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.
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 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.
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.
During the recent US presidential election, California voted to change it’s state constitution to exclude gay couples from being married (proposition 8). Prior to the election, the Californian supreme court had overturned a regular law that banned gay marriage as being unconstitutional. Thus the (successful) move by social conservatives to change the state’s constitution.
Via Andrew Sullivan (1, 2, 3, 4) and in a demonstration of the move towards David Brin’s “Transparent Society,” I give you http://www.eightmaps.com where you can see the names, addresses, employer and amount donated of everybody that gave money to the proposition 8 campaign, all arranged on a Google Maps mash-up.
Brad Setser (there are lots of pretty graphs on his site):
There is only one way to square a record trade surplus with the sharp fall in reserve growth:
Hot money is now flowing out of China. Here is one way of thinking of it:
The trade surplus should have produced a $115 billion increase in China’s foreign assets. FDI inflows and interest income should combine to produce another $30-40 billion. The fall in the reserve requirement should have added another $50-55 billion (if not more) to China’s reserves. Sum it up and China’s reserves would have increased by about $200 billion in the absence of hot money flows. Instead they went up by about $50 billion. That implies that money is now flowing out of China as fast as it flowed in during the first part of 2008.
And in December, the outflows were absolutely brutal. December reserves were up by $20 billion or so after accounting for valuation changes – but the fall in the reserve requirement alone should have pushed reserves up by at least $25 billion. Throw in a close to $40 billion trade surplus and another $10 billion or so from FDI and interest income, and the small increases in reserves implies $70 billion plus in monthly hot only outflows … That’s huge. Annualized, it is well in excess of 10% of China’s GDP. Probably above 15%.
The mystery being, of course, who is doing the “hot money” transfers. Chinese companies? Investors from Taiwan or Hong Kong? Investors from further abroad? Brad seems to suspect the second:
Over time, if hot money outflows subside, China’s reserve growth should converge to its current account surplus (plus net FDI inflows). That implies ongoing Treasury purchases – though not at the current pace – barring a shift back into “risk” assets. And if hot money outflows continue, watch for Hong Kong and Taiwan to buy more Treasuries. The money flowing out of China doesn’t just disappear … it has to go somewhere.
Important: Much of this post is mistaken (i.e. wrong). It’s perfectly possible for America to have an M1 money multiplier of less than one even if they were an entirely closed economy. My apologies. I guess that’s what I get for clicking on “Publish” at one in the morning. A more sensible post should be forthcoming soon. I’m leaving this here, with all its mistakes, for the sake of completeness and so that people can compare it to my proper post whenever I get around to it.
Update: You can (finally) see the improved post here. You’ll probably still want to refer back to this one for the graphs.
Via Greg Mankiw, I see that in the USA the M1 money multiplier has just fallen below one:
At the time of writing, the latest figure (for 17 December 2008) was 0.954. That’s fascinating, because it should be impossible. As far as I can tell, it has been made possible by the wonders of financial globalisation and was triggered by a decision the US Federal Reserve made at the start of October 2008. More importantly, it means that America is paying to recapitalise some banks in other countries and while that will help them in the long run, it might be exacerbating the recessions in those countries in the short run.
Money is a strange thing. One might think it would be easy to define (and hence, to count), but there is substantial disagreement of what qualifies as money and every central bank has their own set of definitions. In America the definitions are (loosely):
They aren’t entirely correct (e.g. M1 also includes travelers cheques, M2 also includes time/term deposits, etc.), but they’ll do for the moment [you can see a variety of countries’ definitions on Wikipedia].
The M1 Money Multiplier is the ratio of M1 to M0. That is, M1 / M0.
In the normal course of events, regular banks’ reserves at the central bank are only a small fraction of the deposits they hold. The reason is simple: The central bank doesn’t pay interest on reserves, so they’d much rather invest (i.e. lend) the money elsewhere. As a result, they only keep in reserve the minimum that they’re required to by law.
We therefore often think of M1 as being defined as: M1 = M0 + deposits not held in reserve.
You can hopefully see why it should seem impossible for the M1 money multiplier to fall below 1. M1 / M0 = (M0 + non-reserve deposits) / M0 = 1 + (non-reserve deposits / M0). Since the non-reserve deposits are always positive, the ratio should always be greater than one. So why isn’t it?
Step 1 in understanding why is this press release from the Federal Reserve dated 6 October 2008. Effective from 1 October 2008, the Fed started paying interest on both required and excess reserves that regular banks (what the Fed calls “depository institutions”) held with it. The interest payments for required reserves do not matter here, since banks had to keep that money with the Fed anyway. But by also paying interest on excess reserves, the Fed put a floor under the rate of return that banks demanded from their regular investments (i.e. loans).
The interest rate paid on excess returns has been altered a number of times (see the press releases on 22 Oct, 5 Nov and 16 Dec), but the key point is this: Suppose that the Fed will pay x% on excess reserves. That is a risk-free x% available to banks if they want it, while normal investments all involve some degree of risk. US depository institutions suddenly had a direct incentive to back out of any investment that had a risk-adjusted rate of return less than x% and to put the money into reserve instead, and boy did they jump at the chance. Excess reserves have leapt tremendously:
Corresponding, the monetary base (M0) has soared:
If we think of M1 as being M1 = M0 + non-reserve deposits, then we would have expected M1 to increase by similar amounts (a little under US$800 billion). In reality, it’s only risen by US$200 billion or so:
So where have the other US$600 billion come from? Other countries.
Remember that the real definition of M1 is M1 = Physical currency in circulation + deposit accounts. The Federal Reserve, when calculating M1, only looks at deposits in America.
By contrast, the definition of the monetary base is M0 = Physical currency in circulation + reserves held at Federal Reserve. The Fed knows that those reserves came from American depository institutions, but it has no idea where they got it from.
Consider Citibank. It collects deposits from all over the world, but for simplicity, imagine that it only collects them in America and Britain. Citibank-UK will naturally keep a fraction of British deposits in reserve with the Bank of England (the British central bank), but it is free to invest the remainder wherever it likes, including overseas. Since it also has an arm in America that is registered as a depository institution, putting that money in reserve at the Federal Reserve is an option.
That means that, once again, if Citibank-UK can’t get a risk-adjusted rate of return in Britain that is greater than the interest rate the Fed is paying on excess reserves, it will exchange the British pounds for US dollars and put the money in reserve at the Fed. The only difference is that the risk will now involve the possibility of exchange-rate fluctuations.
It’s not just US-based banks with a presence in other countries, though. Any non-American bank that has a branch registered as a depository institution in America (e.g. the British banking giant, HSBC) has the option of changing their money into US dollars and putting them in reserve at the Fed.
So what does all of that mean? I see two implications:
With forecasts for annualised U.S. real GDP growth in 2008:Q4 as low as -6% (!) and seriously smart people worrying about next year, both from the left and the right, you really do have to wonder how ugly it’s going to get. Looking at the world as a whole is a recipe for staying under the covers tomorrow morning, too.
… are this opinion piece in the FT by Joseph Stiglitz, this brief blog entry by Matthew Yglesis and this blog entry by Robert Cringley.
Stiglitz’s piece makes, to me, a compelling argument for letting the firms go into Chapter 11 bankruptcy, albeit (given the state of the market) with government guarantees for any further financing they may need for restructuring. The following four paragraphs are among the most succinct and clearly written on the US car industry:
Wall Street’s focus on quarterly returns encouraged the short-sighted behaviour that contributed to their own demise and that of America’s manufacturing, including the automotive industry. Today, they are asking to escape accountability. We should not allow it.
[…]
The US car industry will not be shut down, but it does need to be restructured. That is what Chapter 11 of America’s bankruptcy code is supposed to do. A variant of pre-packaged bankruptcy – where all the terms are set before going before the bankruptcy court – can allow them to produce better and more environmentally sound cars. It can also address legacy retiree obligations. The companies may need additional finance. Given the state of financial markets, the US government may have to provide that at terms that give the taxpayers a full return to compensate them for the risk. Government guarantees can provide assurances, as they did two decades ago when Chrysler faced its crisis.With financial restructuring, the real assets do not disappear. Equity investors (who failed to fulfil their responsibility of oversight) lose everything; bondholders get converted into equity owners and may lose substantial amounts. Freed of the obligation to pay interest, the carmakers will be in a better position. Taxpayer dollars will go far further. Moral hazard – the undermining of incentives – will be averted: a strong message will be sent.
Some will talk of the pension funds and others that will suffer. Yes, but that is true of every investment that has diminished. The government may need to help some pension funds but it is better to do so directly, than via massive bail-outs hoping that a little of the money trickles down to the “widows and orphans”.
I would perhaps suppliment Professor Stiglitz’s words by proposing that government support to workers laid-off as part of the restructuring could be improved dramatically over the provisions currently available. They should not only include lengthening the duration of unemployment payments and paying for retraining programmes, but also payments to help with relocation if anybody is willing to (voluntarily!) move to find work. An Obama administration might also be reasonably expected to look to Michigan for skilled manual labour in it’s push for infrastructure renewal/expansion.
Yglesis’ brief note observes a vital co-ordination problem when it comes to restructuring what is genuinely a global industry:
One thing here is that as best I can tell none of the five countries — US, Japan, Germany, France, Korea — with substantial auto industries are willing to let their national favorites fail. And yet there seems to be substantial global overcapacity in car manufacturing. If a few of the existing firms are allowed to fail, then the survivors will be in good shape. But if nobody fails, then all the firms worldwide will be left suffering because of overcapacity problems, all potentially drawing bailouts and subsidies indefinitely.
Finally, Cringely’s piece investigates how a successful US car firm ought to be run by imagining that Steve Jobs (of Apple) was running it. The idea is not his. Thomas Friedman briefly mentioned in early November that …
… somebody ought to call Steve Jobs, who doesn’t need to be bribed to do innovation, and ask him if he’d like to do national service and run a car company for a year. I’d bet it wouldn’t take him much longer than that to come up with the G.M. iCar.
It was something of a trite comment, and it was picked up by many people in the IT industry who got a little over-excited when imagining the details of what functionality the iCar should have (for example). In contrast, Cringely looked at the most important thing that somebody trying to emulate Apple might bring to the car industry: it’s design and manufacturing process:
… embracing these [new technologies] requires the companies do something else that Jobs came to embrace with Apple’s products – stop building most of their own cars.
There are two aspects to this possible outsourcing issue. First is the whole concept of car companies as manufacturing their own products. There is plenty of outsourcing of car components. Most companies don’t make their own brakes, for example. Yamaha makes whole engines for Ford. Entire model lines are bought and rebadged from one maker to another. But nobody does it for everything, yet that’s what Steve Jobs would do.
All the U.S. car companies are closing plants, for example, and all are doing so because of overcapacity. But what would happen if just one of those companies — say Chrysler — decided that two years from now it would no longer actually assemble ANY of its own vehicles? Instead they’d put out an RFQ to every company in the world for 300,000 Chrysler Town & Country minivans as an example. Now THAT would be a dramatic move.
And a good one, frankly, because with a single pen stroke most of the overcapacity would be removed from the U.S. car market. Chrysler would have to shut down all those plants and lay off all those people, true, but doing it all the way all at once would change the nature of the company’s labor agreements such that there wouldn’t be a whimper. When you are eliminating 8 percent of capacity the tussle is over WHICH 8 percent. When you are eliminating ALL capacity, there is no tussle.
So Chrysler reaches out to contract manufacturers in this scenario and you know those manufacturers would fight for the work and probably give Chrysler a heck of a deal. For current models, for example, Chrysler could probably sell the tooling and maybe even the entire assembly plant for a lot more than they’d get from the real estate alone. But that particular advantage, I’d say, would be unique to the first big player to throw in the production towel.
In this scenario, Chrysler becomes a design, marketing, sales, and service organization. What’s wrong with that? They can change products more often and more completely because of their dramatically lower investment in production capital. They can pit their various suppliers against each other more effectively than could a surviving car manufacturer. It’s what Steve would do.
This is brilliant stuff.