Friday, November 28, 2014

The Financial Fire Next Time

NEW HAVEN – If we have learned anything since the global financial crisis peaked in 2008, it is that preventing another one is a tougher job than most people anticipated. Not only does effective crisis prevention require overhauling our financial institutions through creative application of the principles of good finance; it also requires that politicians and their constituents have a shared understanding of these principles.

Today, unfortunately, such an understanding is missing. The solutions are too technical for most news reporting aimed at the general public. And, while people love to hear about “reining in” or “punishing” financial leaders, they are far less enthusiastic about asking these people to expand or improve financial-risk management. But, because special-interest groups have developed around existing institutions and practices, we are basically stuck with them, subject to minor tweaking.

The financial crisis, which is still ongoing, resulted largely from the boom and bust in home prices that preceded it for several years (home prices peaked in the United States in 2006). During the pre-crisis boom, homebuyers were encouraged to borrow heavily to finance undiversified investments in a single home, while governments provided guarantees to mortgage investors. In the US, this occurred through implicit guarantees of assets held by the Federal Housing Administration (FHA) and the mortgage agencies Fannie Mae and Freddie Mac.

At a session that I chaired at the American Economic Association’s recent meeting in Philadelphia, the participants discussed the difficulty of getting any sensible reform out of governments around the world. In a paper presented at the session, Andrew Caplin of New York University spoke of the public’s lack of interest or comprehension of the rising risks associated with the FHA, which has been guaranteeing privately-issued mortgages since its creation during the housing crisis of the 1930’s.

Caplin’s discussant, Joseph Gyourko of the Wharton School, concurred. Gyourko’s own 2013 study concludes that the FHA, now effectively leveraged 30 to one on guarantees of home mortgages that are themselves leveraged 30 to one, is underwater to the tune of tens of billions of dollars. He wants the FHA shut down and replaced with a subsidized saving program that does not attempt to compete with the private sector in evaluating mortgage risk.

Similarly, Caplin testified in 2010 before the US House Committee on Financial Services that the FHA was at serious risk, a year after FHA Commissioner David Stevens told the same committee that “We will not need a bailout.” Caplin’s research evidently did not sit well with FHA officials, who were hostile to Caplin and refused to give him the data he wanted. The FHA has underestimated its losses every year since, while proclaiming itself in good health. Finally, in September, it was forced to seek a government bailout.

At the session, I asked Caplin about his effort, starting with his co-authored 1997 book Housing Partnerships, which proposed allowing homebuyers to buy only a fraction of a house, thereby reducing their risk exposure without putting taxpayers at risk. If implemented, his innovative idea would reduce homeowners’ leverage. But, while it was a highly leveraged mortgage market that fueled the financial crisis 11 years later, the idea, he said, has not made headway anywhere in the world.

Why not, I asked? Why can’t creative people with their lawyers simply create such partnerships for themselves? The answer, he replied, is complicated; but, at least in the US, one serious problem looms large: the US Internal Revenue Service’s refusal to issue an advance ruling on how such risk-managing arrangements would be taxed. Given the resulting uncertainty, no one is in a mood to be creative.

Meanwhile, there is strong public demand – angry and urgent – for a government response aimed at preventing another crisis and ending the problem of “too big to fail” financial institutions. But the political reality is that government officials lack sufficient knowledge and incentive to impose reforms that are effective but highly technical.

For example, one reform adopted in the US to help prevent the “too big to fail” problem is the risk retention rule stipulated by the 2010 Dodd Frank Act. In order to ensure that mortgage securitizers have some “skin in the game,” they are required to retain an interest in 5% of the mortgage securities that they create (unless they qualify for an exemption).

But, in another paper presented at our session, Paul Willen of the Federal Reserve Bank of Boston argued that creating such a restriction is hardly the best way for a government to improve the functioning of financial markets. Investors already know that people have a stronger incentive to manage risks better if they retain some interest in the risk. But investors also know that other factors may offset the advantages of risk retention in specific cases. In trying to balance such considerations, the government is in over its head.

The most fundamental reform of housing markets remains something that reduces homeowners’ overleverage and lack of diversification. In my own paper for the session, I returned to the idea of the government encouraging privately-issued mortgages with preplanned workouts, thereby insuring them against the calamity of ending up underwater after home prices fall. Like housing partnerships, this would be a fundamental reform, for it would address the core problem that underlay the financial crisis. But there is no impetus for such a reform from existing interest groups or the news media.

One of our discussants, Joseph Tracy of the Federal Reserve Bank of New York (and co-author of Housing Partnerships), put the problem succinctly: “Firefighting is more glamorous than fire prevention.” Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending.

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    1. Commentedroberto martorana

      intuition from where I started is that the current macroeconomic model produces an imbalance of negative money supply atrraverso the creation of credit securities of which it is requested via a return higher interest than it is created,to resolve this I suppose a new rule for central bank: a model that integrates the concepts between von Hayek and J.M. Keynes,because it keeps the economic freedom of enterprise and market , creating resources that can be used by the government but to the extent that they are created and without increasing the tax burden... when one of the central bank(respectively of each country or through international agreements) have a new emission of money whith each rate the same bank print corrispective quantity of money of the rate ,off C.B. budget,and give this quantity ( to compense the monetary mass to solve the lack natural compensation previously provided by 'gold mining ..) at a pubblic commission that use for pubblic necessity etc etc...we resolve three problem :pubblic necessity,pubblic balance,and market crisis,;for example : the B.C. have a emission of hundred billion unit and fix a rate of 3% and give this money to commercial bank,at the same moment print 3 billion and give these to pubblic commission that spend for pubblic problem....
      (More on:Teoria della compensazione della massa monetaria this is my page about a new theory macroeconomic conception monetary system ,and any contribute are well accepted )

    2. CommentedRamesh Kumar Nanjundaiya

      How to prevent the next global financial crisis. Professor Schiller has analysed the present global situation very well indeed. Here is my 5 cents: Any discussion on the ongoing Global Financial crisis/situation will not be complete unless we see the roles being played by U.S. and a majority of International Banks: US and International Banks: Libor rigging allegations continue to cost well known international banks. So what is in store for the overall banking business going forward and the impact on its sincere customers:
      Year 2012/13 saw the opening up of the Pandora’s Box of banking scams (thanks to the exposure of Libor rigging fiasco [news broke in June 2012] by the well known international (sic) Barclays Bank) where many known caught up banks followed suit with the exposure for all possible type of financial rout (including FOREX manipulation) affecting the common man. All the hefty fines paid by various well known international banks (to be still paid) has left a bitter taste on their activity thereby resulting in setback for the ongoing global business and the economy. Essentially, many businesses and consumers will remain wary and uncertain in 2014 and will be reluctant to commit to major spending and investment decisions. The ongoing write down of asset values will continue and banks will have to accept credit losses thereby giving rise to small banks merging to remain sufficiently capitalized. Two types of business focus will arise from the banks:
      1. Banks in the developed countries will still continue with restructuring efforts whereas, 2. Banks in developing countries will focus on growth due to the sheer size of the population (the middle class – the target sector). This class of spenders has shown that they have the necessary buying power and this is driving the economy and consumerism. How to go about this: The global banking industry needs to build “customer trust” all over again. To do this, new set of reforms are urgently needed to fundamentally reshape and rehaul the scam ridden banking industry. That there are going to be challenges in reshaping is an understatement for the banking industry, be it in the area of resolution planning, structural reforms and/or disclosure norms, etc will eventually define the approach for banks to win trust and structure their global banking activity in a sustainable and ethical way going forward.

    3. CommentedKen Presting

      Prof. Schiller is right to want to prevent the next crisis, but I'd suggest he has the problem of the workman whose only tool is a hammer - he is advising us to assume hat financial crises are nails.

      There is substantial evidence that the latest financial crisis was less an economic event than a criminal event. Home buyers were tricked, regulators were tricked, investors were tricked, and financial institutions tricked each other. And by "tricked" one should understand "felonious fraud." The SEC has extracted substantial settlement penalties from some of the guilty parties. That is important evidence, at least in the American cases.

      The crises in Greece and Italy are even more obviously caused by crimes, but Spain and certain others are less well reported in the American press. This is a useful topic for further journalism.

      In the meantime, those who propose novel economic structures to avoid future crises should also keep in mind the role of processes like auditing and transparency.

      Who said, "We won't be fooled again?"

    4. CommentedJames Goodman

      The problem here may not be that effective regulation of financial markets is beyond the reach of government. Rather, it can be said that a sole focus on regulating financial markets will lead to reductive hypotheses in reducing risk, and ignores deregulation in other areas of the economy as a contributing factor to financial instability.

      In particular, a focus on prevention would necessitate increased regulation of both financial and labor markets. The role of labor market deregulation is conspicuous as policy that contributed to increased risk in the housing bubble, yet this is being largely ignored by subject matter experts and politicians. For example, overleverage and low disposable income encapsulates both financial instability and the need for increased regulation of financial and labor markets in four words.

    5. CommentedProcyon Mukherjee

      The housing bubbles in the past were all predicable to say the least, the current one in the making, is as well.
      In attempting to identify bubbles before they burst, economists have developed a number of financial ratios and economic indicators that can be used to evaluate whether homes in a given area are fairly valued. Indicators describe two interwoven aspects of housing bubble: a valuation component and a debt (or leverage) component. The valuation component measures how expensive houses are relative to what most people can afford, and the debt component measures how indebted households become in buying them for home or profit (and also how much exposure the banks accumulate by lending for them).

      But the question is while we can always say whether we are approaching a meltdown or not, we cannot be certain that the market participants would all acknowledge and respond in the same manner. This is where the timing of the burst is uncertain, nothing else is.

    6. CommentedEdward Ponderer

      I believe what where the wisdom of the crowd--which can be a lot smarter than even the finest of individual or small teams of experts -- is that something must be done fundamentally about corruption before any "new, better plan" is attempted. Simply put, power stake holders with with egos like all outdoors, will find a way to feather their nests at others expense in any system of rules.

      Per Godel's Theorem, in any system of rules based on certain axioms--assumed or empirical, there are always actions whose legality cannot be proven or dis-proven in the system. That is, there is always something that you can get away with--even if it is a "nickel and dime to death" tactic--which blows the fail-safe of the system. Adding this new found axiom to the fail-safe, yet anther loop-hole is guaranteed to be there. According to Albert Einstein and Robert Oppenheimer who served as Godel's witnesses at his citizenship hearing, the morning there of they found him very distressed. The reason is that in reviewing the US Constitution and its set of checks and balances during the night, he applied his methodology and discovered a loop-hole which would allow the United States to transform into a de facto authoritarian without changing anything de jure. [The frightening reality is that we may be seeing this process already taking place.]

      This must be clearly understood--because it ultimately reduces any general economic win-win recovery plan to a new, win-lose game for the clever financial strategist--who can never have enough money because he cannot ever have enough of the game.

      And the game is ego, and says that no matter how much I win, I only really win if you lose. Its a subconscious horror, but it is an underlying driving force responsible for ever growing misery in this world.

      This must be overcome by a grass-roots effort at developing and integral emphasis in education--on atomic rules of human relationship, and from their, setting up the right atmosphere via social media, set up new values for the ego of being the big winner by being the biggest contributor to society rather than owning the finest art work. In short, establishing mutual responsibility over the theme of looking out for number one, is crucial--and really is ultimately the only way--even to look out for number one. Which is why our own egoism will even help us here if we properly incorporate it.

      And if we go blindly building on the sand of untutored human nature, we will just sink evermore quickly into the quicksand for the useless struggle.

    7. CommentedMarc Sargen

      I don't see this solving the issue. If you encourage a situation where housing assets are by law diversified the most likely result you will find is that the diversified assets will become increasingly correlated.
      People forget that he mortgage backed securities were an evolutionary product of the desire to diversify risk owned by regional S&L's after the S&L crisis.
      The risks of home ownership is quite clear. The risks of a diversified home pool LLC will perplex financial experts.

    8. CommentedMichael Cohen

      There are four basic reasons the financial collapse could have been foreseen and could have been prevented
      A)The housing market bubble came about for understandable reasons and B) was relatively easy to avoid.

      Even after the market collapse, C) a financial meltdown was also understandable and D) could have been avoided.

      Let's see how
      A) Could the market bubble have been foreseen? Yes and here is why:
      - Housing prices were obviously inflated when mortgage costs doubled as a percent of income, that was a clear indication that the prices were unsustainable
      - When the business of writing mortgages, holding mortgages was broken down among three separate groups (mortgage brokers, CDO Bond holders, and mortgage servicers) the incentives for fraud and financial mismanagement became unstoppable. Mortgage brokers were incented to write large volumes of high cost low quality loans and had no incentive to care if they ever got paid off
      - Banks provided an excess of capital by laying off the loans on investers as CDO's
      - Mortgage servicers had no incentive to keep people in there homes and made money through expensive and wasteful foreclosures then benefited them but destroyed the homeowners, encouraged housing abandonment and degradation and destroyed the residual value of the CDO's
      B) Could the housing bubble have been avoided? Yes
      - The people who lend money can and should be forced to have an interest in making sure the loans are sound. There are many ways of doing this. Lender should be required to maintain a substantial portion of the risk of default.
      - A key enabler of the housing market bubble and CDO fraud were the ratings agencies who somehow managed to transform toxic waste into AAA bonds. They traded there credibility in for cash and the public paid the price

      C) The housing market collapse did not have to lead to a financial meltdown.
      - If the loss in housing prices was more gradual and could have been shared by home owners and banks, then the losses could have been absorbed and people could have stayed in there homes. But this did not happen because loan servicers made more money from foreclosures and had not desire to let people stay in there homes. This accelerated the rate of foreclosures that started a death spiral of abandonment, neighborhood blight further reductions in home values and more foreclosures.

      - Even with all this the market might have held up if it wasn't for credit default swaps. Thanks to the "investment Modernization Act" these were unsecured unregulated and mostly out of sight. For every dollar in lost mortgage debt there were Ten dollars of Credit default swaps held that may or may not get paid off.

      With all this uncertainty, a mortgage crisis metastasized into a full fledged banking meltdown. Nobody knew if the Swaps they wrote to hedge there bets were good. Nobody trusted other peoples books, the overnight inter bank interest rate skyrocketed and the financial markets threatened to seize up.

      and finally D) Could the housing market drop be contained and the financial crises avoided? Again the answer is yes.

      - First, mortgage services should be required to act for the benefit of the bondholders (many of who would be banks), or better yet, lenders should service there own mortgages like they use to do. Home owners could then be allowed to stay in their own homes if they were able to pay market rents on their homes or support a mortgage at then current housing prices and interest rates. Throwing a person out of a home they can afford at current prices only leads to abandonment, and housing deterioration.

      - Finally credit default swaps must be reigned in. People who write them should be required to carry adequate reserves like insurance companies. Outside parties without cash at stake should not be allowed to use credit default swaps as a way to make bets that only serve to amplify the impact of financial problems.

      The financial crises was foreseeable and preventable, we just don't have a government that is willing and able to serve the real interests of the American people.

    9. Portrait of Keith Roberts

      CommentedKeith Roberts

      While consumers glaze over at most financial talk, their self-interest is very directly engaged by relevant and clearcut disclosures, and the public has repeatedly showed strong support for good disclosure. Hardly any home buyers, or even very sophisticated depositors and investors in bank financing are unaware of the "skin in the game" that's left after lenders package up and sell off their mortgages. Perhaps the disclosure of this fact is already mandated by Dodd-Frank or the CPFA, but I have not heard about it.

    10. CommentedRalph Musgrave

      There’s a brutally simple solution to all this advocated by Lawrence Kotlikoff, John Cochrane, and Positive Money, as follows. Anyone who deposits money in a bank and seeks interest knows perfectly well that the bank can only get interest by lending the money on (e.g. to mortgagors). Those depositors are effectively investing, so they should carry the normal risks involved in investing: including the possibility that they lose all their money. Though losing everything would be almost unheard of: losing say 10% might happen from time to time.

      That system would mean an end to bank subsidies, including the TBTF subsidy, plus it would be impossible for banks to SUDDENLY fail though they could perfectly well decline to nothing over a few years. That in turn means no more credit crunches.

      Of course banks would fight that tooth and nail: banks want to take excessive risks, keep the profit when the risks work out, and send the bill to the taxpayer when they don’t. For Kotlikoff, Cochrane, and Positive Money, see:

    11. CommentedHan Tacoma-Emons

      I really fail to see why people think it Is such a complicated matter. The Pilgrims of St. Michael provide a simple answer that does not satisfy those who have vested interests in maintaing the status quo.

    12. CommentedEric Coote

      Obviously we will never get a solution from chattering classes (although I respect Schiller - somewhat). The answer is already being implemented by the energetic. Blackrock and the like invest, or the Banks to print what they like - buy up all the housing stock at a discount and then sit back as rentiers (or sell off the income stream - or hypothecate and re-hypothecate it). Works great as long as you have the benefit of a USA style prison system for those bastards that don't have any respect for the gift of housing, so they trash it.
      Maybe the Government can increase the QE to pay the rent directly to the bank. Just like Government bonds?
      In the end the bankers will own everything - and nothing!
      The people will build there own (reality!).

    13. CommentedWorld View

      I respect the author for his views and nobel prize. He is an expert in behavioral finance. However I disagree that the problems or solutions are too complicated. In fact it is too simple.
      1. The incentives to make returns are far higher than the incentives to minimize risk in US financial services sector.
      2. It is not in the best interests of a bank or any institution to have part-ownership when they can get away with selling those MBSs to ignorant investors in rest of the world or seek US bailout when necessary.
      3. We do not need experts managing the economy and telling the common man that the solutions are too complicated so that the experts can handle it. If the economy could be managed, then all these crises would not have occurred in the first place. Let the economy be. Please.
      4. Instead of promoting part ownership, why not just let the financial institutions that made these mortgages fail.
      5. The the cost of bailing out US is shared by Rest of the world and not just US taxpayers. In fact it is the bondholders (and US dollar holders) not the US taxpayers who bail out US again and again.

    14. CommentedROBERT BAESEMANN

      One problem with the mortgage backed securities (MBSs) business is the extent of the asymmetry in information created by the asymmetry in who has skin in the game. In the housing markets here in California, mortgage brokers who work closely with real estate agents and brokers assemble many loan packages. These loan packages are the basis for financial institutions who create the new mortgages. When at their pretentious best, mortgage brokers and loan officers will speak of underwriting standards and actuaries who assess risks, but there are no formal standards imposed by any regulatory authority. Property appraisals and buyer qualifications are variables of choice for players in a game.
      In 1992, at least some putative underwriting standards were based on lenders’ access to IRS confirmation of the borrowers’ income as reported on the borrowers’ filed Forms 1040. Yet around 2005, the now infamous strawberry picker in Bakersfield secured a $750,000 mortgage with an annual income of about $14,000. There seems little reason to doubt that property appraisers who want to work for a living learn how to generate estimates that justify the mortgages. (For example, if appraisers were obligated to buy the property they appraised at the price they assigned to it, the appraised values might be very different from what we now observe.)
      These observations seem to seem to reflect a disconnect between information about market conditions and the original lenders. Then the original lender can resell the mortgage with no regard for deficient information, which means the originators of new mortgages have no incentive to assess reliably the risks of default on those mortgages.
      Evidently, this disconnect is of no regard to the financial institutions that consolidate individual mortgages because the creators of MBSs could impose requirements for underwriting standards and actuarial criteria on the mortgage originators. That the originator of the MBSs have no skin in that game seems to be the reason that all of the skin ends up with pension funds and others like them, and these ultimate lenders are almost completely removed from information about default risks that apply to the assets they hold.
      This seems to be a serious violation of the assumption of perfect information and a very serious problem that only government regulation can solve.

    15. CommentedMarc Laventurier

      There is a law firm in San Francisco and Paris, Sirkin & Associates, that has specialized in fractional ownership and financing for decades.

    16. CommentedVal Samonis

      It is interesting how everybody conveniently forgot all those toxic assets sloshing around the world.

      Val Samonis
      Vilnius University