The Dollar

The NYTimes reports that the dollar is weakening:

The dollar skidded to its lowest point in five months this week, battered by creeping fears that Washington’s costly efforts to stimulate the economy are growing harder to finance and may set off an unwelcome bout of inflation. Analysts are increasingly concerned that a rise in prices could hurt consumer spending, deepening the recession.

While the facts are undisputed, some of the analysis is weird as is the title:

As Dollars Pile Up, Uneasy Traders Lower the Currency’s Value

This makes the movements sound almost like some conspiracy, or a mystery. One analyst is quoted to the effect that this is all psychology. But this cannot be right. The dollar has been on a slide for almost a decade due to our excessive borrowing from the rest of the world. The financial crisis caused a temporary reversal in the process -- that was psychological -- fear caused people to hold dollars. But fundamental factors mean the dollar has to decline. While the article presents a graphic for the dollar for the last three months, look instead at the last 6 years.


When you look at the dollar against the euro since 2002 you can see that the economic crisis caused a temporary halt to a longer term problem. And nothing we have done to deal with the recession -- big deficits, lots of central bank credit -- is going to make the dollar stronger in the future.

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.

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.

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.

Behavioral Finance and the Crisis

David Brooks argues that the current financial crisis will be a coming out party for behavioral economics. His starting point is Greenspan's recent confession:

As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

But this misses a key point. The major players were rational. They made money because they received bonuses based on returns that hid risk. The problem was agency not irrationality. What Greenspan apparently missed is the fact that the managers of corporations do not have interests that coincide with the shareholders. The separation of ownership and control is an old issue in economics. We know that when agency problems arise incentives are need to get the agent to act in the interests of the principal, here the shareholder. To get agents to pursue profits incentive contracts give them shares. But the downside risk is zero -- you cannot indenture as a slave a manager who loses big money. Hence, the manager has big incentives for risk taking. This is what happened.

Now one can argue that the boards of directors or very top managers should have watched risk more closely. But they were booking large profits and large bonuses. Had they believed that markets were efficient they might have wondered how they were earning such large returns -- where are the associated risks that allow this. But instead they assumed markets were inefficient and assumed they had hired wizards. Notice that this is exactly the opposite of the view that Brooks is expressing.

This is not to say that behavioral finance may not have good insights about issues related to the financial crisis (and finance in general, here is a survey), but certainly not in the way argued by Brooks and most commentators today.

Flight to Safety

The unwinding of the carry trade and the flight to safety is causing the yen and dollar to appreciate. This is what is spreading the crisis to many emerging markets.

I gave a talk on the financial crisis this week and I noted that this crisis was unlike typical ones in one big way. When most countries experience a financial crisis currency flows out and the biggest problem is to defend the currency. The IMF then comes in and pushes lower government spending to create confidence in the future of the economy. But our crisis has caused the dollar to appreciate as the whole world demands the safety of the dollar. Hence, our government is increasing spending. We have created a new type of financial crisis. That is the risk when it comes from the financial center.

Are Banks Lending?

Joe Nocera argues in the NYTimes today that many banks are using their recapitalization to buy other banks rather than make loans. While he decries this tendency, it still represents some consolidation of the financial sector. That should make it healthier. I think that lending will be down because of fear of recession and tightening credit standards. After making so many bad loans, banks are going to look tougher at credit standards. That seems like a rational response to what has happened. It will make the recession more severe.

What this really points to is that now the recession is not due to lack of liquidity but to fear of lower earnings. The impact of the financial crisis has already been felt. Genie cannot get back in the bottle.

Recession May be Bad

Officials at the Treasury and the Federal Reserve are expecting a serious recession, according to this article in the Financial Times. One quote captures the feeling, that from former Fed Vice Chair, Alan Blinder:

“It looks to me like the economy has fallen off a cliff...The game is now about making sure this recession is less deep and less long than the 1982 recession.”

One difficulty in forecasting how deep this will be is the fact that the crisis is international. Another, is to understand how US households will respond to the cut in their wealth. Will savings rise in reaction? We have depended for a decade on households consumption based on the growth in asset prices. Now that households cannot rely on this, what will happen to consumption?

Causes of the Financial Crisis

Tyler Cowan discusses the causes of the financial crisis in the New York Times. His one paragraph summary is that:

Over all, then, the three fundamental factors behind the crisis have been new wealth, an added willingness to take risk and a blindness to new forms of systematic risk. All three were needed to bring about the scope of the current mess — so that means we’ve had some very bad luck on top of everything else.

New wealth matters because it led to the savings glut and a fall in real interest rates. The money had to go somewhere. The problem is where the financial system channeled those savings.

It is important to also recognize that when a boom takes place those who are betting on the bubble continuing are making large gains. They tend to shout down then naysayers at that point. That is why it is hard to implement any policy to pop the bubble. Given this is unlikely to ever change, one would hope we can at least implement policies that reduce systemic risks. But that is also easier said than done.

The Crisis is Spreading

The crisis is now spreading to other economies (see this article), like Iceland, that relied heavily on borrowing at low interest rates to support their debt. Now repayment is very difficult.

Following the virtual seizing up of the Icelandic economy, countries such as Hungary, Argentina and Pakistan look vulnerable as they struggle to pay their bills. These countries took on large amounts of debt in the good times, when credit was cheap, and are now running out of money to pay them off because banks and investors refuse to lend to them.

This is the contagion. But while the crisis causes a recession in the US, the cost to emerging economies may be much greater.

Arrow on the Crisis

It is always important to listen to Kenneth Arrow on any topic. Here he talks about the financial crisis. Important passage:

the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity.

TED Spread

The TED spread, the difference between the rate at which banks borrow from each other, LIBOR, and the rate on Treasury Bills is a key indicator for the problems in the interbank market. Perhaps as a result of the European moves towards a bank rescue plan the TED spread fell 1.4% today. But it is still very high. You can see from the chart below that the TED spread is still much higher than in the summer. But at least today is some positive news.

Crisis Resolution

Momentum is building towards some type of bank recapitalization. A group of economists has published a set of essays describing how some resolution might take place. The essays are here. What is evident is that a broad group of academic economists see that some type of recapitalization is the way to go.

Europe Agrees to a Bailout Plan

European governments announced an agreement on a bailout plan. Here is an article that describes the agreement. The plan includes recapitalization of banks and a guarantee of interbank lending. It is clear that markets were worried about the lack of a plan, and this announcement may be good news Monday morning. Of course we will want to see more details in how this works. It seems that the details of many plans are rarely as good as the announcements. In particular, as Floyd Norris notes, "they left it up to each nation’s government to provide details of how its own banking system would be protected."

The plan asserts that it will “support systemically important financial institutions and prevent their failure.” But it is not clear which institutions will qualify as such. More important, this may not free up interbank lending if one of the banks is clearly not "systemically important."

But this action still seems to be a good step.

Plan B

Luigi Zingales offers an interesting alternative bailout plan. His plan focuses on ways to recapitalize the banking sector and to deal with the mortgage crisis. His Plan B idea is to stop the piecemeal reaction to developments in the financial crisis and implement a comprehensive plan.

Here is the core idea regarding the bank part of the bailout:

The core idea is to have Congress pass a law that sets up a new form of prepackaged bankruptcy that would allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are pre-specified and banks could come out of it overnight. All that would be required is a signature from a federal judge. In the private sector the terms are generally agreed among the parties involved, the innovation here would be to have all the terms pre-set by the government, thereby speeding up the process. Firms who enter into this special bankruptcy would have their old equityhodlers wiped out and their existing debt (commercial paper and bonds) transformed into equity. This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. In other words, they are close to being insolvent. By transforming all banks’ debt into equity this special Chapter 11 would make banks solvent and ready to lend again to their customers.

I wonder if policymakers in the US are ready for such a comprehensive solution. Certainly Congress did not display the attention nor energy with regard to Plan A. Perhaps the deepening of the crisis would help, but prior to the election I think we are going to have to rely on the discretionary power of Bernanke and Paulson.

We had better hope right now that some effort towards bank capitalization appears early this week.

Not to Worry?

Casey Mulligan has an op-ed in the New York Times telling us not to worry about the financial crisis. His basic argument is:

The non-financial sectors of our economy will not suffer much from even a prolonged banking crisis, because the general economic importance of banks has been highly exaggerated.

Mulligan argues that the return to capital in the non-financial sector is still high. But it was also high prior to the Great Depression (I am not arguing we are going to have one, but...). It is hard to believe, however, that the drying up of credit will not hurt the rest of the economy. State governments, for example, are coming under great difficulties, and this is before taxes start to fall from reduced spending.

In the fall of 1929 America's leading economist, Irving Fisher, argued that "Stock prices have reached what looks like a permanently high plateau." When the Depression did arise he contributed an important explanation of debt deflation. Perhaps, Mulligan will be our next Irving Fisher.

Compared to Mulligan's article, this piece by Laurence Kotlikoff and Perry Mehrling is tame. They argue that the financial crisis brings offsetting gains as asset prices fall. Focusing on financial losses alone, overstates the problem. But financial bubbles lead to misallocation of capital. Capital has been wasted and will have to be written off. These are real losses. Of course, some people will be able to purchase homes at cheaper prices, but the losses will impact on further investment. They are probably correct that Paulson and Bernanke will not make the mistakes that translated the credit crisis of the early 1930's into the Great Depression. But when an economy deleverages from the levels we have seen, the economy is going to suffer.

Greenspan's legacy

The New York Times has this article on Greenspan's legacy. The focus is on the failure to regulate derivatives. I have to admit that at the time I was on the side of Greenspan, and Rubin and Summers. Like most economists, I just assumed that a government agency headed by a lawyer could not understand the role of a complex financial contract.

Hubris is no substitute for analysis I guess.