Research Economist at the Bank of England
In my previous piece on this, I highlighted that the fiscal multiplier will be different for different ways of “spending” the money (I put spending in quotes because there is also the possibility of simply offering tax cuts). Via Menzie Chinn, I see that the Congressional Budget Office has put out estimates of the fiscal multiplier for different forms of fiscal stimulus:
That’s table 5 from this document.
Okay. First, a correction: There is (of course) a market for CDOs and other such derivatives at the moment. You can sell them if you want. It’s just that the prices that buyers are willing to pay is below what the holders of CDOs are willing to accept.
So, here are a few thoughts on estimating the underlying, or “fair,” value of a CDO:
Method 1. Standard asset pricing considers an asset’s value to be the sum of the present discounted value of all future income that it generates. We discount future income because:
The discounting due to the risk of non-payment is difficult to quantify because of the opacity of CDOs. The holders of CDOs don’t know exactly which mortgages are at the base of their particular derivative structure and even if they did, they don’t know the household income of each of those borrowers. Originally, they simply trusted the ratings agencies, believing that something labeled “AAA” would miss payment with probability p%, something “AA” with probability q% and so on. Now that the ratings handed out have been shown to be so wildly inappropriate, investors in CDOs are being forced to come up with new numbers. This is where Knightian Uncertainty is coming into effect: Since even the risk is uncertain, we are in the Rumsfeldian realm of unknown unknowns.
Of course we do know some things about the risk of non-payment. It obviously rises as the amount of equity a homeowner has falls and rises especially quickly when they are underwater (a.k.a. have negative equity (a.k.a. they owe more than the property is worth)). It also obviously rises if there have been a lot of people laid off from their jobs recently (remember that the owner of a CDO can’t see exactly who lies at the base of the structure, so they need to think about the probability that whoever it is just lost their job).
The first of those is the point behind this idea from Chris Carroll out of NYU: perhaps the US Fed should simply offer insurance against falls in US house prices.
The second of those will be partially addressed in the future by this policy change announced recently by the Federal Housing Finance Agency:
[E]ffective with mortgage applications taken on or after Jan. 1, 2010, Freddie Mac and Fannie Mae are required to obtain loan-level identifiers for the loan originator, loan origination company, field appraiser and supervisory appraiser … With enactment of the S.A.F.E. Mortgage Licensing Act, identifiers will now be available for each individual loan originator.
“This represents a major industry change. Requiring identifiers allows the Enterprises to identify loan originators and appraisers at the loan-level, and to monitor performance and trends of their loans,” said Lockhart [, director of the FHFA].
It’s only for things bought by Fannie and Freddie and it’s only for future loans, but hopefully this will help eventually.
Method 2. The value of different assets will often necessarily covary. As a absurdly simple example, the values of the AAA-rated and A-rated tranches of a CDO offering must provide upper and lower bounds on the value of the corresponding AA-rated tranche. Statistical estimation techniques might therefore be used to infer an asset’s value. This is the work of quantitative analysts, or “quants.”
Of course, this sort of analysis will suffer as the quality of the inputs falls, so if some CDOs have been valued by looking at other CDOs and none of them are currently trading (or the prices of those trades are different to the true values), then the value of this analysis correspondingly falls.
Method 3. Borrowing from Michael Pomerleano’s comment in rely to Christopher Carroll’s piece, one extreme method of valuing CDOs is to ask at what price a distressed debt (a.k.a. vulture) fund would be willing to buy them at with the intention of merging all the CDOs and other MBSs for a given mortgage pool so that they could then renegotiate the debt with the underlying borrowers (the people who took out the mortgages in the first place). This is, in essense, a job of putting Humpty Dumpty back together again. Gathering all the CDOs and other MBSs for a given pool of mortgage assets will take time. Identifying precisely those mortgage assets will also take time. There will be sizable legal costs. Some holders of the lower-rated CDOs may also refuse to sell if they realise what’s happening, hoping to draw out some rent extraction from the fund. The price that the vulture fund would offer on even the “highly” rated CDOs would therefore be very low in order to ensure that they made a profit.
It would appear that banks and other holders of CDOs and the like are using some combination of methods one and two to value their assets, while the bid-prices being offered by buyers are being set by the logic of something like method three. Presumably then, if we knew the banks’ private valuations, we might regard the difference between them and the market prices as the value of the uncertainty.
This is mostly for my EC102 students. There’s been some argument in the academic economist blogosphere over the size of the fiscal multiplier in the USA. The fiscal multiplier is a measure of by how much GDP rises for an extra dollar of government spending. There are several main forces in determining it’s size:
Much of what you’ll read arguing for or against a stimulus package will fail to take all of those into account. People are often defending their personal views on the ideal size of government and so tend to pick-and-choose between the various effects in support of their view.
Uh oh. This doesn’t look good at all. I did Engineering for my undergrad, spent five years working in Computer Science and am now becoming an economist.
On the plus side (for me, at least), my wife studied Philosophy and Political Science in her undergrad, is now in Law school and speaks four-and-a-half languages.
There’s a perennial idea of proposing Northern Ireland as a model of how progress might be achieved in the fighting between Israelis and Palestinians. After reading this recent posting by Megan McArdle, one of the difficulties in such an idea becomes plain.
In Northern Ireland, both sides had moral, if not logistical, support from larger powers that were themselves allies. So while the nationalists found it difficult to trust the British government, they would generally trust the US government, who in turn trusted the British government, while the same chain applied in reverse for the loyalists.
By contrast, while Israel receives moral and logistical support from the USA, none of America’s close allies really comes close to giving the Palestinian cause at large, let alone Hamas in particular, the sort of tacit support that America gave the Irish nationalists.
Continuing on from my previous thoughts (1, 2, 3, 4) …
In the world of accounting, the relevant phrase here is “fair value.” In the United States (which presently uses a different set of accounting requirements to the rest of the world, although that is changing), assets are classified as being in one of three levels (I’m largely reproducing the Wikipedia article here):
Level one assets are those traded in liquid markets with quoted prices. Fair value (in a mark-to-market sense) is taken to be the current price.
Level two and level three assets are not traded in liquid markets with quoted prices, so their fair values need to be estimated via a statistical model.
Level two assets are those whose fair value is able to be estimated by looking at publicly-available market information. As a contrived example, maybe there is currently no market for a particular AA-rated tranche of CDOs, but there are recent prices for the corresponding AAA-rated and A-rated tranches, so the AA-rated stuff should be valued somewhere in between those two.
Level three assets are those whose fair value can only be estimated by appealing to information that is not publicly observable.
These are listed in the U.S. Financial Accounting Standards Board (FASB) Statement 157. In October of last year, the FASB issued some clarification/guidance on valuing derivatives like CDOs when the market for them had dried up.
Brad DeLong, in early December last year, was given a list of reasons from Steve Ross why we might not want to always mark-to-market (i.e. assume that the fair value is the currently available market price):
- If you believe in organizational capital–in goodwill–in the value of the enterprise’s skills, knowledge, and relationships as a source of future cash flows–than marking it to market as if that organizational capital had no value is the wrong thing to do.
- Especially as times in which asset values are disturbed and impaired are likely to be times when the value of that organizational capital is highest.
- If you believe in mean reversion in risk-adjusted asset values, mark-to-market accounting is the wrong thing to do.
- If you believe that transaction prices differ from risk-adjusted asset values–perhaps because transaction prices are of particular assets that are or are feared to be adversely selected and hence are not representative of the asset class–than mark-to-market accounting is the wrong thing to do.
- If you believe that changes in risk-adjusted asset values are unpredictable, but also believe:
- in time-varying required expected returns do to changing risk premia;
- that an entity’s own cost of capital does not necessarily move one-for-one with the market’s time-varying risk premia;
- then mark-to-market accounting is the wrong thing to do.
Continuing on from my previous post on this topic, Paul Krugman has been voicing similar concerns (and far more eloquently). Although his focus has been on the idea of a bad bank (to which all the regular banks would sell their CDOs and other now-questionable assets), the problems are the same. On the 17th of January he wrote:
It comes back to the original questions about the TARP. Financial institutions that want to “get bad assets off their balance sheets” can do that any time they like, by writing those assets down to zero — or by selling them at whatever price they can. If we create a new institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.
I suspect, though I’m not certain, that policymakers are once more coming around to the view that mortgage-backed securities are being systematically underpriced. But do we really know this? And how are we going to ensure that this doesn’t end up being a huge giveaway to financial firms?
On the 18th of January, he followed this up with:
What people are thinking about, it’s pretty clear, is the Resolution Trust Corporation, which cleaned up the savings and loan mess. That’s a good role model, as far as it goes. But the creation of the RTC did not rescue the S&Ls. The S&Ls were rescued by (1) having FSLIC seize them, cleaning out the stockholders (2) having FSLIC pay down enough debt to make them viable (3) reselling them to new investors. The RTC’s takeover of the bad assets was just a way for taxpayers to reclaim some of the cost of recapitalizing the banks.
What’s being contemplated now, if Sheila Bair’s interview is any indication, is the creation of an RTC-like entity without the rest of the process. The “bad bank” will pay “fair value”, whatever that is, for the assets. But how does that help the situation?
It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it — and that if only we get the price “right”, the banks will turn out to be solvent after all. In other words, we’re still in Super-SIV territory, the belief that fancy financial engineering can create value out of nothing.
Tyler Cowen points us to this article in the Washington Post that describes the issues pretty well. Again, the crux of the matter is:
The difficulty is that banks think their assets are worth more than investors are willing to pay. If the government sides with investors, the banks will be forced to swallow the difference as a loss. If the government pays what the banks regard as a fair price, however, the markets may ignore the transactions as a bailout by another name.
Tyler Cowen’s own comment:
If the assets are undervalued by the market, buying them up is an OK deal. Presumably the price would be determined by a reverse auction, with hard-to-track asset heterogeneity introducing some arbitrariness into the resulting prices. If these assets are not undervalued by the market, and indeed they really are worth so little, our government wishes to find a not-fully-transparent way to give financial firms greater value, also known as “huge giveaway.”
Right now it seems to boil down to the original TARP idea or nationalization, take your pick. You are more likely to favor nationalization if you think that governments can run things well, if you feel there is justice in government having “upside” on the deal, and if you are keen to spend the TARP money on other programs instead.
There should really be a question mark at the end of that title. As far as I can tell, no-one really knows.
I mentioned yesterday that the US government has just given a guarantee to Bank of America against losses in a collection of CDOs and other derrivatives that BofA and the US government agreed were currently worth US$81 billion (the headline guarantee is for $118 billion, but $37 billion of that is cash assets that are unlikely to lose value).
Last November the US government did the same thing for Citigroup, but the numbers there were much larger: US$306 billion.
The deal with Bank of America is a better one because the $81 billion of toxic assets had to be bundled with $37 billion of cash that will almost certainly create a (small) profit to partially offset any losses.
Nevertheless there is a general question of how they arrived at those numbers given that the market for those assets has dried up: nobody is buying or selling them, so there aren’t any market prices to use.
The problem is hardly unique to America. From today’s FT:
[M]inisters and regulators are examining loans already on banks’ balance sheets, which are becoming more impaired as the economy deteriorates. Concern about the eventual size of losses on them is one reason British banks have recently reined in lending.
Final decisions are not expected imminently from the Treasury. But Mr Brown has spoken recently of the problem of “toxic assets” on balance sheets, raising speculation that a “bad bank” solution will be adopted.
The prime minister has also said Britain is looking at different models. These include schemes whereby the government buys up bad assets in return for cash or government bonds; and schemes where banks keep the assets on their balance sheets but the government insures them against loss. The latter method was adopted by the US government this week to shore up Bank of America.
The Bank of England is moving towards the idea of a so-called bad bank, since private sales of bank assets are proving difficult or impossible. But it raises difficult questions: how should assets be valued; should gilts be issued for the purchases; or should money be created.
Mr Darling also notes that a US toxic asset relief scheme proved difficult to launch because of banks’ refusal to sell assets at a price acceptable to the government. Offering insurance against future losses on bad assets could prove more attractive.
“The other problem is that the banks haven’t asked us to do this yet,” said one government official. “We would be asking the banks to give us a load of crap and they’d say to us: ‘What are you going to pay us then?’”
The credit crisis will not end until we know which banks are solvent and which are not, and we won’t know that until we know the value of those CDOs. Despite the fact that they can’t sell them, banks are loath to write them off completely. Also from the FT today:
With speculation growing that the government will be forced to stage another bank rescue, the prime minister told the Financial Times he had been urging the banks for almost a year to write down their bad assets. “One of the necessary elements for the next stage is for people to have a clear understanding that bad assets have been written off,” he said.
Speaking amid mounting market concerns that banks face further heavy losses, Mr Brown said: “We have got to be clear that where we have got clearly bad assets, I expect them to be dealt with.”
Is it just me, or do you get impression that we’re watching a very expensive game of chicken here?
Felix Salmon points out the absurdity of the situation:
A couple of major developments on the Ecuador front: yesterday, finance minister Elsa Viteri came out with the rather stunning decision that the country would make the coupon payments on its 2015 global bonds — despite deciding to default on the 2012s and the 2030s. And today, the Ecuador CDS auction closed at 31.375%, meaning that anybody holding an Ecuador CDS will receive 68.625 cents on the dollar.
Viteri’s decision opens up a major legal battle: there’s no doubt that Ecuador’s legions of creditors will attempt to attach those coupon payments the minute they arrive in the US. And I, for one, can’t imagine for a second that holders of the 2012s and the 2030s will take Ecuador up on any forthcoming offer to buy their bonds back at 30 cents on the dollar when the country is happily paying the 2015s in full.
This is not the first time Ecuador has tried to pay some foreign creditors without paying others who are pari passu. Ten years ago it tried a very similar trick with its Brady bonds — with disastrous results. But I don’t think that Ecuador has any grand strategy here; instead, the most likely hypothesis is that a well-connected financier has greased enough palms to make sure that he gets paid out on both his 2015s and his credit default swaps.
What all this means in practice is that Ecuador is now behaving so erratically that there’s no point even attempting to deal or negotiate with the present administration in anything like good faith. Instead, the holders of the 2015s will thank their lucky stars and hope that they actually receive their money; the professional vultures will be spending a lot of time in federal court in lower Manhattan; and most of the rest of the holders of the 2012s and the 2030s will simply wait for the next Ecuadorean president to come along. Because this one just isn’t acting logically.
*sigh*
Bank of America is being handed a butt-load of cash:
Bank of America will on Friday receive $20bn in fresh capital from the US government and a guarantee on most of a further $118bn of potential losses on toxic assets.
The emergency bail-out will help to cushion the blow from a deteriorating balance sheet at Merrill Lynch, the brokerage BoA acquired earlier this month.
[…]
The package is on top of the $25bn BoA received from Tarp funds last October, and underscores the depth of the financial difficulties affecting the world’s leading banks.
At this point, BofA has received US$45 billion in hard cash and – more importantly, to my mind – a guarantee against US$118 billion of CDOs and related assets that they hold, many of them from their takeover of Merrill Lynch.
I don’t really want to get into whether bailouts in general are worthwhile, or if this one in particular is worthwhile. What I want to rant about is the nature of this bailout and in particular, that guarantee. It’s been done in a manner highly similar to the one given to Citigroup last year, so my criticism applies to that one as well.
Here is the joint Press Release from the US Federal Reserve, the US Treasury Department and the FDIC.
Here [pdf] is the term sheet for the deal with Bank of America.
The guarantee is against a pool of assets broken down as:
Profits and losses for the pool will be treated as a whole. The fact that one third of the pool is cash (and cash equivalents) will have been insisted upon by the US government because they will almost surely generate at least a minor profit that will offset losses in the derivatives.
In the event of losses on the pool as a whole, BofA will take the first US$10 billion of losses; the US Government will take the next US$10 billion of losses; and any losses beyond that will be split 90/10: the US government will take 90% of them. That gives a theoretical maximum that the US government might be liable for as 10 + 90%*(118-20) = US$98.2 billion. In all likelihood, though, the cash assets will hold or increase their value, so the maximum that the US government can realistically be imagined to be liable for is 10 + 90%*(81-20) = US$64.9 billion.
But kicker is this: There was no easy way for them to arrive at that number of $81 billion. The market for cash is massively liquid (prices are available because trades are occurring), so it is easy to value the cash assets. The market for CDOs, on the other hand, is (at least for the moment and for many of them, forever) gone. Unless I’m mistaken, there are no prices available to use in valuing them. Even if there were still a market, CDOs were always traded over-the- counter, meaning that details of prices and volumes were secret.
Instead, the figure of US$81 billion is “based on valuations agreed between [BoA] and the US [Government]” (that’s from the term sheet).
I want to see details of how they valued them.
When TARP was first envisaged and it was suggested that a reverse auction might take place, the rationale was for “price discovery” to take place. The idea – which is still a good one, even if reverse auctions are a bad way to achieve it – is that since nobody knows what the CDOs are really worth, confusion and fear reign and the market drys up. Since nobody can properly value banks’ assets, nobody can tell whether those banks are solvent or not.
The generalised inability to value CDOs remains, and will continue to remain, a core issue in the financial crisis.
Suppose that the true value of BoA’s CDOs is US$51 billion. At some point, we will collectively realise that fact. The market will become (at least semi-)liquid again and the prices will, at least approximately, reflect that value. But since the BoA and US government had agreed that they were worth US$81 billion, it will technically look like a $30 billion loss and so will trigger the US government handing $19 billion (= 10 + 90%*(30-20)) to BoA and unlike the $45 billion in direct capital injection, the government will get nothing in return for that money.
Therefore, BofA had an enormous incentive to game the US government. No matter what they privately believed that their CDOs were worth, they would want to convince the Treasury that they were actually worth much more.
The US government isn’t entirely stupid, mind you. That’s why the first $10 billion in losses accrue to BoA. That means that for the money-for-nothing situation to occur, the agreed-upon valuation would need to be out by over $10 billion. On other hand, that means that instead of telling a little white lie, BoA has an incentive to tell a huge whopper of a bald-faced lie in convincing the Treasury.
That is why I want to see details on how they valued them.
Felix Salmon thinks that both Citigroup and Bank of America should be nationalised:
[N]either institution is capable of surviving in its present form much longer. [Hank Paulson and Tim Geithner] should embrace the inevitable and just nationalize the two banks.
…
[T]his isn’t a bank run: Citi and BofA aren’t suffering from liquidity problems. They have all the liquidity they need, thanks to the Fed. The problem is one of solvency: the equity markets simply don’t believe that the banks’ assets are worth more than their liabilities.
The problem being, as I explained above, that nobody knows what the assets are really worth and the market is simply assuming the worst as a precautionary measure.
I’m not yet convinced that they should be fully nationalised. I just don’t think that the government should put itself in a situation where it promises to give them money for nothing in the event that their private valuation turns out to be too high (i.e. the market is correct in believing that they’re worth bugger-all).
Barry Ritholtz wants to know why the heads of Citi and BoA are still there:
Like Citi, the B of A monies are a terrible deal for the taxpayer — not a lot of bang for the buck, and leaving the same people who created the mess in charge.
Organ transplant medicine understands certain truths: You do not give a healthy liver to a raging alcoholic, as they will only destroy the organ via their disease/bad judgment/lifestyle.
In this, I agree with him entirely.