In an article in today’s New York Times, Yale Professor Robert Shiller makes a very important point: the remedies proposed by the powers that be for the burgeoning housing mess are woefully inadequate:
….our reaction to the current crisis is anemic….The “Super S.I.V.” rescue plan, instigated in October by Henry M. Paulson Jr., the Treasury secretary, in an effort to prevent a meltdown of the market for so-called structured investment vehicles, will be less than a tenth the size of the Federal Home Loan Bank System that is still with us from the 1925-33 debacle.
The FHASecure bailouts announced by President Bush in August, to help borrowers whose adjustable-rate mortgages are resetting at prohibitively high rates, will likely amount to only roughly 2 percent of the amount of mortgages guaranteed by Fannie Mae.
Congress is already on track to eliminate the provision — Section 1322 of Chapter 13 of the bankruptcy law — that prohibits courts from adjusting terms of first mortgages. But there could be more fundamental changes to bankruptcy law than that.
Shiller is spot on. One of the things that has been disconcerting as we’ve watched conditions in the housing and credit markets deteriorate is the lack of willingness to consider regulatory remedies. It is quite clear that one of the major causes was the lack of oversight and specifically, unwillingness to impede “innovation”. As we have said before, innovation is not a virtue. The Titanic, thalidomide and lobotomies were all innovative.
Regulators have become oddly unwilling to supervise, and it isn’t simply the result of the Bush Administration’s antipathy to any restraints on corporations. Regulators have become hostage to a free market ideology and seem unable to recognize that it is merely a belief system, not an immutable truth. Hopefully articles like Shiller’s will give them some badly-needed perspective.
Shiller offers some proposals to illustrate the scale and scope of measures needed. My favorite is the establishment of a Financial Products Safety Commission, the brainchild of Elizabeth Warren.
One areas he omits, however, and he may have considered it to much to bite off in a piece of this length, is securitization. Securitization has become an integral element of the mortgage market, yet it is a flawed process, with misaligned incentives, information loss, insufficient accountability, difficulty in pinning liability on culpable parties. More and more securitized products are becoming the subject of concern, yet there is not enough bank equity for them to step back into their “buy and hold” role. But for some bizarre reason, regulating aspects of the securitization process is treated as a third-rail issue. Things will likely have to break down further before anyone will take the need for reform seriously.
Although no one wants to touch the issue of what to do about the rating agencies, if their credibility drops any lower, investors may stop believing the ratings. Ironically, it may become imperative to subject them to a new regime if they are to be trusted again.
From the New York Times:
Bankruptcy law is a risk management institution, and such an institution should adopt more modern practices. For example, Andrew Caplin, professor of economics at New York University, has proposed that in personal bankruptcy proceedings, the courts should be allowed the latitude to substitute real estate equity — a share in the ownership of the property, to be realized when it is eventually sold — for first mortgage debt. This could let troubled borrowers stay in their homes, and might be better in terms of efficient risk sharing: it would provide incentives for the mortgage industry and would be friendlier to prospective home buyers who would otherwise face higher mortgage rates to pay for others’ bankruptcies.
In light of modern financial theory, this would also be a good time to think about the nature of the implicit subsidies given to government-sponsored enterprises like Fannie Mae and Freddie Mac and whether they provide enough incentives for them to properly manage their own risks as guarantors of mortgages. We should think about whether the F.H.A. should be encouraged to take on a bigger role that might compete with activities of the subprime lenders that have grown so rapidly over the last decade. We might create a new consumer-oriented regulatory authority, like the Financial Products Safety Commission that Elizabeth Warren, a professor at Harvard Law School, has been advocating. It would monitor financial products for consumers and draft regulations to prevent practices like the recent widespread issuance of adjustable-rate mortgages to low-income borrowers who couldn’t afford the rate resets.
The real estate appraisal industry needs to rethink its methods. How did it happen that appraisers acquiesced in valuations that were more and more discordant with economic fundamentals? Basic concepts and procedures need change.
Beyond that, we should think creatively about how to use vastly improved tools for risk management and apply them to mortgages. For example, I and my colleague Allan Weiss (now C.E.O. of Index Capital Advisors) proposed in 1994 to make home equity insurance — insurance on the market value of a home — part of a home mortgage contract. Had our proposal been put into place on a large scale, it would have gone a long way toward ameliorating the current crisis and reducing the need for personal bankruptcies.
The radical financial innovations of the 1930s were possible because the real estate crisis and other economic problems of the Depression created a sense of urgency. Innovation, after all, tends to come in troubled times.
We should take full advantage of the innovation opportunities stimulated by our current troubles. We would emerge much stronger and better for it.
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Another round of regulatory whack-a-mole is exactly what we don’t need here.
The regulatory cycle: a regulatory system imposes de facto administrative pricing. (Eg, nominally-private ratings agencies: administrative pricing for interest rates.) Prices get out of whack with reality. Eventually something breaks. The remedy: more and better administrative pricing. Lather, rinse, repeat.
This is a classic complexity collapse. People like Shiller and Warren are acting as a classic regulatory entrepreneurs. (Is Shiller still trotting out his behavioral theory of the business cycle? Is the SIV collapse just another example of animal spirits run awry? Inquiring minds wanna know.) Adding another band-aid to the giant ball of band-aids will fix the problem. For a while. Until someone in the Caymans figures out how to take advantage of one of the 15 new ways to game the system.
This is simply Gosplan finance. How many centuries will have to pass before people learn that administrative pricing doesn’t work?
What we need is not better appraisals or another layer of regulators and compliance officers, but a financial system in which private corporations can’t make money by dumping risk on Uncle Sam. Sadly, this only seems farther and farther away.
Mencius Moldbug,
As my colleague Amar Bhide pointed out in a 1993 Harvard Business Review article, the US equity markets, which (at least until the dot-com days) most people considered to be a model, could not exist without regulation. Equities, unlike bonds and commodities contracts, are ambiguous and not well suited to be traded on an arm’s-length, anonymous basis. Thus regulation is the only way to achieve a liquid market (assuming that that it the policy goal).
Similarly, banks are wards of the state. As we learned in the Depression, if you let depositary institutions fail, people put their money in mattresses and the economy collapses.
I suggest you read this post on how banks hold central bankers hostage. Unfortunately, we cannot allow major financial institutions to go under. The collateral damage is too great. They know it and take advantage of it.
Therefore the only solution is regulation. If the taxpayer is untimately going to have to pay for the recklessness of bank and investment banks, they need to be kept from doing reckless things (or at least large scale reckless things). Firms that play a critical role in financial intermediation need oversight. Risk taking is fine, in fact necessary, but it is properly in the hands of wealthy individuals and their agents, such as hedge funds (and bank and investment bank exposure to hedge fund via lending similarly needs to be monitored).
I suggest you also read this post. It discusses how attitudes toward regulations have shifted over time, and a heavily regulated framework worked well for nearly 40 years until it started to break down. The writer, former Reserve Bank of Australia governor Ian Macfarlane did, argues that our framework of light regulation is similarly breaking down.
Mencius Moldbug,
I also don’t know what you mean by “administrative pricing.” Regulation has involved pricing in the past (i.e, checking accounts formerly could not charge interest rates) but for banks, that was largely undont by the early 1980s so they could compete with products offered by the securities industry, such as money market funds.
Similarly, the Securities Acts of 1933, 1934, and the Investment Company Act of 1940 have nothing to do with pricing. Yet these form the foundation of securities regulation.
The rating agencies do not set prices (their credit models were mistakenly used for pricing for collateralized debt obligations because there was no trading markets, but that was a bug, not a feature). Similarly, the Fed controls only the short end of the yield curve. 17 Fed fund rate increases merely produced a negative yield curve; the latest rate cuts have actually increased long bond yields because investors view the cuts as inflationary. Yet the Fed hoped to drive the whole yield curve down (they wanted, among other things, to lower mortgage rates, but fixed rate mortgages key off longer term rates).
“we need… a financial system in which private corporations can’t make money by dumping risk on Uncle Sam.”
The use of ‘Uncle Sam’ suggests either an abstract notion of ‘the people’ who somehow prevent private corporations from dumping risk on them through massive thought experiments — or, more likely, that there is such a thing a government entity. What does it do?
“Can’t” suggests that what that government entity does is somehow related to preventing getting risk dumped on it.
How might that government entity prevent private corporations from dumping risk on the government entity?
Well, whatever it might do involves costs. Those costs, in turn, must get paid for somehow — which takes us to fees or taxes, which, in turn, mean that some effect is had on pricing (if only to cover the private corporation’s costs to avoid said fees and/or taxes.)
Then, there’s the actual activity. This government entity does something in order to avoid having private corporations dump risk on it.
Now, whatever that activity is causes those private corporations to somehow, some way respond. That means they will incur costs, risks of success/failure, etc that, if they’re competitors seeking returns on capital, will lead them to innovate in ways that minimize the risks and costs and maximize the returns.
Those things, in turn, tend to affect pricing, among other things.
So, it seems that pricing, among so many other issues, will somehow be affected — whether directly by the actions of the government entity or indirectly.
But, anti-regulatory folks will be very frustrated. And rail against regulation of any sort while demanding that private corporations not be allowed (interestin word: ‘allowed’) to dump risk on Uncle Sam.
Whack-a-mole?
Yes, but who is the mole?
I think one rule that would-be regulators wouldn’t want to admit but which is essential: keep it simple, and refuse to let banks take on too complicated structures onto their balanced sheets. Banks are able to do this because regulators, unable to assess themselves what’s on banks books, let banks use their own private models to assess risk and determine capital adequacy, and these models are validated if they can be back-tested in the past 5 or 10 years. This doesn’t work for the proverbial once-a-century-flood (heck, it doesn’t work for once every 20-years floods). But these floods happen. In fact, these floods happen every few years or so. (And there’s no paradox here; there’s just lots of different types of floods. Notice that it’s quite probable that one day this year will see either a new century high or low temperature for that day.)
So some modest suggestions:
While risk assessment is a value-added activity, regulators cannot determine effectively which banks’ risk assessments are better or worse vs the extreme conditions which are likely to result in a bank going under. Therefore, risk assessment which depends on a bank’s own assessments (models, etc.) should not be used to determine how much capital a bank needs. Therefore, someone outside the bank – a regulator – must determined this figure. Therefore, the regulator must be able to understand everything that is on the banks’ books. Therefore, the regulator must determine what can be allowed on the books, and these determinations must resist the banker’s temptation to complex products (complex means non-transparent means larger profits). In this the regulator must be modest (and this goes against the nature of regulators) and be able to admit when he doesn’t understand something. I think a corollary of this kind of reasoning is: banks which are too big to fail must be limited to simple activities; if a bank becomes too big to fail because it is partaking in complex activities, it must be (ruthlessly) shut down and its activities unwinded.
Equities, unlike bonds and commodities contracts, are ambiguous and not well suited to be traded on an arm’s-length, anonymous basis. Thus regulation is the only way to achieve a liquid market (assuming that that it the policy goal).
Milk is the only thing that makes Grape-Nuts edible. But that doesn’t mean Uncle Sam has to own the cow.
A regulator in a free market has to earn the value of its stamp. Its business actually depends on its reputation capital. Whereas a regulator which is an organ of the State depends on the credibility of said State.
I have never understood how the same people who rant and rave endlessly about Curveball and yellowcake can ascribe, to exactly the same institution which made the decision to invade Iraq, the credibility that is needed to regulate something like a ratings agency.
In other words, you seem to believe this institution is so credible and reliable that it can rate the raters. Wow! How does anything lower than the angels acquire this level of credibility?
I mean, imagine if you assigned this function not to Congress, but to the combined reportorial staffs of the FT, the NYT, and the WSJ. These have to be the world’s most credible people. (If not, there’a more credulity loose in the world than you probably want to think.) Do you think they are credible enough to rate ratings agencies? If so, why? If not, why not?
Similarly, banks are wards of the state. As we learned in the Depression, if you let depositary institutions fail, people put their money in mattresses and the economy collapses.
Believe me, as an Austrian, I am quite aware of this!
Note also that if you let SIVs fail, pension funds keep their money in T-bills and the economy collapses. Insanity, as they say, is doing the same thing over and over again and expecting a different result.
Mismatched-maturity finance depends not only on a sovereign regulator. It depends on a sovereign regulator with the power to debase the currency. Or to impose legal tender, which is the same thing.
I’m sure you’re aware that for most of the last millennium, debasing the currency was considered the very soul and essence of tyranny. Notable economic thinkers who dissented from this consensus included Ezra Pound, Silvio Gesell, and, of course, the great John Law.
Of course, economics is science now. It’s a matter of mathematical proof. Nobody has to go and rant on the Italian radio. They use real numbers, real theorems, and real models. With differential equations and everything. So these sorts of comparisons are quite irrelevant.
And there’s certainly no way this entire system of thought could be just a little coprolite of low-rent academic patronage from the 1930s. Why, FDR was a great man! He never would have allowed any such thing.
I also don’t know what you mean by “administrative pricing.”
A bond is a good, like a car, a dog, or a boxcar of wheat. Its price in a free market is set by supply and demand. Its price in an administrative pseudo-market is set by the State.
The price of a bond depends deterministically on two factors: the risk-free interest rate of the same maturity schedule as the bond, and the probability of default.
If the former is set by an agency of the State, and the latter is assigned by an NRSRO which is in practice an agency of the State, the bond is administratively priced.
Of course, your definition of these words may vary. Hopefully my definition is clear enough that if “administrative pricing” is not the phrase you prefer for this phenomenon, you can select some other.
Also: no, the Fed does not control the long end of the yield curve.
That end is controlled by the PBoC and the GCC. And their assorted co-conspirators in BWII. All of which are thoroughly official agencies. They are just independent of Washington. At least in theory.
I mean, you do link regularly to Brad Setser’s blog, don’t you? Are you really that innocent about the actual structure of the global monetary system? Impossible. There must be some other point you’re trying to make, which I’m just not getting. Perhaps you could rephrase.
“I and my colleague . . . proposed in 1994 to make home equity insurance — insurance on the market value of a home — part of a home mortgage contract. Had our proposal been put into place on a large scale, it would have gone a long way toward ameliorating the current crisis”
Would it not, in fact, have made the crisis worse? Insurance means passing risk to someone else, not making risk go away. But wouldn’t his equity insurance contracts simply have created yet another pool of poorly understood risk to be securitized and/or derivatized and passed on to greater fools? And wouldn’t that have created an even falser sense of security that would have encouraged lenders and borrowers to take even more insane risks??
Schiller is a very smart guy but even he doesn’t seem to be entirely willing/able to grapple with the core of the problem, which is that “insurance” plus adaptive expectations equals speculative euphoria — whether the guarantee in question is provided by the U.S. Treasury or the alchemy of securitization.
Peter,
That’s an excellent example of what I meant by “dumping risk on Uncle Sam” – thanks.