Big Players and Uncertainty, Part 2

Some readers may recall an earlier post in which I explained that many of the failures of the attempts at government intervention have to do with the fact that the government is exercising discretionary power that change the rules of the game on a largely ad hoc basis. Particularly, I referenced Roger Koppl’s theory of Big Players, in which a large entity that is largely immune from the profit-loss mechanism wields significant discretionary power. Under these circumstances, such discretionary power can be a major source of uncertainty and therefore causes market participants to shift resources away from productive uses and toward predicting the behavior of the Big Player (incidentally, Axel Leijonhufvud makes a similar point in his classic, “Costs and Consequences of Inflation“).

In the earlier post, I referenced the ad hoc behavior of the Treasury in developing the bank bailouts and suggested that, consistent with the theory of Big Players, such behavior only served to generate uncertainty. I have not been alone in this analysis. For example, John Taylor’s new book similarly criticizes such ad hoc behavior on the part of the federal government as exacerbating the crisis.

Thus, I was not at all surprised to read the following story from NPR, in which one bank CEO explains why he decided to give the TARP money back:

[CEO Joseph] DePaolo says Signature returned the money for three reasons: Legislation passed Feb. 17 would limit the compensation for salespeople, make it difficult to recruit bankers and cause uncertainty.

“With the new legislation, they changed the rules in the middle of the game,” he says. “We didn’t know how many more rule changes or legislation would come down, maybe telling banks, ‘This is what you can do with your lending. This is what you can do with your clients.’”

I will reiterate a point that I made in the earlier post:

If the government really wants to help, they can start by setting the rules now and following through on their promises. So long as they continue to change the rules on a daily basis, uncertainty will prevail, the stock market will remain volatile, and the credit markets will remain frozen.

Abandoning Principles

Oliver Hart and Luigi Zingales write in the WSJ:

This year will be remembered not just for one of the worst financial crises in American history, but also as the moment when economists abandoned their principles. There used to be a consensus that selective intervention in the economy was bad. In the last 12 months this belief has been shattered.

Practically every day the government launches a massively expensive new initiative to solve the problems that the last day’s initiative did not. It is hard to discern any principles behind these actions. The lack of a coherent strategy has increased uncertainty and undermined the public’s perception of the government’s competence and trustworthiness.

Read the whole thing.

Bailout Passes

The bailout novel bill has passed the Senate by a wide margin complete with meaningless giveaways and patches:

The Senate specializes in high-stakes legislating by enticement, and the long list of sweeteners it added was designed to attract votes from various constituencies.

In addition to extending several tax breaks popular with businesses, the bill would keep the alternative minimum tax from hitting 20 million middle-income Americans and provide $8 billion in tax relief for those hit by natural disasters in the Midwest, Texas and Louisiana.

Tax cuts new and old are favorites for most House Republicans. Help for rural schools was aimed mainly at lawmakers in the West, while disaster aid was a top priority for lawmakers from across the Midwest and South.

Another addition, to extend the deductibility of state and local taxes for people in states without income taxes, helps Florida and Texas, among others.

[...]

The rescue bill hitched a ride on a popular measure that gives people with mental illness better health insurance coverage. Before passing it, senators voted by an identical 74-25 margin to attach the massive bailout and the tax breaks.

Financial Crisis/Bailout Linkfest

There is utterly too much to comment on and opinions range quite widely, so I thought that I would provide interesting links:

• Bloomberg (HT: Barry Ritholtz):
  

  Treasury Secretary Henry Paulson’s $700 billion proposal to stabilize the banking system may push the national debt to the highest level since 1954, threatening an erosion of foreign appetite for U.S. bonds.

  The plan, which asks Congress for funds to buy devalued securities from financial institutions, would drive the debt above 70 percent of gross domestic product and the annual budget gap to an all-time high, possibly exceeding $1 trillion next year, economists estimated.

• Calculated Risk:
  

  …many people are saying the government can only lose a portion of the $700 billion because there will be offsetting assets. This is true in the Fannie and Freddie conservatorship (the mortgage assets mostly offset the debt of Fannie and Freddie), but it is not true here. Although Paulson and Bernanke are talking about hold-to-maturity prices, they are also talking about both buying and selling securities. A little math will show that if you take a loss (say 30%) on each transaction, it doesn’t take many transaction to lose most of the entire $700 billion.

• Securitization, Liquidity, and Market Failure, Paul Davidson:
  

  Keynes’s LPT can provide the explanation. LPT presumes that the economic future is
  uncertain. Consequently, the classical ergodic axiom that is fundamental to any efficient market theory is not applicable to real world financial markets. Keynes’s analysis presumes that, in the real world of experience, the macroeconomic and financial systems are determined by a nonergodic stochastic system. In a nonergodic world, current or past probability distribution functions are not reliable guides to the probability of future outcomes [Davidson, 1982-3, 2007]. If future outcomes can not be reliably predicted on the basis of existing past and present data, then there is no actuarial basis for insurance companies to provide holders of these assets protection against unfavorable outcomes. Accordingly, it should not be surprising that insurance companies that have written policies to protect asset holders against possible unfavorable outcomes resulting from assets traded in these failing securitized markets find they have experienced billions of dollars more in losses than the companies had previously estimated. [Morgenson, 2008]. In a nonergodic world, it is impossible to actuarially estimate insurance payouts in the future.

• How About a Market?, Felix Salmon
• Credit Is Flowing, Sky Is Not Falling, Don’t Panic, Robert Higgs
• Why Paulson is Wrong, Luigi Zingales:
  

  Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

• The Paulson Sale, WSJ:
  

  There is a better — and more transparent — way to put public capital into the banks while protecting taxpayers: through the Federal Deposit Insurance Corp. The FDIC has long had the power to handle failed banks. But in 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA) that limited the FDIC’s ability to provide assistance to struggling but still solvent banks.

  The exception is when there is a risk to the entire financial system. In that case, the President, Treasury Secretary and two-thirds of the Fed board can authorize such open-bank aid. The current moment would seem to qualify. Yet the White House has so far refused to trigger this exception and let the FDIC work with the likes of Wachovia, Morgan Stanley, and others before they crash and burn.

  Whether or not the Paulson plan passes, President Bush should sign the FDICIA waiver. This would allow Treasury and the FDIC to inject new capital into banks early enough to prevent failures; in return, the feds could impose some discipline in the form of management dismissals and preferred stock or warrants that would protect taxpayers when the banks recover. This also beats the Congressional idea of attaching taxpayer warrants to the Paulson plan, which will be much harder to administer to hundreds of banks as opposed to one at a time through the FDIC.

• What Would Hayek Say?, Peter Klein
• An Open Letter Opposing the Paulson Plan
• Where is the Credit Crunch?, Alex Tabarrok:
  

  I look at the situation as follows. Banks are bridges between savers and investors. Some of these bridges have collapsed. But altogether too much attention is being placed on fixing the collapsed bridges. Instead we should be thinking about how to route more savings across the bridges that have not collapsed. Government lending may be one way of doing this but why lend to prop up the broken bridges? Instead, why not lend directly to the investors who are in need of funds? After all, if these investors exist and have valuable projects that’s where the money is! Let the broken bridges collapse, taking the shoddy builders with them. Instead focus on the finding and rescuing the victims of any credit crunch, the investors who need funds.

• Let’s Get the Bank Rescue Right, R. Glenn Hubbard, Hal Scott, and Luigi Zingales, WSJ op-ed:
  

  Any solution should observe three guiding principles: It should (1) restore the stability of the financial system quickly and at the lowest possible cost to the taxpayer; (2) punish those who are responsible for losses; and (3) address the root cause of the crisis — the price collapse in the residential real-estate market. In doing so, the solution should respect the rule of law by spelling out the proposal in sufficient detail for the Congress and the electorate to pass judgment. To the extent possible, it should follow proven precedents.

  The administration’s current proposal fails to meet these principles.

Where Do We Go From Here?

The federal government announced the takeover of Fannie Mae and Freddie Mac today. The stock market applauded the move sending stocks soaring. However, the recent moves of the Federal Reserve and the Bush administration raise important questions about where we are heading. (Before we discuss where we are heading it might prove useful to understand how we got here. For a quick primer, click here, otherwise continue on.)

Our friend Thomas Palley posted an op-ed on his page about a month ago anticipating the “scapegoating” of regulation:

The conservative argument is government’s provision of an implicit guarantee to Fannie and Freddie distorted the market by giving them subsidized finance. The implication is that this enabled them to pump up the housing bubble, while simultaneously making them the dominant players in the securitized mortgage market.

[...]

The insinuation that Fannie and Freddie were primary movers of the housing market excesses of 2004 – 2006 lacks even superficial merit. This is because since 2003 both Fannie and Freddie have had limited asset growth, and Fannie’s assets actually fell significantly after 2003.

Moreover, the roots of the crisis lie in the sub-prime market. That is where “no doc” and “zero down” mortgages proliferated, where loan originations exploded in volume, where losses started, and where the bulk of losses have been so far. Yet, Fannie and Freddie are prevented from financing such mortgage products by their charters.

These facts should make clear that Fannie and Freddie did not cause the crisis. Instead, it was driven by loose and negligent lending by banks and Wall Street.

Palley then concludes that the companies should be nationalized and that stricter regulation is necessary. While he is correct to point out that Fannie and Freddie did not cause the crisis, I must disagree as to the implications of their existence and his policy conclusion.

While it is clear that Fannie and Freddie did not cause the crisis, they have subsequently rose to its center. The reason that Fannie and Freddie are at the center of the crisis is due to the fact that they have risen so much in size. The implicit guarantee of it debt has led to a de facto subsidization of mortgage debt (beyond that which is in the tax code) through the organizations’ ability to issue bonds at lower rates. So while Fannie and Freddie did not cause the crisis, the increase in size coupled with (and as a result of) the implicit guarantee of the debt has created a potentially heavy tax liability on taxpayers, which has been made larger (and explicit) by the announced government takeover.

So where do we go from here?

Increasingly, there is a greater push for more regulation. However, I am not certain the more regulation is what is necessary. The current regulatory system is a disaster, full of overlapping agencies and poor performance. The Fed is responsible for oversight of its member banks and bank holding companies; the Treasury department for national banks; states for state banks (even those within the Federal Reserve system); the FDIC for state banks that are not members of the Federal Reserve system, but are insured. The entire system is entirely too complicated to navigate. Further, many of the innovations such as securitization arose in response to government regulations such as reserve requirements and, more importantly, restrictions on interest payments for deposits.

Perhaps more troubling is the development of new programs within the Federal Reserve to deal with this crisis. I have previously mentioned that the Fed has performed admirably in the face of the crisis, but this point needs to be better clarified. The Fed, contrary to its performance during the Great Depression, has been vigilant in its effort to serve as lender of last resort. However, as Allan Meltzer has pointed out, they have surpassed this goal and have actually become the “creditor of last resort.” This distinction is important because as lender of last resort, a central bank is an entity that serves to provide liquidity to the market whereas the creditor of last resort refers to a central bank that holds all of the bad debt that others are unwilling to hold.

The creation of the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF) have expanded the role of the Federal Reserve and allowed them to provide liquidity to the market in new and unique ways. However, as I have argued elsewhere and as John Taylor and John Williams have pointed out, these efforts have done little to close the widening risk spreads. For example, the spread between the LIBOR (London Interbank Offer Rate) and the Overnight Indexed Swap (OIS) remains elevated several months after the origination of the new tools of the Fed.

The continued elevation of the risk spreads continue to lend support to my hypothesis that they do not reflect a lack of liquidity, but rather the persistence of counter-party risk. They also raise concerns about the recent expansions of Federal Reserve power. These new tools obviously serve as a means to providing liquidity to all members of the financial sector, but restoring confidence is much more complicated. One hope of the Fed was that these tools would provide other institutions with the confidence to lend with one another and accept commercialized debt obligations (CDOs) as collateral. However, these other institutions are not blessed with the ability to print currency nor are they backed by the government of the United States. The failure of the TAF and the PDCF to reduce the risk spreads and restore confidence therefore raise grave questions about this recent expansion of power.

The complicated structure of regulation in the banking industry and the unending desire of financial institutions to circumvent regulation suggest that adding additional layers is not sufficient nor is it desirable. However, some type of regulation is necessary. Even under free banking systems, clearinghouse associations provided regulatory oversight of their member banks. Rather than create new regulations, we need to consolidate regulatory agencies and oversight so that it is easier for the firm to comply and for the regulator to observe. Further, we need to get the Federal Reserve out of the business of regulation and begin to eliminate the programs that have pushed the Fed’s power too far to the role of “creditor of last resort” and have proven unable to restore confidence to the markets. Finally, the takeover of Fannie and Freddie should begin a slow and gradual process toward their ultimate elimination. We need not continue to subsidize home ownership at the potential cost of taxpayers.

This isn’t enough to fix all of the current problems, but it is a start.

A Federal Government Fix

Our friend James Pethokoukis of U.S. News and World Report recently asked me to provide my thoughts on a federal government bailout to “fix” the housing market and stabilize the economy. You can read my thoughts here (along with those of Russ Roberts, Dean Baker, Don Luskin, Craig Newmark, John Tamny, and Daniel Mitchell).