Tuesday, December 30, 2008

financial catastrophe bonds and moral hazard

Four months ago, at the Jackson Hole conference, Kashyap, Rajan, and Stein proposed something of a financial catastrophe bond scheme for financial companies, in which they be required to meet a more stringent capital reserve requirement conditional on a financial catastrophe; the expectation was that this requirement might be met with an insurance mechanism of some kind that would cause the financial company to receive an equity infusion in that situation. They suggested a kind of secured insurance, but it seemed to me that a financial catastrophe bond (which they mention late in their paper) was both simpler and otherwise superior; the company would have a liability that, in the event of crisis, would disappear, converting to stockholders' equity.

The usual problem with insurance is moral hazard, and there's some of that here. There is some hope that, to a reasonable approximation, the financial company would not be able to instigate a financial crisis, but it does seem as though some behavior can be expected to reap worse whirlwind in case of financial crisis than otherwise, and that this sort of private behavior on a large scale intensifies systemic fragility. Historically financial crises are frequently preceded by bursts of poor loan underwriting; this is the sort of macroeconomic misalignment that finds itself in need of wrenching correction when the mania abates. A bank that finds itself choosing between loans that are relatively uncorrelated with the likelihood of disaster and loans that are feeding a mania (and are likely to go bad when it ends) will find the latter partially insured by the KRS scheme, and may well find them more relatively attractive than they should.

What seems perhaps safer to me is, rather than to have the liability disappear altogether, to have the liability convert to preferred equity. Concerns about an effective bank run or even an unwillingness of banks to lend should be alleviated just as well in this case as in theirs, insofar as the assets and liabilities pari passu and junior to senior unsecured debt work out the same. The common equity, however, is not shielded from the losses; the catastrophe bond claim remains senior to it. If equity drops dangerously low, the large subordinated class allows for a straightforward nondisruptive prepackaged bankruptcy, wiping away the liability only by handing the ownership of the bank over to the holders of what were originally the catastrophe bonds. It might, in fact, be worthwhile to give that preferred stock voting rights even before control of the company might pass to it; in any event where the liability is converted, it is likely that a good portion of the marginal dollar in assets belongs to that class rather than common equity. To avoid a bank's being permanently stuck with a capital structure that it may not like, it might make sense that such a preferred stock also be callable — it would be expected that calling the preferred stock would not be allowed by regulators unless the equity position of the company were comfortable.

Such a catastrophe-bond-converting-to-preferred-stock would surely be more expensive than ordinary unsecured debt, with which it would be pari passu if the institution fails idiosyncratically, but would likewise be less expensive than preferred equity. Which it falls closer to would provide a hint as to market perceptions of the correlation between the bank's risk and financial sector disaster risk. It should be somewhat cheaper than the original financial catastrophe bond variant. It also, insofar as management can be trusted to exercise its fiduciary duty to the shareholders, also largely eliminates the moral hazard problem mentioned in the second paragraph. It's a little bit more complicated (though not more complicated than the original secured insurance suggestion that KRS made), and it's more complicated in such a way that I expect there are complications I've missed. (One I've not missed so much as glided past is the disposition of dividends on that preferred stock.) Still, I think this is a step in a positive direction from what I've read before.

Monday, December 22, 2008

instruments of fed policy

I've been reading about the 1907 financial panic, and once again it looks as though a period of good times leads to leverage which serves both to intensify the correction and to make it more painful. I've come to believe that, where the Fed does see something that looks like a bubble, it should try to take steps that to thwart its being facilitated by debt; if it has fundamental support, the worst that removing leverage would do is to slow the equilibration. Likewise, the point of having reserve requirements for banks is that they be able to absorb some losses of capital without going below zero, but if you keep reserve requirements fixed, those losses of capital will result in going below the reserve requirements — you've simply moved the baseline from that standpoint. Zero is undoubtedly a special number, and solvency an important characteristic regardless of regulatory compliance — especially in terms of systemic stability — but in a time when banks are increasingly risk-averse of their own free will and many of them, while still solvent, don't have money to lend even to low-risk potential borrowers, it seems like we could benefit from lower reserve requirements.

The fed occasionally changes reserve requirements, perhaps most notoriously in 1937, when it felt the need to "mop up excess liquidity". That history notwithstanding, I wonder whether some interesting research could be done on whether the fed could effect policy with any greater success if it regarded regular changes in the reserve requirements as a normal tool to put to that service.

home ownership for the poor and boundedly rational

It is obvious again that lending too much money to people with poor credit and financial means is a bad idea, and there is a resurgence in support for the traditional mortgage in which the purchaser makes a real down payment and a 30-year fixed-rate mortgage payment and won't be lent the money if those terms can't be met. Partly in response to this I've read and heard some sympathy expressed for poor people who have no savings but are "responsible people with good credit", suggesting that home-ownership is a privilege to which these folks should be allowed. I'm not a fan of home-ownership fetishization in general — there's nothing wrong with renting, folks, and there shouldn't be a moral opprobrium thrust upon it — but if we wanted to promote home-ownership in a responsible way for this class of people, there are almost certainly better and worse ways to do it.

I want to start by clarifying who we're talking about; I would suggest that anyone with no savings is not a "responsible person" unless — maybe — they have tenure or a government pension. (Someone just out of school has an excuse; the entirety of this discussion supposes we are talking about someone who is not inclined, on an ongoing basis, to put aside something easily regarded as "savings".) Supposing "responsible" means that they don't deliberately incur liabilities they can't meet, and supposing that in fact that whatever liabilities they do incur they will manage to meet — no unanticipated drops in income — then someone who can't save up a down payment but makes their bills almost certainly suffers from a form of impulse control in which money "lying around" is calling out to be spent. This impulse control also seems to be implicit in a lot of discussions of one value of homeownership (with a mortage) being "building equity"; if you can buy a house that costs $1000 a month in ownership expenses, including mortgage, of which $100 goes to "building equity", then (ignoring tax distortions for the moment) on average, over large expanses of space and time, you can rent a similar place for $900 and put $100 a month in savings, and build your equity in a savings account. The primary difference with the mortgage is that if you don't put in the $100, you're in default; you have somebody pressing you to build equity, which you don't have with the savings account. Economics types will sometimes refer to a "forced savings" component to a mortgage, and this is what one has in mind. Whether buying or renting is the better use of money is likely to be specific to the details of the situation — how long the individual expects to stay put, how much they value being able to remodel, whether there's a special reason to believe the house will appreciate in a way that's not priced into it, etc. — and is not simply a function of buying versus renting per se.

If we want to help people with this kind of impulse control, though, short of simply giving them money (which they would presumably spend anyway), it seems we need, one way or another, a forced savings mechanism. The obvious "solution", then, is a federal mandate that renters put money into a savings account every month, which money they couldn't touch unless they move. Perhaps better, though, would be a way to allow people to choose to commit to a forced savings plan. I have two variants that seem at least plausible to me.

One is essentially a no-money-down version of a shariah-compliant mortgage: the bank buys the house and rents it back to you, allowing you to purchase a share in the house on a pre-set schedule. This can be made to look very much like a regular mortgage, except that the bank goes into this explicitly aware that it is taking on the price-appreciation risk of the house. I'm not sure, in the United States, that banks are the most obvious institution to organize something like this; REITs are. They buy and sell and manage real estate as their regular business.

The second idea is more of a rent-to-own structure; the homeowner puts together the same sort of deal, in which a higher-than-market rent is charged over a five-year lease, and at the end of the five years the lease has an associated cash-out value and includes either the obligation or an option to buy with the cash-out value available as a down payment. This even more transparently lends itself to REITs.

In the former case the forced savings, as in a regular mortgage, was hidden in the ownership of the house in the form of home equity; in this case it's hidden in the cash-out value of the lease. In either case there's a long-run contract whose terms are breached by failing to make this conversion of liquid wealth into something less liquid. In both cases, the terms of the deal should be amenable to both a buyer and a seller on market terms, so that there should be no need for a government subsidy. It might be, though, that there's a status quo bias or coordination problem in the market, where there's little willingness to try these things because it isn't much done yet and wouldn't be worth working out for a one-off; it is also possible that the mortgage interest deduction and other terms of the tax code discourage this sort of thing. If the commanding heights in Washington think long-term home ownership for this class of people is a social good, creating some kind of tax incentive or subsidy to encourage REITs to do this might be an efficient way to do it with taxpayer money.

Monday, December 8, 2008

systemic risk

Banks should be required to sell short large baskets of each others' securities so as to reduce the correlation of their own likelihood of failing with that of other banks in the system.

Saturday, November 22, 2008

external effects of propensities to save

There's reasonable concern by people — e.g. Warren Buffett — that low domestic savings rates for long periods of time will ultimately prove unsustainable, and will be corrected by a real depreciation in the dollar. This analysis takes place over a period of time for which money is typically supposed to be neutral; would a highly interconnected region of the United States experiencing a sustained (but unsustainable) low savings rate be expected ultimately to see local prices rise (and wages fall) relative to prices (and wages) nationally? I guess it seems reasonable. I might want to think about more details of the likely nature of such an imbalance.

If Arizona and Florida are, for some reason, less relatively conducive to productive work than to retirement than the rest of the country, you could see a sustainable low savings rate as current wealth flows to those states indefinitely. I suppose prices might end up higher there because of that, but if real wages rose to the same levels as the rest of the country, the comparative advantage in retirement would presumably wane.

The question of "sustainability" is likely more one of the stock of wealth accumulated than of purchase-related flows; in the case I just gave, the sun states are never in debt to the rest of the country. "Wealth", though, is hard to measure; net wealth is a concept related to expected future creation of consumer goods, not past flows (what you might call the "cost basis" of that wealth). In many contexts, especially on a large scale, one might expect one to proxy the other fairly well, but it is a macroeconomic fact that foreign investment from the United States tends to take the form of equity, while foreign investment from many other countries — certainly from Europe to the developing world, and from the rest of the world into the United States — more often takes the form of debt, such that observing changes in net flows of investment income makes the United States look like much less of a debtor nation than you would expect from looking at past trade deficits. (I.e. U.S. investors see a higher rate of return on their past investment than foreigners do.) Little in economics is very backward-looking; the past is relevant insofar as it informs the future. These forward-looking indicators should be more meaningful.

This still doesn't answer my title question, though; what is the impact on me of my neighbors' not saving enough money? I still need to think this one through.

Keynsian multipliers

In a closed economy, savings = investment; if someone has a marginal propensity to consume of 70%, that's a marginal propensity to save of 30%, so if you give them an exogenous windfall, 30% of that feeds back into GDP through investment, giving them that extra 30% in income, which then becomes another 9% of the original sum, so that you get a multiplier of 10/7. Of course, the multiplier effect is hampered by the fact that so much leaks out through the consumption channel instead; as marginal propensity to consume goes up, this only gets worse.

liquidity traps

When interest rates get quite low, the normal basic tool of monetary policy — lowering a targeted interest rate — becomes less effective. At low enough interest rates, simply hoarding any new money put into the system becomes inexpensive; this is the liquidity trap, where the central bank tries to flood the system with more currency and that extra currency heads promptly to mattresses.

Even injecting extra money into the system, once short-term interest rates are zero, requires something other than an interest rate target, but, as Milton Friedman noted and Ben Bernanke quoted, dropping enough money from helicopters ought to eventually trigger inflationary expectations. More fuel efficient and orderly is a process of quantitative easing, or simply a partial monetization of the national debt; these should have similar monetary repercussions. Once inflation is expected, the cost of putting money under a mattress instead of looking to purchase real goods (possibly investment goods) becomes higher.

Part of the problem is that real investments lock up resources for long periods of time; if short-term rates go to zero, leaving normal monetary policy feckless, long-term rates may still be high enough that investors are insufficiently confident that they can produce real returns in excess of the opportunity cost of capital. The mattress may be a less interesting destination for long-term savings than treasury bonds are; monetary authorities would rather neither be as attractive as real investment. Very long term real interest rates should not go negative; one can imagine fantastic projects — an oft-cited example would be to fill in some patch of water with land — that ought, given enough time, to produce returns that exceed the cost. If long-term nominal yields on treasury debt can be pushed down, and inflation expectations can be pushed up, such projects — or more likely ones — should start to attract investors.

One simple way to do this would be for the federal reserve to go about its quantitative easing by purchasing long-dated treasury debt, inflating the currency supply while reducing the relative attractiveness, even in nominal terms, of those modes of saving. The Federal Reserve (in the United States) could do this; alternatively, the same result should come from the Treasury simply shortening the duration of its debt issuances, effectively — relative to its previous policies — selling short term debt (which the fed has pinned to a zero yield) to buy up its own long-term debt. Much of the federal government's recent emergency borrowing for the recent programs to shore up the banking sector has taken the form of bills maturing in the next year, with most of it considerably shorter than that. I wonder, if one looks at the usual impact of monetary policy, whether including the duration of the federal debt, or something like that, adds any predictive value, particularly in times of low interest rates.