Perhaps I am attributing too much importance to a single speech, but the Minneapolis Fed President Gary Stern’s “Credit Market Developments: Lessons for Central Banking,” reveals a lot of what is wrong about the way policymakers are thinking about our credit crisis. And if Stern’s position is widely held within the Fed, we are in worse trouble that I imagined.
I’ll first deal with what I consider to be the overarching problem, namely, ideological bias, and then deal with the particulars in his speech.
The MarketWatch summary of Stern’s speech gave me cause for pause:
Federal regulators should be cautious in efforts to craft a regulatory response to the disastrous subprime mortgage meltdown, Minneapolis Fed President Gary Stern said Sunday.
Stern said he was not defending the status quo but simply urging caution.
Now, on the surface, this sounds reasonable, except that the Fed has yet to advance a single proposal as to what to do in response to the subprime crisis, save its interest rate cuts and suggesting that Fannie and Freddie purchase jumbo mortgages. But these moves are merely palliative; they don’t address the underlying causes. So to urge caution without serving up proposals has the effect of forestalling action.
Since I thought MarketWatch might have exaggerated or taken comments out of context, I decided to pull the speech. It turns out they understated what Stern said (italics mine):
The overarching theme of my remarks this morning is that regulators of the financial services industry are likely, perhaps inevitably, to confront difficult tradeoffs in designing policies responsive to the recent tumult in financial markets…..
Policymakers will certainly find opportunities to improve current regulations and practices; the status quo will need to change in some areas. But, as we will see, and as foreshadowed previously, tradeoffs suggest that policymakers will want to be extraordinarily careful in addressing perceived inadequacies in the current environment.
Extraordinarily careful? Perceived inadequacies? You don’t need to be expert in bureaucrat-speak to recognize that this is code for “don’t touch that dial.”
How can Stern use “tradeoffs” as an argument to do very little? Remember, his speech is about the broader credit crisis, not just subprimes, as MarketWatch suggested. How do you want to count the damage that we need to count on one side of this tradeoff? Let’s see, we have subprimes at anywhere from $150 to $500 billion. We have the train wreck that is just starting in commercial real estate, which may be a mere $100 to $150 billion. Then we have losses and writeoffs on collateralized debt obligations, which we have said could add up to $750 billion (although some of that is already included in subprime losses). Of we could simply rely on the forecast by Goldman chief economist Jan Hatzius that home foreclosures could reach $400 billion and will trigger a $2 trillion reduction in lending, which in turn will trigger a “substantial recession.”
Even though regulation entails costs in terms of reduced efficiency and reduced profitability, the scale of the damage argues for incurring those costs. Yet, incredibly, Stern is arguing against meaningful change despite overwhelming evidence of serious problems. How can that be?
I can come up with only three rationales:
1. The debate has gotten away from the Fed and is being driven by Congress. Stern is trying to tell the pols not to stick their noses in matters that are over their pretty little heads. While this is plausible, I don’t see Fed officials taking the steps needed for them to influence the debate around regulatory reform. You can’t expect legislators with very unhappy constituents to do nothing.
2. Stern recognizes that what our financial system is what Richard Bookstaber, in his book Demon of Our Own Design, called a “tightly coupled system,” like a nuclear reactor. In tightly-coupled systems, measures to increase safety can often have the opposite effect.
3. Stern (and likely his Fed colleagues) believe in a lightly regulated system and are unwilling to back the level of intervention and oversight that is needed to effect fundamental change.
Although the rationale for Stern’s posture may be 2, I believe the real reason for his belief is 3. He and his colleagues have grown up in a regime that sees minimal government intervention as virtuous, and find it difficult to consider anything else. While it is an ideological bias, it is so pervasive that many wouldn’t even recognize it as a belief system. It’s simply what is widely held to be good practice.
Perhaps the point is made better by another central banker, the former governor of Australia’s Reserve Bank, Ian MacFarlane:
But that still leaves the central bank with a very limited armoury with which to fight a potentially dangerous asset price boom – the interest rate, which it does not have a clear mandate to use, and public suasion, which is of limited effectiveness. How would it cope if it faced an asset price boom of the magnitude of those that occurred in the US in the 1920s or Japan in the 1980s? Not very well, I expect, but it would probably be held largely responsible for the distress that accompanied the bubble’s eventual bursting.
Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy. This has acquitted itself well over the past 15 years and is still working effectively, but over the next decade or two will probably face the type of challenges I have outlined.
No one is very good at picking the next major epoch, and we mainly react after the damage has been done. I am influenced by the fact that as the great inflation of the 1970s was building from the mid-1960s, no one, including the central bank, had a mandate to prevent it. As we struggled to come to grips with it, governments made decisions that effectively gave the central bank a mandate, and central banks worked out a framework that to date has been effective in dealing with it. No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.
The challenges that MacFarlane envisioned have arrived, and they are calling the old policy framework into question, yet Stern and his ilk continue to cling to it. It is almost certain that whatever new paradigm comes into being will place more constraints on intermediaries and agents, but it looks like we will have to have the train wreck in order to get consensus on the need for reform.
To some of the particulars of Stern’s speech. It has four sections, “The Originate to Distribute Model,” Reliance of External Credit Analysis,” “Excessive “Liquidity,” and “Risk Taking and Government Support.” In each, he makes the critic’s case and uses it as a foil for his argument.
On “The Originate to Distribute Model”:
….the alternative—the originate to distribute model—has a core and fundamental economic advantage propelling it: specialization. Over time, firms have developed that specialize in the distinct steps of the lending process, from originating the loan to funding it. Such specialization contributes importantly to cost efficiencies, innovation, and a broadening of access to financial capital. Another advantage of the model is diversification; the originate to distribute process allows a firm to significantly diversity the asset side of its balance sheet.
In short, these benefits are valuable in that they facilitate effective use of resources. Actions to limit specialization and diversification would therefore likely to be costly, with adverse consequences for economic performance and living standards over time. Policymakers would need to consider such costs in assessing reforms proposed to constrain the originate to distribute model.
Ahem, don’t the 15% to 20% fall in housing prices, a falling dollar, and the recession that Hatzius and his colleagues increasingly predict represent an “adverse consequence for living standards’?
And Stern seeks to scare his audience into submission with a false dichotomy: you either accept the originate to distribute model as is, or you go back to having banks hold loans on their balance sheets. There is no willingness to consider methods to improve incentives or information flow, or more clearly define liability, that may reduce the bad outcomes of this system while keeping many of its virtues.
In his “Reliance of External Credit Analysis” Stern argues:
While not an expert in this area, I think it important that we think critically about what constitutes excessive reliance on external credit analysis in these circumstances…..
To be specific, it could be exceptionally costly for each investor to build the infrastructure required to conduct serious credit analysis, and these costs need to be weighed against the losses suffered by investors in the current regime. Moreover, were the agencies unique in underestimating the losses in, say, the subprime mortgage market? It is not obvious that a different infrastructure will produce better results.
More positively, the rating agencies represent one way of economizing on the production of information on credit instruments. And by charging issuers, they also try to address the public nature of this information for, once the information is produced, there is almost no cost to distributing it and hence it is otherwise difficult to get paid. Absent these charges, there could be too little credit information produced. Overall then, reforms that might compromise the viability of the agencies or discourage use of ratings present the tradeoff of potentially raising costs and ultimately requiring another solution to the issues the agencies help to address.
This discussion deals completely at the level of theory, and fails to mention any of the problems that have made the rating agencies a lightening rod of criticism. Amazingly, Stern defends the “issuer pays” system without even acknowledging the conflicts of interest that creates!
The real problem may be that there are only three large rating agencies, If there were were eight or ten, as there was the Big Eight accounting firms pre-Enron, you could put the worst out of business for their misdeeds, and the rest would be sufficiently chastened that they would behave for the next five to ten years. But now if any of the Big Four behaves badly, the regulators are as hamstrung as they are with the rating agencies. They are too central to be shut down.
Although this would never happen, one remedy would be to break the rating agencies up, say by product line. The new baby rating agencies will as quickly as they can try to reestablish full product suites (and with Wall Street rapidly downsizing, they could hire decent people). Then you’d have enough to be able to discipline miscreants.
Another alternative is to make them liable for their ratings. As most readers know, the rating agencies claim a First Amendment exemption, arguing that all they offer is opinion (David Einhorn pointed out that they are not in the business of free speech, but rather “paid for speech.”) It would take a good deal of though to determine what sort of failings would make them liable (and I confess to not having worked through it yet).
Regulation of the agencies may become necessary for a different set of reasons: they become so discredited that no one believes them any more (we are well on our way to that point). Given that the agencies are increasingly perceived to be compromised and perhaps incompetent (or easily deceived), investors will be increasingly at sea as to how to assess complex securities (and many are simply avoiding them).
The “originate to distribute” model will shrink to a fraction of its former size if ratings come to be seen as unreliable. And even if the rating agencies decide to implement reforms themselves, they are likely to be mistrusted (“fool me once, shame on thee, fool me twice, shame on me”). At that point, regulation would likely be the only avenue for resurrecting faith in ratings.
Stern then moves on to “Excessive “Liquidity”:
….some observers attributed outsized risk taking to provision of “excessive liquidity,” an evocative but highly imprecise term, on the part of central banks. Others attributed the situation to the so-called savings glut.
In either case, some have asserted that preemptive action on the part of central banks—and particularly the Federal Reserve—could have cooled the credit markets and at least damped the excesses and losses suffered by subprime mortgage borrowers and investors. This argument deserves serious consideration, but it should be recognized that such preemptive action is not without costs…
Interestingly, the excesses in asset prices perceived in recent years seem related, at least casually, to innovation. Consider the run-up in prices of technology stocks in the late 1990’s and this year’s turbulence linked to pricing of structured financial products and subprime mortgages. It may be costly to try to address these situations ex ante if, in fact, such actions would inhibit the underlying innovation. Common to all of these concerns is the difficulty of appropriately valuing financial assets. It is quite plausible that, in pursuing preemptive action, the unintended consequences rival or exceed the desired outcomes.
This is just plain intellectually dishonest. Many critics have described the Fed’s actions in much more precise terms: cutting short term rates to 1%, which was a negative real interest rate. Negative real interest rate produce speculation.
Instead, Stern acts if the need to “cool the credit markets” somehow came out of the blue (yes, those nasty oversaving Chinese forced us to drop interest rates to the floor!) rather than was created by the Fed’s interest rate actions.
Similarly, his argument about innovation is specious. Innovation is not a virtue like faith or charity. A particular innovation is not valuable by virtue of merely being innovative (if so, virtually every venture capital proposal would be funded and become a barn-burning success); the measure of the value of an innovation is whether on balance it is beneficial. The jury is out on subprimes, but is it already clear that a lot of the so-called innovations, like no-doc loans, teasers, and high LTV loans, particularly in combination, weren’t innovations, but simply bad ideas.
Big Pharma is full of examples of promising drugs that never made it to market. Why? Either they failed to show sufficient efficacy, meaning they didn’t offer a compelling benefit, or they had potentially dangerous side effects. Why should the world of financial services innovation be any different? Their so-called innovations often deliver limited user benefits (but are more attractive for the producer) and in the case of products like subprime loans, came with toxic side effects, like bankruptcy.
Stern’s next section is “Risk Taking and Government Support”:
…..policymakers have to determine their tolerance for the tradeoff between market discipline and instability.
While true in general, I do think that the market discipline—instability tradeoff has been exaggerated. In fact, by taking steps to reduce the threat that the failure of a large bank, or decline in asset values in one market, will spillover to other institutions or markets, policymakers can actually increase market discipline and simultaneously achieve greater financial stability.
Let me expand on how we might approach this happy state of affairs. Right now, uninsured credits or large banks likely expect government support in the event of problems at such institutions….
But if policymakers act in advance to reduce the probability and/or magnitude of spillovers, they also reduce the incentive to protect creditors. And if creditors accurately perceive the change in circumstances, they then have greater incentive to appropriately apply market discipline.
What kind of proposals might accomplish these ends? I have co-authored a book which addresses these matters in detail; suffice it to say here that constructive proposals range from limiting the size of losses in the first place (a form of effective prompt corrective action) to reducing the degree to which exposures on payments systems can act as the conduit for spillovers. One specific option we discuss in the book is scenario planning, which might usefully simulate, for example, a failing bank situation. Policymakers can, in the simulation exercise, consider if they have or can get adequate information, if they have adequate powers to address the situation, and what if any changes may be advisable prior to the development of a real problem.
Sterns’ book presumably does a better job of presenting his ideas, but his examples above are unpersuasive. “Limiting the size of losses” means “intervening earlier.” The lower the downside for taking risk, the greater the incentive to be reckless. How could this possibly increase moral hazard? The payments system idea isn’t explained at all, but that could be viable.
Having worked with scenario planning, my experience is that its main benefit is to encourage institutions to take low probability/high downside known risks more seriously and put in place low cost insurance. Bank failures are a known risk and should be the a major focus of regulatory attention and planning. If they need scenario planning to work through these issues (which implies they haven’t already contemplated them in adequate detail), God help us.
In fairness, one idea we like that is in tune with Stern’s concept is driving as much trading activity as possible on to exchanges.
Finally, from Stern’s conclusion:
My comments this morning are not intended to defend the regulatory and financial status quo, although I can understand that some may interpret them in that way. Rather, they are meant to suggest that there is likely little, if any, “low hanging fruit” to harvest and that, specifically, reforms may well impose inefficiencies and other costs of their own.
Baloney. Here is some low hanging fruit and readers can no doubt come up with more items:
All residential mortgage brokers will be subject to Federal reporting and oversight (presumably at least along the lines of the requirements for brokers employed by regulated banks, although those may need to be toughened too).
Requiring the prospectus for any rated security to be filed with the SEC (right now, even regulators cannot get copies of collateralized debt obligation documents unless someone is kind enough to pass it to them because they are made available only to “qualified investors” and the Fed is not a “qualified investor”!. I am not certain CDOs will survive this downturn, but if they do, they will have to go to more standardized structures, and this move would facilitate that.
Standardized disclosure of mortgage terms, particularly payments and fees. Definitions, method of calculation (and inclusion of taxes and insurance), terminology, placement in the mortgage documents (and any preliminary selling documents) will be consistent.