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July 19, 2009

Economist's View - 3 new articles

"Why Toxic Assets Are So Hard to Clean Up"

John Taylor and Kenneth Scott argue that "sheer complexity" is at the heart of the financial crisis:

Why Toxic Assets Are So Hard to Clean Up, by Kenneth Scott and John Taylor, Commentary, WSJ: Despite trillions of dollars of new government programs, one of the original causes of the financial crisis -- the toxic assets on bank balance sheets -- still persists and remains a serious impediment to economic recovery. Why are these toxic assets so difficult to deal with? We believe their sheer complexity is the core problem and that only increased transparency will unleash the market mechanisms needed to clean them up.
The bulk of toxic assets are based on residential mortgage-backed securities (RMBS), in which thousands of mortgages were gathered into mortgage pools. The returns on these pools were then sliced into a hierarchy of "tranches" that were sold to investors as separate classes of securities. ...
But the process didn't stop there. Some of the tranches from one mortgage pool were combined with tranches from other mortgage pools, resulting in Collateralized Mortgage Obligations (CMO). Other tranches were combined with tranches from completely different types of pools, based on commercial mortgages, auto loans, student loans, credit card receivables, small business loans, and even corporate loans that had been combined into Collateralized Loan Obligations (CLO). The result was a highly heterogeneous mixture of debt securities called Collateralized Debt Obligations (CDO). The tranches of the CDOs could then be combined with other CDOs, resulting in CDO2.
Each time these tranches were mixed together with other tranches in a new pool, the securities became more complex. Assume a hypothetical CDO2 held 100 CLOs, each holding 250 corporate loans -- then we would need information on 25,000 underlying loans to determine the value of the security. But assume the CDO2 held 100 CDOs each holding 100 RMBS comprising a mere 2,000 mortgages -- the number now rises to 20 million!
Complexity is not the only problem. Many of the underlying mortgages were highly risky, involving little or no down payments and initial rates so low they could never amortize the loan. ...
With so much complexity, and uncertainty about future performance, it is not surprising that the securities are difficult to price and that trading dried up. Without market prices, valuation on the books of banks is suspect and counterparties are reluctant to deal with each other. ...
The latest disposal scheme is the Public-Private Investment Program (PPIP). ... But the pricing difficulty remains and this program too may amount to little. The fundamental problem has remained untouched: insufficient information to permit estimated prices that both buyers and sellers find credible. Why is the information so hard to obtain? ... CDOs were sold in private placements with confidentiality agreements. ...
This account makes it clear why transparency is so important. To deal with the problem, issuers of asset-backed securities should provide extensive detail in a uniform format about the composition of the original pools and their subsequent structure and performance, whether they were sold as SEC-registered offerings or private placements. By creating a centralized database with this information, the pricing process for the toxic assets becomes possible. Making such a database a reality will restart private securitization markets and will do more for the recovery of the economy than yet another redesign of administrative agency structures. ...

I am becoming convinced, after reading articles like this and from other research on this issue, that forcing these transactions through organized exchanges that monitor and mitigate counterparty risk is a good idea. Here's a discussion of the issues:

On the derivatives side, the administration had already indicated that it would push for all standardized derivatives to be traded through an organized exchange or cleared through a clearing house. ... Exchanges bring a real benefit from transparency about the pricing and volume of trades, as well as making it easier for regulators to track trading positions of major parties. In contrast, much of the trading volume in derivatives now takes place "over the counter," between two counterparties who are not generally required to report details of the trade and who take each other's credit risk in regard to the transaction. This credit risk is often mitigated by requiring collateral, but it is clear in retrospect that this process was not well-managed in many cases, leaving a large number of institutions very exposed to the credit risk of AIG, for example. The major exchanges dealing in derivatives use central clearing houses that act as the counterparty to both sides. ... It should be noted that using a clearing house does not eliminate counterparty risk altogether. The clearing house could become insolvent itself if enough of its counterparties fail to meet their obligations. This should still represent a diminution of the total credit risk in the system, since clearing houses are well-capitalized and operate in a clearly defined business..., but there could be extreme circumstances where a government rescue would be required. The big controversy with derivatives is what to do about customized derivatives. The use of derivatives to manage risk by sophisticated corporations is pervasive. Sometimes those derivatives are significantly cheaper or more effective if they cover the exact risk rather than using one or more standard derivatives to approximate the desired protection. It would be a great shame to lose those efficiencies altogether by banishing customized derivatives, but there is also a fear that financial firms will deliberately sell slightly non-standard derivatives in order to avoid the tougher rules on standardized ones. This is another area where the devil is in the details. The trick will be to provide incentives or requirements to use standard derivatives where possible, while leaving the ability to use customized ones where they serve a genuine need. The administration's proposal attempts to strike this balance. It will be interesting to see what comes out the other end of the legislative process...

One solution is to subject transactions for customized derivatives (which have their uses) that cannot go through organized exchanges or clearinghouses to discouragingly strict margin and capital requirements.

"The Most Misunderstood Man in America"

Michael Hirsh wonders why the Obama administration hasn't consulted Joe Stiglitz more often on economic policy issues, and suggests the answer is an ongoing feud with Larry Summers:

The Most Misunderstood Man in America, by Michael Hirsh, Newsweek: ...Even in the contentious world of economics, [Joe Stiglitz] is considered somewhat prickly. And while he may be a Nobel laureate, in Washington he's seen as just another economic critic—and not always a welcome one. Few Americans recognize his name... Yet Stiglitz's work is cited by more economists than anyone else's in the world... And when he goes abroad—to Europe, Asia, and Latin America—he is received like a superstar, a modern-day oracle. ...

Stiglitz is perhaps best known for his unrelenting assault on an idea that has dominated the global landscape since Ronald Reagan: that markets work well on their own and governments should stay out of the way. ... The subprime-mortgage disaster was almost tailor-made evidence that financial markets often fail without rigorous government supervision, Stiglitz and his allies say.

The work that won Stiglitz the Nobel in 2001 showed how "imperfect" information that is unequally shared by participants in a transaction can make markets go haywire, giving unfair advantage to one party. The subprime scandal was all about people who knew a lot—like mortgage lenders and Wall Street derivatives traders—exploiting people who had less information... As Stiglitz puts it: "Globalization opened up opportunities to find new people to exploit their ignorance. And we found them." ... The solution, Stiglitz says, is to ... develop a balance between market-driven economies—which he favors—and government oversight.

Stiglitz has warned for years that pro-market zeal would cause a global financial meltdown very much like the one that gripped the world last year. ... Since at least 1990, Stiglitz has talked about the risks of securitizing mortgages, questioning whether markets and authorities would grow careless "about the importance of screening loan applicants." ...

To his critics—and there are many—Stiglitz is a self-aggrandizing rock-thrower. ... Stiglitz's defenders say one possible explanation for his outsider status in Washington is his ongoing rivalry with Summers. ... Since the early '90s, when Summers was a senior Treasury official and Stiglitz was on the Council of Economic Advisers, the two have engaged in fierce policy debates. The first fight was over the Clinton administration's efforts to pry open emerging financial markets, such as South Korea's. Stiglitz argued there wasn't good evidence that liberalizing poorly regulated Third World markets would make any one more prosperous; Summers wanted them open to U.S. firms.

The differences between them grew bitter in the late 1990s, when Stiglitz was chief economist for the World Bank and took issue with the way Treasury Secretary Robert Rubin, and Summers, who was then deputy secretary, were handling the Asian "contagion" financial collapse. After World Bank president James Wolfensohn declined to reappoint him in 1999, Stiglitz became convinced that Summers was behind the slight. Summers denies this...

Despite the Obama team's occasional efforts to reach out to him, Stiglitz remains deeply unhappy about the administration's approach to the financial crisis. Rather than breaking up or restructuring the big banks that failed, "the Obama administration has actually expanded the notion of 'too big to fail,' " he says. ...

Today, settled as a professor at Columbia, Stiglitz occasionally finds himself welcomed in the nation's capital, though usually at the other end of Pennsylvania Avenue, to testify before Congress. While he had no great desire to go back into government, friends say he was deeply disappointed when an offer didn't come from Obama last fall. Not surprisingly, Stiglitz believes his old rival was behind it, though Summers denies this. ... Stiglitz may a prophet without much honor in Washington, but he seems to be determined to keep the prophecies coming.

This isn't the first time Michael Hirsh has written about this. Though the question has changed from "why didn't Obama appoint Stiglitz to a key position within the administration" to "why doesn't the administration consult Stiglitz more often on economic policy issues," last December he made most of the same points:

OK, enough with the Obamamania already. I have a major bone to pick with our all-praised president-elect. Where, Mr. Obama, is Joseph Stiglitz? Most pundits have pretty much gone ga-ga over your economic team: The brilliant Larry Summers... The judicious Tim Geithner... The august Paul Volcker... But lost amid the cascades of ticker tape is the fact that, astonishingly, you didn't hire the one expert who's been right about the financial crisis all along—and whose Nobel Prize-winning ideas will probably be most central to fixing the global economy.

This is not speculation. A source close to Stiglitz told me Thursday that the Columbia University economist has been left out in the cold, even though he was expecting at least an offer. ...

Stiglitz, more than anyone on the Washington scene, was the biggest fly in the ointment of "free-market fundamentalism" pressed on the world in the '90s by Summers, Geithner and their mentor, former Treasury secretary Robert Rubin—advice that has now contributed to the worst financial crisis since the Great Depression. ... Sure, I know the rap on Stiglitz:... he's too often "off the reservation," won't stay on the message, and doesn't play well with others—especially Summers. (Summers is said to have pressured former World Bank president Jim Wolfensohn to fire Stiglitz in the '90s...) Unquestionably, Stiglitz has occasionally gone overboard in his criticisms... But Obama has made a point of declaring that he wants dissonant voices in his administration. So why not Joe Stiglitz?

I can understand not offering Stiglitz a key position within the administration, he might not always stay on message and that scares the political managers (though the fact that they accepted Summers undercuts the argument that they wanted to avoid people who are potentially politically explosive, though perhaps they'd agree to one, but not two, and Summers was the one). But in the first article Stiglitz is quoted as saying that "We've talked one or two times," and it's harder to understand why the administration hasn't consulted him more often on economic policy issues.

Update: Paul Krugman:

Morning Joe: I think this Michael Hirsch piece on Joe Stiglitz somewhat misses the point.

Yes, Joe should be playing a bigger role — he's an insanely great economist, in ways you can't really appreciate unless you're deep into the field. I'd say that he's more his generation's Paul Samuelson than its John Maynard Keynes: as with Great Paul, almost every time you dig into some sub-field of economics — finance, imperfect competition, health care — you find that much of the work rests on a seminal Stiglitz paper.

But the larger story is the absence of a progressive-economist wing. A lot of people supported Obama over Clinton in the primaries because they thought Clinton would bring back the Rubin team; and what Obama has done is … bring back the Rubin team. Even the advisory council, which is supposed to bring in skeptical views, does so by bringing in, um, Marty Feldstein.

The point is that even if you think the leftish wing of economics doesn't have all the answers, you'd expect some people from that wing to be at the table. Yet I don't see Larry Mishel, or Jamie Galbraith … Jared Bernstein is it.

Joe Stiglitz stands out because in addition to being on the progressive wing, he's also, as I said, a giant among academic economists. But I think the real story is more about excluded points of view than excluded people.

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