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Tuesday, March 17, 2009

Some Banking Points

Okay, I am well and truly sick now. The virus the Chief gave me may have been a flu virus, which would explain why he got so ill from it.

But I would like to point you all to a couple of banking/risk related posts:

At Ace: Sweet Fancy Moses: Bank Rapped for Keeping Balance Sheets, um, Balanced; Feds Censure It for Not Aggressively Enough Pouring Money Down CRA Rathole. The bank was slapped with a "Needs to Improve" CRA rating due to low loan volume. And ordinarily that makes sense, but when you find yourself operating in a poisoned environment in which people have written bad loans for low rates all around you, you may reasonably get "paranoid about credit quality", and you almost certainly will have to pull back on your lending to avoid being sucked into the black hole created by loose lending. It's not a net negative, because once the bust happens, you'll have the money to lend to worthwhile borrowers who are getting cut off from the larger institutions.

The Anchoress. Here's a topic you might have thought you'd never see at The Anchoress, but when she does it, she does it well. First she links to a paper on Ponzi schemes in political economies which advances the theory that there is some rationality to how this happens:
This paper argues that if agents correctly believe in the possibility of a partial bailout when a gigantic Ponzi scheme collapses, and they recognize that a bailout is tantamount to a redistribution of wealth from non-participants to participants, it may be rational for agents to participate, even if they know that it is the last round. We model a political economy where an unscrupulous profit-maximizing promoter can design gigantic Ponzi schemes to cynically exploit this “too big to fail” doctrine.
Then she throws in a bit of history relating to the GSEs. It's an excellent post.

In the Clinton administration, there was a very close partnership between the large financials and the government. For example, there was the Mexican bond bailout and intervention in hedge fund problems a la LTCM. It is no accident that when Enron realized it was about to blow, they had a govie contact the government and expected the government to intervene.

Here, from March 2006, is a somewhat long post from Econotech addressing the basic problem: that governments (not just the US) had kept bailing out financials out of fear, which created a financial culture that was unafraid of risk and that therefore felt free to create bubbles in the belief that whatever was destroyed in the popping of the bubble, it would not be them:
The deliberate opacity of the credit and derivative markets (which is being addressed behind the scenes in places such as the Counterparty Risk Management Policy Group) makes the current credit excesses potentially dangerous, especially given the unfathomable size of the markets (derivatives are $300-400 trillion in notional value).

The big speculators in these markets ultimately expect to get bailed out, yet once again, should their overly leveraged trades ever blow up in their faces, e.g. as they have been going all the way back to the Latin American debt crises of the 1980s, through the S&L crsis, the Mexican bond crisis, Asian financial crisis, Russian default crisis, Brazil and Argentive crises, and ultimately the TMT equity crash, in the last case through Greenspan's negative real interest rates for three years igniting a global real estate boom and Japan's zero rates funding speculative global "carry trades." Yes, it'a long list, and these bailouts have been a bipartisan political policy.

This combination of enormous gains on opaque private trades with the public providing implicit insurance against economically-destabilizing losses (the "too big to be allowed to fail syndrome," a la the LTCM precedent in October 1998) is blatantly NOT fair and honest and creates immense "moral hazard" which greatly distorts global capital flows into speculative activity and away from real productive uses.
Yes, it does.

I'd like to close with a slice of MoM's Mom theory, which beats Greenspan's theory all hollow. Greenspan's theory, as explicated in his Jackson Hole remarks in 2005:
The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.

The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.

Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.

The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher.5 The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted o cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions.6 The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

6. Capital gains do not add to GDP. The higher prices of plant and equipment and homes are reflected in an economy's cost structure, which directly or indirectly increases prices of goods and services, leaving real output largely unaffected. Capital gains, of course, cannot supply any of the saving required to finance gross domestic investment.
Greenspan blew enough bubbles to make it obvious that he believed bubbles could be managed, and earlier in this speech he blew a little bubble about the Fed's risk management:
Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve, at its core, crucial elements of risk management. In this approach, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy.

The risk-management approach has gained greater traction as a consequence of the step-up in globalization and the technological changes of the 1990s, which found us adjusting to events without the comfort of relevant history to guide us. Forecasts of change in the global economic structure--for that is what we are now required to construct--can usefully be described only in probabalistic terms. In other words, point forecasts need to be supplemented by a clear understanding of the nature and magnitude of the risks that surround them.

Mom's Mom theory:
My mother's theory of risk management was that as soon as any company started reporting mostly income from capital gains, she sold the dang stock. She'd give them a period of time to restructure and actually make some money, but if they couldn't show any actual, significant business income derived from sources other than buying, selling and arbitraging other businesses and assets, out the door it went. For example, she sold Tyco in the first half of 2001 because she couldn't figure out how the company was really making real money. Her idea was that if it wasn't making money from anything but arbitrage, a bust was coming. My mother was an excellent investor.

I believe that my mother was correct, and that periods of wealth and trade generated mostly from non-income-producing capital gains always produce a serious subsequent bust. I believe that such risks cannot be managed because of a very simple set of economic facts:
  1. To monetize capital gains (spend them), one must either borrow against the assets or sell the assets,
  2. Selling assets limits the growth of capital gains,
  3. If borrowings rise consistently and disproportionately more than incomes, real spendable income is being diverted to loan servicing, thus creating the need to borrow more to get spendable income,
  4. Eventually, either lenders will become unwilling to lend or borrowers will be unable to service their debt,
  5. After which, large numbers of people will have to sell assets to monetize capital gains,
  6. Which destroys the capital gains,
  7. Which abruptly lands the lenders in a game of strip poker, which they are doomed to lose.
Therefore the only question is whether growth in borrowing on asset value has reached the point at which it is consistently outstripping growth in incomes (Step 3). Once it has, the earlier the correction the better. Sustainable growth in GDP cannot be derived from ever-growing debt burdens, as Greenspan concedes in footnote 6.

Greenspan believed that the role of central banks wasn't to diagnose and correct bubbles.

I believe that is one of the main functions of a central bank, and that it is not difficult to tell when a bubble is emerging.

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