Catch the wave

I keep trying to warn my friends in the Federal Reserve about the tsunami that’s coming their way.

I don’t always agree with Representative Barney Frank (D-MA), but I thought his remarks in yesterday’s
Boston Globe were right on target:

Well-functioning financial markets depend on transparency and confidence that institutions are playing by clearly defined rules. Both were in short supply in the months leading up to the August meltdown and remain so today. Large pools of unregulated capital, often highly leveraged, especially in hedge and private equity funds remain opaque and have been joined by massive sovereign investment funds to transform the financial landscape in ways that are out of reach of regulators here at home and in other wealthy countries. We lack the information that we need to ensure safety and soundness as well as the confidence that comes from the requirements mandating governance and reporting standards that apply to publicly traded companies.

To an important extent these new pools of capital are structured in a fashion that allows them to avoid the scrutiny that is required of firms and financial institutions in the regulated sectors. We should not be surprised. It is a fact of life that investors and firms will seek to innovate their way around whatever regulatory strictures apply, whether they deal with health and safety, labor protections, or reporting obligations. This tendency has been exacerbated by a 30-year attack on the very notion of a regulatory role for governments and loud professions that the market not only knows best, but knows everything.

Our job is to understand the changes in the financial marketplace and consider what we must do to ensure that our regulatory system is able to keep up with those changes. Innovation is as important in financial markets as it is in product markets, but it would be foolish to act as if regulatory structures, designed for a different world, do not have to be as nimble and innovative as those they regulate.

On the other side of this argument we seem to have Fed Chair Ben Bernanke, who argues that lenders have learned their lesson and these problems are being corrected on their own. Now, I happen to believe there is also a lot of truth to what Bernanke is saying here as well. But I would invite those in the Federal Reserve to look a few months down the road and ask how this discussion is going to play out if, as I fear likely, the financial consequences of previous reckless real estate lending continue to grow. Each new report of another failed institution, another family losing their home, another pension fund without the money to pay the retirees, and another decline in real estate prices is going to mean more pressure for the kinds of changes that Representative Frank has called for, and burn more of the political capital of anyone who tries to argue against them.

While I agree with what Representative Frank had to say, the devil is in the details. I would vastly prefer to have the staff at the Federal Reserve craft these reforms. But doing so requires the Fed to get on board now to try to set the direction for this debate, before they get swept aside by a political tsunami.

I’ve never been very good at surfing, but I think I understand the theory. You have to make sure your board is moving before the wave actually reaches you.

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38 thoughts on “Catch the wave

  1. James I. Hymas

    I agree with what Representative Frank had to say

    Why? You didn’t quote any evidence or argument – merely some assertions.

    Thus far, the regulatory system has been working quite well; action has been necessary to calm down one of the market’s regular shifts from greed to fear, but that’s just part of the game.

    How is increased regulation going to improve anything?

  2. NoFate

    I heard an interesting quote about parenting a while back. It states that as a parent you can play the role of fan, coach, referee or team mate – but you can only choose ONE of these roles and be effective.

    It seems to me the same applies to the Fed and Wall Street. I fear they are playing team mate when they should be playing ref. The idea that this mess will clean itself up and then never happen again seems about as likely as an NFL game going smoothly without any refs.

  3. James I. Hymas

    With respect to the GSEs, I think we’re in pretty good agreement, as I noted in the comments at the time. If they look like banks and walk like banks and leverage like banks – then sure, regulate them like banks. I have no problems with that; there will be some (perhaps including you) who feel that Congress was addressing a public need not being met by normal banks and that there should be some kind of special treatment for the GSEs within such a framework – and I look forward to hearing those arguments.

    It’s a long way from the GSEs to hedge funds and sovereign wealth funds, however. I’m afraid I don’t see the connection.

  4. Josh Stern

    I agree with the viewpoint that it is risky to have so much (leveraged) capital being invested by funds where a large portion of the manager’s compensation is asymmetrically tied to performance. That is, the manager he gets wealthy in big up years, and loses nothing except reputation if the fund goes bust – even then there is usually openings for someone with “experience” who claims to have learned lessons. It’s rational in such a situation for the manager to take large risks using huge leverage. Recent events have shown that the possibility of many leveraged funds using similar strategies is significant.

    An important question is what sort of regulation would reduce that extra risk without being too onerous.

  5. JDH

    James Hymas, what are your thoughts about off-balance sheet entities that (1) buy mortgage-backed securities (how different is that from making a loan?), (2) fund these through commercial paper (subject to the bank runs problem just like traditional deposits), and (3) turn out to imply large potential liabilities for regular banks?

    As for truly private hedge funds, I have not advocated regulating them directly, but would favor restrictions on the extent to which entities such as public pension funds can invest in them.

  6. MTHood

    “But I would invite those in the Federal Reserve to look a few months down the road and ask how this discussion is going to play out . . .”
    One or two years ago would have been a good time to pose this question about the housing/credit bubble, in my opinion. Both you and the Fed were asserting that there was no bubble, right? If you would like, I will copy and paste the quotes again.
    So, I would respectfully suggest that your ability to comment on what should be done now has been greatly compromised by your previous inability to see the storm coming.

  7. James I. Hymas

    (1) I think the Structured Investment Vehicles that bought mortgage-backeds and financed with commercial paper are great! They took on a lot of risk that was not appropriate for banks to take on. They’re having their heads handed to them at the moment, but it is the function of speculators to have their heads handed to them.

    They cannot imply any potential liabilities for regular banks unless the regular banks have made some sort of business decision to allow such liability in exchange for potential profit. These investments by the banks are subject to regulation for concentration, collateral and everything else.

    I have commented elsewhere that bank regulation should be reviewed once the dust settles from the current mess to ensure that capital requirements are sufficiently stringent to ensure that – even if there are one or two spectacular failures – the whole system doesn’t come down. I confess I’m not certain whether a line comittment results in an increase to risk weighted assets – it certainly should, and it should be relatively large, or scaled, since demands for liquidity are going to come in batches.

    I recently highlighted on my own blog an academic paper that argued such lines were profitable for banks, because they will be used in times of stress, when rates the banks can charge will be high, while at the same time the banks will benefit from a flight to quality (not so much as government paper, certainly, but benefit nevertheless). This effect is not just profitable, claim the authors, but forms a significant part of banks competitive advantage over non-banks.

    So – the off balance sheet entities will try new stuff and maybe dance too close to the edge on occasion – but that’s the price paid for innovation and when it works they’ll get paid handsomely for it. As long as the Fed maintains regulatory control over the actual banks, then I don’t see any problem.

    (2) I don’t see how your position is in agreement with that of Rep. Frank. You are talking about regulation of the investor; he is talking about regulation of the investee.

    As you may remember, I disagree with your position that new regulation is necessary and claim that enforcement of the current Prudent Man Rule is a preferable ‘principles based’ approach. But your position on allowable investments for public pension funds does not appear to have any implications regarding direct regulation of private hedge funds, or of sovereign wealth funds.

  8. phyronic

    So buy real estate in Mayfair… not NYC or Connecticut..
    Isn’t it ironic that whatever crisis seems to have occurred as was located predominantly in European Banks and Hedgefunds… not to mention Australia…
    The metaphor that one should take away from this mini crisis… is that for now the US has a lead in the financial market’s battleground…
    We still create the products…and then sell them to second tier institutions and countries round the world..
    Change that and you eliminate perhaps the one sector where America still holds an unambiguous edge…

  9. David Pearson

    I worry that the Fed does not hear enough dissenting views amongst the academic community. Presumably Bernanke wants the respect of that community and would be on the look out for such a shift in views.
    The question I have tried to raise in this comments section is why academics have been slow to realize the impact of excessive leverage. I believe that it was due to over reliance on econometric modeling which increasingly saw volatility as being pushed further and further out the “tail”.
    So it is refreshing to see an academic getting out ahead of the curve, as you have done recently. Perhaps this signals a shift, and Bernanke will pay attention. The danger, of course, is that realizing the problem is there does not necessarily yield a cure. The consensus seems to be, for those that are “worried” like Martin Feldstein, that deep cuts in rates are a near-costless solution.

  10. JDH

    Mt Hood: OK, I’ll bite. Here’s what I wrote on December 27, 2006:

    I continue to be concerned about whether the housing downturn could lead to widespread bankruptcies or default. Calculated Risk notes one assessment that 1 in 5 of the subprime mortgages originated in the last two years will end in foreclosure. It is difficult for me to be quantitative in predictions about these dynamics, other than to recognize the possibility of some nasty negative feedbacks setting in. But so far, I think we have to say, it hasn’t happened yet. And a replay of 1994-95 looks like the narrow favorite on which to place a bet.

    I grant that my “narrow favorite” is looking less and less likely now. That means I’m forever banned from commenting on what we should do next?

    As for this term “bubble”, this has become a bumper-sticker slogan that means different things to different people. I have always been very precise about how I was using that term. So, before you go any further on your high horse, please do the same and define exactly how you are using the expression “credit bubble”, and its precise connection to past statements of mine that you have in mind. I expect that what you mean by “bubble” and what I mean by “bubble” are likely very different things, and that we still see things fundamentally differently.

    David Pearson: I think the key issue is that the majority of academic economists (myself very much included) have a strong belief that most people don’t throw their money away for no reason. We therefore want to try to understand the situation in terms of the financial incentives for actors to have behaved as they did. To my mind, the story has yet to be satisfactorily developed in those terms, and if it were, there would be no problem persuading Bernanke or anybody else.

    What persuaded me that there is an issue here is as I learned of the magnitude of loans that had been extended with no down payment, no documentation of the borrower’s ability to repay, or to people with problems handling debt. I then observed the extent to which a relatively modest shock to incomes and real estate prices (much milder than what I believe may be yet to come) could generate such enormous financial implications. That’s what convinced me that something is seriously wrong here.

    As I stated in Jackson Hole, the key question that we need to answer to really understand what happened is, Why were loans extended at such terms?

  11. James I. Hymas

    key question that we need to answer to really understand what happened is, Why were loans extended at such terms?

    I don’t think you’re ever going to get a very satisfactory answer to that one, Professor. It’s in the nature of financial markets to overshoot.

    Why were billions of dollars poured into tech stocks? Why are loans made to emerging markets with a history of default? Why was Tokyo’s Imperial Palace worth more than all of California at one point? Why do value stocks outperform growth stocks?

    In this particular case I see the problem as being, in part, a question of portfolio managers reaching for yield. Rates were low (because of the Fed, or the savings glut, or both) so a product offering, say, LIBOR + 200 became awfully attractive.

    You may wish to note that the phenomenon of reaching for yield was exacerbated by low interest rates and by low spreads on “real” mortgages guaranteed by the GSEs. You cannot outperform the index by being 100% in GNMA securities (at least, not by much) you have to go even deeper into the risk/reward continuum.

    If an investment manager wants the account when the competition is promoting LIBOR + 200, then in most cases he’s got to find a credible way to claim he can get LIBOR + 220. In some cases, he can dismiss the competition as risky and get the account (or part of it, for diversification, you understand) with an offer of LIBOR + 100. The last thing he can do is go into a complex analysis of the competing product and show that while it does yield +200, given the risks involved it should yield +250 and therefore is too risky for the expected return (it has a negative expected value, in your parlance).

    Any PM who tries that sort of thing (assuming he has the ability to do so) will lose his audience after the first 30 seconds and be the butt of jokes at the time the selection is made.

    Intermediation does not just occur in between the mortgage signer and the PM; intermediation also occurs between the beneficiaries and the PM hiring process. Those who hire the PM are, typically, not finance people and will make the decision based on interpersonal and reputational reasons, not twenty pages of closely reasoned mathematics.

    You have previously criticized – or, at least, questioned – the San Diego pension plans. I’ll bet you recognize the paradigm.

    I have enormous respect for the Ontario Teachers Pension Plan and OMERS. I am not as familiar with CALPERS, but I’ve heard good things about them, anyway! And the Harvard Endowment has a good reputation. These institutions have one thing in common: there is no hiring process. From the fund’s perspective, there is an ability to build trust in their investment management team on a daily basis; critically, from the investment management team’s perspective, there is no need to go through the presentation song-and-dance to have the decision made on random factors because they have captive capital.

    I suspect that a thorough study will reveal that captive investment managers outperform the wild-type; such a study probably already exists.

    But, while I am always willing to listen to new ideas, I have a strong bias against increased regulation. Investment management is already the most thoroughly regulated business on the planet; a rules-based approach offering a rules-based safe-haven from the fiduciary chain that runs between a retired schoolteacher to a NINJA mortgage holder is likely to do more harm than good.

  12. MTHood

    Professor Hamilton,
    First, I view you as one of the good guys. You state your positions publicly, and you provide a forum for anonymous know-littles like me to take pot shots! Good for you.
    Second, I agree with you: the term bubble can be an impediment in this discussion. Allow me to frame my point differently.
    On one end of the spectrum, some people warned that the rapid rise in house prices would cause problems down the road. Whether they used imprecise terms like bubble is beside the point; they warned, they predicted bad things would happen. In some cases they even encouraged those in power The Fed, regulatory agencies, Treasury to take action.
    On the other end of the spectrum, some people dismissed those warnings. They did not encourage preventative action.
    In the first group, I would place people like Shiller, Calculated Risk, Barry Ritholz.
    In the second group, I would place the NAR, mortgage brokers, investment banks.
    Today it seems rather clear that the first group has been more accurate than the second. Agreed? (I mean, we are talking about taking action to protect the economy against the tsunami thats coming.)
    Many people took positions between these extremes, but often their positions shifted over time.
    Lets take three key dates:
    1. June 2005 the (roughly speaking) top of home price appreciation and homebuilder stock prices
    2. February-March 2007 Collapse of New Century and the sub-prime explosion
    3. Now
    In June 2005, your position, Professor Hamilton, was not very close to the first group, from my reading. In the two quotes below from 6/18/2005 and 6/23/2005, you focus on the fundamentals. For example: But economic fundamentals look to me like the more obvious place to start in trying to understand exactly what’s happened to U.S. house prices over the last 5 years.
    More important than your emphasis on the fundamentals, however, was the absence of warnings. Yes, one can find some caveats, but for the most part, in June 2005, you were dismissive of those raising the alarm (see 6/18/2005, Babble about a housing bubble).
    By December 2006, as you note, you began to voice more caution, but it wasnt until after the problems with New Century and other sub-prime operations exploded in Feb-Mar 2007 that you acknowledged the problem of lax lending, which others had highlighted much earlier. And even then, on 3/23/2007 you wrote in Bubble, bubble, toil and trouble:
    So all of this looks to me to be consistent with the story I was telling two years ago, according to which the housing market, on the way up and on the way down, has been driven by fundamentals.
    Skip ahead to today and now you write: I keep trying to warn my friends in the Federal Reserve about the tsunami that’s coming their way.
    I just didnt see you warning about this tsunami in June 2005 or March 2007.
    Thats my point.
    I didnt expect the NAR or Bear Stearns or Paulson or Greenspan to sound the warning. But when independent, fair-minded economists like you didnt, I was surprised.
    Warnings from people like you could have done some good.
    Why did you miss it? How did you miss it? Thats what I want to know.
    Until I hear that explanation, its hard for me to read:
    I keep trying to warn my friends in the Federal Reserve about the tsunami that’s coming their way.
    P.S. Yes, Ive been wrong many times, and, its true, I dont know jack about economics. So, the issue isnt me and my high horse. But even a dumb *ss like me saw this problem brewing (I think getting a home loan should be as easy as ordering a pizza), so Im mystified that so many professionals like you didnt.

  13. MTHood

    Blog entries cited in the post above:
    June 18, 2005
    Babble about a housing bubble
    There’s been much discussion recently of whether the U.S. is experiencing a speculative bubble in house prices. Like previous historical bubble sightings, this one only seems to pop up in situations where the fundamentals on their own might justify significant price increases.
    And right now housing bubbles seem to be popping up all over the place. Calculated Risk, writing at Angry Bear, finds one in Miami. Tyler Cowen thinks he maybe sees one in D.C. David Altig expects to hear about one whenever Robert Shiller is on the radio. And Brad Setser is now upping the ante, looking for bubbles in France and all around the globe.
    . . .
    It’s noteworthy that over the last 5 years, the three states with the highest population growth rates as reported by the Census Bureau– Nevada, Arizona, and Florida– have also been among the locations that saw the biggest increase in home prices. Forces such as these, rather than a random distribution of irrational exuberance, seem a more natural explanation for why some communities got bubbled and others didn’t.
    June 23, 2005
    What is a bubble and is this one now?
    . . .
    It may be a good idea to take a hard look at any possible moral hazard problems lurking in our present financial institutions. But economic fundamentals look to me like the more obvious place to start in trying to understand exactly what’s happened to U.S. house prices over the last 5 years.
    March 23, 2007
    Bubble, bubble, toil, and trouble
    . . .
    So all of this looks to me to be consistent with the story I was telling two years ago, according to which the housing market, on the way up and on the way down, has been driven by fundamentals. Low interest rates and rapid population and employment growth relative to the supply of available housing were the main factors driving house prices up, and the reversal of those will be the main thing causing real estate prices to come down.
    The one thing to which I think I was not paying enough attention two years ago was the role of lax credit standards and even fraud ([1], [2]) in addition to low interest rates as factors fueling the boom. I have been coming around to the view that there may have been some significant market failures behind that. My first worry here is about Fannie Mae and Freddie Mac, and the second concerns whether some of our institutions have the right incentives for fund managers to properly value lower-tail risks. This ready availability of credit, over and above the low interest rates themselves, I now believe was an important factor contributing to the real estate boom.

  14. JDH

    But Mt Hood, I am still not agreeing, even today, that house prices themselves were the problem. Part of the evidence I offered in the March 2007 entry from which you quoted was the observation that the biggest problems with defaults as of that time were occurring in the areas in which real estate price increases had been the most modest. If the whole problem was the prices themselves, how could that be?

    Instead I believe the real problem was the processing of credit risk by the mortgage market. I agree with you that Calculated Risk was well ahead of me in understanding this issue, though as a long-time reader you’ll surely agree that I have quoted and admired his analysis from the beginning of this blog, if not always agreeing with the full force of his conclusions.

    I’m not sure I recognize my current understanding as being reflected even in Shiller’s most recent writing on the topic. I have always thought that he could be right that there might be a significant drop in real estate prices. As I noted for example in June 2005: “even if the current situation is driven entirely by market fundamentals, there still is a substantial possibility of a significant decline in house prices should those fundamentals turn south.” I’m now much more worried about how destabilizing this might be, so perhaps in that sense you might say I have come around some to Shiller’s view. But I have never found his explanations of the economic processes involved something I could understand and endorse.

  15. James I. Hymas

    MTHood: The level of financial markets are not affected by ‘smart people’ and ‘dumb people’. The financial markets are affected by little ants.

    One ant on its own is pretty dumb – it has only a 51% chance of being right on any particular question at any given time. Maybe there are some superstar ants with a 60% chance, but the norm is 51%.

    Financial markets are a nest of 100,000 of these little ants. When they vote on the proper level of rates, or stock prices, or mortgage loans, they’re usually going to get it right. Sometimes, though, they get it wrong. It’s not a big deal and it conveys very little information regarding the forecasting ability of those ants who, wrongly, voted with the majority on that particular question.

    Forecasting is a hellish game to play. You can be the best analyst in the world, you can create the best stock forecast ever seen, and you can still buy United Airlines on September 10. Financial markets are a chaotic system, to say the least. The best course of action for any player is to realize that – particularly if he is better than average ant, with a 55% track record – to make as many small bets as possible and try to let statistics do the rest of the work.

    You’ve criticized the investment banks, inter alia, for their role – they are the least important of the players. They’re shopkeepers, nothing more. They’ll sell what people want to buy, whether that’s internet stocks or low graded sub-prime mortgage tranches. This action conveys no more information regarding the product than is provided by a retailer selling Barbie dolls. Maybe Barbie dolls are a poor role model for young girls; maybe they’re just toys. All the retailer cares about is that his customer wants to buy them.

    With respect to the sub-prime mortgages, I suspect that those who bought the highest-grade tranches are going to do just fine. Those who are currently selling at whatever price they can get because either they or their investors read in the paper that it’s all garbage are going to lose some money. Those who are currently buying at fire sale prices are going to make out like bandits.

    Maybe JDH was wrong on housing/mortgages – or maybe he was not right enough soon enough. And maybe you were right. Who cares? I’m a lot more interested in the question of whether CIT Group three-year bonds are a good buy at governments + 300bp. I’ll continue reading JDH’s comments in order to get a better background on that decision. Should I make that bet as one of my thousand little bets? If I do make that bet and I’m wrong, does that make me stupid?

  16. Josh Stern

    “a relatively modest shock to incomes and real estate prices (much milder than what I believe may be yet to come) could generate such enormous financial implications. That’s what convinced me that something is seriously wrong here….the key question that we need to answer to really understand what happened is, Why were loans extended at such terms?”

    Many commentators have focused on high grade investment ratings given by Moodys, S&P, et al. to very low quality securities. I haven’t seen anyone argue that isn’t a good place to focus. As long as loan originators are different than loan holders and security valuation is based mainly on the ratings of these agencies, they will continue to be a weak point in the system. In the case of mortgages, perhaps the govt. could set up mandatory publication of loan related statistics in a timely fashion that would give more early warning to buyers – e.g. collateral estimates, default rates, etc. Even if that worked, it would leave the same vulnerability for other types of securities.

  17. David Pearson

    I don’t know what the bar is for a “satisfactory” explanation of investor actions. Clearly, though, a large number of investors employed econometric models that yielded two key results:
    -defaults are most correlated with employment loss
    -nominal real estate prices are highly unlikely to fall at a national level
    It was therefore completely rational for them to buy securitized subprime, stated income, 100% CLTV ABS. I personally had fixed income hedge fund managers tell me that they stress tested their subprime holdings, and that the confidence interval around not experiencing losses was multiple sigmas.
    Beyond that, the perverse incentives offered to hedge fund managers are common knowledge. Its quite possible, given their access to leverage, that these funds dictated the marginal price of these securities for the past few years.
    Granted the above falls well short of empirical proof, but its at least a plausible argument for why investors would, “throw their money away.”

  18. MTHood

    James I. Hymas,
    The financial markets are still part of a larger society, are they not? You know, a society where people have kids, make plans, write poems.
    If the consequence of being right or wrong costs you your bonus, youre right, I dont care. I dont care about your trades, I dont care about your CIT Group bonds. And I further agree, that if you and your fellow trader ants are crushed, its not a big deal and it conveys very little information.
    If the consequence of being right or wrong costs people their jobs, their homes, their families, then, yes, I do care.
    The financial markets exist to serve society, not the other way around.
    And if the trader ants set fire to the colony, the worker ants just might eat, inter alia, a few of those scrawny little peckers not a big deal, just a bet gone wrong.

  19. Tedk

    You say, “…I am still not agreeing, even today, that house prices themselves were the problem…Instead I believe the real problem was the processing of credit risk by the mortgage market.”
    Isn’t that “processing of credit risk” a euphemism for saying that there was ‘loose lending’ or ‘easy credit’? And if so, are you saying that such lending practices don’t necessarily cause prices to rise to bubblicious levels?

  20. JDH

    Tedk, yes, I am agreeing there was loose lending and easy credit and I am agreeing that these caused house prices to rise farther than they should have.

    As for whether such prices should be described as “bubblicious”, I have always used the term “bubble” to refer to a situation in which prices rise for no reason other than the fact that people expect them to keep going up. I do not believe that to have been the case. Prices in Michigan were also inflated relative to what they should have been, and the cause has litle to do with the expectation of rapid rates of increase in future real estate prices.

    And let me say a word about why this semantic issue makes a difference. If Shiller is right, Michigan should have nothing to worry about. If I am right, they do. If Shiller is right, this is an unavoidable consequence of the psychology of markets. If I am right, there are particular regulatory changes that could address the causes of the problem.

  21. tedk

    Thanks for the explanation. But I don’t see why a bubble, regardless of how one defines it, has to be nationwide?
    The way to explain your observation about the rust belt, I think, is that in the coastal markets there has always been pent-up demand (population growth, jobs, higher salaries, etc.) that is lacking in the rust belt. It is easier for ‘expectations’ of price rise to become a stampede under such conditions. The pent-up demand and continuing loose lending explain why prices are slow to fall, why defaults are not high, etc. in the coastal markets when compared with the rust belt.
    In other words, fundamentals are in fact stronger in the coastal cities, but such better fundamentals lead people to raise their expectations to unrealistic levels, especially when there is loose lending.
    In the DC area market, 95% of the hundreds of people I met during 2003–2006 were saying the market would never go down because of…[one or the other of these fundmentals].
    Now one can see on
    that in places like Herndon, Sterling and Manassas, houses are selling at up to 40% off last sold prices.
    It is true that such price drops are not yet widespread enough for the median to fall significantly. So I understand that, as an economist focused on the data, you can’t go with what a subset of the market is experiencing. But such obervations matter and may help you to modify your models if possible.

  22. James I. Hymas

    Many commentators have focused on high grade investment ratings given by Moodys, S&P, et al. to very low quality securities. I haven’t seen anyone argue that isn’t a good place to focus.

    I’ll give it a go!

    I’m not aware of any evidence that Moody’s & S&P got it wrong to any enormous extent. I don’t think any evidence can even be considered for another few years or so, until we see how many of the highly rated securities actually default, as opposed to merely falling in market price.

    S&P has issued a press release regarding their highly publicized mass downgrades; there is some discussion on my blog.

    At any rate, they are irrelevant to the analysis since they are completely outside the chain of fiduciary responsibility. They give advice only; if some players not only abdicated their responsibility for credit analysis but levered up their bets substantially they have only themselves to blame. If they were imprudent in their speculations, they will have to answer for that to their fiduciaries.

    It will be very difficult to prove one way or the other, but I’ll bet a nickel that the easy credit provided by the financial markets did the economy a service by reinforcing a trend to extremes. Economic – and individual human – damage has been done, but what has been avoided? The excesses have been confined largely to the financial system as opposed to the real economy (as far as one can say that when talking about housing) and risk is now being reassessed largely at the expense of speculators who can afford it, rather than those who can’t.

    Japan’s land price bubble of the ’80’s was accomplished without the helping hand of sub-prime mortgage securitization; it lasted a long time and Japan’s economy has still not recovered, twenty years later.

    Another example is George Soros breaking the Bank of England in 1992. There were many then, and are probably many now, horrified at the thought that a grubby little trader would dare to thumb his nose at the wise politicians and socially responsible bureaucrats who determined the correct value of Sterling. He (and others) cost the British treasury a lot of money; I assert that the cost of maintaining a bogus exchange rate would have cost a lot more over time – just not as spectacularly. There’s implications for the remnimbi there…

    MTHood – I regret that my views on the mechanics of financial markets have enraged you. If you can suggest improvements to my model I will be happy to listen.

  23. Charles

    I don’t see that either monetary or regulatory fixes are going to get us through this one.
    If banks (or federally insured instruments) start to go down, US government obligations will rise at a time when the rest of the world is less inclined to loan us money. Normally, we would raise interest rates to attract investors, but if we do that now, we will head into a recession, exacerbating the deficit.
    I think that we could prevent a mortgage crisis with ca. $100B, if spent through carefully targeted fiscal policy. To achieve the same effect through monetary policy would send the dollar through the floor and inflation through the roof. And regulation will keep the next horse in the barn, but it won’t recapture the one that’s already left.

  24. Stuart Staniford

    The way I have come to think about the efficient market hypothesis is this. Markets are asked to answer a very large number of questions, so the conceptual space of “all prices quoted in financial markets” is a very high dimensional one. Within that space, there are subspaces where it is fairly straightforward to tell that certain kinds of relationships should hold, and that violations of those relationships would be a profit opportunity. For example, if the exchange rates of dollars, sterling, and yen were such that it was possible to change money from dollars into sterling, from there into yen, and then from there back into dollars, and end up with more dollars than one started with, then that would be an obvious, negligible-risk, profit opportunity. The proper consistency conditions amongst present exchange rates are analytically tractable, and we would expect arbitrage to enforce them pretty strongly.
    However, many questions that markets are asked to answer are *not* analytically tractable. Ideally, the price of a stock should be the net present value of the future cashflows. However, the future performance of a company depends on such an enormous number of variables that there is no straightforward way of using this constraint to estimate the price. There is no straightforward rational procedure to decide the proper price of a given stock. In this situation, investors apply their best judgement – they focus on whatever variables they think most likely to be important (management quality, recent performance, trends in stock prices, etc, etc), integrate all the information internally, and then make an educated guess. Some people’s judgement is better than average, and they can beat the market (Warren Buffett is my existence proof). So although in the stock market, people would act rationally if they could, there simply is no reliable way to know what rationality demands (in contrast to symmetry constraints amongst exchange rates, for example).
    And so once we are in this situation of “impossible rationality”, we would expect people to start applying all the heuristics and biasses that psychologists and behavioral economists have spent the last couple of decades teasing out. In particular, social psychology becomes important. In highly uncertertain situations, people look to those around them for help in forming a judgement (in most situations, it’s a good way to not look like a fool). Once those internal within-market social forces become stronger than the input from fundamentals, then markets can oscillate much more than fundamentals would dictate (as Shiller pointed out at length in his book Market Volatility.
    Like Tedk, I have had the experience of talking to a lot of people at social occasions here in San Francisco over the last few years. The bulk of them are homeowners, most with very aggressive mortgages. None of them believed house prices in San Francisco would decline. They did not believe taking out their mortgage was excessively risky. In effect, they believed that prices would rise for a long time (if not forever, at least long enough that any possible future decline was irrelevant to decision-making). Now that prices are declining, most believe they will not decline very much or for very long. Given that the credit markets have now decided that the bulk of mortgages made in California in the last couple of years are in fact too risky, I do not see how they can possibly be any more right now then they were a couple of years ago. Without those mortgages, many people cannot afford current house prices, and therefore prices will have to decline until the market is in equilibrium.
    I realize these are just anecdotes. But JDH, as a professional academic in this area, before believing that people are acting rationally in the housing market, wouldn’t you want some survey evidence? I would suggest that in 2004 and 2005, most housing market participants (in California at a minimum) would have believed that prices would continue to rise indefinitely. This, I believe meets your definition of a bubble. Simply asking a suitably sized random sample of housebuyers seems far the most straightforward way of settling the question. Does such evidence exist? If not, why not?

  25. DickF

    Barney Frank wrote:
    To an important extent these new pools of capital are structured in a fashion that allows them to avoid the scrutiny that is required of firms and financial institutions in the regulated sectors. We should not be surprised. It is a fact of life that investors and firms will seek to innovate their way around whatever regulatory strictures apply, whether they deal with health and safety, labor protections, or reporting obligations. This tendency has been exacerbated by a 30-year attack on the very notion of a regulatory role for governments and loud professions that the market not only knows best, but knows everything.
    Our job is to understand the changes in the financial marketplace and consider what we must do to ensure that our regulatory system is able to keep up with those changes. Innovation is as important in financial markets as it is in product markets, but it would be foolish to act as if regulatory structures, designed for a different world, do not have to be as nimble and innovative as those they regulate.
    Oh great, just what we need, central planning as a growth industry. In the past I often found myself agreeing with Barney Frank, but in recent years he has lost his way. Perhaps his most important advisor has died.
    Let me take it a little at a time.
    Concerning capital pools – government regulations have forced the capital pools into more and more inventive areas totally out of the control of government especially off-shore. One of the reasons we saw Germany and France have a problem with our sub-prime crisis is because US businesses were offloading to Europeans because of over-regulation of US business, better treatment in Europe.
    Frank states, “…a 30-year attack on the very notion of a regulatory role for governments and loud professions that the market not only knows best, but knows everything.” Can anyone say, with a straight face, that we have fewer government regulations and less of a role of government in disrupting the market today than 30 years ago? Can you say Sarbanes-Oxley?!!!
    Our job is to understand the changes in the financial marketplace and consider what we must do to ensure that our regulatory system is able to keep up with those changes. I know that Barney Frank would like to hide his intentions but they come through loud and clear here. The job of congress is not to allow the economy to produce growth, jobs, and general prosperity. Their job is to “ensure that our regulatory system is able to keep up” with changes in markets that free capital and production. His job is to control not produce.
    Frank says, “…regulatory structures…have to be as nimble and innovative as those they regulate.” This is simply impossible for the same reason that government creates problems when it attempts to regulate. A small committee, even a large committee, will never have the wisdom nor the creativity of millions of investors, especially when the regulators have no businsess experience beyond how to pad time charged to a legal client. As we have seen with the sub-prime crisis, central planning only makes things worse.
    And we have academics praising this idea of a growth industry in regulation and central planning? Is it any wonder we are having problems? America is great because of freedom. Nations fall because of government abuse of power accomplished through regulation and central planning.

  26. Josh Stern

    TedK, regarding mis-rated securities, consider, for example, John Mauldin’s description of AAA rated CDO’s composed from lower tranches mortgage-backed loans:
    The investment grade ratings for these almost seem like mis-use of copyright. But even much of the AAA rated stuff from the middle tranches of plain asset-backed was apparently premised on the idea that a nationwide decline in home prices was very unlikely. How could that be? Lots of people were predicting this. Another widely documented problem was the inherent conflicts of interest for the rating agencies that were paid by the issuers and not the buyers.
    Of course it is true that buyers *should* always do their own due diligence, but a market where prices were not predominantly set by the agency ratings at the time of issue would be very different than the existing one…perhaps a lot smaller. Lots of potential buyers probably did do due diligence and passed on the most problematically rated stuff, but that still left a large enough pool of buyers willing to purchase at prices in-line with the ratings.

  27. kharris

    I would tend to agree that the Fed is unable to play a multiplicity of roles. I think the parenting advice, however, is bunk. Parents need to be lots of things. Kids need lots of things, and what they need changes, in little ways and in big ways. When my kids need a referee, I have no business saying “oh no, I decided to be a fan…oh well.”

  28. James I. Hymas

    But even much of the AAA rated stuff from the middle tranches of plain asset-backed was apparently premised on the idea that a nationwide decline in home prices was very unlikely. How could that be? Lots of people were predicting this.

    It doesn’t really matter how many people were predicting it. There were a lot of people who were not only saying that housing was a good investment, but were actually plunking down good money based on that premise.

    And while moral hazard might well be a problem with sub-prime mortgages, these comprised only about 20% of the market in 2006.

    It is not the function of credit rating agencies to make a detailed prediction of the future and to assign ratings based on this prediction. I think they would lose a lot of credibility if they were to say something like … “Toyota makes lousy cars, therefore they won’t be able to sell so many in the future, therefore we’re cutting them to BBB-” – an extreme example, but I’m sure you get my point.

    Such judgements about how future events will affect credit ratings are Credit Anticipation plays and are the purview of Portfolio Managers, not credit rating agencies.

    The agencies should – and will – make a judgement about an investment instrument’s exposure to a particular asset class and apply a notch or two of downgrade – or look for a higher degree of overcollateralization – based on that exposure; it would be the height of irresponsibility for them to predict a crash in housing prices or any other prices and assign ratings based on a high probability of their guess being right.

    That’s for PMs to decide. Several players (e.g., Deutsche Bank) have done very well with credit anticipation. Maybe they’ll do as well next time; maybe not.

    Another widely documented problem was the inherent conflicts of interest for the rating agencies that were paid by the issuers and not the buyers.

    I don’t understand why you feel this is a problem. It’s well known; the agencies don’t make any secret of it; I believe it’s in the course materials you have to learn before you can stand behind a teller’s window and sell $100-worth of money market fund.

    Their reputation for probity is all they have; and you don’t need to look at one of their transition analyses for very long to realize that their track record is very good.

    I listen very carefully to their advice; they have access to management that I don’t have; they have a lot more time to devote to each issue than I have; their track record shows that they don’t just throw these advantages away.

    But if I were to rely blindly on their advice and not just place a small bet based on a particular piece but lever it up 20:1 … well, if this were to be the case, I should lose my license.

    If PMs want credit advice given to them in a fiduciary manner, those facilities are available. All you have to do is pay for them. The PMs who are currently complaining so loudly about inaccurate ratings and conflicts of interest should be explaining to the regulators why they did not do so.

  29. Joseph Somsel

    We should remember that Rep. Franks has a vested interest in market disruption and political blowback. The worst the effects on the economy, the more that a liberal politican can call for increases in government power over it.
    Perversely, one of the factors making the disruption worst is the uncertainty of future government responses. As Amity Schales illustrated in her book on the Great Depression (“The Forgotten Man”) FDR’s unpredictability had the effect of putting capital “on strike” until the certainty of WWII resolved the government’s war on wealth.
    Rep. Franks seems to be doing what he can to increase the uncertainty.
    I have to second Stuart’s observations about Bay Area housing. People took for granted that prices would rise without thinking about who could earn enough to pay the mortages on the appreciated prices. My own quip has long been that in the Bay Area, one either paid the owner or paid the banker but that a family man would always pay as much as he could for a home.
    In the long run, Bay Area prices seldom collapse given the population pressures and the general strong economy. They do plateau for years on end, at least since WWII.

  30. Josh Stern

    TedK is correct that my comment above was in response to James Hymas, and this follows his follow-up above.

    James, I have difficulty interpreting your remarks above. Do you actually disagree with any of the following points: 1) Market participants understand bond ratings as qualitative rank orderings summarizing a rating agency’s belief about estimated cash flow from the bond’s interest payments and return of principal (c.f. ratings to historical probabilities); 2) bond raters commonly use both quantitative and qualitative criteria in arriving at their ratings; and 3) a significant chance of a nationwide drop in housing prices adds to the likelihood of defaults and non-return of principal for MBS? I’ll go forward under the premise that you do agree with those basic points. Then the problem I see with the argument you are making above is that it equivocates between different things. The credit agencies didn’t err by failing to predict that a large housing downturn *would* happen. Rather, they erred if their assigned ratings implied that a large housing downturn was extremely unlikely. If, in 2005, the probability of a 20% appreciation in residential real estate over the next five years was was 70% and the probability of a 15% depreciation was 30% (I know that is a weird bimodal distribution, but hopefully the point for our purpose is clear) then the speculator buying a house to flip can still be rational while *at the same time* the rating agency giving a AAA rating to certain tranches of low-collateralized MBS is completely FUBAR. It is the job of the credit rating agency to anticipate the likelihood of various risks.

    Regarding the second point of why there is a problem with conflict of interest in the credit rating agencies…it is basically just another factor, along with the small number of competitors in the rating oligopoly, that make the market less efficient than it could be. This article goes into detail and raises the possibility that inefficies have accelerated over time: ratings negotiation

    Your third point that buyers have to take responsibility for knowing what they are buying is one I already agreed with above, but noted that reliance on the time savings of trusting rating agencies allows the debt market to be much larger than it would otherwise be. I take it as given that much of the conversation on this site is about how to improve things systemically, and in that light, “Don’t trust the rating agencies and do all your own work,” doesn’t strike me as a good overall solution for the current market.

  31. James I. Hymas

    Josh – Yes, I agree with the three axioms you put forward. I will note that the information given through your link is a simplified transition analysis.

    Now, let’s take a look at your numbers – I recognize that these were given merely as examples, but let’s take a look at them anyway. You suggest a 70% chance of +30% return on housing, and a 30% chance of -15% return. Let’s further assume that (i) the worst case scenario arises, and (ii) every single mortgage was for 100% of the price of house at time of purchase and (iii) not a single dollar of principal was paid down prior to … (iv) every single mortgagor defaults, is foreclosed, and recovery is 85% of the mortgaged amount.

    Is that gloomy enough?

    On my blog I had a quick look at an actual securitized mortgage: Bear Stearns Asset Backed Securities Trust 2005-1. S&P downgraded some of the junior tranches of this on August 24.

    The most senior tranche, rated AAA, comprised about $314-million at issue, compared to a total value for the offering of $395-million. I am not sure to what extent this particular offering was over-collaterallized; let’s say zero.

    In this particular case, the package of assets can decline by 1 – (314/395) = 21% before the AAA tranche starts feeling the pain. Which still leaves some cushion given the extremely gloomy scenario given above.

    I’m not giving the Credit Rating Agencies any kind of free pass. Maybe they did screw up, but I want to see a whole lot more analysis before damning them. There are way too many people out there who assume that packages of sub-prime were packaged holus-bolus into AAA securities, with no tranching or overcollateralization whatsoever, which is simply not the case.

    A rational evaluation of their performance will not be available for some period of time; we’ll just have to see how many defaults there really are and how much recovery after default there really is. I’m not going to rush to judgement, claiming that declining prices is proof the agencies screwed up, as so many PMs and regulatory-wannabes would have us believe. Prices and defaults and liquidity are three very different things.

    The Jesse Eisinger article you linked to was interesting; I linked to it myself. There is no doubt that some ratings-shopping occurred; it always has and always will. But I’m going to wait for a proper transition analysis before I conclude that not only were the credit agencies wrong, but that they were also negligent.

    I’m entirely in favour of constructive solutions! Before getting all fired up, however, I need to be persueded that there’s an actual problem; I’m not convinced that this is the case. Those who feel that the fact that credit rating agencies are paid by the issuers is a deal-breaker have lots of alternatives – I linked to one independent third party as one possibility.

    The problem with forcing the agencies to gain all their revenues from the buy-side is that there will be a lot of free-riding – unless you also force the buy-side to purchase subscriptions. That will still – probably – give a free ride to retail (who will purchase bonds in the market-place at prices that will have been affected by research they didn’t pay for) unless a decision is made to ding them, as well. Which implies that the logical end of this path is nationalization of the agencies and I have a really, really tough time believing that this would be an improvement.

    If I remember correctly – not always a good bet! – the SEC had various documents on their website at one point, dating from the seventies, I think, when the change from ‘subscriber pays’ to ‘issuer pays’ was a big issue. Perhaps somebody will dig up these documents and link to them.

    What we might see in the market-place is a trend to independent agencies. It is entirely possible that investment management firms will either trumpet their subscriptions to third party services (such as CreditSights) or tout the resources poured into their internal credit analysis departments (which many of the bigger players already have). It will be up to the trustees of pension funds (among other investors) to decide whether such efforts will constitute a competitive advantage.

    But please, dear God, don’t let that decision be made by regulators and politicians!

  32. Josh Stern

    James, in the fictional example above, you are apparently calculating the safety of the collateral for the AAA tranches, but not their probability of default. For these MBS to actually be AAA, their probability of default would be near zero. Also, if you go back to the Mauldin link I posted above, you’ll see descriptions of CDOs with AAA ratings that would have little or no recovery in the fictional scenario.
    In the real world, the market has been shouting out loud and clear that it thinks lots of MBS stuff was over-rated, and the imbalance of buyers and sellers has crushed the market for new mortgage originations. I have to admit that I expected the defense of Moody’s to be along the lines of “they couldn’t have known” rather than “they actually got the ratings correct”. Should there be more regulation? Probably the S.E.C. should up reporting requirements for certain product categories. To make an analogy with equities and analysts, we can rank order the value of information as follows: reported financials > estimated future earnings > analyst target price + buy/hold/sell recs. So there would be value in making the more fundamental information about a loan that is meant to be used as a tradeable commodity as accessible as the less fundamental, more subjective information that is the agency ratings. Since the market already has this information for bonds from large publicly traded corporations, it may have failed to notice its relative absence for many ABS related classes.

  33. James I. Hymas

    I am at a bit of loss to understand what you mean with your distinction between “safety of collateral” and “probability of default”.

    The issue I used as an example (the BS ABS 2005-1, Class A) are not collateralized. They are unsecured obligations of a trust. As long as the trust meets its stated obligations, the issue is not in default (see “Events of Default”, page S-80 of the prospectus). Incidentally, while I was looking through the prospectus, I decided to copy-paste this:

    The following table summarizes certain
    characteristics of the mortgage loans as of
    the cut-off date:
    Number of mortgage loans……………………3,527
    Aggregate principal balance…………..$394,649,130
    Average principal balance………………..$111,894
    Range of principal balance………$1,041 to $800,000
    Range of mortgage rates……………0.00% to 16.50%
    Weighted average mortgage rate……………..8.032%
    Weighted average combined
    loan-to-value ratio……………………84.50%
    Range of scheduled remaining
    terms to maturity……….9 months to 361 months

    There’s lots of other information in the prospectus. I don’t know about you, but the highly senior nature of the AAA tranche of this issue gives me a high degree of comfort that the trust will be able to meet its obligations – with respect to the AAA tranche, anyway! As S&P noted when downgrading the more junior tranches, the losses experienced have exceeded the losses expected to a sufficient extent as to increase the chance that the obligations to the junior note-holders will not be met.

    I will admit I didn’t read the Mauldin link. It required a subscription (free, admittedly) to his newsletter and I have very little interest in subscribing to his newsletter. If you would like to identify the issue and tell me where to find a prospectus – and tell me what he’s so upset about – I will have a look.

    I will bet you a nickel that there won’t be much more than usual to worry about. What underperforming portfolio managers, the press, the regulatory wannabes and the politicians are asking me to believe is ‘Ha ha ha! Those idiots at S&P assign triple A ratings at random! They’re so stupid they didn’t even realize mortgages can default! What a bunch of dummies!’ Sorry, life isn’t usually quite so exciting.

    Yes, the market has been shouting loud and clear that it thinks lots of MBS stuff was over-rated, and the imbalance of buyers and sellers has crushed the market for new mortgage originations. So what? Seven years ago the market was shouting loud and clear that 150% of all grocery purchases would be executed over the internet. The market very often shows that it really doesn’t know squat.

    On the one hand, there are credit anticipation plays going on. Credit Anticipation is an entirely reasonable fixed-income strategy but I am just as hesitant to place blind faith in the ability of PMs to get it right every time as I am to place blind faith in the ability of Credit Ratings Agencies to get it right every time. In this particular case, we are seeing not just a mass movement out of perfectly good, well secured sub-prime-mortgage based trusts, we are seeing three month government paper at ridiculous levels. This smells to me more of panic than analysis.

    I’m of two minds regarding your suggestion regarding increased regulatory reporting requirements. I would love to have more information about the stuff I’m offered. On the other hand, if I don’t have information I feel sufficient, I can walk away. And on the third hand (since this is an economics blog, I feel perfectly entitled to three hands), I know that most PMs – and other buyers – won’t look at the information if it’s available anyway. This will hurt their results, but they can always run crying to the press and blame the ratings agencies. Why not?

    With respect to my so-called defense of the ratings agencies … they might have screwed up, as I said. It’s also entirely possible that they executed their function with absolute perfection and have simply been overtaken by events. I’ll want to see a transition analysis in five years. Until then, I’ll keep an open mind and give them the benefit of the doubt where doubt remains – as it does with these AAA tranches we’ve discussed. After all, they’ve got a fifty-year track record that is head and shoulders above virtually all of their critics.

  34. PrefBlog

    September 17, 2007

    Panic, thy name is retail:
    Despite the credit-market uproar, redemptions from money market funds were described as lower than expected at $915.5 million. Bond funds had $368.1 million in net redemptions excluding reinvested distributions, and Canadian …

  35. James I. Hymas

    Here’s some moral hazard for you, Professor, if you happen to be running out of examples!

    The purchase of AAA rated mortgage bonds isn’t unusual for Freddie Mac, according to company spokeswoman Sharon McHale.

    “It’s a regular way we have been providing liquidity to the mortgage market,” she said.

    So Freddie Mac, which has been highly leveraged and will become even more highly leveraged, is making tons of money buying AAA tranches of sub-prime from SIV’s, et al. which are having a tough time remaining leveraged.

    And in this particular case the seller was CIT Group, whose bonds and equities have been hammered over the last six weeks because it holds – gasp! – AAA tranches of sub-prime.

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