When and How to Recapitalize Banks

In this crisis, the problem of how, and when, to recapitalized banks, is forefront. Several assume that the market, or the government, should merely add equity. This is often conflated with 'nationalization', but really we are not contemplating the US government actually buying and running banks prospectively. They are really considering various ways of become silent partners.

In any case, the recapitalization issue really falls into three separate cases that should be handled differently. Let us examine the case where this is prudent. In scenario 1 below, the bank starts out with a traditional 10% equity ratio, or 10 to 1 leverage. This is a 'safe' level of equity, in that it is sufficient for both regulators, that is, by law, and for debtholders, that is, by the market.



If there is a loss of 0.5 'units', we now have an undercapitalized bank. Both regulators, and debt holders, are unhappy with this state of affairs. In this case, the optimal thing to do is merely let the market recapitalize. Equity owners are unwilling to lose the franchise value of the bank, say from brand name and existing customer relationships. So, they are willing to appease regulators and debtholders by accept dilution to maintain the little value they have. One might facilitate this via the Meltzer plan, of having the government match fund equity investors. The bottom line is that equity owners, that is, those who direct management, will agree to this remedy.

In scenario 2 below, the bank starts out again with 10 to 1 leverage, but loses enough value (say 1.1 units) via write-downs so that the bank is insolvent, its debts are worth more than the assets. In this case, the government may wish to make the debt holders whole to retain the franchise value of the bank. Equity owners are wiped out, however. That is, all they need do here, is put in 0.1 units, and then equity owners are willing to add the other unit. This cost of 0.1 units, is less than if they acquired the bank, and sold off the pieces. There is a significant going concern value that is preserved if the failed bank is sold to another bank, the main way a bank is recapitalized, compared to if the bank is merely liquidated by the government. These losses are twofold. First, there is the value loss from exiting customer relations that are now reassigned, and brand value of the bank (really, capitalized future customer relationships. Secondly, the government is probably a less efficient in liquidating assets than the private sector because they do not have an incentive to merely maximize the return on the bank assets. These costs are large and significant, and was documented in examining the S&L crisis in the late 1980's (see Christopher James, Journal of Finance, Sep 1991).



In scenario 3 below, the losses are so large (say 5 units), no amount of equity infusion would be greater than any gain from maintaining the franchise value, or avoiding the extra costs of relative government inefficiency. If the government burns, say, 1 unit of franchise value, and also 1 unit via their incompetence, this is 2 units, still better to wipe out the bank and sell it off as opposed to paying debt owners 5 units to save the 2. The optimal action if for the bank to be simply acquired by the government, small depositors are made whole but bank bond owners lose principle.



For banks that are presumed insolvent, the question is whether the loss is sufficiently small so that it is less expensive to taxpayers to maintain its franchise value. The crucial question, therefore, is whether banks are solvent given their current values, not in some stress test. The adequacy of capital refers to scenario 1, but this should be self-correcting, because equity owners will accept dilution in order to avoiding losing franchise value. Insolvent banks need government action, but there is a difficult decision about liquidation versus bailing out bank debtholders, and here one should focus on the current value of the assets, and the bank's franchise value, as opposed to a stress test.

The Treasury should tread lightly, because a currently solvent bank that is merely undercapitalized under certain hypothetical scenarios is like a bank who is technically insolvent when one writes off Goodwill. This latter scenario resulted in several billions of US liability in the S&L crisis, as several banks found that changing the rules on bank goodwill merely destroyed an accounting contrivance, in the process creating a bank that violated the regulatory requirements and destroyed the bank's franchise value because by law it had to be taken over, even though equity and debt owners were willing to operate the bank. Destroying a bank's franchise value in such a manner destroys real value, and the courts agreed with this. It is not the legal liability I am concerned with, rather, the suboptimality of destroying bank value, from the relative inefficiency of government bureaucrats or the franchise value loss.

A zombie bank is like scenario 3 where the bank is not shut down by the government. The government keeps it alive, via forcing debtholders to renegotiate their terms, but the bank is insolvent no new equity owners are forthcoming. The bank owners, afraid of losing the option value of their ownership, merely wait for inflation to make the nominal value of assets rise above the value of the debt, but if inflation remains low, this may take a long time. Interestingly, in these situations, the small amount of equity does not generate the inordinate risk taking from taking advantage of the 'heads I win, tails the government loses' approach to the bank, but rather, a timid owner waiting for nominal prices to make the bank solvent.

The key is that for solvent banks one might think match funding equity infusions is worthwhile, and indeed it seems reasonable to assume that such an investment will be ok, because investors are also investing new capital on equal terms. But for insolvent banks, the only way to get the capital ratios back to solvency involves government injections, not mere match funding. No equity owner will take scenario 3 back to solvency, because investing 5 units to bring it back to normal, would be a transfer of 4 units to the debt owners, meaning, new investors would add 5 units to get 1 unit of bank ownership, a poor investment relative to buying stock in a solvent bank, of which there are many.

Meltzer's Bank Plan

Timmy Geithner's stress test looks at the effects of macro economic changes on bank balance sheets, an exercise surely to not generate effects larger than their standard errors. This will be manifest in the absence of standard errors in what they produce, and any scientific forecast includes standard errors.

But one might say, just stress the market by 3 standard deviations. Yet, if the market falls another 50%, one must anticipate a total collapse of the financial markets, so I think yes, if we can't figure out how to keep financial markets from going into a tailspin, it's "start over" for the American financial system. I don't think that's going to happen, I'm just saying in a scenario where banks on average are writing down their risky (ie, non-Treasury) assets by 20%, implies imagining everyone is insolvent because there is an accelerator mechanism at play here. Thus, I don't think such an exercise would shed much light on the puzzle of whom to shut down. With that scenario, the answer is trivial: everyone. Then the question is, how is the government going to replace our current financial system, as they will no doubt feel obligated to do?

Longtime Federal Reserve scholar Allan Meltzer suggests the Fed merely say they will match fund equity investors in banks. Say a bank wants $20B, if it can raise $10B, the government will add $10. If banks think they are solvent, then bank equities owners will prefer dilution to being stopped out due to liquidity concerns. If a bank is insolvent, it will find no equity investors, and so then be taken over in the way the S&L's were disposed of in the early 1990's. This has the advantage of using the market to determine who is solvent, not some arbitrary stress test.

If I were Treasury Secretary, I would do nothing. Luckily, Geithner has such low gravitas that's all he can get away with, going through the motions, generate reports, testify in front of Congress 3 times a week, that in the end does not amount to much. Thus, I am pleasantly pleased with Geitner because if he had more credibility he might actually be able to do something; given the predilections of the Obama team it would be worse than doing nothing.

Economists Aren't More Stupid than Other Scientists

While economists have been taking a beating for not predicting the future correctly, it is useful to remember that when you take a physicist to the real world, he too has little to say. Consider our understanding of our solar system, a seemingly straightforward issue.

Mercury: Has an abnormally large iron core. For its size, its density seems too high. This is a puzzle. Leading theory: hit by asteroid.

Venus: Venus rotates in a clockwise fashion, in contrast to other planets. Leading theory: an asteroid hit it to spin the other way

Earth: No one knows where the water came from. Leading theory: snow comets hit us. The moon's origin, also, is not obvious, because it doesn't have enough iron, and if it just spun out of a really fast spinning earth, the earth would still be spinning fast or the energy release needed to slow the earth down would raised the temperature to 1000 degrees Celsius. Nebula forming two planets, or planetary capture, don't work. Leading theory: an asteroid hit the early Earth, creating the moon.

Mars:There appears to be evidence that Mars used to have water, as it seems to have lots of old lake beds and dry river beds. Why did the water leave? The atmosphere is currently about 0.3% of the earth's, so currently water goes immediately from ice to water vapor and then floats into space. So where did the atmosphere go? Solution: solar winds, or an asteroid hit it and pulled away the atmosphere.

Jupiter: Jupiter is 1300 times the volume of the earth, yet spins around once every 10 hours. Puzzling.

Saturn: Where did the rings come from? At some point in Saturn's early history, a moon about 300 km across got too close to Saturn and was torn into pieces. Or, it's also possible that two moons collided together, or a moon was struck hard enough by an asteroid that it just shattered.

Uranus: Uranus spins on its side, rolls around like a ball, unlike the other planets. This is a puzzle, because in theory, the solar system started as a spinning nebula of debris that generated a similar spin to it agglomerated parts, and also because its moons circle the planet on a different axis. Solution: an asteroid hit it. The moon Miranda has a very strange surface. There are huge faults, smooth plains, and curiously shaped rifts, smooth in some areas, rocky in others, that make it seem like it has different parts. A leading explanation: hit by asteroids.

You can only use the 'hit by an asteroid' explanation so many times, before it starts sounding like a filler for 'we have no good theory'.

We have a lot of work to do figuring out lots of prosaic stuff. Nobel physicist Robert Laughlin points out, much interesting physics are emergent phenomenon, they are not derived from basic forces. Very little, if any, collective organizational phenomenon, such as crystallization and magnetism, has ever been deduced from its lower lower-level parts.Those predicting the End of Physics are ignoring all the interesting problems that are not potentially generalizable to everything.

A physicist's ability to predict the terminal velocity of rocks falling from the Tower of Pisa, is like an economist predicting that when you subsidize something you get more of it. True in itself, but few are interested in such isolated phenomena.

TARP Recipients Discover One of Many Conditions

An amendment prohibits any recipient of TARP funding from hiring H-1B visa holders. These are the visa given to most highly skilled analytical types in finance. Bank of America recently rescinded job offers to 66 foreign born students graduating from US business schools.

Number of H-1B visas per year: 65,000
Number of illegal immigrants per year: at least 500,000

I am not a libertarian who believes in open borders, because as Milton Friedman noted, we have a welfare state that makes this not merely a transaction between two consenting adults. If we allow in the 3 billion worldwide who make less than a dollar a day, they will be happy for a while, but then they will complain they are being treated poorly and demand more rights, paid for by taxpayers. The second their kids are born here, they are US citizens. And basically, once in, they are de facto citizens, because it is politically impossible to deport illegals in any large number. Further, we apply exclusions only to those who follow the law. If you break the law, you get in. This is not a good filter.

Heck, Mexico doesn't allow illegals from Guatemala or Honduras, and you don't see illegals marching in Mexico City. Indeed, you don't see this in Tokyo, Frankfurt, or Paris. I like the Canadian, or Singaporean system. Why not have open borders to someone with a college degree who has a job here? As per unskilled workers, we have an excess supply here, and a simple way to raise their wages would be to stop this supply from increasing further.

I know banks are stressed, but I imagine over the next several years there will be many public interest inspired conditions on the TARP monies that will turn out to be similarly stupid. When you receive a favor from the Don, he owns you.

Good News for Cougars

It seems the highest IQ children would have 15 year old men mating with 40 year old women. According to a new study, published Monday in the online journal PLoS Medicine (see here), paternal age at conception generates a linear decrease in child IQ, whereas maternal age rises sharply to age 25, then rises very slightly throughout her life. See graph below cropped from the paper. The solid line is the IQ of the child as a function of the mother's age, the dotted line as a function of the father's age. They held constant race, gestational age, socioeconomic factors, marital status, other parent's age, and mental illness, and had about 33,000 observations. Sounds pretty solid.



Thus, by having my kids at 35, 37, and 41 I probably cost my kids about 4 IQ points. Then again, if I had kids in my early 20's, they wouldn't be here, some other DNA would, so they really can't complain. Plus, they enjoy the advantage of a ripened mother. I'm sure they will complain anyway.

Out-Sourcing Risk Management

The latest Basel Accord consultation document raises the prospect that banks must conduct their own due diligence on each of the assets underlying securitisation transactions – a requirement that could make the securitisation market out of reach for many small firms. They also note that

A bank should conduct analyses of the underlying risks when investing in the structured products and must not solely rely on the external credit ratings assigned to securitization exposures by the CRAs (Credit Rating Agencies). A bank should be aware that external ratings are a useful starting point for credit analysis, but are no substitute for full and proper understanding of the underlying risk, especially where ratings for certain asset classes have a short history or have been shown to be volatile. Moreover, a bank also should conduct credit analysis of the securitisation exposure at acquisition and on an ongoing basis. It should also have in place the necessary quantitative tools, valuation models and stress tests of sufficient sophistication to reliably assess all relevant risks.

The question raised is whether out-sourcing risk management is ever acceptable. Clearly, in the latest crisis the rating agencies errored. Yet, the rating agencies generally don't go against conventional wisdom. I see no indicators suggesting that while the rating agencies ignored the risk of falling housing prices, more than a handful out of tens of thousands standard financial institutions were applying a 25% stress test to these assets.

There are clearly problems with relying on someone else, especially when they are wrong. But there are problems with in-house analysis too. Consider the pros and cons of an external risk management, such as provided by traditional rating agencies, that centralizes risk measurement:

Pros:
1) regulators need only analyze one framework, and can simultaneously address the risk to an asset class with one thorough vetting process.
2) avoid conflicts of interests within banks that may lead to excessive pressure on risk managers to understate risks.
3) create tranparency in risk measures that allow for greater liquidity, including the hypothecation of assets as collateral, or the existence of trading markets that enable a bank to sell or buy assets to meet liquidity or capital needs.
4) there may be scale economies in evaluating risk. Do we need each bank to reunderwrite IBM's unsecured credit? What about Citibank's credit card receivables?


Cons:
1) If the centralized authority makes an error, it has systemic implications (one error is magnified)
2) There are conflicts of interest between the centralized risk monitor and the various entities it is evaluating.These are inescabable, because if one moves from an issuer pays model, to a buyer pays, then the buyer's intests are in play. He probably will have a large inventory, and would probably want to see continued stable, high ratings for an asset class, just as an issuer would. Further, there would be a free rider problem among credit analysis buyers, which would potentially cause an underinvestment in them, because the centralized authority can not seize sufficient revenue from the value they produce. So, in any scenario, there is conflict of interest for an external ratings provider.

In a crisis, the first reaction is usually to centralize various decentralized functions. Think about the reaction to 9/11 and the calls for one unit in charge of intelligence gathering. Centralization has considerable benefits, which are often alluded to if you ever have to deal with an institutional IT infrastructure and their latest plan to centralize information.

I think the fundamental question is whether one thinks systematic errors are caused by key focal points, in this case, Moody's and S&P, or one thinks the more basic error was a ubiquitous incorrect belief. I tend to the latter. The rating agencies were not leading the adoption of NINJA loans, they were led by regulators, legislators, the government sponsored housing entities, and of course investors. It is too simplistic to blame a formula, or a specific group for this crisis, as no one was arguing that assets should have a stress test for a 30% housing decline back in 2006. No one. With hindsight, that was a mistake, but one everyone made. It is nice to think that people would have independently applied this if it was in their bailiwick, but just as no congressman wanted to appear to squelch more homeowning, and thus prohibit the US Housing and Urban Development Department from encouraging no down payment mortgages.

Consider David A. Andrukonis, risk manager for Fannie, was let go for fighting Bill Syron's plans to accept more mortgages with weaker underwriting standards (Syron got $38MM, Andrukonis was let go). He was a risk manager telling his CEO that a risk that has never materialized, but is based on theory, should inhibit more volume into a higher revenue and ROE activity. He lost, as has every risk manager in such a scenario. With hindsight, NINJA loans are indefensible, but in real time objecting was futile. When there is big money to be made doing X, a theory but no data arguing against X, is not compelling.

I don't think this mental blind spot came from outside, it crept in through a lack of confounding data to the idea that these weaker (err, innovative) lending criteria were too risky, and this belief was so endemic because it reflected the righteous goal of increasing home ownership to the poor, especially minorities. People believe bad analysis when they get the answer they like, and everyone liked the answer. Even the American Economic Association granted great honors on those writing that existing lending criteria were (see the seminal prized pub in early form here), if unintentially, racist, while their critics were left in obscure universities and journals. With over $2 Trillion (that's 2 thousand Billion) in loans targeted towards 'traditionally underserved communities' (ie, people with bad credit, no down payment), the money created deep and broad vested interests. The rating agencies were not necessary for this problem.

Lastly, regulators are already overwhelmed by data, as the process of outsiders evaluating a complex financial institution is simply very difficult in the best of circumstances. They ask for risk reports, they will get them, but tables of exposures cross-tabbed by originator, region, etc., will just be butt-covering documentation. To think regulators have the ability to analyze anew thousands of institutions individual risk underwriting just means they will be more overwhelmed. They will look for key words, perfunctory analysis that consultants will teach banks that are necessary, which in the end makes the underwriting just as susceptible to group-think as before. But at least the external rating agency is monitored critically, in a straightforward fashion, and there is some competition (ie, Fitch, S&P and Moody's). The myriad decentralized reports will have the added baggage of serving two purposes. Hitting the hot-buttons everyone knows regulators are looking for, while pretending to be some great alpha-inspired individualized edge, built from the bottom up.

Rahm Emmanuel stated the Obama administration should never let a crisis go to waste. I think crisis bring out the worst in individuals and collectives because they overreact indiscriminately, and this usually merely kills an error that is now so obvious as to be irrelevant going forward anyway. The bottom line is that people need to have good incentives, good data, and good judgment. If losing 80% of one's market cap is not sufficient incentive for firms to address this optimally given their specific contexts, why does one think the incentives, data, and judgment of legislators and bureaucrats in Washington or Basel are going to be better? Because they are selfless public servants? That's a grade-school view of politics. I'm not saying markets are perfect, merely that regulators mandating decentralization of all risk measurement, is worse.

We Need More Depressions

One problem in this crisis is that economics has basically one Great Depression dominating its data. Thus, we are like doctors looking at a patient who is sick, having only one experience with a very sick man. Now, if that man had pneumonia, and the new patient has something else, your cures are going to be no good. Cross country studies are good, but even there we are left with a handful of comparables, and all come with obvious dissimilarities that prevent generalizations. As Russ Roberts says, 'It's one event!'

Judge Defines Douchebaggery. Really.

Some women found their pictures in the book Hot Chicks with Douchebags. They sued for defamation. The judge dismissed the complaint, basically after noting the book was clearly satirical, and so was protected by the first amendment. Some of the commentary in the ruling is very funny, primarily because the judge avoids obvious jokes and puns:

In light of these guidelines, the Court has carefully scrutinized the book and the context in which the photographs appear. On page 70 the title heading is “The Federbag”. It contains three paragraphs, all of which describe a type of male who the author considers a “douche celebrity.” He described a federbag as “famous in their own minds, they live the celebrity rock star life style while being neither celebrity nor rock star.”
...
The book begins by defining a “douchebag” and including a definition which is not recognized in the dictionary. In fact, it appears to be one made up in order to be humorous. At the end of the book, in his acknowledgment, the author states “I must give a special round of thanks to all the participants and contributors on the blog whose enthusiasm and hilarious commentary mocking the douchescrote and celebrating the hott have kept me going.” On the rear cover there is a quote “Douchebags need a smack.” This quote is attributable to “Gandhi”.

The Court concludes that there is no actionable defamation. The book is replete with obvious attempts at satirical humor. For example, how can a person reasonably believe that in 1981 archaeologist Renee Emile Bellaqua uncovered in a cave in Gali Israel a highly controversial Third Century religious scroll suggesting that the “douchey/hotty” coupling was a troublesome facet in early social religious structures? Or would a reasonable person believe that Jean-Paul Sartre stated “man is condemned to be douchey because once thrown into the world he is responsible for every douchey thing that he does”? Or that John Hopkins has a Department of Scrotology or that there was a Theban King Seqenenra Tag, in ancient Egypt known as “gito of the southern city”? An examination of the book reveals that old photographs of paintings are doctored to suit the satire in the book. The author also defines a completely fictitious time period “BG”, before the actor Richie Grieco and “AG” after the actor’s impact on the douchebag male style.

The Court finds that the text and photographs do not constitute defamatory falsehood of or concerning any of the plaintiffs.

I wish I had a judge with common sense like that.

A Totally Unfair, Very Funny Takedown of CNBC

Check out John Stewart mocking CNBC.

The Daily Show With Jon StewartM - Th 11p / 10c

CNBC Gives Financial Advice

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Important Things With Demetri Martin

Political Humor
Joke of the Day

Corporate Leverage Did Not Cause the Bubble

The attached graph shows leverage ratios for Commercial and Investment Banks over time. There's a little jump at the end for investment banks, and I suspect a lot of that was due to the fact that as the Asset Backed market shut down mid 2007, all the stuff coming on their books they used to sell, they had to keep.

Note that many people say leverage caused the bubble. Only in a certain sense. Home buyers were too leveraged (no money down). Any owners of these assets were implicitly too leveraged by owning them. Basically, if the base constituents of the portfolio is leveraged, everything above it is too. But strategically, at corporate level, the Assets to Liabilities ratio was not a major player in this crisis. And, of course, no bank should ever own investment grade securities trying to make money on the spread.

Leverage and the Crisis

The recent crisis has created a cottage industry in articles with various primary culprits: hubris, too little regulation, government encouraging lending to poor neighborhoods, credit default swaps, Viking machismo, copulas, regulatory capital requirements, value-at-risk, the Basel 2 regulator accord, Greenspan's easy money, too-big-to-fail, Chinese investment, asymmetric bonuses, the repeal of Glass-Steagall, and finally excessive leverage by financial institutions. Leverage, what the Brits call 'gearing', is the ratio of assets to equity (think Archimedes) I have worked a lot examining bank default models based on financial ratios, and how ratings, equity returns or spreads relate to leverage, and for banks there just is not that much there historically. Leverage, historically, is not a very powerful indicator of financial performance for financial institutions (it works for nonfinancials, however). Not that it does not matter, only that leverage ratios observed represent equilibrium solutions to various problems, and the residual cross sectional correlation is generally uninformative. The nature of the assets and liabilities is orders of magnitude more important than what the balance sheet shows, which is why I do not actively trade financial institutions. Bank financial statements are too opaque to be useful, a problem that has really exacerbated this crisis because they now find they can't demonstrate they are not insolvent.

Consider first the return on a strategy going long BBB (Baa) bonds, short AAA (Aaa) bonds. This strategy's total return is listed below.


Note that on average, you make money in this strategy. Indeed, this is a prominent financial puzzle, because the return on this trade represents a higher return than generated via standard utility functions. That is, the annualized Sharpe ratio is about 0.4, which is around what it is for the stock market, which itself generates the well known 'equity premium puzzle'.

Note also that the drawdown to such a strategy varies over time. It was about 20% in the Depression (1930's), and recently experienced a 15% drawdown. One can imagine someone thinking the Depression is no longer a relevant benchmark, in which case, a 6% drawdown is a reasonable worst case scenario. Now, most investors apply capital of around 3 times the worst case scenario, which means, using the lenient 6% worst case scenario, 18% capital. The return, per year, is merely 1.4% annually, so a 1.4% return on 18% in capital (these are a function of par bonds at work) is about 7.8% return on economic capital, which is generally not a good investment for something with so much uncertainty. Thus, while on a Sharpe ratio this may seem a puzzle, given the leptokurtosis (fat downward tail) in bonds, one should not base the risk capital as a function of the standard deviation, but rather, a stress test, which in this case makes this a bad trade (alas, utility function theorists focus on standard deviations). The strategy makes sense for banks only in the context of a product that is 1) not market to market and 2) generates auxiliary revenue via servicing of the loan.

Thus, I am truly puzzled that many banks ended up, basically, with a highly levered position long high grade mortgages funded at the bank funding rate (usually A rating), because even if this crisis did not happen, and the BBB rated Mortgaged Backed Securities did not experience defaults, the mark to market from standard variations in the BBB-AAA spread makes it a loser for investors. I suspect many backed into this trade as UBS did, via first acquiring the securities to repackage into mezzanine securities sold at fat margins, but then were stuck with the high grade securities, and rationalized this as not a problem by looking at historical BBB default rates and ignoring the mark to market. In any case, they should have had a leverage ratio of 5.5:1 (1/0.18) if they want to 'arb' the AAA-BBB spread, so the really high leverage rates of investment banks implies they were not looking at the spread volatility, irrespective of default rate and housing price assumptions.

But is this a key to our financial debacle? Did they merely take on 30 times leverage to arb some thin investment grade spread? Looking at investment bank leverage ratios (assets/book equity), we see that Lehman, Merril, and Bear Stearns were all around 30 in December 2007. Yet, they were around these levels in 1995. Sure, some, like Citi and Morgan Stanley, moved up considerably over that period, but these moves were the exception. Thus, in general, there was not a big increase in leverage, as it was confined to a handful of investment banks. Nevertheless, we do see a relation between leverage and stock returns. Using all US investment banks with market cap over $1B in 2006, and looking at stock returns from 2006 to present, we see a modest, but significant, negative relation. Higher leverage implies a higher future market decline.


But these are investment banks, and when someone on television says 'banker', they usually mean 'investment banker', which is a very different animal. Bankers have modest incomes, and except for the highest echelons, are not not your quintessential Masters of the Universe. They understand the nitty-gritty of underwriting and servicing loans, as opposed to trading and making deals. The leverage ratios of commercial banks, if anything, went down over the past decade, from an average of 12 to around 10. Most banks are commercial banks, not investment banks. We see little relation between leverage in 2006 and subsequent stock market performance (using those US banks with market cap greater than $1B in 2006). This is a typical banking relation, where book leverage, in general, is not correlated with things like ratings, spreads, and other financial performance metrics.


Thus, I think the investment banks that warehoused significant amounts of market traded BBB rated debt were making a bad trade, and were much too highly levered to make this trade. This seems to explain some of the problems for these firms. Yet, most banks were not increasing leverage, and there is little relation between the leverage and future returns we see in commercial banks, as both have lost about 60% in market cap since 2006. So although leverage has some relevance, this is a second order consideration in the big picture.

The key is the quality of the mortgages, and for investors looking at financial statements, there was basically zero meaningful information on how the nature of mortgage assets changed for banks back in 2006.

The Unpredictability of This Crisis

As this crisis wears on, fewer and fewer people remember being surprised by it. For example, in a Blogginheads episode, Megan McCardle and Dean Baker both noted they anticipated the collapse even though Baker called for a 10% decline in housing back in 2002, which is about 20% below December 2008 level. But last April, as these problems were becoming apparent, I was at a meeting by the National Bureau of Economic Research, where all the top financial economists got together. Markus Brunnemeier gave a talk on the housing bubble and noted that about $200B in value had been destroyed via the housing price decline, and this represented only a couple percent in the stock market. The implication was the market had already overreacted. The consensus was this was correct, and I must admit I was no different.

I think what is most surprising about this is the accelerator mechanism that propelled a housing bubble into so many other sectors. It destroyed the market value of all sorts of assets, and seems caught in a positive feedback loop. A related puzzle is that the crisis seemed to start in the US, but the US equity market has declined less than most other countries, and our currency has strengthened. One of my favorite bank analysts, Tom Brown, called for a bank stock bottom last summer. I don't feel bad not understanding or anticipating this, because I know many thoughtful people missed it too, and that very few crises are understood in real time. Sure, with hindsight, I'm seeing connections, how a total lack in trust has created declines in market values which cause declines in banks that have to mark more and more of their assets to market, but realistically going back to last year I don't see how I could have anticipated this other than being a permabear, or knowing about the prevalence of NINJA loans. Indeed, maybe that is the missing variable, that one could not have predicted this problem without knowing how crazy mortgage underwriting became.

Popular not Original

In an interview on YouTube, Michael Hardt, author of Empire, noted that

Q: The two of you wrote a book Empire ... and has become kind of an intellectual best seller, it has been translated into 22 languages ... Why do you think the book had such an impact?

Hardt: Um. One never knows these things. But, one I idea I've had is that that the book the book is not terribly original. And I mean that in a good way, not out of any kind of modesty. Truly original books don't get read. Truly original books, no one can understand. What we are saying is not exactly obvious, but is, but people are already thinking. ... Books in general that have a kind of intellectual success are books people are ready for.

That's a pretty refreshing take by a successful author.

All Banks are Insolvent if You Think They Are

A major difference between banks, and nonbanks, is the inherent susceptibility towards runs. No bank can withstand a run, which is a major reason why we have Central Banks to act as Lenders of Last resort. They key is simply that a bank is a way to intermediate between savers and investors. Most investments into real good take a year, or 5 years, to generate any return. If you sell them before completed, you will usually sell them at a loss irrespective of their worth. Most savers want the ability to retrieve all of their money instantly, in case they need to pay for some emergency.

The solution to this problem, is to rely on the statistics that imply most people will not want all their money right away at the same time. Indeed, with deposit insurance, there are few consumer runs on banks as happened in the 1930's and before. But, most banks and large complex financial institutions have lots of short term debt that rolls over, and if a sufficient number of investors do not roll over their debt, the bank either has to issue long term debt, or liquidate their assets. In times like 2008, both scenarios were inconsistent with viability.

Thus, a problem today is that we have no idea what the assets of a bank are really worth, because the information provided by banks does not allow someone outside to know the proportion of mortgages they hold with Fico scores<600, LTV's>100%, vintage less than 5 years, etc. Without this necessary information people make extrapolations based on what they know, such as where various types of debt trades. But to say the traded debt is a decent proxy for all their assets is absurd, and unfortunately that's how assets are being treated.

In the past week, prominent internet economists Tyler Cowen and Paul Krugman suggested that banks are insolvent, meaning, the value of their assets is below the value of their liabilities. They offered no data to support this assertion, I presume they merely inferred it via the stock market. Unfortunately, they are definitely correct if investors refuse to roll over short term debt, many large banks are insolvent, but this is just a self-fulfilling prophesy true at any time in banking.

It's a difficult problem, especially because simultaneous to financial stabilization plans, we have vague stress tests that could indiscriminately wipe out banks, as any official proclamation a bank is insolvent implies, through the dynamics above, they are insolvent. We also have various home owner bills that could drastically reduce mortgage values, such as changing the bankruptcy laws so that not only are these loans non-recourse, but the banks effectively do not have a first claim on the collateral as previously assumed. Further, such legislation could encourage a second wave of mortgage defaults as people try to qualify for the government's booty.

The markets are in such a funk that market valued accounting, applying market valuation estimates based on proxies, probably does imply a lot of insolvency. Yet non-mortgage loss rates are not outside the norm of past recessions and thus far are containable. The proxy approach using market values would unnecessarily destroy a great amount of franchise value so needed at this point in time. I get the feeling I'm reliving the US history from 1931-33, where the government turned a major recession into a Depression by misunderstanding the importance of providing liquidity and other ham-fisted efforts to fix things (Smoot-Hawley tariffs). Merely heeding M2 will not be sufficient to save us. Bernanke understands the importance of banks in recessions, as he thought Friedman was right to blame the Federal Reserve for its role in the Great Depression, stating on Nov. 8, 2002:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

He needs to also remember that one characteristic of recessions is that they are all different.

Dairy Beats Meat

An interesting fact in Cochran and Hapending's 10,000 Year Explosion, is that raising cattle for milk, as opposed to meat, generates 5 times the calories for a set amount of land. Thus, the milk raising people were able to outbreed, and eventually overwhelm, those whose cultures did not raise cattle for milk. The interesting point is that this is a strange form of genocide, because a lactose intolerant group could not simply adopt dairy farming, because without the lactose tolerant gene, it would be useless (and uncomfortable). Eventually, groups battle, and the numbers of the lactose tolerant simply overwhelms the lactose intolerant. Culture and genes are linked, because with the lactose tolerant genes you can't have a dairy culture, and without a dairy culture, you can't select for lactose tolerance.

I love a tall glass of milk, any time of the day. I still remember that on steak day my most mostly Jewish frat brothers would look in disgust as I drank milk with my steak. It wasn't the Talmudic restrictions that bothered them, rather, they found the combination repulsive, like eating chocolate covered potato chips.

Inconsistent Blurbers

As a separate issue, I noted Bhide's book has a blurb by uber-blurber Lawrence Summers:

Bhidé provides a fresh and reassuring perspective on America’s technological position in an increasingly global economy. Anyone interested in our economic future and especially our technology policies should read this book.
~Larry Summers

In Prophet of Innovation: Joseph Schumpeter and Creative Destruction, Thomas K. McCraw quotes Larry Summers saying that 'if Keynes was the most important economist of the 20th century, then Schumpeter may well be the most important of the 21st.' I don't see how both views can be considered so important. Emphasis is everything, and they point in very different directions.

You can admire works that are directly in contrast because they make good cases for their contradictory points. You might appreciate Barro and Krugman's take on the stimulus package because they are clear expositions of conflicting arguments. Yet that interpretation is probably too generous for your average conflicting blurb (as when Peter Bernstein, author of hagiographies of the founders of the Modern Portfolio Theory, writes a blurb for Taleb's Black Swan, which argues such ideas are worse than useless). A lot of public praise seems to reflect Oscar Wilde's observation that 'One can always be kind to people about whom one cares nothing'.

Bhide's Entrepreneurs

A neat book by Amar Bhide called The Venturesome Economy is about innovation quite different than that of the classic view given by Joseph Schumpeter. It's an important argument, well worth reading, because if he's right, we need fewer engineers, and more B-Schoolers.

Bhide emphasizes not the courage or genius of the entrepreneur, but rather the unintended effects of all the various forms of knowledge generated by the massively multiplayer innovation game that sustains economic growth. These mid level innovations do not show up in patent counts, and individually they are small steps, but they add up, especially because there is so much unsung innovation across the American economy. Bhide emphasizes the mundane innovations from many people making prosaic modifications to the status quo. Think of Wal-Mart's innovations in logistics, Apple's in design, or Proctor & Gamble in marketing. Hardly something to get excited about, but these are the engine for prosperity. He also highlights the importance of consumers taking risks when they buy, say, a new computer or software, as these risks have similar return characteristics as investments, and are essential for generating feedback to the producers. Innovation guru Joseph Schumpeter, in contrast, emphasized the entrepreneur (think Henry Ford), making it seem that we need to incent Unternehmergeist (entrepreneur-spirit) for specific technologies or companies.

Innovation is not so much from trade secrets that are regionally clustered, or deep ideas like the transistors, but rather from the willingness and ability of people to develop these ideas and technologies into products. Apple's successful iPod mainly came from technology outside the US as opposed to anything local in Silicon Valley, and was based on their great marketing and design expertise. Thus, maybe all those arrogant MBA's, who couldn't take the derivative of x² if they had access to their college math texts, and got B's for showing up, are really the key to our economy? Clearly, if true, the first implication is there is no God.

Emphasis is everything and if the Bhide interpretation is correct, Schumpeter's books seem much less important. Schumpter emphasizes brilliance, great men and great companies, whereas Bhide emphasizes the effect of a system where outliers are not so important.

Unfortunately, Bhide does not highlight exactly what kinds of policies, laws, morals, etc., are necessary or sufficient to generate a robust amount of mid level and consumer entrepreneurship. Thus, he does a nice job of convincing us that this is where the key to productivity lies, but is rather vague of why it occurs more in some places than others. For example, he suggests emphasizing the service sector more, in contrast to technologies, noting that Wal-Mart type productivity is one of the US's true strengths. But when he discusses this application to US health care, he seems without a clue as to why the innovative and productive US service sector fails so massively in that one area. It's a bit like a great book on psychology where at the end, the author suggests we watch more sunsets or look into our heart, advice that is boring or useless. True wisdom should lead to better practices, not merely a good read.

Geithner's Stress Test Revealed

The crack team at the Treasury, headed by veteran enterprise-wide capital allocations specialist Tim Geithner, revealed their stress test. The following scenarios are modeled:

The stress test assumes an unemployment rate averaging 8.9% in 2009 and 10.3% in 2010, a 3.3% contraction in gross domestic product in 2009 and home-price declines of another 22% in 2009 and 7% in 2010.

They then merely see how the various bank exposures are affected by these assumptions, including their ability to raise new capital, and 'other risks that are not fully captured in regulatory capital calculations.'

Well, that sounds reasonable if I didn't know anything about banks, but alas, you only fully realize The Experts are usually talking out of their backsides when you hear one talk about something near and dear to you, and note they have not a clue what they are talking about. Then, an epiphany: perhaps it's the same when experts discuss the Gaza strip, health care, everything? In my twenties I felt I didn't understand anything. Now I realize the experts don't know much about their expertise, so it's nothing to get too worked up about. Geithner is an expert in the Robert Rubin sense, who wasn't concerned with things like Citi's asset composition, but knows about getting access to the big politicos that affect essential regulation (isn't that what managing a bank is all about?).

Banks do not have an asset labeled GDP, Unemployment, or Homes. They merely have assets with various uncertain correlations to these factors. Some correlations are truly causations, as in mortgages and home prices, but even there, the connection between one and the other is very complicated, depending a multitude of characteristics in addition to these assumptions (vintage of the loan, its Loan-to-value, the credit score, income and wealth of the borrower). In other cases, such as looking at loans to shipbuilders, the connection is far removed.

If you think finding correlations between asset prices and basic assumptions is easy, consider that Peter Schiff, someone pounding the table that home prices were overvalued because of reckless underwriting standards. His portfolios actually performed horribly last year, because he assumed that this assumption implied a weaker dollar and the US equity market would underperform. You can be totally right on assumptions, but the complexity of the economy renders that insight irrelevant.

Or consider that business cycle forecasting is so fruitless because the particular drivers of each recession are different. The Stock-Watson leading economic indicators model failed to predict the 1990–1991 recession, and an updated version of the model (one that would have caught the 1990 recession) then failed to predict the 2001 recession.

Stock and Watson discuss this failure and argue that it is hard to predict recessions because each is caused by a unique set of factors. For instance, housing and durable goods consumption was strong preceding and throughout the 2001 recession, because the decline was focused on high technology manufacturing. By contrast, in the 1990–1991 recessions, housing and durable goods spending slowed considerably. As Stock and Watson say, “Without knowing these shocks in advance, it is unclear how a forecaster would have decided in 1999 which of the many promising leading indicators would perform well over the next few years and which would not.” Thus, note the stress test primarily involves housing, because that has fallen the most in the past couple of years. Three years ago, it probably would have included a big decline in internet stocks, whereas in 1980 an inflation or oil shock. One wonders what kind of trouble such thinking can lead to, this extreme reliance on the past couple years in forecasting the next couple years...

So, assuming you know where a few pieces of a complex economy are going is a very thin basis for any meaningful stress test. What are the implications for things like one's small business credit lines, credit cards, or airline leases? If you are using real data, you will probably have only 3 recessions at most in your historical analysis, and chances are, the coefficients on many asset classes will be insignificant, but all will be highly uncertain. Just yesterday, I was remarking on an article that blamed the subprime crisis in large part on people assigning too much credence in uncertain correlations. The correlations in a copula are infinitely more precise than any correlation with GDP, Housing prices, and Unemployment. Thus, the results of this exercise is so imprecise it can hardly be the basis for any action. Hopefully, the Treasury shrewdly recognizes this and are actually targeting a placebo effect.

People have to realize that banks are not portfolios of market traded bonds, with lots of data that make for some sort of fat-tail adjusted Value-at-Risk, or beta, meaningful at the bank holding company level. Further, most banks are not investment banks. A standard bank has most of its book not marked to market, its loans highly illiquid, and the best data one has is limited, multidimensional, noisy, has selection biases, and refers to a market with changing parameters (see mortgage underwriting innovations in the 1990's).

Geithner noted he will wrap this up by April. Given the absurdity of this exercise, they should shoot for Friday and save everyone a lot of time. It won't be any more accurate by taking two months.

Increasing Unemployment Insurance is also a Bad Idea

In various debates, the FreeMarketer eventually faces the question "If you don't like Obama's plan, what are you going to do?" The cowed quasi-libertarian then notes her affinity for increases to unemployment insurance, because it seems rather non controversial.

Unfortunately, it is not obvious unemployment insurance is a good thing, and the question reflects two flawed assumptions. First, that attempting to help generally helps. Second, that the situation will not improve without top down policies from Washington. Even Marx stated we should not judge policies based on their intentions, and the batting average for government relief programs is well below the Mendoza line. As per the situation not improving, since the Industrial Revolution began that has been the case. Japan's lost decade, meanwhile, was rife with Keynesian stimulus packages, and they now have trains going everywhere to prove it.

In 2008, unemployment insurance duration was increased 50%, from 26 weeks to 39 weeks. Now, Obama wants to expand state unemployment benefits to part-time workers and others who where previously ineligible to receive the funding, increase the benefits, and increase their duration further.

One iron-clad rule of economics is that whenever you subsidize something you get more of it, so increasing unemployment benefits increases the amount of unemployment. There really is not another side to this, as in the more well-known minimum wage debate.

For example, Bruce Meyer ("Unemployment insurance and Unemployment Spells") found that higher benefits reduce the probability that insured unemployed workers will leave unemployment. He did this by measuring the probability is measured as a ratio of newly employed workers at the end of the week to those unemployed at the beginning of the week. He finds a 10% increase in the benefits decreases this probability by 5.3%. A paper by Stephen Nickell found that looking at US and Europe from 1983-96, those 8 out of 15 countries with an unemployment rate 120% of the US had relatively generous unemployment benefits. He notes that generous unemployment benefits decreases the willingness of the unemployed to find employment, and increasing the duration of the entitlement increases long-term unemployment. In sum, raise unemployment benefits, expect a higher unemployment rate.

Everything has costs and benefits. The benefits of increasing unemployment insurance is the increased income of those getting more benefits, and--though this is highly cynical--that those supporting such transfers win status or votes by signaling their compassion through their willingness to support redistribution (it is easy to win votes when a disproportionate amount of the wealth comes from a minority). The costs are delaying the millions of individual transitions needed in the economy, because recessions basically inform us that we need fewer people in some fields and companies and more in others. What should the unemployed do next? I don't know, and people in Washington don't know either, because it depends on the specific skills of those diverse unemployed individuals and what the market is paying for those skills, data that is not available to our politburo. Only individuals are in the best position to solve this problem, and giving them cash may actually not be in their best interest because it just delays inevitable hard choices.

Don't Blame The Quants, Felix

It would be nice to think that this crisis was a huge math error. Some geek in a cubicle hit the wrong button on his HP12-C. Doh! Alas, it is not the case. Any error this pervasive is not from some obscure assumption, but an assumption that everyone was comfortable with. If an obscure technical assumption drove investors into various bonds, there should be a large group of investors who would have quants who disagreed, and they would have not been exposed. That is, quants may have no common sense, but on obscure technical results, they are smart and often disagree. Yet not one of the major investment banks worldwide escaped this craze. It's as if all the geeks thought the 5th digit of Pi was 6.

The only reason everyone made the mistake was that it was from an assumption that everyone seemed to think was reasonable, something quants did not have the authority to affect: that housing prices would not fall significantly. Look at Shiller's update Irrational Exuberance from 2005, and there's a chapter on the Housing Bubble, where he notes that recent housing price increases 'probably won't continue', hardly a clarion call to avoid housing. When everyone is doing something, and think it's right, the quants will perforce generate supporting documentation. Scientists in that way are like lawyers, advocates, not for a paid client, but rather, the ephemeral verities of the current zeitgeist. With $4B for global warming research, and much less for anti-global warming research, it is no surprise many scientists are documenting various evidence of global warming: people like the results, they aren't as skeptical, more likely to get published, get a grant, get on a government project, etc.

UBS used a 10-day Value-at-Risk on its residential mortgage backed portfolio to assess its risk, using data from the benign 2000-2005 period. This was an error. But UBS was going to invest in mortgages anyway, because presumably this collateral does not decline much if ever, so this was all standard rationalization of preconceived objectives.

Felix Salmon wrote a piece in Wired, where he fingers the copula function as the primary culprit.

And (David) Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

He then quotes some quants, like Darrell Duffie, who states that "corporate CDO world relied almost exclusively on this copula-based correlation model". Well, derivatives textbook authors might like to believe that their formulas underlie most financial activity, but I suspect the number of people using copulas in their sales pitch was low, no more than 5%, because most investors, big shots who actually make portfolio decisions, do not like pretentious mathematics. Perfunctory metrics may be ubiquitous, but they are still perfunctory. The decision makers are rich, powerful, kind of smart, do not feel embarrassed by their lack of knowledge in obscure technical trivia, and surely are not intimidated by it. Of that limited set, the copula itself, irrespective of the broader knowledge about mortgages and housing price trends, was probably the driver of 10% of those purchases, because even for investors who like formulas, most require a bigger picture. Thus, I generously estimate about 0.5% of all mortgages were bought because of David Li's Frankenstein formula.

Copulas, value at risk, correlations, credit scores, one might add standard deviations, means, and Microsoft Excel's 'solver'. These concepts can get tricky, but the basic assumption in the mortgage crisis, that housing prices would not fall significantly, was not tricky, and people with the authority to make decisions were not swayed by these technical issues, rather, they used them to validate their earlier beliefs.