Back to Keynes II

Greg Mankiw seems to agree with me about the current relevance of Keynes. So does Tyler Cowan. He is creating a discussion of the General Theory at Marginal Revolution.

Morgan Stanley and Short Selling

This article in the Wall Street Journal reports on short selling regarding Morgan Stanley in September. Recall that CEO John Mack attacked short sellers for what happened to the stock price, and was instrumental in getting the SEC to initiate the short selling ban. The interesting tidbit in the article is that hedge fund clients of Morgan Stanley reacted by pulling their funds out as revenge:

But within days, more than three-quarters of Morgan Stanley's roughly 1,100 hedge-fund clients had put in requests to pull some or all of their assets from the firm, according to a person familiar with the operation. Even though most kept some money at the firm, Morgan Stanley couldn't process all the withdrawal requests at once, adding to market fear.

As Felix Salmon argues the notion of a bear raid on Morgan Stanley does not hold water. The cost of insuring against Morgan Stanley default increased because investors needed to hedge, not because of a bear raid. Two months later the cost of insurance is down but the stock is still in the doldrums. As Salmon notes:

Even now, after yesterday's massive rally and a further uptick this morning, Morgan Stanley stock is trading at less than $15 a share. Clearly the stock price is not being driven down by manipulative speculators taking advantage of an illiquid CDS market to sour sentiment.

What I wonder about is how much the loss of business caused by the attack on short sellers cost Morgan Stanley.

Back to Keynes

It is hard right now not to think about the economics of John Maynard Keynes. We appear to be in an environment where the lessons of the General Theory are once again relevant.

Given the developments in macroeconomics in the last 25 years it is a bit hard to type those words. Yet is surely seems to ring true today. After all, our current economic crisis is not the result of some external shock -- indeed, the boom continued while oil prices sky-rocketed. The crisis is related not to external events but to the unraveling of a bubble. In essence, it is essentially a failure of coordination. As investors fear for the future they rush for security. T-bill rates fall to near zero, lending to the private sector decreases dramatically, and income and employment start to spiral downwards. That is why so many now call for a severe dose of fiscal stimulus (see, for example, this article by Paul Krugman).

As my colleague Neil Wallace mentioned to me today, what is striking about our current situation is that unlike, say, Katrina -- which had serious, real destructive effects for both capital and labor but had little impact on the overall economy -- our current dilemma seems to stem directly from fear and expectations. Fear of the future has had very serious real effects. "Animal spirits," or the lack thereof, is the important factor. Investment is on strike right now and we seem to be in a liquidity trap where credit expansion is ineffective at combating the slump.

The return to the economics of Keynes at this moment makes me think about the "corridor hypothesis" that my former teacher Axel Leijonhufvud proposed. He argued that in normal times the market system works well to bring us back to equilibrium. Within the corridor of stability it is like a thermostat -- a negative feedback device. The problems that Keynes wrote about occur when we are outside the corridor. Then we cannot rely on the market to automatically restore equilibrium. That is where the economics of Keynes is relevant. Unfortunately, for us, we now appear to be in that situation.

I suppose that during a long period of stability it is not surprising that we ignore the lessons about effective demand failures. The lessons seem archaic. Now the same lessons seem very relevant. Good fortune allowed us to ignore the economics of Keynes for a while. Perhaps the consequence of assuming that those lessons were no longer applicable is the reason that we recklessly created an environment that caused us to leave the corridor.

Citigroup's Descent

The failure to adequately manage risk is the theme of this article in the NYTimes. One of the highlights concerns Citigroup's analysis of the risk of its mortgage holdings:

...when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Another amazing item is that Citigroup mainly relied on ratings agencies rather than its own risk managers to assess the risks from assets like CDO's. One might understand this if Citi was just selling the assets to gullible investors (which it did), but it held huge slices itself, and it is the losses on the assets it retains that have caused such large losses.

It is amazing to read how a company could lose $220 billion in market value in just two years. As Brad DeLong emphasizes, however, the losses in market value dwarf the announced losses on CDO's and other real estate loans. DeLong's argument is that the risk premium on holding Citi equity has risen as the crisis worsened. After all, the probability that the government will dilute the shares in a takeover has increased dramatically. He takes the rise in the risk premium as the major factor causing the value of Citi's shares to decline so dramatically.

DeLong's analysis is based on the observation that banks are institutions that trade on reputation and trust. The borrow short and lend long. Hence, they are always on the edge in a financial crisis. The risks bank take that are sensible in normal times appear insane in rough times.

Rescue package soon to follow.

Zimbabwe Hyperinflation

According to calculations from Professor Steven Hanke, the annual inflation rate in Zimbabwe has reached 89.7 sextillion percent (89,700,000,000,000,000,000,000%). On the bright side, it is only about 79.6 billion percent per month. If you go to this site you can see a table that shows its massive acceleration.

Frightening Picture of the Day

Frightening picture of the day. This is the corporate cost of borrowing in real terms, from Paul Krugman. Inflation expectations are taken from the difference between 20 year Treasury bonds and 20 year TIPs. You can really see the sharpening of the crisis. A key part of this is the decline in inflation expectations.



A related piece of information is that the spread between high yield bonds and Treasuries rose to 18.6% on Wednesday. The spread was only about 8% in August.

Agency

I've said before that the key problem that led to the crisis was agency. Incentives for financial decision makers encouraged risk taking. An article in today's Wall Street Journal provides some evidence, in the form of earnings of top executives in finance and home-building over the last five years. A key finding:

Fifteen corporate chieftains of large home-building and financial-services firms each reaped more than $100 million in cash compensation and proceeds from stock sales during the past five years, according to a Wall Street Journal analysis. Four of those executives, including the heads of Lehman Brothers Holdings Inc. and Bear Stearns Cos., ran companies that have filed for bankruptcy protection or seen their share prices fall more than 90% from their peak.

Of course such earning filtered all the way through the financial system. Bonuses and earnings were high at investment banks because the risk taking led to high current earnings, and because insufficient attention was paid to the associated risks that the decisions that produced those earnings implied.

The key point is that these people were obviously not stupid, and the crisis is not due to stupidity, but rather to a system that rewards current performance without attention to risk. To paraphrase James Carville, "it was the incentive system stupid."

Origin of the Subprime Mess

Michael Lewis, of Liar's Poker fame, has an article that discusses the origins of the subprime crisis. As usual with him, it is very readable. The most important parts are the discussion of synthetic CDO's, though I am not sure that discussion is as clear as the rest of the article. But it is worth reading.

Saving the Taxpayers II

Regarding my previous post on the corporate raider plan to save GM I should make two points. First, I need to amend my argument to make GM bankrupt without a government bailout. This is easy: I need to suppose that the market currently factors in some amount of bailout with an expected value greater than $1.8 billion. Then the current value of cash flows is less than the value of all its liabilities. The government is still better off buying and selling the company if it can receive enough to offset some of the claims it will face in the event of bankruptcy. I will show this later.

The key point to make is that for the government the legacy costs are sunk. It is going to have to pay them in the event of bankruptcy. So any net revenue it gets lowers the taxpayer burden relative to bankruptcy. This is not true for the private corporate raider. To the private corporate raider the legacy costs are like a tax. But the government can internalize this tax. The private raider cannot.

Saving the Taxpayer from GM bailout

It seems likely that the government is going to devote taxpayer funds to a bailout of GM. It seems to me, however, that acting as a corporate raider the government can do a lot better for the taxpayer, and for other stakeholders as well. This seems bizarre, but I think it is correct. Here goes.

A Bailout for the Taxpayers: Government as a Corporate Raider

We hear that GM is likely to go bankrupt if the government does not offer a bailout. It is losing $2 billion a month, and by the end of the year its cash reserves will fall below feasible operation. We also hear that GM's problems are the result of legacy costs. These costs are a fixed cost that GM cannot unilaterally cut, and these prevent GM from investing in R&D and new models. Hence, it puts GM at a competitive disadvantage relative to other auto companies.

Let us suppose that this is true. It seems that the government, by acting as a corporate raider, could make everyone better off – surely compared with a bailout. The simple way to think of this is that GM is a company with two divisions. One produces autos and earns revenue. The other produces health and pension benefits but sells nothing. The combined value of this company is now valued at about $3 per share, which gives a current market valuation of GM at $1.8 billion. Let us suppose that legacy costs are $20 billion, and for simplicity assume that this is GM's only debt. Then the present value of cash flows must equal debt plus equity, so the present value of cash flows is $21.8 billion.

Now suppose the government purchased all the shares of GM at the current price (ignore for now the problems of making a tender). The government owns all of GM. Now it creates two companies, by splitting the two divisions. It then sells the auto division to the private sector. What would this company be worth? If the cash flows of the company were unchanged it would be worth $21.8 billion. With these proceeds the government could fund the entire legacy costs, since this is just the difference between what GM sold the auto company for and what it paid for the whole company.

But GM claims that its legacy costs are hurting its competitiveness. If this theory is correct then the expected value of GM auto cash flows would be higher if the company was relieved of the legacy costs. Hence, the government ought to get even more than $21.8 billion. If the theory is correct, splitting up the company this way ought to produce value. And remember, the legacy costs are now fully covered (perhaps they should not be, but that is a different question).

Notice that the current value of GM may be higher than it is really worth. The market may have factored in the expectation of a bailout. Perhaps, the present value of the bailout is worth $1.8 billion. Even if this is true, the government would make money on this raid as long as the expectation of future cash flows rises by more than $1.8 billion when the auto division is relieved of these costs.

How does this compare with bankruptcy? If the government does not bail out GM the company will still be restructured. But in that case the government will be stuck with the legacy costs, which will be turned over to the PBGC. The retirees will be worse off because the PBGC will pay perhaps 40 cents on the dollar of obligations (I am not sure that 40% is the right number, but you get the idea). More important, however, the government is worse off. Why? Because when GM emerges from bankruptcy the government will owe 40% of the legacy costs but have no revenue to fund this (there is future tax revenue, but they get that under the corporate raider plan too). The current shareholders are worse off because under the corporate raider plan they at least get $1.8 billion.

If this deal is so good why doesn't a private investor do it? Notice that if a private investor made a tender for GM its price would rise, lowering the gain of the deal. Presumably the government can purchase all the shares outright without having to accede to SEC regulations on tenders. Moreover, the private investor would have to be large enough to be able to fund the legacy costs until the new company is re-sold. Without this the unions would not accept the deal. In fact, it would probably be illegal for the private raider to split the company into these two divisions without putting up a guarantee for the legacy costs. But the US government could do this easily.

It seems like everybody wins. Surely, it is better than a bailout that allows GM to continue to operate with the legacy costs for more months, hoping the auto market will turn around. The only reason why this would not work would be if GM's argument that its operations are hampered by legacy costs is not really true.

It could be that GM's losses are sufficient to drive the company bankrupt even without the legacy costs. In that case the government would be out the full $20 billion for the legacy costs and receive nothing for the auto company, or perhaps some smaller amount, say $5 billion (which means the market is currently valuing the potential bailout at $16.8 billion = $21.8 billion - $5 billion, which is hard to believe given that the probability it takes place is less than certain). Then the government will be out $17 billion. Presumably in that case it can restructure the legacy costs, recognizing that if the company had gone bankrupt, which it certainly would in this case, the government would inherit the legacy costs anyway.

Let us suppose that if the government inherits the legacy costs it has to pay 40%. So if the company goes bankrupt the government is out $8 billion. Then even if the auto-GM is only worth $5 billion (as in the previous paragraph) as long as the government settles the legacy costs for less than $11 billion, the government is better off, and certainly the retirees are better off.

So far I did not consider corporate debt, aside from the legacy costs, but it is not hard to include this in the analysis. Suppose that there is $10 billion of corporate debt. Then GM's cash flows would be worth $31.8 billion ($1.8B + $20B legacy +$10B in corporate debt). If GM's theory is correct, then nothing is changed in the analysis. Absent the debt the company can be sold for $31.8 billion, which is enough to fund the legacy costs and the debt.

The interesting case is when GM's theory is incorrect, when the company is worth less than its current debt plus equity. To continue with the previous example, suppose the government can sell it for only $5 billion, so it is left with $3 billion after the purchase price. This now has to cover $27 billion in debt (corporate plus legacy). Using the 40% rule the government must reserve $8 billion for the retirees. The question then is how much of the $3 billion goes to the corporate debt holders and how much to the legacy costs. If the government pays 20 cents on the dollar to the debt holders, it can still pay $8.5 billion to the retirees, who are better off than under bankruptcy. Is 20 cents on the dollar fair? The government sold assets for $5 billion that had $27 billion in debt. Surely under bankruptcy proceedings the debt holders would have done even worse.

And what about the taxpayers? Even in this case they are better off. The government saves half a billion in this most pessimistic scenario compared with bankruptcy. And if GM is really worth something the government and the other stakeholders share in the gain. Alternatively, under a bailout the government is out the subsidy plus the same legacy costs if it is unsuccessful. And if GM still labors under the legacy costs there is no improvement in its operations. So the corporate raider solution is the best way to protect the taxpayer.

More Fannie Losses

Fannie Mae reported quarterly losses (also here) of $29 billion for the third quarter. This is a huge amount of losses, greater than all of Fannie's profits from 2002 to 2006 -- the height of the boom in housing. This suggests that we have not yet reached the bottom of the housing boom.

It is also instructive of the unintended consequences of government policy. Apparently, Fannie is having great trouble refinancing its bonds. The reason is that as a GSE Fannie has only an implicit government guarantee. But banks now have much more explicit government guarantees, indeed many are partially government owned now. So the costs of borrowing for Fannie (and Freddie) are much higher. This will make it harder for Fannie and Freddie to extend lending which the government wishes they would.

Porsche Financial Engineering

As a Porsche owner I am convinced of the quality of Porsche's engineering. But now we have more details about Porsche's financial engineering. Apparently, Porsche was able to engineer a short squeeze on VW shares as it moved to become the majority owner of the firm. The squeeze briefly made VW the most valuable company on earth, and it made Porsche, already the most profitable of auto companies a huge return.

Surprising Country Risk Ratings

Merrill Lynch analysts have decided to go back to country risk analysis the old-fashioned way, by looking at indicators of macroeconomic and financial stability (see this article). Specifically, the look at indicators such as: the current account financing gap, FX reserves/short-term external debt ratio, exports to-GDP ratio, private credit-to-GDP ratio, private credit growth, loans-to deposits ratio and banks capital-to-assets ratio.

Using these indicators they obtain the following country risk rankings which are a bit surprising.


Now I am not yet ready to move my assets to Nigeria. It is important to note that a country might do well on some of these rankings by having a horribly underdeveloped financial system. This would certainly lower private credit growth for example. And primary exporters will do well since they have high foreign exchange earnings. Still the rankings are interesting. They indicate that those countries that were the go-go countries in the boom are much more risky now.

Financial Engineering

What role did financial engineering -- complex quantitative financial models -- play in the financial crisis? This article in the New York Times discusses this issue. The article notes:

“Complexity, transparency, liquidity and leverage have all played a huge role in this crisis,” said Leslie Rahl, president of Capital Market Risk Advisors, a risk-management consulting firm. “And these are things that are not generally modeled as a quantifiable risk.”

Math, statistics and computer modeling, it seems, also fell short in calibrating the lending risk on individual mortgage loans. In recent years, the securitization of the mortgage market, with loans sold off and mixed into large pools of mortgage securities, has prompted lenders to move increasingly to automated underwriting systems, relying mainly on computerized credit-scoring models instead of human judgment.

An important point, noted by Andrew Lo is that while academic economists were receptive to his warnings of the risks associated with financial innovation Wall Street was not. The reason is that Wall Street had little incentive to listen as long as profits were high. He points out that we have fire safety regulations even though buildings have little risk of burning down, and financial regulation is needed for the same reason.

Gary Gorton and AIG models

Gary Gorton, Professor of Finance at Yale, has written one of the best articles on the panic of 2007. The essential point is that:

The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages...When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks.

It turns out that Gorton was also responsible for producing the risk models that AIG was using to value credit default swaps. This article explains his role and how the models failed to account for the key risks that led to AIG's downfall. As the article notes:

Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances.

Felix Salmon also links to the article and has a good discussion. He notes:

At heart, here, is an age-old debate over the value of any fixed-income instrument. Let's say you buy a bond at par which makes all its interest and principal payments in full and on time. Then you're happy, and making money. But let's say that a couple of years after issue, that bond is trading at just 10 cents on the dollar. Have you lost money?

The answer of depends on how many such bonds you hold, and what your counterparties think. And AIG got into trouble when it could not come up with sufficient collateral to meet the demands.

How we got into this mess

How did a Wisconsin school board, a German bank located in Dublin, and the New York Subway system get caught in the financial crisis? The New York Times has the first in a series on this here.

The saga is interesting, but the story is familiar. "Financial experts" convince boards that complex financial products will lower their borrowing costs and increase their returns. The risks in the products are not adequately considered. An event occurs which reveals the true risks.

Despite the familiarity it is an interesting story.

Shiller on Failure to Forecast the Crisis

Robert Shiller argues that economists distaste of behavioral finance is the reason why warnings about the crisis were ignored. Shiller was one of the few economists who warned about the housing boom, so his experience is worth considering. I still think, however, as I discussed in a previous post, that it was the lack of belief in market efficiency that got us into this mess.