Not So Fast on the Moral Hazard

Last week American International Group requested assistance in the amount of $40 billion from the Federal Reserve. This was rejected only to have A.I.G. come back with a second request, this time for $75 billion. Over the weekend the Federal Reserve and the Treasury decided to let Lehman Brothers fail. On Monday and today the editorial pages were full of adulation about the reinstantiation of the rule of moral hazard. “If Lehman is able to liquidate without a panic … the benefits would include the reassertion of ‘moral hazard’ on Wall Street.” (“Wall Street Reckoning,” The Wall Street Journal, 15 September 2008, p. A22) “It was a brave decision. By abandoning Lehman Brothers, a 158-year-old piece of Wall Street furniture, and refusing to remove their hands from their pockets when Merrill Lynch came calling, Hank Paulson, US Treasury secretary, and Tim Geithner, governor of the Federal Reserve Bank of New York, had one of the busiest weekends of dispassion on record.” (Persaud, Avinash, “Lehman Had to Fall to Save the Financial System,” Financial Times, 16 September 2008, p. 13).

But then on midday Monday, New York state started waiving insurance regulations to allow A.I.G. to make a complex set of financial transfers to try to gather up enough collateral to cover it’s debts at a downgraded credit rating. At midday today when it started to look like a private bailout package being negotiated between J.P. Morgan and Goldman Sachs was faltering, the Federal Reserve stepped in to assist in the negotiations. Then it appeared that the Federal Reserve would be playing a key role in the package, but Fed spokesman was declining comment. Now, late this evening the Federal Reserve is announcing that it’s not going to be facilitating a private loan to, but outright buying a controlling interest in A.I.G. (de la Merced, Michael J. and Eric Dash, “Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake,” The New York Times, 16 September 2008):

In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said.

The Fed’s action was disclosed after Treasury Secretary Henry M. Paulson and Ben S. Bernanke, president of the Federal Reserve, went to Capitol Hill on Tuesday evening to meet with House and Senate leaders. Mr. Paulson called the Senate majority leader, Harry Reid, Democrat of Nevada, about 5 p.m. and asked for a meeting in the Senate leader’s office, which began about 6:30 p.m.

The Federal Reserve and Goldman Sachs and JPMorgan Chase had been trying to arrange a $75 billion loan for A.I.G. to stave off the financial crisis caused by complex debt securities and credit default swaps. The Federal Reserve stepped in after it became clear Tuesday afternoon that the banking consortium would not be able to complete the deal.

Extraordinary indeed! It would seem that the Federal Reserve and the Treasury aren’t so bullish on moral hazard after all.

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The Other D-Word: Default

How bad is the current spate of financial upheavals (the federally backed buyout of Bear Stearns, the federal takeover of Fannie Mae and Freddie Mac, the hasty buyout of Merrill Lynch, the bankruptcy of Lehman Brothers, the impending joint federal-private bailout of American International Group)? In trying to explain the seeming double standard in the actions taken by the federal government in response to Bear Stearns back in March and Lehman Brothers this past weekend, today’s Financial Times Comment & Analysis section includes the following tidbit as one of a number of explanations (Persaud, Avinash, “Lehman Had to Fall to Save the Financial System,” 16 September 2008):

Third, there was an alarming factor not present at the time of Bear Stearns’ collapse that argued strongly against new government guarantees. Since the August rescue of Freddie Mac and Fannie Mae, credit markets have begun to price in the possibility of a default by the US government. The implied probability remains a fraction of 1 per cent but it is an unprecedented development.

It’s hard to know what to make of this. It could be just an investors’ parlor game, like the market on Hollywood has-been career comebacks. Or it could just go to show that unhinged paranoiacs aren’t confined to remote cabins. Some work in the bowels of high finance as well. After the past few months it would hardly be the first sign of a less than steady hand on the till. But there it is. The possibility of a default by the U.S. government has gone from beyond the pale to remote.

Membership Has Its Limitations

I am vehemently opposed to any sort of loyalty cards that are now de rigueur at almost all stores where you make a purchase of any regularity or size. I think a lot of people see them as a harmless way to save a few bucks. And that’s what they are — for now. But they are obviously a foundation on which to build. But build what? Well, the FTC’s deceptive marketing practices lawsuit against CompuCredit is sure suggestive (Silver-Greenberg, Jessica, “Your Lifestyle May Hurt Your Credit,” BusinessWeek, 19 June 2008):

The allegations, in part, focus on CompuCredit’s Aspire Visa, a subprime credit card for risky borrowers. The FTC claims that CompuCredit didn’t properly disclose that it monitored spending and cut credit lines if consumers used their cards at certain places. Among them: tire and retreading shops, massage parlors, bars, billiard halls, and marriage counseling offices. “The company touted that cardholders could use their credit cards anywhere,” says J. Reilly Dolan, assistant director for financial practices at the FTC. “What they didn’t say was that you could be punished for specific kinds of purchases.”

And the more general point:

With competition increasing, databases improving, and technology advancing, companies can include more factors than ever in their models. And industry experts say financial firms increasingly are looking at consumer behavior, as CompuCredit did.

Of course the corporate idiocy here is mind-boggling. First they target a sub-prime demographic, but then cut them off for the very behaviors that made these people sub-prime in the first place. Really? CompuCredit was unaware that the underclass blew their money on scratch tickets and payday loans?

I don’t suspect that this is leading to some insidious world of PreCrime, where government thugs scoop you up, guilty on the basis of a statistical analysis. Rather, nudge style, it will just become the accepted background of people’s expectations. People will recognize an incentive and respond accordingly. “Oh, no, we can’t go out for happy hour. We’re trying to get our credit score up for a home loan.”

The Committee to Save the World, Ten Years On

The Committee to Save the World, Time Magazine, 15 February 1999

It’s mostly consigned to the past, but it increasingly seems to me that the Asian financial crisis of 1997-98 and the attendant reaction of U.S. economic policy makers was the watershed economic event of the present era. The economic handlers of the time, most outstandingly Alan Greenspan, Robert Rubin and Lawrence Summers came as close to the rank of heros as economic policy makers are allowed (“the committee to save the world” in Time Magazine’s famous formulation). During the period 2 July 1997 through 23 September 1998 — the floating of the Thai baht to the deal to bail out Long Term Capitol Management — the Federal Reserve held rates steady at 5.5 percent, then in September, October and November made a succession of impressively restrained off-committee 25 basis point rate cuts. The firebreak held and the U.S. economy got another 24 months of economic growth, crossing the line to become the longest uninterrupted economic expansion in U.S. history in February of 2000. On such a basis is the formidable reputation of Alan Greenspan built.

But the unenunciated strategy of Greenspan, et. al. during this period was to stave off the spreading crisis by converting the vast and voracious American body of consumers into the buyer of last resort for the world. The countries in crisis would be propped up through IMF aid packages, but also through the newly enhanced competitiveness of their goods on the U.S. market. This was accomplished through the aforementioned interest rate cuts, but also at Treasury through the strong dollar policy.

U.S. trade deficit, 1991-2005

Source: Wikipedia; U.S. Census Bureau, Foreign Trade Division

The broadest mechanism by which interest rates work is through home mortgages. As interest rates decline they set off a wave of home loan refinancing, liberating spending previously sunk into housing costs. That combined with the (psychological) wealth effect of the stock market and a historic credit binge came together in the person of the American consumer to pull the world back from the brink. A glance at the above graph of the trade deficit shows that 1997 was the inflection point.

In so far as the way that the U.S. opted to combat the global spread of the anticipated “Asian contagion” was to transform the U.S. consumer into the buyer of last resort through loose credit, the collapse of the housing market bubble is the continuation of, or the knock-on effects of the Asian financial crisis of 1997-98. It could only be postponed, not avoided; transformed, not stopped. Old wine in new bottles.

It was fairly apparent to most observers during the late 1990s and 2000s that the Federal Reserve was struggling to stave off a crisis and did the best that it could, but was merely kicking the can down the road. There was plenty of commentary at the time that the Fed was merely letting pressure off one bubble by inflating another. And inside the Fed they were fully aware that this was what they were doing, but they had to deal with the crisis at hand and figured that they would cross the bridge of the iatrogenic consequences of their policies when they came to them.

In this sense the ultimate cause of the present economic crisis is a structural imbalance in the world economy that has a tendency to generate crises. One portion of the world, the developing, produces without consuming and as a result experiences a glut of savings. The other, the U.S., consumes by borrowing the surplus savings of that other portion of the world. Witness the current account deficit of the United States with China and the strategic fallout thereof. The problem is political-economic in nature and the ultimate solution lies in the realm of politics, not behind the scenes financial wizardry.

A Broad View of What Constitutes a Bank

In today’s column Paul Krugman (“It’s a Miserable Life,” The New York Times, 20 August 2007) points out an interesting aspect of the current financial crisis:

The key to understanding what’s happening is taking a broad view of what constitutes a bank. From an economic perspective, a bank is any institution that offers people liquidity — the ability to convert their assets into cash on short notice — while still using their money to make long-term investments.

Consider the case of KKR Financial Holdings, an affiliate of Kohlberg Kravis Roberts, a powerhouse Wall Street operator. KKR Financial raises money by issuing asset-backed commercial paper — a claim that’s sort of like a short-term C.D., used by large investors to temporarily park funds — and invests most of this money in longer-term assets. So the company is acting as a kind of bank, one that offers a higher interest rate than ordinary banks pay their clients.

It sounds like a great deal — except that last week KKR Financial announced that it was seeking to delay $5 billion in repayments. That’s the equivalent of a bank closing its doors because it’s running out of cash.

The problems at KKR Financial are part of a broader picture in which many investors, spooked by the problems in the mortgage market, have been pulling their money out of institutions that use short-term borrowing to finance long-term investments. These institutions aren’t called banks, but in economic terms what’s been happening amounts to a burgeoning banking panic.

Mr. Krugman points out that while the banking industry narrowly defined is well regulated — that is, both brought under law and made more uniform and predictable — by a host of institutions — the FDIC, the Federal Reserve, various banking laws, the Basil accords, et cetera — these other bank-like institutions are not similarly covered. Hence, the Fed can modify its rates all it wants and the FDIC may offer insurance, but these don’t effect the pricing of asset backed securities or the willingness of investors to purchase commercial paper in anything like the way that they effect regular banking.

Just as the financial sector innovates, so regulation and governing institutions should innovate as well. Unfortunately the sort of consensus that produces institutions like the Federal Reserve or the FDIC come only out of major crises — not the sort at which we are currently looking. For that, the financial system will have to build up a lot more pressure.

Public Financial Institutions

Thomas Barnett is conservative leaning and — ironically enough — is one of those intellectuals who is stupid in exactly the way that conservatives predict intellectuals to be: he tends to trip over his own intelligence. A perfect example is his completely incoherent take on the recent, sudden burst of the housing bubble (“Nice analysis of the sub-prime ‘crisis’,” 13 August 2007):

The only crisis I see coming out of the subprime shenanigans (such new tricks to fleece people will always be with us) would involve governments assuming they should bail out all those hedge funds that long dabbled in this stuff. O’Driscoll makes a great comparison to the S&L crisis of years ago: so long as financial institutions assumed the FDIC bailout was coming, they’d pawn off the risk to the government instead of effectively discounting it themselves.

Really? The only crisis he sees is moral hazard? So we’re courting moral hazard toward no specific end?

Government intervention isn’t bailing out “all those hedge funds”: it is protecting the rest of us — not necessary culpable in the “shenanigans,” but still subject to the consequences thereof — from spreading economic misery. To suggest that this same old moral hazard argument that economic conservatives have been making since 1913 is somehow penetrating analysis of our present day woes is completely retrograde. Moral hazard is real, but people with less pronounced agendas have a lot more interesting things to say about the subject than that in the face of it we should do nothing.

The FDIC, the Federal Reserve, the SEC, punitive, but stabilizing taxes, transparency laws, etc. were created specifically because “foolish” investors engaging in “shenanigans” could be found well before any of these public sector economic institutions ever existed; and further, to protect non-privileged investors who did everything by the book from said “shenanigans” — in other words, to prevent the spread of irrationality. Once a critical mass of people begin to act irrationally — e.g. in a financial panic — rationality flips and the irrational becomes the rational thing to do.

And as if this wasn’t disconnected enough, then there’s this parenthetical aside:

(since finance is–to a large part–a young man’s game, the bulk of the front-line players tends to age out every dozen years or so, which pretty much guarantees you new forms of shenanigans with the same regular frequency)

It’s all fine and good to use pejoratives such as “shenanigans” and “foolish” — as Mr. Barnett does — to describe less than perfectly rational market actors who continue to fall for plaid-out investment schemes such as the housing bubble long after their true nature has become more than apparent, but if less than perfectly rational behavior is in fact systematic, as Mr. Barnette suggests with this theory, then what’s the point of moralizing about it? Systematic problems should be dealt with through systematic solutions — and not systematic solutions that entail mass suffering for all of society.

The Federal Reserve and Mortgage Backed Securities II

So it turns out that what was unusual about the Friday open market operations of Federal Reserve was even more narrowly technical still. The Federal Reserve always accepts mortgage backed securities as collateral, but usually issues loans backed by this sort of collateral at a less favorable rate. What was unusual on Friday was that the Federal Reserve issues all loans at the most favorable rate, no matter the collateral.

Kevin Drum passes along an e-mail from Stephen Spear, a professor of economics at Carnegie Mellon University, in which the Professor relates a conversation with a Federal Reserve colleague about the operation (“Friday’s Liquidity Event,” Political Animal, The Washington Monthly, 12 August 2007):

Here’s what I’ve been told by a colleague at the Fed:

First a minor point: Most of the open market operations that the Fed does (including Friday’s) are short-term collateralized loans and not outright purchases of securities. Friday’s loans were all overnight (well, over the weekend, actually, maturing on Monday). So the Fed is technically not buying anything; it’s been making short-term loans of cash against collateral.

The Fed accepts three categories of collateral for these loans. One is Treasury securities, another is other government agency securities, and the third is mortgage-backed securities that are federally guaranteed. Because they are federally guaranteed, the mortgage-backed securities the Fed accepts are (obviously) the very best.

Typically the interest rate on these short-term loans varies slightly depending on the type of collateral offered by the borrower. Treasuries get the lowest rate; mortgage-backed securities the highest. (The details of the last 25 OMOs, including the rates for each type of security, are available here.)

What was unusual about Friday (other than the size of the operation) is that the Fed announced it would lend against all three types of collateral at the same rate.

To quote my Fed colleague on this: “I’m not sure why we did this. I think the idea was that given the size of the operation we did not want to risk disrupting the Treasuries markets, but there may have been other motivations. The expectation was that borrowers would primarily use mortgage-backed securities, since these have the lowest opportunity cost to the borrower.”

On the web page above, you will see that for Friday’s operations, under collateral type it just says “mortgage-backed.” What this means is that mortgage-backed securities or any better securities were allowed as collateral — in other words, all three types were acceptable. Apparently, the media misinterpreted this as saying that the Fed was only accepting mortgage-backed securities, which led to the headlines about the Fed buying these things up.

So, the bottom line is that the Fed’s actions on Friday were unusual, but not tremendously so. It did three OMOs instead of the usual one. The quantity of reserves lent out was larger than normal, and the way collateral was handled was slightly unusual. But the general operating procedure, including the type of collateral accepted, was completely standard. It would seem that the media is trying to make the story a lot more sensational than it truly is.

Given the extraordinary amounts of money here along with tweaks to the usual policy, obviously the Federal Reserve sees a problem requiring extra-ordinary measures, but obviously not the panic initially reported by the press.