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.

New Bretton Woods?

Sebastian Mallaby discusses the possibility of a new Bretton Woods agreement. He points out that it will be important how China reacts to the situation:

Today it is the rising power that pursues mercantilist policies via its exchange rate. China's leadership, which sits atop an astonishing $2 trillion in foreign-currency savings, could trade a promise to help recapitalize Western finance for an expanded role within the IMF. But China may simply not be interested. The future of the global monetary system depends on whether China aspires to play the role of Roosevelt -- or whether it prefers to be a modern Churchill.

But I wonder about another problem. The Bretton Woods agreement had the benefit of having the century's greatest economist, John Maynard Keynes, essentially running the show. He led the British delegation. There are plenty of good economists today, but any new agreement is going to be led by Presidents and Prime Ministers. Who will be the Keynes of the new agreement?

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.

What's Next

Joe Nocera discusses some proposals to deal with the housing problem, which is, after all, the core problem of the financial crisis. Until we deal with this problem in some way the crisis is likely to get worse, not better.

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.

Keynesian Recession Coming

It looks like we are in for a real Keynesian recession. The liquidity crisis seems to have led to a stop to bank lending, so we are approaching a liquidity trap. Demand is now falling, witness the drop in retail sales announced today which shook the markets, and this is a sign that the recession is already underway. If monetary policy is ineffective due to bank's unwillingness to lend, we are in the almost classic "Keynesian type" recession of old textbooks.

The relevance of Keynes to our current experience was highlighted by Robert Skidelsky in this column. He is perhaps correct when he writes that

To understand how markets can generate their own hurricanes we need to return to John Maynard Keynes.

But I think he overstates his case considerably when he argues that " mainstream theory has no explanation of why things have gone so horribly wrong." In particular, he expresses the view that is prevalent now that economists focus on efficient markets blinded them to

Greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics -- the forces that drive boom-bust cycles -- only exist off the balance sheet of their models.

This is factually incorrect. We have models of bubbles and herd behavior. But more important it ignores the point that much of the problems we have now are the result of ignoring market efficiency. When investors believed they could earn extra return for no extra risk they were not basing their behavior on efficiency. The carry trade is an example of profiting from the absence of efficiency. The problems we now face are that markets caught up. The excess returns they were earning were just a compensation for the losses that are now incurred. If savers and investors had assumed that they could not earn extra return for no extra risk they would have been in index funds not CDO's. They would not have been fooled by ratings from ratings agencies.

Economists' Views on the Recapitalization

The Wall Street Journal collected some opinions of academic economists on the recapitalization plan. One item of dispute seems to be whether it is better for the government to claim preferred or common shares. The former means more security for taxpayers and no voting rights. But it also could induce more risk taking on the part of banks close to the brink. Preferred shareholders get paid first, so for the common shareholders who are close to being wiped out more risk may be better.

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.

End of the Carry Trade

The carry trade is a bet where you borrow at low interest rates and lend at high rates. Typically, you borrow in Japan and invest in Australia. Your bet is that the interest differentials are not signaling that the Yen will strengthen relative to the weaker currency. For long periods you make small gains. Iceland seemed to be operating as a huge carry trade hedge fund.

It seems now, however, that the carry trade may be ending. The Yen is strengthening in the wake of the crisis. Notice that the carry trade is a bet that markets are not efficient -- that interest parity will not hold. For long periods of time it seems that one can make money going against this. But eventually the reckoning occurs. The problem with such bets is that when they unravel it is a very hard landing.

The carry trade was very profitable for years prior to the Asian crisis. But it unwound quickly and caused large losses when the Yen did appreciate. I wonder if the current unwinding will spread the pain now.

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.

Short Sales Ban Ends Tomorrow

The ban on short sales ends tomorrow. Will stocks collapse? Probably not, perhaps the reason why stocks tanked Tuesday was in anticipation of the lifting of the ban. After all, if prices are expected to fall tomorrow nobody will hold them today.

Another interesting date to watch is October 10 (in an earlier post I got the date wrong, October 23 is the date that WAMU bondholders will have their auction. Lehman's auction is in a couple of days, but this just strengthens the point I am making). That is the day that the auction will take place to settle the credit default swaps relating to the Lehman bankruptcy. The amount that is owed in this case could be $400 billion. Fear over how this will play out is just another factor in the general uncertainty over the economy.

Finally, the Fed's announcement that it will purchase commercial paper must reveal that policymakers understand that the credit crisis is really bad. Otherwise they would not have taken this important step. This must have been another shock that hurt markets, but it is good that the Central Bank will take action in this case.

Crisis Goes Global

The financial crisis has gone global (see also here). Emerging markets were hit especially hard, the Morgan Stanley Emerging Market Index fell 11 percent, its larges daily fall since 1987. Russia and Brazil experienced large losses in their stock markets, where trading was suspended. This reflects the global demand for safety. Consequently, funds are leaving emerging markets for safe havens. You can see this by looking at what has happened to the dollar price of the euro. The financial crisis has ironically caused a large appreciation in the dollar.


This is perhaps even more apparent when one looks at an emerging economy currency, such as Brazil.



Notice that this dollar rally reflects a flight to safety. It is not a long-term rise in confidence in the US economy. Indeed, one must suspect that in the longer term the dollar must depreciate to offset the current account deficit, and as a reaction to the increase in liquidity injected into the economy.

Given how thin some emerging markets are, especially Russia, the flight to safety causes very large shocks to domestic stock markets. I will return to the Russian case in a later post because this raises the question of what the shock signals about Russia versus the world economy right now.

Martingales and the Financial Crisis

This article compares the developments on Wall Street to placing a martingale bet. In the martingale game you bet, say, $100 on a coin flip, and keep doubling down if you lose. The game seems to offer certain gain for no risk. If you lose on the first flip you bet $200 on the next, if it comes heads you are up $100 ($200 minus the $100 you lost on the first flip). Just hang around till you get a heads. Seems a sure thing. The problem, of course, is that it is always possible that you get a run of tails that could wipe you out before you win. This is the "law of gambler's ruin."

What is interesting about the game is that you have a high probability of winning a relatively small amount, and a small probability of losing a huge amount. Notice that as long as you don't have the cataclysmic event you are earning positive profits with seemingly no risk. You are a financial genius. You are imitated by other financial geniuses. You get a large bonus for your invention of a strategy that produces such high risk-adjusted returns.

Only you haven't really earned super risk-adjusted returns. You just have not yet experienced the run that produces the big losses. After all, a run of say 10 tails in a row is not all that likely with a fair coin. In the meantime you are the Lord of Wall Street and a Master of the Universe. You probably are playing this game with a lot of leverage too. So when you do crash, you can take others down with you.

Why do smart Wall Street types play this game? There are various explanations, but one obvious one is that while you earn the good returns you are accumulating bonuses that you do not lose when the crash occurs. The incentive schemes of hedge funds and financial institutions in general encourage risk taking. Given that they do it should not be surprising that financial managers take excessive risks.

Financial Crisis Impact on the Rest of the World

Our financial crisis is even causing concern in countries that have been rather critical of the US, especially in Latin America. See this article, for example, which notes:

Whipsawing global markets are already having a ripple effect across Latin America. As nervous investors pulled money out of emerging markets, Brazil’s currency, the real, plunged 16 percent against the dollar last month, resulting in hundreds of millions of dollars in losses at large food and eucalyptus-pulp exporters that placed bad bets on the direction of the real.

The crisis has had a big impact on Russia. The stock market has been closed on two separate days, an investment bank sold a large stake (50% minus 1 share) to an oligarch, and the government has been pumping money to support markets. The reason is that indebted banks have faced margin calls, especially as foreign investors flee to security in the worldwide crisis. What is important to remember is that Russia still has more than $570 billion in foreign reserves. This shows just how linked international markets are.

The Bailout Plan

Economists are divided on the current version of the Treasury's bailout plan. Nobody really likes it, but some believe it is necessary while others argue that it is worse than doing nothing. Here are two good examples, one of each.

Jeff Frankel explains why the current version of the plan ought to be supported. John Cochrane argues to the contrary that this plan is akin to blowing up the dam to prevent boats from sinking.

I think that the current bill is no panacea. But I think that the odds of Congress producing a better bill in the near term are close to zero. So the question is whether this bill is better than nothing. The answer depends partly on how close we are now to a credit meltdown (this article suggests that things are getting worse, as does this one). I think we are close. But as John Cochrane points out this is not sufficient. We have to ask whether this plan will work. John argues that the core of the plan requires "magic" to be successful, as it will not inject sufficient capital into the banking system. Ithink that the essence of the plan is for the government to act as a giant arbitrager (Uncle Sam is bigger even than Warren Buffet) and can purchase underpriced assets that have depreciated due to deleveraging. This can provide some support to the banking system till we can implement some additional reforms.

The big problem is that this is hardly the end of the process of shakeout in the financial sector. It is barely a start.