a high-quality standard is maintained at all levels of the transfer process, and no new concentrations of risk arise

TO BE NOTED: From Mostly Economics:

"Originate to distribute model – distributed fear rather than risks By Amol Agrawal

Alex Weber, President of Bundesbank in his recent speech says:

It has now become clear that the “originate and distribute” model can actually improve the resilience of the financial system if, and only if, a high-quality standard is maintained at all levels of the transfer process, and no new concentrations of risk arise. Since the outbreak of the financial crisis, however, we have learned about a series of distorted incentives, which manifested themselves in lax origination standards for products such as subprime mortgages and in some investors’ excessive reliance on credit ratings. In the end, securitisation, as Claudio Borio from the BIS aptly put it in 2008, has, ultimately, “distributed fear rather than risks”

He also touches on the initiatives taken in Germany and issues for monetary policymakers:

In my view, monetary policymakers should not view boom and bust episodes on the financial markets as unrelated events. Monetary policymakers’ responses to upturns as well as to downturns on the asset markets influence the risk perception of the market participants. Therefore, an (expansionary) monetary policy response which is stronger in the downswing than the (restrictive) response in the upswing creates adverse incentives for investors which could increase the amplitudes of the financial cycle.

A more symmetric approach by monetary policymakers would treat boom and bust episodes not as isolated events but would try to look through the financial cycle in order to steady policy. To be more specific, a more symmetric policy would also consider implicit risks in times when money and credit growth is dynamic, asset prices go up and risk perceptions decline, possibly weighing the need to act despite low current consumer price inflation rates.

This, however, does not mean that monetary policy should downgrade the price stability objective for the sake of other objectives. Indeed, financial crises heighten the volatility of macroeconomic variables such as inflation and growth. Rather, it means that central banks should take a longer-term perspective which takes into account the future inflationary consequences of such unfavourable developments. Given the macroeconomic relevance of financial crises, we have good reason to enlarge our monetary policy time horizon and give low-frequency movements in credit and monetary aggregates more weight in our analytical frameworks and our monetary policy decision-making processes.

Being from Bundesbank, a push for using monetary aggregates is obvious and timely."

Axel A Weber: Reflections on the financial crisis
Text of the Mais Lecture by Professor Axel A Weber, President of the Deutsche Bundesbank, at the Cass Business School, London, 13 May 2009.
* * *
1 Introduction
Ladies and gentlemen
It is an exceptional honour for me to be invited to give this year’s Mais Lecture here at City University. And it is a very welcome opportunity for me to present my reflections on the financial crisis.
The events that have been shaking financial markets since the summer of 2007 and which escalated markedly in September 2008 are occupying the attention of governments and central banks worldwide on an unprecedented scale.
While it is certainly true that attempts to contain the financial crisis and thereby prevent financial market tensions from creating a vicious circle for the real economy is a challenge for monetary policymakers in nearly all areas, I would argue that, for monetary policy in the euro area, the challenges may be even larger than for other industrial economies.
When we recently celebrated the tenth anniversary of the launch of the single currency, it was often stated that the first ten years of the euro have been a notable success with regard to price stability, trade and financial integration in Europe. However, it was also said that the years ahead are likely to pose an even greater challenge.
2 Challenges for monetary policy
And indeed, as I have argued before, the challenges we are currently facing are, in many respects, more demanding than anything else in the euro area’s first ten years.
To that end, it is my firm belief that the value of monetary union has never been greater than during this financial crisis. Try to imagine what would have happened without the single currency. Probably, foreign exchange markets may have been subject to speculative attacks. Currency fluctuations may have aggravated both the financial crisis and real economic tensions – and do not forget the political turbulence implied by such currency tensions.
The financial crisis confronts policymakers with a situation of uncertainty in a very profound sense. Such Knightian uncertainty means that past experience is not of great value when deciding on appropriate policy measures. In such an environment, policy has to strike a difficult balance between short-term and long-term needs. More specifically, in the case of monetary policy, there is, on the one side, a need for resolute action to counter the consequences of the crisis. On the other side, such actions should not undermine the long-term foundations of monetary policy, such as the central bank’s credibility. Striking that balance is not only key to monetary policy, but also to other policy areas, such as fiscal policy and policies that aim to stabilise the financial system. And the appropriate balance is not independent of the institutional background against which these policies operate.
This is all the more true of EMU, where the institutional setting is still comparatively young, the political balance between monetary policy and fiscal policy is more complex than in other mature economies, because it is characterised by the coexistence of a supranational monetary and autonomous national fiscal policies.
These considerations have to be kept in mind when talking about appropriate policy responses. The responses may differ among central banks even in the face of common BIS Review 59/2009 1
economic shocks because of the differing institutional frameworks within which monetary and fiscal policy operate.
Thus, I would like to go on to elaborate somewhat on the challenges for monetary policy, on the approach we have taken in the Eurosystem, and on lessons to be learnt for monetary policy in the longer term.
2.1 A brief account of the financial crisis
When looking at the underlying causes of the recent tensions in the global financial system, numerous culprits have been identified: securitisation, quality of risk management, credit rating agencies, compensation schemes, accounting standards and even expansionary monetary policy – to name but a few.
I am extremely sceptical about any monocausal explanation. Instead, I believe that a cocktail of various ingredients generated the shock waves that have rocked the global financial system.
A key factor was a combination of new and complex instruments for transferring credit risks, and the “originate and distribute” business model of credit institutions.
It has now become clear that the “originate and distribute” model can actually improve the resilience of the financial system if, and only if, a high-quality standard is maintained at all levels of the transfer process, and no new concentrations of risk arise. Since the outbreak of the financial crisis, however, we have learned about a series of distorted incentives, which manifested themselves in lax origination standards for products such as subprime mortgages and in some investors’ excessive reliance on credit ratings. In the end, securitisation, as Claudio Borio from the BIS aptly put it in 2008, has, ultimately, “distributed fear rather than risks”.
However, while financial innovation has undoubtedly magnified vulnerabilities in the global financial system, there is more to the present financial market turmoil than the proliferation of structured finance products. Arguably, the “originate and distribute” model would not have been possible without the benign macroeconomic and financial setting in the years preceding the current crisis: Booming global economic growth, low consumer price inflation, low-level long-term and short-term interest rates, and rising prices of real estate and other assets in many countries – not just in the USA.
The possibility of a mis-pricing of risks and the attendant dangers were perceived by some commentators even before the crisis began. Indeed, central banks, in particular, pointed to such a development. Once the vulnerabilities in the global financial system were revealed in August 2007 and intensified in autumn last year, we all witnessed financial imbalances starting to unwind. Especially after the collapse of Lehman Brothers in September 2008, the process of unwinding of financial imbalances escalated. Frictions spilled over from the core segment of structured products to other asset classes, spreads on credit and bond markets rose dramatically and interbank markets froze.
2.2 Banking stabilisation measures
As solvency risks in the banking system mounted, on both sides of the Atlantic governments in close cooperation with central banks set up rescue schemes that moved away from a case-by-case approach in dealing with troubled banks to broad-based schemes.
The rescue schemes focused primarily on improving the banks’ capital position when the ability to raise private capital became virtually non-existent. Moreover, stabilising banks’ access to medium-term funding through public guarantee schemes served as an additional tool.
2 BIS Review 59/2009
This sketchy characterisation also holds true for Germany. Measures taken in Germany so far by the Financial Market Stabilisation Fund (SoFFin) have focused on the liability side of banks’ balance sheets, because it has been recognised that the financial market problems and, not least, the recessionary economic environment ultimately have a dramatic impact on the banks’ capital position.
The capital-injection and guarantee programmes have contributed to a stabilisation, but have not been able to entirely eliminate uncertainty about banks’ soundness. Hence, the ongoing risk of balance sheet strains as a result of continuing write-downs on problematic assets led to a drying-up of private equity capital issuance and aggravated the issuance of debt (without a government guarantee).
This, together with the fear that these problems could lead to a significantly reduced bank loan supply is likely to be the main reason why governments have recently augmented their previous approaches with plans to provide relief to the asset side of banks’ balance sheets. In that regard, in Germany the establishment of a scheme to deal with problem assets is currently in the legislative making.
I do not want to elaborate in detail on the various proposals that have already been adopted or scheduled to be implemented on both sides of the Atlantic. Instead, I would rather discuss some basic requirements which – as I see it – should be fulfilled by such asset-side measures:
• Banks must be restructured in a way which makes them attractive for new capital. More specifically, new equity as well as new debt capital should not be burdened by risks from the time prior to the stabilisation measure.
• Government intervention should stabilise banks, not subsidise the former owners. Measures should provide guarantees for the continuity of the financial system in the form of insolvency protection for systemically relevant institutions. At the same time, investors who provided risk capital prior to the stabilisation measure are fully liable for any extant risks up to the amount of their capital. This is important not just from a fiscal standpoint, but also for creating an adequate incentive structure for the future.
• Given the uncertainty it currently entails, intervention through the stabilisation of asset positions should, as far as possible, avoid the need to value the assets. Or, to be more specific, approaches in which asset valuation plays a major role in the distribution of risks and losses should be complemented by elements which ensure that existing shareholders – not the banks – fully bear the consequences from possible re-valuations of these assets at a later stage.
2.3 Monetary policy measures taken
I would now like to return to the monetary policy responses of the Eurosystem.
Since the financial market turmoil began in August 2007, the Eurosystem has stabilised the European money market by generously providing liquidity above and beyond the benchmark allotment. This has enabled banks to fulfil their minimum reserve requirements early in the reserve period (frontloading). In the early stages, these measures were accompanied by the use of liquidity-absorbing fine-tuning operations at the end of the maintenance period. At the same time, the Governing Council also tried to stabilise the longer-term maturity segments of the money market by introducing refinancing operations with a maturity of up to six months owing to the continued weakness of interbank trading activities in these segments.
From mid-September 2008, however, as the crisis intensified, the yield spread between secured and unsecured quarterly liquidity in the interbank market peaked at more than 1.8 percentage points. Owing to the renewed sharp increase in banks’ mistrust, the overnight money market also suffered heavily. Further adjustments to liquidity policy were unavoidable under such circumstances. The transition to fixed-rate tenders with full allotment of all bids BIS Review 59/2009 3
decided upon in October 2008, together with a widening of the collateral framework in our refinancing operations, ensured that all banks received the liquidity they needed at the interest rate deemed appropriate from a monetary policy perspective.
The escalation of the financial market turmoil from mid-September onwards and the global shock to confidence led to a considerable change in the outlook for the real economy and price stability changed. Against this background, the Governing Council of the ECB has lowered its main policy rate decisively since October 2008 from 4.25% to 1%.
Moreover, given that very short-term rates are now at an appropriate level, the Governing Council decided at its meeting last week to implement further measures in order to fulfil its primary goal – that is, safeguarding medium-term price stability. These measures include the introduction of tender operations with a maturity of 12 months and outright purchases of covered bonds up to a maximum amount of €60 billion. The Governing Council will provide detailed information on the covered bond programme after its next meeting.
Such “non-standard” monetary policy measures extend the traditional monetary policy toolbox of the Eurosystem. They reflect the bank-based nature of the financial system in the euro area – which implies that monetary policy impulses are predominantly transmitted through the banking system – by aiming to improve funding conditions for banks.
All in all, the monetary policy actions and the rescue schemes for banks in stress have helped to stabilise the financial system at a time when systemic stability was at risk. Thus, they have put a floor under the tail risk of a self-enforcing uncontrolled downward-spiral from feedback effects between the financial and the real spheres.
However, monetary policy has created an enormous expansionary stimulus – not just in the euro area but also worldwide. While this stimulus is currently warranted, we have to keep in mind that it has to be reduced or even inverted very quickly as soon as the overall situation improves. The need for such a quick retraction of the expansionary stance stems from at least two factors. The first is that part of the monetary stimulus will remain in the pipeline for some time due to the usual lags of monetary transmission. The second is that there is a possibility of the recovery taking place in a more dynamic way than currently expected (if the factors that caused the non-linearity in the downswing work favourably in the upswing as well). Both factors could lead to inflationary risks making a rapid and powerful comeback, and we should all be aware of this.
All policy responses, especially the monetary policy actions, cannot – and should not – prevent the necessary adjustment processes in the financial system. Above all, the excessive leverage in the financial system needs to be corrected. Short-term policy measures should do no more than try to manage this deleveraging-process in an orderly way, that is, it should prevent unnecessary collateral damage to the rest of the economy.
Moreover, monetary and fiscal policies are unable to provide shelter for the domestic economy against the global symmetric confidence shock that hit the global economy after the collapse of Lehman Brothers. They can only attempt to dampen some of the second-round effects on the domestic economy by trying to stabilise domestic demand.
Public finances in Germany indeed are contributing noticeably to macroeconomic stabilisation. The German government has implemented discretionary measures in a magnitude of over 2% of GDP for the years 2009 and 2010. Most of the effects of these measures have still come into effect. With regard to fiscal stabilisation it is also necessary to keep in mind that its effects should not only be evaluated by discretionary measures alone. Built-in adjustments in public budgets – so-called automatic stabilisers – provide stimulus through a rule-based fiscal framework. These automatic stabilisers are more important in countries with larger social security systems and progressive tax systems. For example, in Germany the contribution of automatic stabilisers in 2009 and 2010 will be nearly 3% of GDP (including developments in profit-related taxes).
4 BIS Review 59/2009
Thus, for a thorough assessment of public finances in its stabilisation role the swing in the overall public deficits is the most adequate measure. According to the latest forecast by the European Commission – which is plausible in our view – the overall public deficit will deteriorate by 6% of GDP over 2009 and 2010. This is somewhat less than in the UK, but it makes clear that – contrary to some popular misperceptions – Germany’s fiscal policy is markedly contributing to stabilising the economy.
There is not only a structural adjustment need in the international financial system. In addition to a marked cyclical shock, some real imbalances in the global division of labour are being corrected through the current global downturn. Stabilisation policies should not try to prevent these processes; returning to a status quo ante is not a sensible option.
Given the recent encouraging signs from financial markets and a number of leading economic indicators, I believe there are some grounds for being optimistic that the pace of decline in economic activity will decelerate markedly in the months ahead. However, it is certainly not advisable to be overly optimistic that the recovery process is safely on track. This will most likely be a gradual process with growth rates – notwithstanding some volatility in quarterly figures – lying below potential for a considerable period of time. This means that economic slack measured by very low rates of capacity utilisation will not diminish rapidly.
And we should take into account that, even if in many countries – including Germany – the worst may be over in terms of negative growth rates, the labour market situation will visibly deteriorate in the quarters ahead.
The German economy has been hit hard by the global downturn. Germany as an open and export-oriented economy has its comparative advantage in investment goods. And it has specialised by increasing its degree of openness markedly over the past decade. By doing so, the German economy has benefited from the dynamic global environment of the past few years. Currently, the sharp contraction in the German manufacturing sector makes clear that this kind of specialisation also means a more cyclical overall economy, at least in the face of rare massive common global shocks. An open economy like Germany’s cannot insure itself against truly global shocks regardless of how diversified its export portfolio is in regional or product terms.
With regard to measures stabilising the global economy, one aspect that is too often overlooked is the fact that due to the sharp contraction in net exports since summer 2008 the German economy is de facto stabilising the global economy. A decline in net exports means that less income from global trade flows is absorbed by Germany. Then, by definition, in some other countries net exports must rise, de facto stabilising production in those economies.
2.4 Longer-term lessons for monetary policy
Let me turn finally to what are more longer-term lessons for monetary policy to be drawn from the current crisis. In doing so, I shall take a step back from the sort of crisis management I have just described to the more general issue of conducting monetary policy in the face of procyclical behaviour by financial market participants.
As I have already mentioned, in the first half of this decade, monetary policy was expansionary in most industrial countries. This is indicated by interest-rate based measures of the monetary policy stance as well as by indicators based on money and credit aggregates. At the same time, risk premiums on financial markets have been too low compared with traditional economic models based on macroeconomic factors.
There is an ongoing debate on whether low interest rates may have increased financial market participants’ risk appetite and played a part the dynamic growth of credit aggregates worldwide via a so-called risk-taking channel of monetary policy. Given this debate, the events of the past few months pose some fundamental questions about the role of monetary policy in the financial cycle.
BIS Review 59/2009 5
At this point, I think that some commentators take too narrow a perspective by concentrating solely on the role played by monetary policy during the crisis.
In my view, monetary policymakers should not view boom and bust episodes on the financial markets as unrelated events. Monetary policymakers’ responses to upturns as well as to downturns on the asset markets influence the risk perception of the market participants. Therefore, an (expansionary) monetary policy response which is stronger in the downswing than the (restrictive) response in the upswing creates adverse incentives for investors which could increase the amplitudes of the financial cycle.
A more symmetric approach by monetary policymakers would treat boom and bust episodes not as isolated events but would try to look through the financial cycle in order to steady policy. To be more specific, a more symmetric policy would also consider implicit risks in times when money and credit growth is dynamic, asset prices go up and risk perceptions decline, possibly weighing the need to act despite low current consumer price inflation rates.
This, however, does not mean that monetary policy should downgrade the price stability objective for the sake of other objectives. Indeed, financial crises heighten the volatility of macroeconomic variables such as inflation and growth. Rather, it means that central banks should take a longer-term perspective which takes into account the future inflationary consequences of such unfavourable developments. Given the macroeconomic relevance of financial crises, we have good reason to enlarge our monetary policy time horizon and give low-frequency movements in credit and monetary aggregates more weight in our analytical frameworks and our monetary policy decision-making processes.
That is not to say that such an approach would eliminate financial cycles altogether. However, in the medium to long term, a monetary policy that followed a more symmetric course would do more to dampen damaging financial cycles than a monetary policy that merely tries to limit damage after the event using aggressive interest rate measures.
Here, the Eurosystem’s monetary policy strategy already possesses such a stabilising element in the shape of its monetary analysis. This is especially suited to the analysis of long-term developments.
The recent financial turmoil has shown that the often-criticised monetary and credit analysis has a valuable role to play in monetary policy analysis.
3 Conclusion
The financial crisis means the greatest challenge for monetary policy in decades. Policy responses have to take into account the specific institutional environment under which it operates. Thus, policy responses might somewhat differ among countries even when the underlying shocks are similar.
The Eurosystem has responded in a decisive way to the emerging financial tensions. These measures have reflected the specific circumstances of the euro area – and will continue to do so.
In the euro area fiscal policy is also contributing to dampen the economic downswing. This is also true for Germany, where automatic stabilisers and discretionary measures cause a massive swing in deficit figures in this year and next year. The fiscal policy in Germany contributes visibly to the stabilisation of the macroeconomy. Automatic stabilisers play an important role in that regard.
In a longer-term perspective one lessons from the current crisis and its causes is that monetary policy should treat financial cycles in a more symmetric way. This means taking account of the financial cycle in the upswing as well as in the downturn. In an operational sense it means enhancing the time horizon for monetary policy and paying paying close attention to money and credit aggregates.
6 BIS Review 59/2009

Cumins is not the only realtor who is starting to see some fleeting light at the end of a long and torturous tunnel.

TO BE NOTED: From Reuters:

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Investors pause after surge
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By Ed Stoddard

CLEBURNE, Texas (Reuters) - Small-town Texan realtor Rick Cumins is going to see a paycheck in April -- his first since December.

"I've got two pending closings in April, one for a property worth $55,000, the other for $68,000. They'll pay the rent," he told Reuters in his modest office in the town of Cleburne, about 20 miles south of Fort Worth.

Cumins is not the only realtor who is starting to see some fleeting light at the end of a long and torturous tunnel.

Sales of previously owned U.S. homes rose at their fastest pace in nearly six years in February, data showed on Monday, providing some good news for the recession-hit economy.

They rose 5.1 percent in February to a 4.72 million-unit annual rate, notching their largest gain since July 2003, the National Association of Realtors said. But about 45 percent of the sales were foreclosure or short-sale transactions.

"Yes, it is great news for everyone, but we've still got a lot of homes on the market and not a lot of qualified buyers," said Cumins, 54, whose own small real estate business is on the rocks just a year after he started it.

The North Texas real estate market has not been as badly affected as many parts of the country, thanks in part to a relatively sturdy economy and also to the fact that housing prices did not soar here as high as they did in some other regions.

But small time realtors like Cumins are still feeling the pain here in a sign of the overall gravity of the situation.

A crisis in the housing market sparked by a surge in delinquent "sub prime" mortgages was a key factor behind the U.S. slide into recession.

Now some realtors see the glimmer of a turnaround.

BUYERS EVERYWHERE

"It's like it's been raining buyers, when they've been the scarcest thing in town," said Joan Dodd, a realtor who has worked 30 years in the Phoenix Valley -- one of the areas most blighted by foreclosures as boom turned to bust.

"The buyers are just seeming to come out of nowhere ... We've had a long dry spell, but it seems to be over."

Dodd said she thought interest rates were "fabulously low," which had helped entice buyers back into the market. She further cited an $8,000 tax allowance for first-time home buyers -- a view echoed by others.

Janie Hudson, a Kansas City realtor who has also been in the business for 30 years, said she saw positive trends.

"It isn't great but I don't see any doom and gloom. If they are priced well they are starting to sell," she said.

Just this month, a three-bedroom ranch house, priced at $330,000, sold in its first week on the market at its asking price -- something she had not seen for some time.

Atlanta realtor Renee Kunkler said there were signs that things were starting to pick up and she expected the market to bounce back somewhat by the end of this year.

In recent weeks, Kunkler has seen increased numbers of buyers attracted by low rates and also a perception that there were good deals to be had.

She cited one example in which a buyer this week wanted to offer $600,000 on a house that had originally been priced at $799,000 before being reduced to $699,000.

"All buyers are just obsessed about getting the deal. Nobody cares about loving a house. They care about getting a deal, a foreclosure," she said.

Prices have fallen less heavily in Atlanta's prosperous northern suburbs inside the perimeter freeway than elsewhere in the city in part because of proximity to the city center.

Back in Cleburne, times remain tough for Cumins.

When he started his business a year ago, he owed $19,000 on his own home. "Now I owe $148,000," he said.

As a result of his business woes he has to sell some of his beloved guns from his collection of about three dozen.

"I didn't expect it to get this bad," he said as he sat beneath the stuffed heads of trophy bucks in his office.

(Additional reporting by Carey Gillam in Kansas City, Tim Gaynor in Phoenix and Matthew Bigg in Atlanta; editing by Mohammad Zargham)"

"a tax break for homeowners, enacted in 1997, may have contributed to the housing bubble"

An interesting post from Start Making Sense about the power of incentives:

"Perverse satisfaction?

Today's New York Times notes that a tax break for homeowners, enacted in 1997, may have contributed to the housing bubble that (coupled with pathological defects in our financial markets) did so much to bring us to our grim current economic situation.

Specifically, Congress in 1997, acting at the behest of President Clinton, provided that up to $500,000 of home appreciation would be tax-free on sale. Clinton was practicing silly but no doubt poll-tested populism, boasting that, due to the rule, middle class Americans would never again face capital gains tax on their homes. ( WHY SHOULD IT BE TAXED? )

Now let's roll the tape forward 11 years. According to the Times:

"[M]any economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law. ( WHY DO WE WANT A DISINCENTIVE TO SELL? )

"Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for 'fueling the mother of all housing bubbles.' ( HOW SO? )

"By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one. ( HOMES ARE AN INVESTMENT. THAT'S WHY I BOUGHT MINE, PRIOR TO THIS CHANGE IN THE TAX CODE )

"Together with the other housing subsidies that had already been in the tax code — the mortgage-interest deduction chief among them — the law gave people a motive to buy more and more real estate. Lax lending standards ( THIS IS THE CAUSE. THE OTHERS ARE SILLY ) and low interest rates then gave people the means to do so ( IF THEY COULD HAVE AFFORDED THE HOUSES, WHO WOULD CARE? ).

"Referring to the special treatment for capital gains on homes, Charles O. Rossotti, the Internal Revenue Service commissioner from 1997 to 2002, said: 'Why insist in effect that they put it in housing to get that benefit? Why not let them invest in other things that might be more productive, like stocks and bonds?'” ( WHY SHOULD ANY INVESTMENT BE TAXED? HELLO! )

I happen to know a couple of people who got into the business of buying fixer-uppers, doing renovation work, and then selling for tax-free capital gain, thus achieving exemption for their labor income. There, at least, there was productive activity - but still distortion of economic choice by the tax incentive. ( THE TAX INCENTIVE WASN'T AN INCENTIVE. THE TAX WAS A DISINCENTIVE THAT WAS TERMINATED )

One further idiotic incentive effect was that, as soon as your home begins to approach $500,000 of appreciation, you have an incentive to sell it immediately and buy a new home for the current market price, so that you can run the exemption from zero all over again. Happily (?), however, that is no longer a problem in today's market.

Whenever something like this comes out about special tax breaks that don't merely create perverse incentives ( WHAT'S PERVERSE ABOUT IT? ) but seriously aggravate major economic problems, I have to admit to feeling a twinge of, well, perverse satisfaction that the rules I spend some of my time studying are at least important. Plus I duly note that the problems come from failure to heed the recommendations (e.g., for a relatively broad-based and neutral tax ( WHAT DOES NEUTRAL MEAN?) ) that nearly 100 percent of the experts in my field would make. An unworthy sentiment, to be sure, but I'm only human.

Another big example is the role of the tax system in overly entrenching employer-provided health insurance as the dominant mode of provision ( THAT IS BAD ), to the degree that, while few would advocate building on employer-provided insurance if we were starting fresh, many believe that at this point we need to just accept it as an entrenched feature. Thus, for example, one of the big criticisms of Senator McCain's healthcare plan was that it would have undermined employer-provided insurance without sufficiently putting something else in its place.

The home exemption story is admittedly a bit more complicated than just being a case of stupid Clinton-era populism. Prior to the 1997 enactment, people could generally roll over gain when they sold one home and bought a new one (for at least as much money) within a two-year period. Plus, gains on home sale were otherwise taxable ( WHY? ) while losses were nondeductible ( WHY? ), creating apparent (and some actual) tax bias. The underlying problem is that a "correct" approach would have treated gains and losses symmetrically (leaving aside the issue of taxpayer choice whether or not to sell) when they resulted from market swings, while disallowing recovery only for declines in home value that resulted from home use. Richard Epstein, before he became a libertarian icon, actually wrote an article on this, suggesting that the basis of homes be reduced by depreciation (which would not, however, be deductible since it reflected personal rather than business use), with gain or loss relative to the adjusted basis being equally recognized. That is actually a pretty logical approach, within a standard income tax accounting framework, and the failure to do it, meaning that in some cases properly deductible investment losses were being disallowed, may have helped contribute to the 1997 silliness.

Still, the predominant message here remains: stupid tax breaks interact with other defects in our economic system to help create the current horrific circumstances we face. It's happened before, and it will happen again."

How did it do so? There is no connection between tax breaks and fraudulent or ill-advised loans. None. Why was the sale of the house taxed in the first place? It's a terrible idea that causes a disincentive to buying and selling. Why? The idea that it lead to the current crisis assumes a mechanical view of human behavior, which is clearly false. Under a Human Agency Explanation, it is the committing of fraud, negligence, fiduciary mismanagement, and collusion, along with idiotic loan terms that caused the crisis, not any incentives.

"Households and investors may be holding out for better terms, bigger bailouts and for investors to be made whole"

Thomas F. Cooley on Forbes considers mortgage relief efforts:

"According to the most recent data, as many as one in 10 mortgages in the U.S. are delinquent or in foreclosure. The continued decline in housing prices has been exacerbated by the decline in the economy. The housing sector is caught in a continued downward spiral.

Foreclosure is a slow and costly process and represents significant dead weight loss for the economy. Estimates are that the cost of foreclosure is 30% to 35% of the value of a house. Moreover, there are externalities that are associated with properties that do foreclose in that they contaminate the value of neighboring properties. This issue is also critical because reducing losses to default and foreclosure will help stabilize the financial system by reducing the actual losses--and the uncertainty about them--that are passed through the financial system to the holders of the mortgages and mortgage-backed securities. Default losses are concentrated in the "first loss" and mezzanine tranches of collateralized debt obligations, which has made them highly toxic to the financial institutions holding them."

I didn't know that about CDOs.

"Here is the question: Given the attention that has been devoted to the problem of troubled mortgages and the number of programs that have been put forward to address them, why so little impact? The simple answer is that the programs are badly designed.'

How so?

"Some examples: Hope for Homeowners is a Federal Housing Administration program designed to modify existing loans by writing down the principal, offering insurance against further default and introducing shared appreciation on the property. Fannie Mae and Freddie Mac laid out plans for restructuring mortgages that lower payments but extend the term on the loan or involve balloon payments. The Federal Deposit Insurance Corporation (FDIC) has proposed to restructure troubled mortgages by lowering payments, but with no write-down of principal and with a balloon payment due at the end. So far, the response to these programs has been minor. Why?

First, they start with lousy incentives. Both Hope for Homeowners and the FDIC programs are available to homeowners who are delinquent by several months in their payments. If you want to restructure your mortgage, what does this tell you? Stop making payments! Sensibly, most bank restructuring programs require borrowers to show good faith by keeping payments current before they will consider restructuring."

It's not smart. However, wouldn't this incentive theoretically lead to more people taking advantage of the offer?

"Another problem is that restructuring per se is not a great solution. For the most part, it simply kicks the can down the road. Lowering current payments but requiring either a balloon payment or an extended payback term postpones the problem without solving it. Moreover, since it does nothing to address the negative equity of the homeowner, it increases the probability of secondary default if prices or owners' incomes continue to fall. For all of these reasons, owners become essentially like renters, with all of the adverse incentives that may imply."

It's not a great solution, but we're not looking for great here.

"The existing approaches to loan modification do not balance the incentives of the borrowers and the lenders. Shared-appreciation mortgages (which are a component of the FHA plan) do this well. Shared-appreciation restructurings offer a debt for equity swap whereby, in return for modifying the loan, the borrower must give up some of the future appreciation in the value of the property. Designed properly, this would discourage borrowers from seeking modifications if they can continue to pay their mortgage."

This would seem to be a good plan.

"The biggest obstacle to loan modifications by far is securitization--the fact that an estimated 80% of the troubled loans have been sliced and diced and sold to many investors. This gets in the way of servicers who might otherwise be given incentives to modify loans in ways that are in the best interests of society. Existing commercial law allows loan servicers to make only changes that are in the holder's best interest--"not materially adverse to the Owner." The law also says that if a mortgage is in default or in the servicers' opinion close to it, then servicers have no authority to make changes in interest rates, or principal amount, or time of payments."

This is a problem, although people seem to disagree on how big it is. Servicers might have more leeway than many have assumed, and are simply using this problem as a bargaining chip.

"Could Congress pass a law that allowed servicers to modify loans by invoking a standard such as "a good faith effort to advance the collective interests of holders"? Possibly it could, but it may run into the problem that the constitution provides that "Congress shall make no law impairing the obligations of contract."

That's problematic.

"The most important role for public policy is to provide incentives for servicers to restructure and modify loans, to make certain that shared appreciation contracts are part of the policy mix, and to address the legal barriers to modifying securitized loans. It may well be that policy inaction and dithering is the largest barrier to progress to date. Households and investors may be holding out for better terms, bigger bailouts and for investors to be made whole. If so, it is simply because the leadership in Washington has been unable to focus on an unambiguous approach to the problem. In the meantime, neighborhoods collapse."

That's been the real problem. People are waiting for government largess. It's a terrible problem, because, politically, it doesn't look good if the government isn't seen as trying to help homeowners as well as financial concerns. Everybody in this process knows that. That's why there has been no solution. There's no good compromise available as yet. Somebody is going to have to blink.

"A better approach is to design legislation that better aligns the incentives of bankers with the public interest."

Here's an analysis that centers on incentives which, while they don't force people to do things, can be effective in making people adjust their actions and dispositions. From Jonathan B. Berk in the FT:

"In any financial crisis, it is possible with 20/20 hindsight to identify the specific proximal causes. Armed with this knowledge, legislators are invariably tempted to outlaw specific activities."

Attempting to focus in on specific problems is a mistake.

"After all, if these activities had been illegal before the crisis, surely the crisis would have been avoided. The flaw with this seemingly plausible logic is that it ignores the incentives that affect people’s behaviour. A better approach is to design legislation that better aligns the incentives of bankers with the public interest."

Okay. Let's see where he goes with this.

"Bankers are incentivised to make money. Inevitably, their actions expose the economy to the kind of breakdown we saw in October. With new regulations on their behaviour, future crises will no doubt look different, but they will not be eliminated."

I don't like inevitably, but more than likely is fine.

''The only way to avert crises is to treat banking in the same way we treat polluters: Create an environment that internalises the negative externalities that banking activity generates. That is, we should give bankers incentives so that they do not want to engage in the kind of risk-taking that exposes the whole economy to a meltdown.'

This makes it sound like bankers are invariably thieves or insane risk takers. Don't we have laws already on the books? Why don't we see if they apply first?

"To address this, we need to examine the effect of leverage. When investors invest borrowed resources, a problem known to financial economists as “asset substitution” is created: If the investment goes bad, the investor can declare bankruptcy and leave the debt holders bearing the costs.

Because of this downside protection, risk takers have an incentive to take on more risk than they would if there was no leverage. Most debt holders are well aware of these incentives, and ordinarily they monitor the behaviour of the risk takers with policies like margin requirements."

I thought that collateral had to do with how much money you needed to deal with losses that occurred in tough circumstances, not to protect against insane lending.

"By doing so, they avoid exposing themselves to unduly large losses and lessen the likelihood of a larger financial meltdown. But when the government implicitly insures debt holders by bailing them out in bad times, the incentive to monitor borrowers is reduced. The inevitable consequence will be much larger and more costly crises in the future."

Well, this I completely agree with. However, this assumes that the bankers believe that their risk is covered by the government, not that they can just walk away from responsibility. His approach makes it sound as if the bank's clients become lax in their observation of the bank's behavior. So, we agree on the cause, but not on who's acting on the implicit and explicit government guarantees.

"Government action might well be required to address this problem. But it would be a big mistake for legislators to focus on regulating leverage, the activity perceived to have caused the current crisis. Instead, they need to concentrate on undoing the perverse incentives to take on risk that results from the perceived willingness of the government to bail out large risk takers."

The incentives are the guarantees themselves.

"As matters stand right now, it is clear that once investment banks (or whatever these risk-taking entities will call themselves in the future) reach a certain size, they become too big to fail, and thus the entities that hold their liabilities know they can implicitly count on a government guarantee."

That's correct.

"Competitive debt markets will internalize the implications of this guarantee, and the result is that large investment banks will find that they can borrow at artificially low costs of capital, providing yet an additional incentive to take on more risk."

That's correct.

"Because smaller banks will not have this implicit guarantee, they will be at a competitive disadvantage in this highly competitive environment. The likely result is further consolidation of the industry and a compounding of the problem."

They are more likely to be allowed to fail, yes. That's what has happened this year.

"To avoid the mistakes of the past, legislators should begin by taking as given the incentives investment bankers and their lenders face. It is naïve to believe that it is possible to control these incentives by passing tough new laws regulating specific activity such as the amount of leverage."

I don't see why. Doesn't it work for insurance?

"Such regulation would soon become archaic as investment bankers invent new financial products that could achieve the same results without running afoul of the regulations. Instead, legislators should consider reorganising the industry to better align its incentives with the public interest."

It is true that they will try and innovate in order to leverage without running afoul of regulations. Yes.

"Although a full analysis of how this can be achieved will require time and data, there are two policies that I believe are worth considering."

What are they?

"The first, which I have alluded to already, is curbing the size of investment banks. By keeping them small, failures can be allowed in times of crisis without endangering the entire economy. Consequently, government can credibly commit to not bail out these institutions. Debt holders will then have incentive to aggressively monitor these institutions, greatly reducing the likelihood of future financial crises."

This is a very good idea. It would deal with moral hazard by allowing the closure of insolvent banks quickly and effectively.

"A second approach would be to align incentives by reconsidering the corporate structure of investment banking. Less than 10 years ago Goldman Sachs was a partnership. If Goldman was still a partnership today, its partners would be personally liable for all of Goldman’s losses. That is, it would not just be their current bonuses that would be on the line, but their entire personal wealth.

Faced with the potential of personal financial devastation, it is extremely unlikely that the partners would have allowed the firm to get into its current financial straits. By reorganising investment banks into partnerships, the likelihood of another financial meltdown would be reduced far more than, for example, through restrictive regulation on their borrowing and lending activities.

One might argue that reorganising investment banks as partnerships would reduce their incentives to take on risk and thereby hobble their ability to grease the wheels of capitalism.

But it is worth pointing out that for 130 years Goldman Sachs operated as a highly successful and very profitable partnership. If those enormous profits are indicative of the value created in those years, one would be hard pressed to argue that the partnership structure handicapped Goldman’s ability to take on risk or otherwise serve as a valuable middleman."

This seems like overkill, but I do like the point about personal responsibility, so maybe I'll come around to it.

"I believe it is naïve to believe that we can protect ourselves from future crises by simply passing tougher regulations. The political will to make structural changes will likely evaporate once the crisis passes. So although the window of opportunity to make structural changes is short, it would be a mistake to rush to legislative action. Congress should carefully consider how to align the incentives of risk takers before taking legislative action."

I agree that there are problems that cannot be addresses by specific regulations, but I believe that the solution is to divide the financial industry into government guaranteed and not government guaranteed, and then set up an oversight organization that takes a look at financial products by throwing a very wide net, especially for investments that:
1) Transfer risk
2) Magnify risk

Although I believe that individuals are responsible for this crisis, both in terms of responding to the implicit and explicit government guarantees, and committing fraud, negligence, fiduciary mismanagement, and collusion, we don't need to assume that financial people are an especially unethical and greedy group of humans. Rather, we need to focus on the types of incentives and disincentives that motivate and deter most humans.

Smaller banks is a great idea, and personal responsibility is as well, but it might not take the measure of mandating partnerships. Having been in one, I wouldn't be that interested in being in one ever again, even though I can assure you that I'm not going to risk my own money crazily, let alone the money of someone else. But this post was an interesting contribution.

"If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes."

Brendan Brown in the FT confronts this buying of basically interest free bonds:

"A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum."

So, you want interest rates to decline so that businesses, say, can borrow more cheaply, and hire workers, etc., in order to increase buying, and come out of a recession. But what happens when no one is buying and yet interest rates are as low as they can get.

Well, are there any incentives or disincentives to combat this problem, largely associated with the fear of risk and flight into safe investments, such as US Treasuries, that are guaranteed by the government? Now, it's important to understand that this is also an incentive.

One thing you can use are disincentives. Here's one:

"These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels."

So, this a purchase fee added onto the bond. How about taxes?

"In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

These cues lead to the solution."

Basically, change their price after being purchased.

"The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new).

In the interim, 1:1 conversion of banknotes into deposits would be suspended. Instead, a crawling peg would be established. At the start, the exchange rate between deposits and banknotes would be virtually 1:1. At the end it would be 0.9 banknotes/deposit.

As the discount grew, retailers would quote different prices for cash or cheque/card settlement. And as to the note switch-over costs, the “experiment” of Europe’s economic and monetary union demonstrates the feasibility.

The looming conversion would provide an essential degree of freedom for monetary policy. In terms of our illustrative arithmetic, the risk-free interest rate could fall to a negative 3.33 per cent a year without triggering cash withdrawals from the banking system."

As time goes on, the bond becomes worth less, making it a less desirable product.

"Is the exercise worth it?

The main reason for believing it is stems from an appreciation of how the bursting of a global credit bubble influences the equilibrium level of risk-free interest rates relative to risky rates of return and in absolute terms.

Most of us would agree that the bursting process ushers in a period during which soberly-measured risk premiums increase sharply.

This means that the risk-free rate must plunge to be consistent with an average overall cost of capital which reflects the new glut of savings.

So, in terms of our illustrative arithmetic, it is plausible that the neutral risk-free nominal rate of interest in the US and Europe, especially taking account of a likely near-term drop of the price level, is significantly negative.

The central bank and government, by devising a system in which such negativity can express itself, can give a big fillip to the recovery process.

The most direct channel for this fillip most likely passes through the equity market.

Pervasive negative risk-free rates across the advanced economies would underpin equity market levels.

Investors faced with certain substantial nominal loss on risk-free holdings would bid up the price of equity which could offer rich risk premiums even at a presently feebly level of prospective earnings.

And it is equity market developments which hold the key to the economic recovery."

As these looming losses approach, investors will shift from the bonds to stocks, spurring investment and new business and job growth, and I suppose there will be a kind of wealth effect as well.

"As consumers across the globe retrench, the forces of equilibrium should (if not thwarted by zero rate traps) bring about a redistribution of economic output, away from the production of consumer goods and towards capital goods (including technological know-how).

A higher rate of business investment matched by lower consumption now will have a counterpart in higher-than-otherwise consumption in the far-off future.

A resilient equity market with its counterpart in a low cost of equity capital is the key motor behind that transformation.

Firms across much of the global economy would respond to the combination of squeezed profit margins, low equity capital costs and continuing technological progress by “capital deepening” (increasing the ratio of capital to labour).

That would mean a challenging increase in frictional unemployment and pressure for increased social insurance of the losers.

Losses and losers are an inevitable consequence of the big credit bubble which is bursting. In the equity markets these losses reflect swathes of now obsolescent capital stock in the wrong place at the wrong time.

The key to rapid progress towards re-building wealth is to nurture the golden egg of the equity market, in which the coming capital spending upturn will be financed and to minimize monetary disequilibrium in the meantime.

The scheme proposed here for sharply negative interest rates promises much on both objectives."

So, basically, if investors do shift from bonds to stocks ( Or buy corporate bonds, I suppose )

1) Businesses will borrow ( Spending on capital goods, building things )

2) Creating jobs

3) People will spend more

4) The economy will grow

What's with the Golden Egg? It's been used now by McTeer, Becker, and Brown.

Will this work? I have to admit to liking it, because it involves using incentives to refocus the look of risk to the investor. And I believe that combating fear and aversion to risk is the main problem facing us.

"Now there's a clear conflict of interest: Companies paying agencies want a high rating, agencies have an incentive to give high ratings"

David Zetland on Angry Bear offers up a plan to clean up the ratings agency mess:

"I read yet another story on how the credit rating agencies (Standard and Poors, Moodys, Fitch, et al.) failed at their task of rating credit instruments (bonds, derivatives, etc.) to reflect the risk of those instruments.

The credit rating business works like this: Companies that want to issue instruments pay the agencies to rate them (AAA, BBb, etc.) for risk. The companies then sell instruments on the market to buyers who look at the rating when deciding how much to pay. The higher the rating, the higher the price that the companies will get, and the less risk the buyers think they are taking on.

Now there's a clear conflict of interest: Companies paying agencies want a high rating, agencies have an incentive to give high ratings (in exchange for bigger fees, more future business, etc.), but buyers depend on agency ratings.

Unfortunately, buyers cannot pay the agencies. They cannot pay in advance (they are not sure they will buy until AFTER ratings are done), and -- even if they did -- they would suffer from free-riding (if some buyers pay for the rating, other buyers can use that information without paying).

So, how do we fix the system (improving accuracy) while maintaining the current payment relationships? Change incentives in this way:

1. Set a standard fee for rating that depends on the type of instrument, the size of the issue, etc. Such standardization would remove one obvious problem (negotiated fees) while giving agencies an incentive to turn down business that's too complicated to understand.
2. Track the performance of all instruments rated by an agency in a given credit category (e.g., AA-) against all others in that category. Those that underperformed (price fell below the average) are probably riskier than the initial rating indicated, i.e., the agency was overoptimistic. Performance ratings should be weighted by the age of the instrument/rating, the size of the issue, etc.
3. Adjust each agency's fees to equal some fraction of the standard fee based on that agency's performance relative to other agencies, e.g., 80% if ratings are too high (missing hidden risk) or 110% if the ratings are too low (seeing non-existing risk).

Under this system, buyers could observe how accurate agencies are, and companies would have an explicit notion that they are paying for a rating of an agency that's often too optimistic/pessimistic, etc.

Note that this system depends on competition, so it's important to avoid cartels, oligopoly, etc. Even if standard prices are "set" (good place for a regulator), the competition will take place ex-post, when markets "reveal" the quality of the agencies' work.

Also note that #2 alone could do quite a lot to improve matters, but it's nice to link income to performance (#1 and #3).

Bottom Line: We need credit ratings, but we need to punish rating agencies that do a bad job, and the market is the best place for punishment."

I like the attempt. Here's my comment:

"There are two kinds of ratings being used interchangeably here(I'm fudging a bit):
1) Assessing an agreed upon and measurable product from a disinterested viewpoint, e.g., an engine
2) Assessing with more of a value judgment implied, e.g., a movie
If you read this quote from an interview of Eliot Janeway in the IRA, you'll see a transition:

http://us1.institutionalriskanal...pub/IRAMain.asp

""The IRA: The rating agency monopoly up to this crisis could certainly be viewed as a form of legalized extortion. There was no choice for a global issuer but to go to Moody's or S&P.

Janeway: Yes, but even so the job of the rating agencies until as little as a decade ago was to evaluate cash flows. Then came the CDO.

The IRA: Yes but Moody's and S&P were not explicitly paid to notch CDOs each month. They were paid in the primary market effectively acting as an adviser - and sharing in commissions. But there was no "issuer pay" model explicit in the CDO budget for following these deals in the secondary market."
Now, I'm taking liberties to make a point, which is that with this kind of possible conflict of interest, only Type 1 rating can work.
In other words, what credit agencies can rate safely are agreed upon standards, in which all that they are doing is presenting the analysis from outside of the company being rated. Investments like CDO's were more like Type 2, and simply weren't advisable at all to be rated by these agencies.
So, for me, although I would force the agencies to at least compete in pricing, their only use so constituted is to look over boilerplate figures and rate them. Of course, they are not responsible for the figures. The companies are.
The alternative is for investors to set up ratings agencies, which, if confined to basic analysis, I'm not so sure couldn't break through the entry problems. But how the hell do I know.
Don the libertarian Democrat | Homepage | 11.20.08 - 9:29 pm | #"

Here's his reply:

@Don: Good point, but "my" system would reduce the upward, subjective bias (your #2) because agencies would LOSE money when they were over-optimistic.
David Zetland | Homepage | 11.20.08 - 10:55 pm | #

I see his point, if this can be measured. But we still have to contend with Robert Waldmann's point about essentially ratings fixing.

"Don

In my "model" they are all equally good (or bad) because they choose to be so -- they follow each other as "about as good as the other two" is plenty good enough.

I think that, if investors are rational, the entry cost of becoming a credit rater should be huge. My complaint about them is that they gave AAA to assets which had not stood the test of time. Obviously, I would pay no attention to a credit ratings agency which did not have a decades long record. I don't think I'm the only one. I'd guess that a new agency would have to work for years or decades before anyone cared what they said and only then could begin to have positive revenues let alone profits.

The fees are, apparently, not really fees, because the agencies rate bonds even if they are not paid. That is claimed in the article I linked to as
this in "damn 'this'" upthread. It appears that 98% of firms pay for their bonds to be rated even though the credit rating agencies rate the bonds of the remaining 2%. The fees are, in any case, a tiny part of the cost of capital. I'm going to post this now then get the reference.
Robert Waldmann | Homepage | 11.18.08 - 12:03 am | #"

"nervous investors sought sanctuary from the turbulence in equities and other asset classes."

Here's more evidence of the Flight From Risk going on in the FT:

"The spectre of looming deflation drove government bond yields on both sides of the Atlantic to historic lows on Thursday as nervous investors sought sanctuary from the turbulence in equities and other asset classes.

Some US Treasury bills were quoted at 0 per cent, while the two-year note and the 30-year bond recorded their lowest yields since they were first regularly issued in the 1970s. The five-year note was at its lowest since 1954, based on historical data from the Federal Reserve. In the UK, the two-year gilt yield dropped to its lowest level since since the second world war."

So, people are buying bonds with no interest in order to buy a government guarantee that their money is safe. Does this even make sense?

"Buying government bonds as a safe haven investment has dominated flows in recent months. The latest moves come as increasingly worrying economic data point to rising unemployment and plunging inflation.

“Given the recent deflationary data, not just in the US but globally, the world is starting to build in a Japan-style deflationary scenario,” said Jim Caron, head of interest rate strategy at Morgan Stanley."

It can make sense in a time of Deflation, since your money is essentially appreciating in value because you can now buy more with it at cheaper prices. Is Deflation even realistic given the Fed?

"Recently, the Federal Reserve’s effective Fed funds rate has traded at around the 0.25 percentage point level, well below the target rate of 1 per cent. Meanwhile, Treasury inflation securities have moved to price in deflation for the next nine years.

Bill O’Donnell, strategist at UBS, said the bond market was reacting to the very low effective Fed funds rate and the possible start of a deflationary period. “The mood is ‘give me Treasuries at the expense of all other asset classes’ as spreads blow out and stocks slump,” said Mr O’Donnell.

Tom di Galoma, head of Treasury trading at Jefferies & Co said: “There is no place to hide but in US Treasuries. You cannot hide in corporate or mortgage bonds.”

So, investors are buying US Treasuries because they're the safest bet, and are willing to get almost nothing for that. It's hurting investment because investors are avoiding corporate and mortgage bonds, read loans. TIPS see deflation for 9 nine years. Is this even realistic?

"Deflation fears drove the 30-year swap rate to more than 50bp below that of the 30-year bond yield. Some investors are using swaps rather than buying bonds to keep their cash reserves intact as they seek greater exposure to long-term rates.

“If you already have a portfolio, using swaps allows you to increase duration without liquidating cash bonds,” said Jay Mueller, portfolio manager at Wells Capital Management."

So there's a rush into Swaps to maintain liquidity to be able to purchase long term rates, read more interest.

"The demand for long-term debt pushed the 30-year bond yield to a new record low of 3.71 per cent on Thursday; the two-year note traded as low as 0.96 per cent."

That shift to government backed long term bonds have driven their interest rate down. Supply and Demand. There's a large supply of fear, and a demand for less risk. But is this rational?

“This is about the collapse of inflation from official numbers this week and the very real spectre of disinflation in the UK,” said Moyeen Islam, fixed income strategist at Barclays Capital. “We expect yields will go lower as inflation is likely to be negative between May and October next year.”

The yields on the two-year German Schatz fell to levels not seen since September 2005. Yield spreads between Germany, the most liquid and deepest bond market in Europe, and other eurozone countries, also widened as it continued to outperform."

Since I don't fear deflation, as opposed to a drop in prices for a short period of time, and always fear inflation, I consider this behavior to basically panic behavior, based on the more unlikely scenarios going forward. Time will tell if I'm being foolish. But, given my beliefs, you can see why I believe that the Fear and Aversion to Risk at the expense of ignoring fundamentals and the most likely outcomes is our main problem now, and we need to attack these fears with incentives and moves to encourage risk.

"to draw up a “world risk map” of global financial institutions to allow financial authorities to quickly identify future trouble spots."

Actually, here's an idea I like, because it focuses on problem areas before they occur. It has the funnel approach I favor of looking for possible problems and then analyzing, instead of trying to micromanage with rules and regulations. From the FT:

"German chancellor Angela Merkel is set to push international leaders to draw up a “world risk map” of global financial institutions to allow financial authorities to quickly identify future trouble spots.

Unveiling the findings of a government-commissioned expert panel on Friday Mrs Merkel also proposed the creation a central body to oversee credit ratings agencies, an international register of major loans and the better alignment of managers’ pay to discourage short-term risk taking.

The chancellor and finance minister Peer Steinbrück are expected to lobby at the G20 world financial summit in Washington this weekend for all financial institutions, markets and jurisdictions to be made subject to proportionate regulatory control in order to eliminate “blind spots” in the financial system.

This supervision is intended to shed more light on the opaque workings of hedge funds and insurance companies, which the government believes have contributed to the severity of the current crisis.

The idea has found support in Europe, the US is thought to be hostile to what it views as a heavy-handed approach.

Ms Merkel said on Friday she was "somewhat surprised" about warnings against too much regulation before the crisis had been overcome."

I don't see the idea of supervision, or fact finding, as heavy-handed, as compared to actual rules. I'll try and find out more about this proposal and how it fares.

"The chancellor will go to Washington armed with a set of policy ideas prepared in the past two weeks by a six-strong panel led by Otmar Issing, a former European Central Bank chief economist.

Prof Issing said the panel had considered ways to reform the world's financial architecture in order to prevent a repeat of the current crisis which had left the financial system "on the edge of ruin".

Among the panel's suggestions isa global risk map which would highlight at a single glance areas where pressure is building up in the financial system.

The map would show all major international institutions and financial products, including credit insurance and asset-backed securities.

Similarly, the group has suggested setting up a cross-border credit register of major loans to provide greater transparency to businesses and governments seeking to evaluate risk.

Credit agencies, which have been criticised for dishing out spurious ratings in the pursuit of profit and failing to spot the build-up of risk, should be subject to a central supervisory body that would report annually on their work the report said.

Furthermore the fee structure of credit agencies must be reformed to incentivise the issue of a correct rating, for example by making agencies buy into the tranches of debt that they rate.

The group also proposed realligning management compensation schemes to motivate long-term performance.

A new compensation model could incorporate both bonus and malus components, similar to the system used in the car insurance industry,an idea favoured by Mr Steinbrück."

I still like it, especially the talk about credit ratings agencies, which Robert Waldmann on Angry Bear claims is basically a cartel.

"John Maynard Keynes called it the Paradox of Thrift, but most economists I know don't talk about it much for fear of being labeled a Keynesian."

I can think of worse things to be called. In fact, I've been called them. Repeatedly. Bob McTeer on The Paradox Of Thrift:

"The economy is facing quite a dilemma-or paradox. Actually, John Maynard Keynes called it the Paradox of Thrift, but most economists I know don't talk about it much for fear of being labeled a Keynesian. The paradox is this: most of us need to save more, i.e., consume less of our disposable income. Yet, if all or most of us try to save more at the same time, income will fall. The paradox comes in because out of the lower income we will likely end up saving less, not more.

The problem for the economy is this: consumption makes up about 70 percent of total spending, and consumption has been supporting the economy for years even though the personal saving rate is close to zero. The reason is that individual consumers who have experienced capital gains in their homes and in their stock or mutual fund portfolios (including those in their pension funds, 401Ks, IRAs, and the like) have thought of those capital gains as saving and thus have been willing to consume virtually all of their current income. (This is legit for individuals, but not for the nation as a whole since resources aren't being made available by capital gains.)"

Now, I see this as a problem of incentives for individuals, not a paradox. The incentives must be re-balanced to motivate individuals to spend and invest.

Here's my response:

Don the libertarian Democrat Says:

1. November 12th, 2008 at 9:29 pm

   “Second, and perhaps more important, “savings” represent loanable funds; an increase in the supply of loanable funds tends to lower interest rates and stimulate borrowing, so a decline in consumable goods with a short time horizon is offset by an increase in production in sectors with longer time horizons. For example, the demand for personal electronics might decline, but the demand for such things as real estate would be stimulated by favorable borrowing conditions.”

   I was going to write this, but Wikipedia says it better than I would have. During a recession, one can pass laws to increase long term investment and infrastructure spending, using tax breaks or government investment.

   As well, use loans and spending to help people start businesses. I actually started a business during a recession as I recall. I got a great deal on my rent at the time.

   By giving benefits to people who aren’t able to spend, with targeted tax cuts and investment, saving can be a good thing at all times. Of course, as a follower of Maimonides, moderation in most things is the wise course.

   The Paradox of Thrift seems more a problem of group versus individual behavior, which can be overcome with countervailing incentives for individuals.

``They are only encouraging institutions to take more uncalculated risks.''

Via Yves Smith, this from Bloomberg:

"Nobel Winner Aumann Says Bernanke, Paulson Steps `Not Smart'

By Tal Barak and Alisa Odenheimer

"Nov. 2 (Bloomberg) -- Robert J. Aumann, the Israeli economist who won the 2005 Nobel Prize in economics, said the steps taken by Federal Reserve Chairman Ben S. Bernanke and U.S. Treasury Secretary Henry Paulson to save financial markets ``weren't smart.''

``The intervention by the regulators to save the U.S. economy will lead to further bankruptcies of banks and insurance companies,'' Aumann said at a rabbinical conference in Jerusalem yesterday. ``They are only encouraging institutions to take more uncalculated risks.''

The crisis in the financial markets was caused by the incentives provided to managers of banks and other financial institutions that caused them to act to their own benefit and not the banks', he said. Bonuses were given on the basis of loan sales, without considering who the borrowers were, he said."

Here's my comment:

Don said...

" Nov. 2 (Bloomberg) -- Robert J. Aumann, the Israeli economist who won the 2005 Nobel Prize in economics, said the steps taken by Federal Reserve Chairman Ben S. Bernanke and U.S. Treasury Secretary Henry Paulson to save financial markets ``weren't smart.''

``The intervention by the regulators to save the U.S. economy will lead to further bankruptcies of banks and insurance companies,'' Aumann said at a rabbinical conference in Jerusalem yesterday. ``They are only encouraging institutions to take more uncalculated risks.''

I'm not qualified, but here goes:

1) Moral hazard has to be enforced from the start, otherwise there's a cascading effect from letting the first few get passes. Actions have effects as do words.
2) Acting for your own benefit and not the firm's or customer's is a breach of fiduciary responsibility.
3) The situation's of the U.S. and Israel are not the same.

Don the libertarian Democrat

November 3, 2008 12:08 PM

Now, I want to make my position clear. I agree that moral hazard is a serious issue. In my mind, it's the most important issue in the crisis, with fraud coming in second. But, in this situation, although the Fed and Treasury could have done a better job, they were correct in assessing the uselessness of moral hazard in this current situation finally. In my opinion, we'd have been dug too far done this time without government action, because the investors, the people with the money, would have take us there.

As to:
1) Uncalculated risks ( I say ignored )
2) Unwise incentives ( I say negligence, and, in some cases, fraud )
I agree with Aumann. But the idea that the government will not intervene in a crisis of this size in the U.S. as our government is now structured and committed, seems crazy to me, even though Aumann and Buiter seem to believe that.

"Natural and understandable, certainly. But also most unwise and dangerous. This is how we got into this mess in the first place."

Willem Buiter with an interesting post on FT about moral hazard, which I hold to be the main problem in this whole crisis:

"Not quite. Sure, the boom looks like the right time to worry about moral hazard and to create the right legal and regulatory incentives to encourage appropriate risk taking. The problem with this recommendation is that it ignores the reality of the political economy of legal and regulatory reform of the financial sector. During financial boom years, the financial sector is rolling in resources and flush with influence. It can buy off, stop or sabotage all attempts at serious reform. The only time the authorities have both the means and the incentives to pursue far-reaching reform of the financial sector is when the financial sector is on its uppers - down and all but out. That means now, when the furies of financial crisis are howling around us.

As regards the two central objectives of establishing the correct incentives for appropriate risk taking (moral hazard, in the loose way in which this phrase is used in the debate) and mitigating the immediate recession, it makes no sense to have a lexicographic preference ordering. Houses on fire provide cute images, but they don’t capture the reality of the choices that have to be made. So the preference ordering between addressing the immediate crisis and moral hazard should not be lexicographic, with the immediate crisis in pole position. A little deeper or longer crisis can be acceptable in exchange for a material improvement in moral hazard.

In addition, Charles Goodhart, Martin Wolf and countless others overstate the extent to which the two objectives of immediate crisis mitigation and addressing moral hazard are in conflict with each other in practice. Often the same quantum of solace can be given to the crisis-hit economy in a number of different ways, some of which are vastly superior as regards their impact on long-term incentives. I will illustrate this with ten examples of what to do and what not to do."

Read the whole post, as he's infinitely more knowledgeable than me. But here's my intrepid comment:

“I hope these ten examples make it clear that we can fight moral hazard and the creation of bad incentives for future excessive risk taking by financial institutions and by all participants in the financial intermediation process, without undermining the effectiveness of efforts to prevent the recurrence of the Great Depression of the 1930s. A crisis is the best time, indeed the only time, to address moral hazard and other perverse incentives in the financial intermediation system.

The time to deal with moral hazard is now, in every action, every policy measure and every initiative taken to address the immediate crisis.”

Your one of my favorite commentators,and you can hope all you want.But with 1,3,4,5,8,9, and 10, you’ve shown that the moral hazard was ignored in practice. At this point, moral hazard means nothing. If the moral hazard were upheld, no one would think it was because of moral hazard. They would simply think that the government had made a fickle and stupid decision to draw the line here and now. Besides, actions matter, and people are now making decisions on those actions, so that moral hazard will be seen not as principled, but arbitrary.

For moral hazard to work, you need to nip the problem in the bud, otherwise it gains its own momentum. It’s too late this time, and stemming government intervention in a crisis is nearly impossible. That’s when voters demand action.

The time to deal with moral hazard is during calmer times, by putting out a clear set of tripwires and actually fulfilling them.

Again, it’s like value investing. The place that you should really be scared and focus on regulations and moral hazard is during the good times. It must work for some, because value investing has worked well for a lot of serious investors who manage to survive crises and even make money during them.

Posted by: Don the libertarian Democrat | November 3rd, 2008 at 3:11 am

"The way to do so is through the shared appreciation mortgage, or SAM. " Sam I Am.

Greg Mankiw considers a proposal to renegotiate mortgages and stop foreclosures:

"I can see the attraction of these ideas, but I have two questions:

1. Would a law giving homeowners the right to write down their mortgages in exchange for equity attract so many homeowners that financial institutions would suffer even bigger hits than they already have? As these authors note, foreclosure is unpleasant for everyone. But because it is so unpleasant, some homeowners who are underwater on their mortgages keep paying them anyway. If we give them a better alternative, why would they?
2. If Congress were to pass a law allowing homeowners to rewrite their mortgage contracts, and lenders suffered losses as a result, what would the constitutional implications be? The fifth amendment says "nor shall private property be taken for public use, without just compensation." Could lenders get "just compensation" for losses that resulted because Congress crammed down an equity-for-debt swap? If so, would this be the best use of taxpayer funds?"

He then gets answers:

"In response to the first question, he writes:

The offer would come from the lender (not borrower) in cases in which there is a stop in payment on the mortgage. Offering this on top of a standard write-down is an option that is currently not in their arsenal, a fact that many of them are not aware of (essentially ruled out by the tax code). One offers incentives for the writedown e.g. by exempting the shared appreciation strip from capital gains taxes. This is then part of the workout routine that would be far more attractive than a pure write-down, and often superior to enforcing default.

Suppose someone stops payment on their mortgage without needing to just because this offer is potentially open. They can be offered some powerful discouragement: (a) Increasing share of appreciation with increasing write down; (b) Give lenders ability to check income. There would then be a high % dedicated to the loan (you won't want this if you are doing fine or expect to recover income); potentially, have payments on the mortgage rise with income if one needs to work this angle harder.

The complete incentive system could be designed in a dynamic manner, adjusting as evidence of excessive use came to light.

In response to the second question:

This would be voluntary negotiation. The idea would be to set up the incentives for it in the tax code. It simply dominates current options in most circumstances."

I would have thought that the answer to both questions would be that the lender makes the ultimate decision. If payment stops, and he doesn't feel the offer is kosher, he can foreclose. In any case, since it's a negotiation, he can say yes or no. All this program does is give government inducement for mortgage renegotiation instead of foreclosure.