idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate

TO BE FILED: From Vox:

"Global imbalances and the crisis: A solution in search of a problem

Michael Dooley Peter Garber 21 March 2009

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This column argues that current account imbalances, easy US monetary policy, and financial innovation are not the causes to blame for the global crisis. It says that attacking Bretton Woods II as a major cause of the crisis is an attack on the world trading system and a sure way to metastasise the crisis in the global financial system into a crisis of the global economic system.

The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda:

1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US.
2. That the crisis was caused by easy monetary policy in the US.
3. That the crisis was caused by financial innovation.

In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry.

When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds¹ that do not generate systemic risks.

International capital flows

One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.² The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us. If so, would not the much larger gross capital flows into and out of the US also cause an outbreak of bad behaviour even without a net imbalance? If this were true, we would have to stop all capital flows, not just net imbalances. In the US context, we are unable to think of any plausible model for such behaviour.

If capital inflows did not directly cause the crisis perhaps they did so indirectly by depressing real interest rates in the US and other industrial countries. We have emphasised that capital inflows to the US from emerging markets associated with managed exchange rates caused persistently low long-term real interest rates in both the US and generally throughout the industrial world (Dooley, Folkerts-Landau and Garber 2004, 2009). Low real interest rates in turn drove asset prices up, particularly for long-duration assets such as equity and real estate.³ At the same time, low real interest rates temporarily reduced credit risks and a stable economic environment generated a marked decline in volatility of asset prices.

We have not argued that a “savings glut” in emerging markets is the fundamental driving force behind these capital flows. We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US. These official capital flows are not offset, but reinforced, by private capital flows because managed exchange rate pegs are credible for China and other Asian emerging markets.

Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future.

Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity. The hard landing predicted for Bretton Woods II was not to be caused by low real interest rates per se but by the sudden end to low interest rates as unsustainable capital inflows to the US were reversed. This is not the crisis that actually hit the global system.

But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.⁴ The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish.⁵ This could just as well have happened with stable or rising real interest rates, as it did, for example, during the lead up to the US S&L crisis in the 1980s, another government manufactured disaster. Falling real interest rates in themselves should make a financial system more stable and an economy more productive.

Imagine a global system with permanent 4% equilibrium real interest rates. Now imagine a system with permanent 2% real interest rates. Why is one obviously more prone to fraud and speculation than the other? The vague assumption seems to be that capital inflows were large and interest rates were low, and this encouraged “bad” behaviour.

The current conventional interpretation is that low interest rates and rising asset prices generated an environment in which reckless and even dishonest financial transactions flourished. One version of this story is that rising real estate prices led naïve investors to believe that prices would always rise so that households with little income or assets could always pay for a house with capital gains on that house. Moreover, households could borrow against these expected capital gains to maintain current consumption at artificially high levels. This pure bubble idea does not provide much guidance for reforming the international monetary system. Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise?

Easy money and financial innovation

There is no sensible economic model that suggests that monetary policy can depress or elevate real long-term interest rates. The Fed could in theory target nominal asset prices (for example equity prices), but it would then lose control over the CPI. Would Alan Greenspan’s critics have preferred a monetary contraction necessary to depress the CPI enough to allow the real value of equities to rise? The Fed could, and may still, inflate away the real value of financial assets but this requires inflation as conventionally measured. This may yet come, but it was not a part of the story in recent years, and it is still not expected by market participants.

Third in the roundup of usual suspects in the blame game is financial innovation. There is no doubt that innovation has dramatically altered the incentives of financial institutions and other market participants in recent years. Securitisation of mortgages, for example, clearly reduces the incentives for those that originate credits to carefully screen applications. But securitisation also reduced the cost of mortgage credit and increased the value of housing as collateral. Private equity facilitated the dismantling of inefficient corporate structures. Venture capital has directed capital to high-risk but high-reward activities. Before we give up these benefits we need to ask if it is possible to retain the advantages of these innovations without the costs associated with the current crisis.

The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers.

Fraud is not a financial innovation. The unhappy fact is that any change in the financial environment can generate new ways to undertake dishonest and imprudent positions. The regulators in turn have to adapt their procedures for monitoring and discouraging such activities. If it is really the case that regulators cannot understand the risks associated with modern financial markets and instruments, then there is a strong case for trying to return to a simple and relatively inefficient system. But we do not believe the story that no one can understand these innovations. To the contrary, it seems clear to us that the bankers that used these innovations to exploit moral hazard knew very well what they were doing and why. The first-best response to this is to attract a few of the many quants who are now unemployed to help enforce the prudential regulations already on the books.

Conclusions

In this crisis, three macro-financial institutional arrangements remain to hold the financial system together. These are the dollar as the key reserve currency with US Treasury securities as the ultimate safe haven, the integrity of the euro, and the global monetary system as defined by the Bretton Woods II view. Attacking the latter as a major cause of the crisis and seeking its end is, at the end of the day, an attack on the basis of the international trading system. It is a sure way to metastasise the crisis in the global financial system further into a crisis of the global economic system.

References

Bernanke, Ben (2007) “Global Imbalances: Recent Developments and Prospects" speech delivered at Bundesbank Berlin September 11.
BIS 78^th Annual Report (2008).
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2004) “The Revived Bretton Woods System,” International Journal of Finance and Economics, 9:307-313.
Dooley, Michael P., David Folkerts-Landau and Peter M. Garber (2009) “Bretton Woods II Still Defines the International Monetary System,” NBER Working Paper 14731 (February).
Dunaway, Steven, Global Imbalances and Financial Crisis, Council for Foreign Relations Press, March, 2009.
Economic Report of the President (2008)
Economist (2009) When a Flow Becomes a Flood,” January 22.
Paulson, Henry (2008) “Remarks by Secretary Henry M. Paulson, Jr., on the Financial Rescue Package and Economic Update,” U.S. Treasury press release, November 12.
Sester, Brad (2008) “Bretton Woods 2 and the Current Crisis: Any Link?", Council on Foreign Relations

Notes

1. Of course, a bank thinly disguised as a hedge fund should be regulated as a bank just as a hedge fund thinly disguised as a bank should be.
2. See Paulson (2008), Dunaway (2009).
3. This is arithmetic, not economics. A permanent fifty percent decline in the level of real interest rates, for example from 4% to 2%, is the same thing as a doubling of an infinite maturity financial asset’s price, provided that the payout from that asset is unchanged. For practical purposes, thirty years is good enough to about double prices.
4. This view has taken hold in central banks see Bernanke (2007), Hunt (2008), BIS (2008). In the financial press, see Sester (2008) and Economist (2009). It should be noted for the record that these claims are always raw assertions, without theoretical, empirical, or even logical basis.
5. The financial system problems in many other countries are independent of regulatory problems in the US. The banking collapses in Iceland, the UK, and Ireland were home grown. The loans of the European banking system to Eastern Europe and to emerging markets in general were independent of US financial system behavior.

Holy Libor, Batman!

TO BE NOTED: From Bloomberg:

"Libor Drops by Most in More Than Two Months as Recession Eases

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By Lukanyo Mnyanda

May 21 (Bloomberg) -- The cost of borrowing in dollars between banks dropped the most in more than two months, adding to evidence that policy makers are unfreezing credit markets.

The London interbank offered rate, or Libor, for three- month dollar loans decreased six basis points today, the biggest drop since March 19, to 0.66 percent, the British Bankers’ Association said. The rate has more than halved this year. Libor is used to set borrowing costs on about $360 trillion of financial products globally, according to the BBA.

The decline coincides with growing signs the worst of the financial turmoil has passed. Europe’s manufacturing and service industries shrank at the slowest pace in eight months in May, a report showed today. Nobel Prize-winning economist Paul Krugman said in Ho Chi Minh City, Vietnam, that the global “freefall” may have ended, with the U.S. economy on course to expand “slightly” in the second half.

“The decline in Libor does gel with a lot things going on, as general volatility and risk aversion have been reduced,” said Padhraic Garvey, head of investment-grade debt strategy at ING Groep NV in Amsterdam. “The market has a nose for things getting better in due course.”

The Federal Reserve committed $12.8 trillion to stem the longest recession since the 1930s and central banks around the world cut interest rates to near zero as they sought to ease the flow of credit. Three-month Libor, one of the rates that determines everything from student loans to mortgages, rose to 4.82 percent in October in the wake Lehman Brothers Holdings Inc.’s collapsed a month earlier.

TED, OIS Spreads

The TED spread, the difference between what banks and the U.S. Treasury pay to borrow for three months, narrowed four basis points to 51 basis points today, the least since August 2007, when the credit crisis began. It peaked at 464 basis points on Oct. 10.

The Libor-OIS spread, another gauge of banks’ reluctance to lend that measures the difference in the three-month rate and the overnight indexed swap rate, decreased to 46 basis points, the least since February 2008. It has dropped from as high as 364 basis points in October.

Libor is derived from a survey of banks conducted by the BBA each day in London. Institutions are asked how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. The BBA then calculates averages that exclude the four highest and lowest quotes, before publishing them before noon.

To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net"

“Fear and Loathing in Las Vegas: Evidence from Blackjack Tables,” finds that players incur substantial losses by playing too conservatively

TO BE NOTED: From the WSJ:

‘Tis Better to Have Bet and Lost

Regrets always have a bitter taste, and those involving gambling tend to linger more than most. But a new paper argues that worrying about regrets may be costing you money.

Regrets: I have a few. Too few to mention… and too few to win big. (Associated Press)

Bruce Ian Carlin of UCLA’s Anderson Graduate School of Management and David T. Robinson of Duke University’s Fuqua School of Business look at how regret affects economic actions in market settings. Their paper, titled “Fear and Loathing in Las Vegas: Evidence from Blackjack Tables,” finds that players incur substantial losses by playing too conservatively.

The authors were able to field test the idea of regret using blackjack tables. Without the participants knowledge, Carlin and Robinson tracked Blackjack bets. The researchers found that more money was lost by playing too conservatively than too aggressively.

The finding tracks with psychologists’ theories about regret. People tend to act more conservatively if there is a chance they will regret their actions. They point to an example of two investors, one who loses money because he failed to sell his shares and another who loses money because he sold his shares. Even if the losses are the same, the second investor feels more regret because he took direct action. The other investor can blame forces beyond his control and doesn’t have to take direct responsibility.

Blackjack offers a useful case study, because there is a basic strategy that produces optimal results. “Players in single-hand deals who followed the basic strategy won 48.1% of the time, very close to the theoretical win rate reported in Blackjack guides. Deviators won only 36.6% of the time, which is statistically significantly lower,” the researchers wrote. “Players that followed the basic strategy won total of over $60,000, while they lost only about $56,000 following the basic strategy. In contrast, only $3,000 was won, and over $6,000 lost in hands that deviated from the basic strategy.”

Carlin and Robinson noted two ways bettors could deviate, either through passive actions (staying pat when you should have taken another card) or aggressive actions (taking a hit instead of holding). They found that not only were passive mistakes more common, but they were more costly as well.

The study has wider implications about the problem of risk aversion. Carlin said that it could lead to inertia in businesses as well as among individual investors. Take the recent drop-off in the stock market. “A lot of older people should have seen the risk of volatility earlier and should have rebalanced their portfolio. But they worried that if they sold and market rebounded they would feel more awful than if market just goes down,” he said.

Carlin points out the problem may even be more severe in the general population. By definition, Blackjack players are gamblers. “This is the behavior among risk seekers,” Carlin said. “Imagine what it looks like among the risk averse.”

an unprecedented transformation exemplified by increased regulation and a heightened risk aversion

TO BE NOTED: From AllAboutAlpha:

"The Ascendancy of Risk Management

Posted By Alpha Male On April 30, 2009 @ 8:36 pm In Today's Post | No Comments

We conclude a week covering hedge fund operations issues with a guest contribution from Abdul Sheikh, CAIA, a Vice President at State Street’s fund administration group. Sheikh makes the case that many attendees of GAIM Ops also made: that independent fund administration may be the only way to fully address investor concerns in the post-Madoff world.

Alternative Viewpoints: The Ascendancy of Risk Management

Special to AllAboutAlpha.com by: Abdul Sheikh, State Street Fund Administration

In the past years, investors used to select fund managers based on three criteria: performance, philosophy and pedigree. But in Deutsche Bank’s annual Alternative Investment Survey released last month (see [1] related post) , “risk management” entered the ranks of the top three selection criteria for the first time, and “pedigree” fell to fifth.

[2]

It’s clear that we are witnessing a paradigm shift in manager selection and asset allocation criteria. Gone are the days of just looking at attributes like track records, top down vs. bottom up approaches, low correlations to markets, and manager size. Recent events have shown that investors need transparency, independent risk analysis, and independent asset servicing.

A State Street study conducted late last year in conjunction with the 2008 Global Absolute Return Congress (see [3] related post) reinforces this - indicating that five out of six institutions (84 percent) expect more disclosure of hedge fund positions and nearly half (49 percent) anticipate more frequent reporting from hedge fund managers. Meanwhile, only a few (19 percent) currently receive some level of consistent transparency across hedge fund holdings. (See chart below from report)

[4]

Institutional investors may believe their portfolios are well diversified. However, do they really know what their concentrations are and what these concentrations mean to them? Depending on the strategy, the managers may be allowed to take on leverage, but only a thorough analysis can determine whether that leverage is accidental or deliberate (and thus beneficial to the overall portfolio). However, this kind of thorough analysis usually requires position-level transparency.

Heightened concerns over transparency and risk management are increasing demand for independent asset servicing. Functions such as securities processing, fund accounting, reconciliations, security settlement and safekeeping are no longer viewed as value-added but necessary. Many industry experts think that the Darwinian processes occurring for the past year will separate the “premier league” of funds from the others. Based on the result of the surveys above, these premier league funds will likely be distinguished by their ability to employ independent asset servicing, provide transparency and use better risk management systems.

Some of these basic asset-servicing functions have traditionally been provided by investment banks and prime brokers. But some are now calling for third party custodians who hold customer assets “off the books” in custodial accounts. Since prime brokers have much more extensive rights in client’s assets - including their ability to rehypothecate their client’s assets - some argue that they expose investors to additional risks.

Without a doubt, we are witnessing an unprecedented transformation exemplified by increased regulation and a heightened risk aversion. As cases like Madoff and Stanford have proven, regulatory oversight sometimes provides a false sense of protection. And that is why investors seem to be saying that fund-level risk management has become more important than ever.

- A. Sheikh, April 2009

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com or State Street Corporation.

Editor’s Addendum: Sheikh’s State Street colleagues seem to agree with his assessment as evidenced by [5] this FT piece earlier in the week:

“‘The old system seemed to work pretty well as long as assets grew,’ says Jack Klinck, head of global investment product services at State Street. ‘But now investors are really nervous. There’s a tremendous focus on ‘who’s your counterparty?’”

“Mr Klinck expects to see a number of large US hedge funds, which have until now done all their administration in-house, outsource this function in order to reassure their clients. ‘Self-administered hedge funds are looking like outliers now. They’re having to break their operating model.’”

Finally, before the AllAboutAlpha.com corporate jet departs the Cayman Islands, we thought you might find [6] this recent Hedge Funds Review Cayman supplement to be kind of interesting:

“There is no doubt the global financial crisis and the push for tighter and more onshore regulation of hedge funds will change the industry forever. Cayman’s role in this is unclear but the government, regulator and industry are confident they have the skills and will to keep the jurisdiction as the number one domicile.”

---

Article printed from AllAboutAlpha.com: http://allaboutalpha.com/blog

"we must instead allow it to be destroyed, to be liquidated in as orderly a fashion as possible, as quickly as possible."

There are lots of people who don't like what I'm calling for. Sudden Debt is one:

"The latest 3-month US Treasury bill auction resulted in 0% rate and was oversubscribed four times. How about that, for deflation and risk aversion, eh?

I am not surprised. This is the hangover following the wild easy-credit party that ultimately saw financial engineering elevated to the same position as real engineering (yes, I was offended). The same party that created the awesome stupidity of $65 trillion in credit default swaps which first allowed piling on much more debt than prudent, and which are now inhibiting the cathartic process of its quick demise.

What's next? Will free money (for the federal government, anyway) result in another Greenspanite bubble? No, no time soon. This development is not something that the government wants, you understand. It clearly underscores the fact that deflation is happening as we speak, that assets carrying even the smallest amount of risk are shunned in favor of mere capital preservation. The debt trap has become - predictably - a deflationary liquidity trap, American economists' and policy makers' greatest phantom menace since 1929.

I will, thus, say it once more: instead of allowing this deleterious process to drag out for years by attempting to preserve debt (as the Fed and Treasury are doing now), we must instead allow it to be destroyed, to be liquidated in as orderly a fashion as possible, as quickly as possible."

I'm certainly for decreasing our debt, but I'm not sure what's being called for. Selling government assets? Increasing taxes? Cutting expenses?

I'll only say that the whole point of my plan is to ultimately reduce the debt and deficit. It is paradoxical that the only way to do that is to temporarily increase our debt, but such is the world.

A Cure For Risk Aversion?

From Floyd Norris:

"Within 18 months, we have gone from a lack of concern about risk to extreme risk aversion. Until that eases, and until it becomes clear that financial institutions are not in danger of collapse, fear could paralyze economies on both sides of the Atlantic."

Anybody have a cure for risk aversion?