Pater Familias

MONEYBALL AND THE FINANCIAL CRISIS. What does MONEYBALL have to do with the financial crisis? The connection is that Michael Lewis, the author of MONEYBALL (which describes how sabermatricians brought statistical analysis to baseball) has written a long, amusing, and scary article about some of the few people in the financial world who foresaw what would happen (link via TwoBlowhards). They not only foresaw what would happen, they made great efforts to publicize what they foresaw. And they made lots of money selling short. But, as the article explains, the short selling only fed the mania. One scary item: the process that got us here depended on the rating agencies giving certain mortgage-based securities a rating of AAA (the highest rating). To quote from the article: “[One of the short sellers called a rating agency] and asked what would happen to default rates if real estate prices fell. The man at [the rating agency] couldn’t say; its model for home prices had no ability to accept a negative number.” In other words, because their model was based on history, and prices had always gone up, there was no possibility they could go down.

DOCUMENTATION: 1,700.000 PAGES. How complicated are some of these securities? A friend sent me a link to a seminar report where James Grant, of Grant’s Interest Rate Observer, described the legal documentation for a collateral debt obligation company as having 1,700,000 pages.

WHERE THERE ARE COINS, THERE MUST BE MARKETS. This article tells of the discovery in the Netherlands of Celtic gold coins which were minted by the Eburones (a tribe that Julius Caesar claimed to have wiped out in 53 B.C) and also of Celtic silver coins which were minted by tribes further north. Coins are strong evidence that there were local markets in Caesar’s Gaul.

BASEL II–WHAT REGULATORS DIDN’T FORESEE. I have posted on the remarkably small percentage of liquid reserves that financial institutions were maintaining before the current crisis. But those institutions were not the only ones that did not foresee the risks. The Lex column in the Financial Times for November 14 points out that under the Basel II accord, “even when playing within the rules, the most conservative banks still became ridiculously geared. Under the most basic version of Basel II, triple A corporate bonds have a 25 per cent risk weighting. That means banks can theoretically ramp up their exposure to this asset class by 50-fold and still not breach the required capital ratio of 8 per cent.” Basel II was adopted (and is still in the process of being implemented), as this Economist article points out, “[u]nder the auspices of the Bank for International Settlements (BIS), a central bankers’ central bank in Basel, in Switzerland.” In other words, top thinkers from all the world central banks were involved in formulating Basel II. The Economist article concludes that “[The chief failing of Basel II] is its reliance on rating agencies and the banks’ own models of the risks that they are carrying—an idea that has been discredited by the way banks have been caught out.” What happened with this latest regulatory reform should make us cautious about formulating sweeping new regulations going forward.

ARE GOVERNMENT OBLIGATIONS THE ONLY WAY TO DIVERSIFY AGAINST CERTAIN RISKS? I linked here to Professor Damodoran’s point that “it is harder to use diversification to reduce risk in portfolios than it was twenty years ago for two reasons: “1. The correlation across equity markets has risen dramatically”;and “2.Securitizing real estate and bringing it into portfolios has made risk in the real estate market more closely tied to the overall equity market.” For diversification to work, the prices of the assets should not be correlated. During a period when everybody is running for the exits together, the prices of all private assets tend to go down together; their movements are correlated. Kids, the lesson seems to be that a proportion of your assets has to be in cash or government obligations to protect against these crises.

ARE GOVERNMENT OBLIGATIONS THE ONLY PROTECTION IN A LIQUIDITY CRUNCH? In the article by Paul Davies that I linked to yesterday, he had an important quote from Hyman Minsky. Minsky, who wrote about how bubbles and financial crises develop, has been receiving a lot of attention recently because recent events make him look far-sighted. In particular, kids, there are a lot of references now to a “Minsky Moment”, which is defined as “the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments.” All this is to say that this quotation of Minsky by Paul Davies deserves attention: “the liquidity of the community decreases when government debt is replaced by private debt in the portfolios of commercial banks.” Government debt is different. In a liquidity crisis, only government obligations—such as cash or Treasury bills—will do. I suppose you could think of the guaranties the government has been issuing as converting private debt into government debt.

CASH RESERVES AND FIRE INSURANCE. Kids, I should say that I think another way of expressing what Paul Davies is getting at is that “efficiency” is not usually used to refer to minimizing only some costs but not others. Put loosely, for me, not having cash reserves is like saving money by not having fire insurance.

DOES REDUCING CASH RESERVES INCREASE EFFICIENCY? Paul Davies had an article in this Friday’s Financial Times which questions recent changes in bank reserve practices. He uses the framework described in today’s other post which treats reductions in bank holdings of traditional reserve assets as resulting from an attempt to increase efficiency by reducing the opportunity costs of holding lower-yield assets. He quotes a Bank of England report from earlier this week which describes the extent to which “banks sought to reduce the opportunity cost of holding liquid assets by substituting traditional liquid assets such as highly-rated government bonds with highly rated structured credit products.” One chart in the report shows that for UK banks, the proportion of total assets in traditional instruments declined from 30% in the late 60’s to almost zero in this decade. Interestingly, most of the decline took place some time ago; the proportion was under 5% through the 80’s and 90’s. Davies concludes that this kind of efficiency “can be a false economy.”

THE VIEW FROM AUGUST—ARE CASH RESERVES INEFFICIENT? I have posted previously on the low level of reserves that investment banks and commercial banks have been holding. An article in August in the Economics Focus section of the Economist presented a contrary view: that capital reserves are inefficient. The article describes a paper which had been presented to the annual Jackson Hole meeting of central bankers. The paper proposed a form of capital insurance for banks in place of reserves. The proposal created a “buzz” at the meeting. The article describes the premise of the paper: for banks to hold more capital “goes against shareholders’ interests, because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have higher returns.”

THE VIEW FROM AUGUST—WAS INFLATION THE MOST IMPORTANT CONCERN? I have kept some issues of the Economist from this August. One of the leaders (a “leader” is an Economist editorial) reviewed the financial difficulties of the previous year. The editorial set out two main goals for central banks: “The central banks’ credibility depends on being prepared to do two unpopular things: raising interest rates, despite the economic pain, and letting financial institutions fail.” And it concluded with a strong recommendation: “Central banks’ credibility should be focused where it is most needed, on controlling inflation. That credibility was too hard-won to be tossed away.” At the time, only three months ago, the Bank of England and the European Central Bank were giving priority to fighting inflation.