was pegged to it.  That ended when we went off the gold standard, and then engaged in double digit inflation throughout the 1970s.  So what is to prevent a world central bank from doing the same?  Say the UN institutes a world central bank.  Can we really trust the UN to produce a steady money supply, transparently and without corruption, avoiding the temptation to abscond with the dough, aka seignorage?  How transparent are central banks now? (try this link)

I believe money is like all goods in that quality matters, and thus reputation for quality matters.  Hence, we need competition, and lots of it.  Free banks did that for us, and they can do it again.

What took Iceland down?

I blame mainly incompetent politicians and central bankers.  Read the whole article in Vanity Fair:

There’s a charming lack of financial experience in Icelandic financial-policymaking circles. The minister for business affairs is a philosopher. The finance minister is a veterinarian. The Central Bank governor is a poet. Haarde, though, is a trained economist—just not a very good one. The economics department at the University of Iceland has him pegged as a B-minus student. As a group, the Independence Party’s leaders have a reputation for not knowing much about finance and for refusing to avail themselves of experts who do. An Icelandic professor at the London School of Economics named Jon Danielsson, who specializes in financial panics, has had his offer to help spurned; so have several well-known financial economists at the University of Iceland. Even the advice of really smart central bankers from seriously big countries went ignored. It’s not hard to see why the Independence Party and its prime minister fail to appeal to Icelandic women: they are the guy driving his family around in search of some familiar landmark and refusing, over his wife’s complaints, to stop and ask directions.

Runner up goes to certain beliefs in "hidden people":

Alcoa, the biggest aluminum company in the country, encountered two problems peculiar to Iceland when, in 2004, it set about erecting its giant smelting plant. The first was the so-called “hidden people”—or, to put it more plainly, elves—in whom some large number of Icelanders, steeped long and thoroughly in their rich folkloric culture, sincerely believe. Before Alcoa could build its smelter it had to defer to a government expert to scour the enclosed plant site and certify that no elves were on or under it. It was a delicate corporate situation, an Alcoa spokesman told me, because they had to pay hard cash to declare the site elf-free but, as he put it, “we couldn’t as a company be in a position of acknowledging the existence of hidden people.”

(Hat tip to Tyler)

Turn up the printing press

So says Scott Sumner:

Many economists simply assume that the current contraction has been caused by the financial crisis. After all, isn’t that obvious? Actually, no. For nearly a year after the onset of the financial crisis nominal GDP continued growing at better than a 3% clip. Now it is plunging. Most seem to assume that this new state of affairs was somehow caused by the Lehman failure, and the subsequent loss of confidence in the entire financial system.

My view is that this reverses the causality; it seems much more plausible that the current problems in the financial system are being caused by the recent (and expected future) sharp fall in nominal GDP. An unexpected decline in nominal
GDP puts stress on a banking system that is based on nominal debt. It is even more disruptive to a system that has become highly leveraged in expectation that the Great Moderation would continue, i.e., that central banks would insure that we never again saw a repeat of the plunging nominal GDP of the early 1930s. And it is devastating in a system that was both highly leveraged and already buffeted by severe losses in residential lending.

The 2007 subprime crisis did not cause the stock market crash of 2008, as stocks were still only modestly below record levels in early June 2008. The October crash occurred when investors began to see deflation and depression on the horizon, and saw that loan losses would spread from the already weakened subprime sector into the sort of commercial and industrial loans which would have been sound had nominal GDP continued expanding at close to 5%/year.

Read the whole thing. I tend to agree. But I'm trying to get his opinion on free banking as a long term solution to financial instability.

(HT to Tyler).

Why did they switch?

The bill did not pass on September 29 because, despite significant pressure from the financial sector, the real side of the economy had not suffered commensurately with the financial side. That is, neither unemployment nor foreclosures were “high enough” in a sufficient number of congressional districts. The regressions show that legislators who switched their vote between September 29 and October 3 likely caved in to the lobbying efforts of the American Bankers Association. Hence, in all probability the October 3 vote would have failed again had it not been for the pressure exerted by the ABA.

That's from Carlos Ramirez, of GMU and the FDIC. He also taught me macro.

One idea you won't hear from Congress

There are, to be sure, risks of political interference from government involvement in banking, but all of the current proposals for increasing lending require more government involvement. The challenge is to find one that increases lending and does the least harm.

If the government starts as a shareholder in new, healthy banks that eventually end up entirely in the hands of the private sector, the political risks start small and diminish. If instead the government combines open-ended and opaque financial support for troubled banks with promises of tight supervision and punishment for bad behavior, the risks are large and grow over time.

That's Paul Romer, not in Congress. He also (most likely) doesn't get paid by the big banks.

(HT to Tyler).

Arnold Kling sums it up

Arnold links to his Congressional testimony, in which he provides an exquisite history and explanation of the crisis. Some excerpts:

To understand the problems inherent with securitization, imagine that you are a bank executive faced with two alternative routes for obtaining mortgage loans—a direct route and an indirect route. In the direct route, your loans are originated by your own staff. You establish standards, policies, and procedures for loan origination. You choose the markets in which you would like to originate loans, and you will probably focus on communities where you know the local economy. You hire and train personnel to follow internal guidelines.

Your compensation policies incorporate incentives for them to accept or reject applicants in accordance with company policy. Once the loan has been made, if the borrower misses a payment, your staff follows company procedures for contacting the borrower and resolving the problem.

In the indirect route, loans are originated by persons unknown to you, following guidelines established by someone else. The loans may come from communities with which you are totally unfamiliar. The originators may very well be paid on commission, which they can only receive if they close a loan—never if they reject an applicant. If the loan gets into trouble, you will have no control over how the delinquency is handled.

No sane bank executive would choose the indirect route over the direct route. In economic jargon, the "agency costs" of the indirect route are prohibitive. The originators of mortgages in the indirect route are operating under incentives that are contrary to the bank's interest. The misalignment of incentives between the bank and those acting as its agents in the indirect route will force banks to incur additional costs to monitor and review the work of the originators. Even with most diligent efforts, the bank is likely to incur higher losses from defaults, as originators squeeze bad loans through the cracks of the bank's monitoring systems.

It is surprising, therefore, that as of 2008, nearly three-fourths of mortgage debt in the United States had been originated using the indirect method. To reach this point required a combination of Wall Street ingenuity and regulatory anomalies.

I like this part too:

The suits treated mortgage securities as bonds, ignoring the power of the embedded options. In August and September, when policymakers began to perceive the severity of the crisis, the suits thought that mortgage securities could not possibly have lost as much value as their market prices indicated. Federal Reserve Board Chairman Ben Bernanke insisted that if the securities were "held to maturity" that they would have higher values. Treasury Secretary Henry Paulson proposed to have the government buy and hold these securities in order to "unclog" the financial system. However, this thesis, which in effect was arguing that the geeks had mispriced mortgage securities, proved to be incorrect. The banks that had invested heavily in these securities were truly under-capitalized. The mistakes had been made by the suits, not the geeks.

I always wondered what finance was really about, or rather why it has become this huge behemoth, representing some 40% of U.S. profits. Now I think I know. It's kind of like law, in that the big money is in finding novel ways to subvert the law, causing more laws to be created, and more opportunities for subversion, etc. Looks like a big part of those profits are nothing more than rent seeking.

This also makes me think that no amount of regulation will ever fix the problem, and that maybe the Austrians are right: we should return to competitive banking.

One word: Mariachi

As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers’. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.

“I’d lie if I said every piece of documentation was properly signed and dated,” said Mr. Parsons, speaking through wire-reinforced glass at a California prison near here, where he is serving 16 months for theft after his fourth arrest — all involving drugs.

While Mr. Parsons, whose incarceration is not related to his work for WaMu, oversaw a team screening mortgage applications, he was snorting methamphetamine daily, he said.

“In our world, it was tolerated,” said Sherri Zaback, who worked for Mr. Parsons and recalls seeing drug paraphernalia on his desk. “Everybody said, ‘He gets the job done.’ ”

At WaMu, getting the job done meant lending money to nearly anyone who asked for it — the force behind the bank’s meteoric rise and its precipitous collapse this year in the biggest bank failure in American history.

Read the rest here. The really funny part is I owned stock in this company. I recall thinking "the banks always seem to win, I should own a bank."

Stuff I don't usually read

I would not be surprised to see the G-20 monetize at least 20% of the U.S. debt markets. THAT MEANS …

Gold would be priced at over $10,000 an ounce.

Currencies would be devalued by a factor of at least 12 to 1, meaning it would take 12 new dollars or euros to equal 1 old dollar or euro.

That's Larry Edelson at Money and Markets. I don't know what to say. Buy gold.

Also see this montage of clips by Peter Schiff, who predicted our current financial mess whilst being laughed at.