Tag Archives: TARP

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.

Taylor on the Crisis

If I could only recommend one economist to read on the current financial crisis, I would choose John Taylor. His latest paper details the causes of the financial crisis as well as the subsequent policy responses (and failures). Here are some highlights:

  • He presents evidence that the Federal Reserve significantly deviated from its historical behavior (the Taylor Rule), which created the boom-bust scenario in housing.
  • He presents counter-factual evidence through the use of simulation that suggests the housing boom would have been avoided had the federal funds rate not deviated from the Taylor rule.
  • He rejects the global savings glut hypothesis.
  • The behavior of other central banks similarly deviated from the Taylor rule and those with the largest deviations also had the largest housing booms.
  • There is a connection between excessive monetary policy and risk-taking.
  • The subprime mortgage market exacerbated the problem.
  • The financial crisis was (is) not a liquidity problem, but rather a counter-party risk problem.
  • There is a strong correlation between the sharp cuts in the federal funds rate and the price of oil.
  • Credit spreads increased in the aftermath of the announcement of the TARP. (Taylor blames this on the uncertainty surrounding the vague discretionary power of the Fed/Treasury in implementing the plan.)
  • From his conclusion:

    “In this paper I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.”

I am teaching Money and Banking again this semester and this paper will undoubtedly be required reading.

Here is a non-gated link to the paper.

The Government, Housing, and The Crisis

It is time to weigh in on some important topics with respect to the current financial crisis. First, I think it needs to be noted that the crisis has already had many stages, each of which likely need to be discussed individually. They can loosely be classified as follows:

1.) The housing bubble (or “How we got here…”)

2.) The bursting of the housing bubble, the increased perception of risk, the fall of Bear Stearns, and the expansion of Federal Reserve power (sorry I couldn’t make this pithy).

3.) Financial market mayhem.

4.) The Hank Paulson Variety Show. (My thoughts here and here.)

Over at Cato Unbound the crisis is being debated by the likes of Lawrence White, Brad DeLong, and Casey Mulligan. Each makes particularly intriguing points, but the main point that I would like to address is in regards to the stages of the crisis. We seem to have gotten to the point where everyone is talking past one another because each is talking about a separate stage of the crisis. For example, White’s essay clearly outlines the incentives put forth by the government that contributed to the housing boom. DeLong, however, counters that White is not addressing the important issue and that he even gets the one he is discussing wrong. I think that there are elements of each of their essays that are correct, but I do not agree with DeLong that they are mutually exclusive.

White is largely concerned with stage 1 listed above. His essay (helps) explain the cause of the housing bubble, but is quite vague on the impact of the economic shock created by its collapse. DeLong is primarily concerned with stages 2 and 3, or in other words the impact of the economic shock. Further, he asserts that government intervention and monetary policy explain little about the shock.

Let’s take this point-by-point. First with regard to monetary policy. DeLong asks:

Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans?

This is somewhat misleading. As our friend David Beckworth points out,

The absolute dollar size of the [open market purchase], however, is not important. What is important is whether these increases in liquidity were excessive relative to the demand for them. One only needs to look at the negative real federal funds rate that persisted over this period to see that these injections were excessive.

I think that Beckworth hits the nail on the head here. These injections were clearly excessive as is evident from White’s chart in his Cato policy paper, in which he compares the actual federal funds rate to that which would be predicted by the Taylor Rule. Further, recent research has shown that low interest rates cause banks to lower their lending standards. These would seem to suggest that monetary policy played in important role in causing the economic shock.

This brings us to the second point in this discussion: did government intervention cause the housing bubble? I believe that the answer is both yes and no. I am on record in saying that Fannie and Freddie (see here and here) did not cause the crisis. In fact, if you read Stephen Cecchetti’s excellent discussion of the early part of the crisis, you will notice that private securitization of mortgage debt was growing much faster than that of the GSEs in the early part of this decade. Nonetheless, I believe that government policy did play a minor role in creating the housing boom (as I will discuss below).

As previously mentioned, monetary policy seems to have played a crucial role in the financial crisis. However, the fact that monetary policy stoked the fire says little about why all of this money flowed into housing. I think that there are two main culprits: (A) Securitization, and (B) Government policy; the former being a necessary condition for the latter to have a meaningful impact. Allow me to explain.

In private conversations with our friend Barry Ritholtz about these matters, he has challenged me to explain why the Community Reinvestment Act (CRA) did not create a boom (or crisis) from 1977 to 2002. This is a fair point and one that I think few (if any) have failed to address. What changed in recent years is that (i) the CRA received some teeth in 1995, (ii) the Federal Reserve lowered interest rates to historic lows for an extended period of time, and (iii) the increased use of private securitization. Ultimately, I think that (ii) and (iii) are the most important both in creating the economic shock and that (i) played a minor role in that the other two factors facilitated the compliance with government policy.

When government regulation is created, there is an immediate incentive to circumvent the regulation. However, the use of securitization essentially made it easier for banks to comply with CRA (by buying securitized mortgages that complied or by issuing the mortgages themselves and selling them off as part of an ABS in the future). Thus far all we have is lower bound estimates of the impact of the CRA on subprime loans, but this lower bound is decidedly not zero. As the link above indicates, a recent Fed study indicated that only about 8% of subprime loans can be correctly tied to the CRA. Nevertheless, as Lawrence White points out in that post, this ignores potential “demonstration” effects. In other words, once banks who are not required to comply with the CRA discover that other banks are making these loans somewhat successfully, they might be more inclined to enter the market to compete directly with these firms (this might explain why 75% of troubled mortgages originate from firms that are not required to comply with the CRA). In any event, however, it is unlikely that the percentage of subprime that originated directly as a result of CRA exceeds 20% and therefore must be deemed a relatively small factor.

To summarize, I believe that monetary policy and the increased use of securitization are to blame for the creation of the economic shock and the subsequent chaos in its aftermath. Nonetheless, I think that government policy does play a minor role in explaining the creation of the shock.

Big Players and Uncertainty

There has been a great deal of discussion lately with regards to the ever-changing role of the Troubled Assets Relief Program (TARP).  Initially, the program was designed to purchase the troubled assets of financial institutions in an attempt to cleanse their balance sheets and get them lending again.  I have previously come out against this plan as it fails to take into account the limitations and dispersal of knowledge within markets.  Perhaps this and other objections were heeded by the Treasury Department, which inexplicably abandoned this stated goal in favor of direct equity injections in troubled financial institutions.  In the aftermath of this decision, little has been done to instill confidence in the financial markets and the capital infusions have done little to increase the lending by the recipient institutions.  Given that many noted economists preferred capital infusions to the purchase of troubled financial assets, recent events beg the question as to why this change in policy has been unsuccessful.

The answer can be found in Fairleigh Dickinson economist Roger Koppl’s theory of Big Players.  Koppl defines a Big Player as a market participant that is substantially large, immune to profit and loss mechanisms, and yields ample discretionary power to have an impact on the market as a whole.  Central banks are perhaps the clearest example of a Big Player and this theory indeed might explain much about the artificial boom that preceded the current mess.  However, the theory is perhaps more applicable in the aftermath of the boom.  Since the onset of the crisis, the Federal Reserve and the Treasury department have acted as Big Players.  They continue to wield significant discretionary power and often take unprecedented action – and at times unexpected restraint.  In other words, to use a tired saying, they are flying by the seat of their pants.  One need not look beyond the TARP for an understanding of the discretionary power of these entities.

The effect of this discretionary power is to increase uncertainty within the financial markets.  Firms that receive capital infusions refuse to increase lending precisely because the rules are changing on a daily basis.  The same goes for investors who must not only predict what the market is going to do, but also the behavior of the Big Players.  Of course, the ability to predict what the Treasury and the Fed are going to do next is substantially difficult.  The result is the herd-like behavior that has been prevalent in the stock market for the last few months.  When there is a high level of uncertainty in markets, participants start relying more on what they believe that others believe than the prospective yield of a particular investment.  The empirical evidence presented by Koppl and his colleagues confirms these claims.  Uncertainty breeds uncertainty.

Nevertheless, some pundits continue to press on.  The same individuals who advocated using capital infusions and who were surprised to find the institutions unwilling to lend are now advocating forcing the financial companies to lend. Markets function well when the surrounding institutional framework is sound.  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.