Relevant and even prescient commentary on news, politics and the economy.

Shopping for Regulators

by Robert Waldmann

Jeff Girth asks “Was AIG Watchdog Not Up To The Job?”

Short answer — no.
Slightly longer answer — that depends, do you think their job was to regulate or to make sure that no one else regulated ? They seemed to think it was the second and managed.

banking regulators and bankers

In 1999, Congress passed legislation allowing banks, insurance companies and securities firms to compete with each other. The new law allowed for a range of possible regulators, from the Federal Reserve to the Securities and Exchange Commission, depending on the mix of financial services a company chose to offer. Holding companies that owned one or more thrifts had the possibility of being regulated by the OTS.

“There was a stampede by commercial and financial firms to get a thrift charter,” said Bart Dzivi, a former counsel to the Senate Banking Committee and now a financial-institutions lawyer in Northern California, “so that OTS could be their consolidated supervisor.”

AIG, like other companies, fell under grandfathering provisions in the 1999 bill and received approval late that year from the OTS to own a thrift in Delaware.


In a March 2007 report on financial regulation, the Government Accountability Office looked at the OTS and found “a disparity between the size of the agency and the diverse firms it oversees.” The report noted a lack of specialized skills at the OTS, which had just one insurance specialist to oversee several insurers such as AIG.

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Felix Salmon explains it all (or at least a few tens of trillions) to me

Robert Waldmann

asked Felix Salmon a question in a comment at Market Movers.

He just responded by AIM (hey does that mean I’m on Felix Salmon’s AIM friends list ? sure does and all I had to do was download and install AIM).

felixsalmon (8:31:29 PM): But I’m interested in a comment you left on my blog:
felixsalmon (8:31:35 PM): “Now as to CDS abuse, tell me a non abuse involving way in which the notional value of CDS is so much greater than the value of all insured D ? If something like that happened with another kind of insurance, wouldn’t you consider it abuse?”
felixsalmon (8:32:18 PM): I think I can answer that quite easily: I enter into a position, and then I unwind it by entering into an equal and opposite position
felixsalmon (8:32:28 PM): and since I’m a trader, I do that many times a day.
felixsalmon (8:32:45 PM): Pretty soon, notional is through the roof, even with no net exposure at all (8:33:02 PM): yes that seems to be an answer (and indeed quite easy).

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Inflation and interest groups in the Carter Years

Robert Waldmann

Matthew Yglesias is very smart, but he is not omniscient. In particular he doesn’t remember things that happened before he was born and it appears that he has fallen for some Republican propaganda.

He writes

In the late 1970s, it just so happened to be the case that the structure of Great Society programs and of then-widespread union contracts meant that the objective interests of union members with automatic Cost of Living Adjustment (COLA) provisions, African-Americans, and public assistance recipients were quite a bit different from the objective interests of other Americans. By contrast, it was relatively easy for Ronald Reagan to assemble a coalition built around lower taxes and inflation that started with the well-off but expanded deep into the middle class. It was actually Carter who began the effort to fight inflation and deregulate certain key sectors of the economy, but that wasn’t a politically sustainable agenda for a Democrat (as witnessed by Ted Kennedy’s very strong primary challenge).

He’s wrong. as I explain after the jump.

The point of his post is that it is hard for Republicans to win elections given widening income inequality that disconnects the experience of their base (the rich) and the majority. True. I’d add that it is hard given high inequality and especially high inequality in (easily taxable hard to hide) W-2 income, since there is so much to be gained for most people from a policy of soaking the rich and spreading it out thin.

But the facts about the 70s are the facts. I was there.

Yglesias seems to be under the impression that AFDC benefits were indexed to inflation. They weren’t. The real value of AFDC benefits declined sharply under Carter. The idea that “public assistance recipients” had less of an interest in fighting inflation than your average non-union worker is simply false. AFDC benefit levels were set by state legislatures and not indexed to inflation. National average real AFDC benefit levels declined sharply during the Carter and early Reagan years, then the decline ended (for a while) around 1984. AFDC plus food stamps declined less sharply (but declined a lot) plus there was a sharp drop 81 to 82 (food stamps are federal). Overall, the recipients of AFDC+food stamps appear to have suffered much more during the Carter years than your average non-union worker.
See here (PDF), page 12.

From 1977 to 1981 the union non union wage differential in the USA decreased from 19% to 16% (17% in 1980) (all very roughly) It is true that inflation crept up during the Carter years. It is not true that this helped Unionized workers relative to non-unionized workers. See here (PDF), page 40.

The Kennedy challenge to Carter had a lot to do with the fact that Carter was generally immensely unpopular (Iran and a recession). Carter’s deregulatory efforts were generally not controversial, mildly popular and barely noticed (I remember I was there). I don’t recall any criticism from Kennedy.

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CDS zero net supply

Robert Waldmann
notes that some have argued that Credit Default Swap demonization is silly because they are in zero net supply so they can’t bring down the financial system (no names or links I will be rude below).

This argument is crazy.

If half the financial firms end up bankrupt and the other half make a killing the disruption will be immense. A gigantic shift from one player to another reduces the sum of their market values. This was shown back in the day by Larry Summers and David Cutler (heard of them) in “The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil Litigation,” NBER Working Papers 2418, National Bureau of Economic Research, Inc.

If the firms don’t know who is long CDS and who is short CDS they don’t know who is solvent. Such uncertainty can cause problems.

In any case, the general equilibrium literature contains a huge section on whether assets in zero net supply can make everyone worse off *If* everyone has rational expectations. The answer is yes.

The argument zero net supply so no problem is completely inconsistent with economic theory (so what) and known facts (so there) and no sensible person can possibly take it seriously.

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Kevin Drum makes me blow a gasket

Robert Waldmann

can’t help but argue at very great length that one sentence by Kevin Drum is totally utterly completely wrong.

“The public face of his economic policy, after all, was almost entirely based on tax cuts, a distinctly conservative notion.”

Andrew Sable makes a much better counterargument than mine here.

Mr Drum has fallen for conservative lies. Their actual policies are tax cuts for rich people. Their hero Reagan signed into law a huge tax increase on the non-rich (Greenspan commission proposals). In practice they cut taxes for rich people.

Obama’s proposal has shifted the debate to whether a refundable tax credit is welfare. The Republicans can’t win this one. He has finally used the argument that Republicans can’t answer. Actually Clinton did it too (and was elected remember) but didn’t follow through. Also I think Obama’s proposal is excellent policy. I think Kevin Drum has fallen for the Republican line or decided that popular populist politics is immoral and we should eat our spinach.

I argue both politics and policy at gruesome length after the jump.

The Republican’s favorite trick is to distract people from tax progressivity by pretending that the only choice on taxes is high or low. Obama has shifted the debate to more or less progressive. I have long thought that such an approach to the debate would destroy the Republican party. The evidence from Tuesday is not proof (there were many reasons for the Republicans to lose) but it is still evidence that Obama’s approach to politics works, not just for one election but to change the debate forever. McCain argued “cutting your taxes is welfare. What about all the plubmers who make over $250,000 a year”. This is not (just) because he is nuts. There is no way to convince the American people that they prefer the Republican approach to Obama’s approach.

He was fighting on Republican turf the same way Grant was on confederate turf at Appamatox. With his tax proposal he has stormed their citadel, crushed their army and left them with the choice between surrender and Guerilla warfare (they will chose the second) [earlier historical analogy was the red army was fighting on German turf in the battle of Berlin — it was correctly spelled but politically not ideal).

Drum’s framing is exactly falling for the Republican trick which have made the last 28 years such a political disaster in the USA.

No one but Mondale runs on a platform of raising taxes. Transforming the debate to one about progressivity is more than any reasonable person could hope for from one candidate no matter how brilliant.

Also Obama’s proposal is good policy.

I think the claim is wrong in many ways. First, the Obama tax cuts consist of giving money to non-rich people (at the expense of the rich) and providing incentives for low skilled people to work (setting a good example for their kids).

This approach has been tried at a much much smaller scale by the Clinton administration (the Clinton tax increase included an increase in the earned income tax credit).

Judged crudely the results were spectacular. Of course it was partly luck with investments in information tech finally producing a productivity speed up but the increase in labor force participation, the shift of the Phillips curve etc are exactly what the most extreme advocates of Obama’s policy would have predicted.

In contrast taxing the super rich will, I honestly believe, have good effects totally aside from getting the money (Matt Yglesias has made many eloquent and convincing arguments for this). The super rich are concentrated in finance. This is a big cost as many smart people are not doing other things that are definitely socially useful but don’t make one super rich. The financial geniuses sure seem to have produced something worth less than nothing haven’t they ? Wouldn’t you rather they had been less numerous energetic and creative ?

Causing the financial sector to shrink by taxing the incomes of the top financiers would, I would guess, be excellent policy even if the revenues were wasted (by the way Larry Summers sometimes argues this — one of the issues on which he flip flops).

On the other hand the case for high taxes on low and moderate income is based on … what ?

1) We need money for universal healthcare, anti-poverty programs, green infrastructure investment/subsidies etc etc etc and we can’t get it just by taxing the rich.

A resonable argument (given Obama’s current proposal especially) but not true. The US rich are so rich that there is plenty of money to grab there. The problem is political. Only if people are convinced that taxing the rich has nothing to do with taxing them will it be possible to get the money for the treasury. I had great hopes for Obama’s doughnut FICA increase (which is even more directed at the rich than his income tax plan). I still do even though he de-emphasized it and it might not happen. Then again it might (tax the rich to save social security is the worlds second best slogan after tax the rich and spread it out thin (the current proposal)).

2. It is demagogic populism.

This is true. What’s wrong with that ? If it is good policy, the fact that people support it for selfish reasons or envy of the rich doesn’t make it bad policy.

Here the idea is that politicians prove their virtue by advocating unpopular policies (based on forcing people to face the bitter truth — or in this case the untruth that the US federal government can’t do it’s job and cut taxes for the non-rich).

I don’t want virtuous politicians. I want politicians who win and implement good policies. The fact that something is popular doesn’t mean it is wrong. Look what happened to Mondale.

3 It’s class war. It would be better to unite than to divide.

This is true. So what ? Who said it is always bad to represent the class interests no matter how large the class and how mild the suffering for the tiny class that will be only super rich rather than ultra rich will be.

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Exit Pollster Hell

Robert Waldmann

update: OK after getting burned in 200 and 2004 (to paraphrase our President:fool me once shame on you fool me uh fool … you can fool me twice) only a fool would believe in exit polls tonight (and note the obvious below). But I just can’t help myself.

Looks like the exit pollers are downplaying them everyone wants to tell me how the 71 votes counted in Georgia split. has average exit polls from the MSM financer/suppressors of exit polls.

Don’t start celebrating now, or, if you do, don’t blame me — blame

update 2: According to the exit polls which you should not trust it is McCain by one (1) in Mississippi. Oh my. For what it’s worth Obama is 9.5% above the Pollster trend from regular non exit polls. If I were Senator Wicker I would be worried, but I’m not so I don’t pay attention to exit polls.

notes the obvious.

This is going to be a longgggg day for exit pollsters. Given early voting, they are going to have to pool results from exit polls and earlier results from people who said they voted early in regular polls. This will not be possible without a wild guess.

They have data on how many people voted early and (bad) data on for whom they voted. The data from polls on early voters is based on a much smaller sample size than exit polls and is not based on a balanced sample of polling places, but it is still relatively OK compared to the number they just don’t have.

They will have information on total early votes and on the percentages of Tuesday votes by candidate, but they will just have to guess Tuesday turnout. I suppose they can ask at their sample polling places, but they will only have a number they can use after polls close (and they typically want to release exit polls the instant polls close).

Since it appears that a much larger fraction of early voters have voted for Obama than will Tuesday voters this will be critical. Assuming total turnout equal to 2004 turnout is a recipe for extreme embarrassment.

I’m sure they have some plan (I’m sure they all have different plans).

I’m not sure I’ll believe anything until actual votes are counted (tomorrow night looks like a longgg night over here at EST + 6 hours).

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WaPo on AIG

Robert Waldmann

read Carol Leonnig’s article which quotes many people arguing that the feds should have let AIG file for chapter 11. The point of the complainers is simple, the takeover has been very (realtively) good for counterparties but not so good for the treasury or, it is alleged, AIG shareholders. I don’t see how people can claim that shareholders would have ended up with something after bankruptcy proceedings, but it is costly to the treasury. Oddly no one mentions that the deal was great for Goldman Sachs, I guess that simple observation is too scurrilous for the Post.

I was interested in the discussion of what AIG did wrong.

AIG’s Financial Products division is the primary villain in the company’s free-fall. It made tens of billions of disastrously bad bets on mortgage investments but may not have carefully hedged those bets or properly estimated its risk.

OK this is simple, there is risk that can’t be hedged by everyone. Someone has to bear aggregate risk. The idea that risk is a problem that can be solved, if one hedges rationally is, uhm, crazy. The idea of an insurance company buying insurance is odd. AIG uhm insures people, helps them hedge, bears risk.

In this case, they took on risk that they shouldn’t have taken on, but there is no reason to think that there was a rational equilibrium in which AIG wrote CDS and then hedged them by shorting the underlying assets.

One can make money by bearing risk or by outsmarting other people. Why would anyone expect an insurance company to be able to outsmart the financial services sector ?

Someone somewhere on the web notes (without naming names) two eminent economists who said that the housing bubble wouldn’t be a huge problem as losses from bad mortgages would only be around $400 billion (similar to the losses when the dot com bubble burst) and the net value of derivatives is zero.

So, assuming people are rational, they will only have an unpleasant surprise similar to 2000.

However, if everyone thinks they are beating the market, because of their clever derivatives trading strategies, the moment of truth for derivatives (bankruptcy in the case of CDSs) will be a very painful shock. The fact that the total supply of derivatives is zero doesn’t mean that the total perceived expected value of derivatives positions is zero.

Similarly if everyone thinks they have hedged aggregate risk by buying and selling derivatives, a mere $400 billion hit which people rated as hedged but it wasn’t can be much more damaging than a $400 billion hit which people knew they might bear.

The argument is that if everyone were rational except for the people writing mortgage contract, then everything will be more or less OK is true, but the hypothesis can’t be reconciled with the volume of trade in derivatives.

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Behavioral Economics and Conservatism

David Brooks has noticed the increasing popularity of behavioral economics. He argues that it would be a mistake to allow the recognition that people aren’t perfectly rational to convince us that policy makers should intervene more in the economy, since they aren’t rational either. My reaction is that, of course, the level of sophistication required to play it safe is less than the level of sophistication required to beat the market and so support for prudential regulations does not require the assumption that the regulators are smarter than market participants.

Matthew Yglesias demonstrates (again) that he is a genius and that a degree in philosophy can be an excellent preparation for economic analysis. He considers the ban on interstate banking — clearly not an optimal policy — and argues that concerns about human irrationality might have convinced us to keep it

when we’re looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there’s no danger there we should be very suspicious. We shouldn’t count on being to fine-tune our results to perfection,

Oddly he entitles his post “The case for crude measures” and concludes “we should either lean in with a heavy hand or else stay away.” His reasoning has nothing to do with this conclusion. He is arguing in favor of conservatism. If something has existed for a long time and seems to be working okay, we shouldn’t change it — even if it is a regulation.

This argument makes sense (and was made by Edmund Burke some time ago I might add). It may have seemed to some people, including economists (one of the groups detested by Burke) that economic theory gave us a simple guide to optimal regulation. It may have seemed to some of them that optimal regulation was no regulation. These people are radicals who trust their own reasoning more than the wisdom of the ages.

Behavioral economics teaches us two things. First it is much more difficult to understand the economy than it would be if we could count on it to be in Nash equilibrium, so we should be cautious about our theories including our theories based on a particular hypothesis about irrationality. Second, we’re not rational either, so we should be humble. Both support conservatism.

The strange thing is that Brooks doesn’t seem to remember what conservatism originally was. He suggests that it tells us we should regulate — that is odd since economies have traditionally been regulated and respect for tradition and things the have been found to serve and work okay would suggest we continue to regulate it. This is particularly odd, because Brooks is unusual among contemporary American conservatives, because he leaves no doubt that he has actually read Burke and, in large part, agrees with him.

Odd that he uses the old old conservative argument in the defense of radical free market experimentation.

Given the polls, it is not odd that Yglesias doesn’t want to admit that a strong case can be made for actual conservatism as I’m sure he believes that it will in the near future become again the ally of right wingness after having spent 8 to 28 years as its nearly effective adversary (that is the least weak of the pathetically weak hindrances to right wing lunacy).

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Hedge fund crisis on shedule

Robert Waldmann

In a particularly silly op-ed Sebastian Mallaby argued that deregulation wasn’t the cause of the financial crisis and presented as evidence the fact that hedge funds, which are regulated even less than investment banks, are doing fine.

Of course the reason that there wasn’t a run on hedge funds is that investors can’t cash in whenever they want to. Mallaby wrote his op-ed just before some (not all) investors had an opportunity to take their money out.

Unsurprisingly, as predicted here, the crisis has spread to hedge funds having been delayed only by the fact that they aren’t bank like, do not borrow short term and are vulnerable only to slow runs (a walks ?)

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Selling equity in your house

Robert Waldmann

was working on a post about how financial innovation is profitable and pernicious. The ideas are that profitable new financial instruments are used to evade prudential regulations and to make financial markets more confusing so unsophisticated investors can be fleeced.

Then I thought of a kind of financial innovation which might be profitable and useful.

One financial innovation which would have been useful if it had taken off is the Shiller local home price bond. This is an instrument indexed to home prices in a locality (that is to say I won’t be able to explain it any more clearly. I’m sure shiller can. Use google scholar). This is something local governments should sell as their property tax revenues depend on local real estate values. That risk can be delocalized, that is, diversified, with benefits both the the local citizens and investors who hold a diversified portfolio of real estate indexed bonds. Good idea. Not profitable.

One financial innovation which caused trouble is the home equity loan. This enabled people to risk foreclosure. It contributed to the current crisis (less than sub-prime first mortgages but some). Atrios has a theory. He thinks that the problem is that people thought they were selling part of their home to the bank, not using part of their home as collateral on a loan. They didn’t understand that the bank bore risk only in the case of foreclosure.

OK so how could people sell part of their home to a bank ? It sure wouldn’t work to say the bank owns 10% of this home and gets some interest rate times the assessed value of the home. First home assessors would make out like bandits. Second the adverse selection and moral hazard problems would be huge.

OK ex Prof Black meet Prof Shiller — the Shiller bond is the instrument which enables home owners to shift the risk to someone else without creating huge state verification costs and agency problems.

The deal is as follows.
Bank give Ms and Mr J. Doe some cash $Z.
Ms and Mr J. Doe owe the bank a constant alpha times the Shiller price index for their locality. Ms and Mr Doe must pay an interest rate of x% (should be indexed but hey let’s not be too innovative make it a fixed nominal interest rate) times their debt plus y% of the outstanding debt each year. So debt in dollars changes with this payment then with the change in the index. y% of the house is collateral.

This way if the local economy tanks and house prices fall, the bank bears the burden (which they can pass on to MBS buying suckers of course). If there is a housing bubble without an increase in wages, the Does have a cash flow problem. They also have equity in their home again so they can sell another bit to another bank to meet their payments.

I think, in this way, it is possible for homeowners to hedge that part of their house price risk that they don’t personally control (doesn’t depend on whether they maintain their house) or have private information on (doesn’t depend on whatever the hell is happening with our plumbing which I don’t know exactly what it is but it will cost the owner(s) of the house where I am typing quite a bit).

That way they can borrow without leveraging up and increasing the risk of foreclosures.

Also works for the thrifty as the bank can agree to pay a constant amount of cash to the Does each year in exchange for the house price indexed flow (which is naturally hedged by new equity generated by changes in local housing prices).

update: I still don’t have a post dumping on financial innovation, but I do have a title “Structured by Cows ?”.

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