Author: James Kwak

When Market Incentives Lead to Bad Outcomes, Continued

A couple of weeks ago, I wrote a post about Atul Gawande’s New Yorker article about health care spending and outcomes. I didn’t claim to have any particular insight about health care economics; I just thought that people should read his article – which, to summarize greatly, argues that there is no correlation between high spending and good outcomes, because the current system does not motivate doctors to seek good outcomes. (Apparently Barack Obama agreed, since the Times reported that “the article became required reading in the White House.”)

Continue reading “When Market Incentives Lead to Bad Outcomes, Continued” →

More Financial Innovation

Felix Salmon discusses reverse convertibles, inspired by a Larry Light article in the Wall Street Journal.

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead. (The terms can depend on whether the stock ever went below the threshold and where it is at the end of the period, which makes the deal worse for the investor, but that’s the basic idea.)

The simplest thing to compare this to is just buying the stock. Compared to buying the stock, there are three outcomes:

The stock ends up below $80: In this case, the reverse convertible is slightly better, because you got the$10 in interest, which is probably more than the dividends you gave up.
The stock ends up between $80 and $110: Again, the reverse convertible is better, because you got $110 (your principal plus interest); it’s a little better if the stock ends up close to $110, a lot better if the stock ends up at $81.*
The stock ends up above $110: Here, you do anywhere from a little worse (if the stock ends at $111) to much, much, much worse (if the stock goes over $200).

The expected value for $100 of stock after one year is about $108 (6% real return on equities plus 2% inflation), so the chances of a gain and a loss (relative to buying the stock) are roughly equal; however, the distribution of returns is asymmetric, because if the stock does poorly your gains are capped, while if the stock does well your losses are not capped. Whether a given reverse convertible is a good deal or not depends on the specific terms – the interest, the term, the threshold, the volatility of the stock, and the transaction fee. But the question I want to ask is . . .

What the hell is the point of this product?

Continue reading “More Financial Innovation” →

Recovery – or Not – in Pictures

Simon’s weekend summary included this sentence on the macroeconomic situation: “The real economy begins to bottom out, although unemployment will not peak for a while and could stay high for several years.”

We are now in that phase of the crisis when there is a lot of arguing about whether things are going well or poorly, and that largely comes down to whether the current slowdown in the rate at which things are getting worse (that’s all it is so far) will be followed by a healthy recovery, a prolonged period of stagnation, or an accelerated contraction brought on by higher oil prices, a new bank panic caused by defaults in credit cards and commercial mortgage-backed securities, or one of any number of other factors. I discussed this topic somewhat impressionistically a month ago; this time I’m going to highlight some analyses done by other people around the Internet.

Continue reading “Recovery – or Not – in Pictures” →

How to Sell Toxic Waste

One point I’ve made a couple of times is that complex structured financial products are sold, not bought. If you want to see how they are sold, check out Zero Hedge’s post on the lawsuit brought by those same Wisconsin school districts that were the subject of the Planet Money/New York Times feature back in November. The second attachment is the Stifel Nicolaus PowerPoint presentation used to sell those school districts a levered bet on a AA- tranche of a synthetic CDO.

It really takes you back to 2006, doesn’t it?

By James Kwak

You Don’t Get a Vote!

Barack Obama came to office as the conciliator, the bipartisanizer, the anti-Bush. But this is going too far.

The administration’s style has been to float policy proposals in public, listen to the responses (from other politicians, from the private sector, and from the blogs that Obama does not read), and adjust accordingly. When it comes to the financial regulation proposal that Tim Geithner is scheduled to deliver on Thursday, there may be little left after all the adjusting.

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The Financial Regulation Debate in One Post

Tim Geithner will be testifying before both Senate and House committees next Thursday on the administration’s proposal for financial regulation. In the meantime, there will be a lot of talk about financial regulation.

The Wall Street Journal (subscription required) and Washington Post (subscription not required) have been reporting on how the administration’s plans have been “pared back.” Those articles mainly dwell on the likelihood that the administration will not try to abolish and consolidate agencies as had once been thought possible (although OTS and OCC may be merged). This is interesting, given that Larry Summers just said that eliminating regulatory arbitrage was one of his key principles.

Tyler Cowen has some intelligent thoughts on why consolidation may not be such a great idea. My feeling is that consolidation could be good insofar as the current situation is clearly bad. I agree with Felix Salmon:

The current regulators have clearly failed at their jobs, there’s no reason for entities like the OCC and the OTS to continue to exist, and it’s worth remembering at all times that the number of large American financial-services companies with intelligent and sophisticated and effective regulation is, currently, zero.

Continue reading “The Financial Regulation Debate in One Post” →

More on Executive Compensation

I was surprised at the number of commenters on yesterday’s post who thought that executive compensation is a red herring or a political talking point or “populist pablum.” I agree that some of the outrage over compensation by TARP recipients is a bit overblown. But I also think that the incentives created by current compensation structures were a serious contributor to the financial crisis – which was, after all, largely about banks taking one-sided risks because of asymmetric payouts (lots of upside, limited downside) – and that fixing those incentives is an important task for regulatory reform.

So, I decided to call on some reinforcements. Lucian Bebchuk, a leading researcher of executive compensation (book; importat paper discussed here), and Holger Spamann have a new paper called “Regulating Bankers’ Pay” that discusses precisely this issue. They conclude not only that regulation of banks’ executive compensation would be a good thing, but that it may actually be better than the traditional regulation of banks’ activities.

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Does the Administration Care About Executive Compensation?

They certainly want you to think they do. Yesterday was Executive Compensation Day in Washington. The Treasury Department appointed Kenneth Feinberg to oversee executive pay at seven companies that have received extensive government aid – AIG, Citigroup, Bank of America, and the car companies and their finance companies. The administration, which always seemed uneasy with the popular outrage over bonuses earlier this year, seems willing to throw the seven sinners to the wolves, while letting the bulk of the financial sector off the hook. Feinberg will only provide advice to other TARP beneficiaries, and banks that pay back TARP money will not even have to deal with that.

This, of course, solves precisely nothing. The problem with “executive compensation” – no, make that just “compensation” – in the financial sector was its structure. Huge end-of-year bonuses tied to short-term metrics, with no corresponding downside risk, motivated people to take on excessive risk in hopes of maximizing those bonuses. And the companies we need to worry about most are not the ones that are most beaten-down today, but the ones that are (relatively) the strongest and will be taking the biggest bets.

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Innovation, Regulation, and Credit Cards

Fresh Air had an excellent interview with Georgetown law professor Adam Levitin, who blogs here. It’s only 21 minutes and I recommend it if you are interested in credit cards or in financial regulation in general.

Credit cards are an interesting if perhaps extreme case of the interplay between “innovation” and regulation in the financial industry. A long time ago, someone invented the credit card. This was a real, beneficial innovation, because it allowed people to make medium-sized purchases on credit. (You could already buy a house on credit, if you put 30% down.) Let’s say that without credit, it would take you nine months to save enough money to buy a refrigerator. Now you could buy the refrigerator and then save the money; it might take you ten months with the interest, but you get to use the refrigerator for that whole time. (A refrigerator could also save you money, because it might allow you to go shopping less often, buy in bulk, and eat at home more.) All good so far.

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Posner, Part II: What Now?

Note: After writing this, I read Brad DeLong’s better review of Posner’s book (hat tip Felix Salmon). I won’t be offended if you go read that instead.

Part I of my comments on Richard Posner’s epic blog discussed the concept of blame. Today I am going to discuss his approach to some policy questions.

Posner’s crisis book is boldly titled “A Failure of Capitalism.” The problem is that when the lens through which you see the world is capitalism – or, more precisely, a flavor of economics that works out to justify capitalism in virtually every instance – it’s not clear what’s left over when capitalism fails.

Posner’s method is simple, and I can do it, too. Basically, for any policy, extrapolate out its effect until you can demonstrate that it will lead to a bad (and preferably non-intuitive) outcome – typically by changing the incentives for rational actors so that they no longer maximize profits and thereby social utility. When you do this enough, it becomes such second nature that you forget to spell out your arguments. Here’s a simple example:

While cramdown would have benefited some homeowners, it would have hurt lenders and thus have undermined the bank bailouts.

That’s the whole argument. Filling in the blanks, Posner is saying that because you have decided (a) to bail out banks, you cannot undertake another policy (b) – which may have its own costs and benefits – because it is in some way contrary to policy (a).

Continue reading “Posner, Part II: What Now?” →

“There Were Ratings That We Saw That Made No Sense To Us.”

This American Life had another good financial crisis episode by the Planet Money team this past weekend. There’s a story on regulatory holes by Chana Joffe-Walt and one on rating agencies by Alex Blumberg and David Kestenbaum. The latter had some money quotes (starting around the 40-minute mark).

Jim Finkel, Dynamic Credit, which creates structured products: “There were ratings that we saw that made no sense to us. We knew the rating agency models and metrics, and we could replicate them ourselves, and we couldn’t make sense of what they were doing.”

Felicia Grumet (sp?), Bear Stearns, who was involved in creating structured products: “It makes me feel really bad, so actually it’s very hard for me to acknowledge . . . I knew what I was doing. I knew I was doing things to get around the rules. I wasn’t proud of it, but I did it anyway.”

One of the heroes is Mabel Yu, a buy-side bond analyst at Vanguard, who couldn’t get the rating agencies to explain the ratings they were giving to structured products – and therefore refused to recommend them internally at Vanguard. Who knew? Not only do you get lower costs at Vanguard, but better fund management, too? (I have most of my money at Vanguard, but it’s in all in index funds or near-index funds, so I guess I wasn’t benefiting from Yu’s research.)

By James Kwak

Annoying Bank Propaganda

JPMorgan Chase has a “community support” page entitled “The Way Forward.” It features a report by JPMorgan executive Michael Cembalest on the credit crisis called “The Big Dig,” which tries to argue that bank lending has actually increased during the credit crisis. Many more accomplished people than I have debunked this myth in the past, but I couldn’t let this pass.

Here’s the main claim: “Changes in credit are often thought to have been wrought by banks. But a simple exercise in forensics reveals that not to be the case: the rise and fall of securitized loan markets have a much larger impact. Bank lending has remained stable throughout, while securitized markets collapsed.”

Changes

in credit are often thought to have been

wrought by banks. But a simple exercise in

forensics reveals that not to be the case: the rise

and fall of securitized loan markets have a much

larger impact. Bank lending has remained stable

throughout, while securitized markets collapsed.

And here’s the evidence:

Continue reading “Annoying Bank Propaganda” →

The State and Local Hole

Although you may pay more taxes to the federal government, there is a good chance that the public services you are more likely to actually encounter in your life are provided by state or local governments – schools, swimming pools, police, fire, etc. While a lot of attention has focused on the federal government’s deficit problems, the problem for state and local governments, which generally have less fiscal flexibility (and cannot print money) is at least equally serious.

Here is the projected aggregate state/local government budget gap under two scenarios. First the “low gap” (optimistic) picture:

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The Problem with Opinion Polls

Back in December, when people actually had debates about whether or not Chrysler and GM would go bankrupt, one of the claims made by the anti-bankruptcy camp was that 80% of people would not buy a car from a bankrupt automaker. That number came from a CNW survey; here’s a summary from Motor Trend (hat tip Jane Hamsher):

A recent study from automotive market research firm CNW surveyed 6000 people intending to buy a new car within six months, and discovered that more than 80 percent of them would switch brands if the vehicle they wanted came from an automaker that went bankrupt. Breaking it down by company, Americans were more likely to abandon domestic automakers than foreign ones, with Chrysler faring the worst — a full 91 percent of buyers wouldn’t take home an Auburn Hills product if the company went bankrupt.

The theory was that bankruptcy would lead to an immediate collapse in sales which would lead to liquidation. (A later study, cited here, said that if the government were involved in the bankruptcy, the number of people who wouldn’t consider buying from GM would be 51%.)

This is what I said in December:

I strongly suspect that 80% is just a poorly worded and interpreted poll question. If you ask people in the abstract if they would buy cars from a bankrupt car company, of course they will say no. But in the real world, if the car they want is made by a bankrupt company, and they get a good deal, they will buy it. Just look at the November auto sales. GM was down 41%; Toyota, Honda, and Nissan were down 34%, 32%, and 42%, respectively. And everyone buying a car in November must have been aware that bankruptcy for GM was a serious possibility. (Besides, haven’t we been talking about a GM bankruptcy on and off for years?) Sure, bankruptcy will hurt sales a little. But 80% is just not credible.

Well, now we know. In May – during which Chrysler was in bankruptcy – Chrysler sales were down 47% from the year-ago period. Overall sales were down 34%, which means non-Chrysler sales were down around 33%. So as a crude estimate, if Chrysler were like the average automaker, for every 100 cars it sold last May, it would have sold 67 cars this May. Instead, it sold 53. That’s a 21% decrease – a lot less than the 91% predicted.

I’m not claiming I can predict auto sales better than other people – I know virtually nothing about auto sales. I’m just saying you shouldn’t rely on polls that ask people what they would do under some hypothetical scenario, since they don’t know what they would do.

By James Kwak

The Economics of RSS

I rarely write about blogging itself – I take it for granted – but Felix Salmon, one of the real proponents of the medium, has a new post on RSS feeds and why they matter. First you should read his original post,* which argues that information providers (such as blogs) should provide full RSS feeds (including the full content of the article), like we do here, rather than truncated feeds (showing just the first few lines), which most but not all ad-supported web sites do. His argument is that the success of a blog depends on getting other bloggers and journalists to link to it, and those bloggers and journalists are far more likely to read your blog if you publish a full RSS feed. I believe his argument, but as he says in the new post, it would be nice to see some empirical research to know if we are wrong.

Like Felix, I read blogs through my RSS reader – Google Reader – and I basically never click through to read the full post if all I get is a truncated feed. So if a blog doesn’t publish a full feed, I am only likely to read a post if it is recommended or excerpted in a blog that does, such as Calculated Risk, Economist’s View, Marginal Revolution, etc. (I do scan a few online newspapers the old-fashioned way – on their web sites.)

Of course, I’m just one blogger, and if the really big guys like Paul Krugman and Andrew Sullivan are happy with truncated feeds, then Felix and I could be wrong. If anyone knows of any empirical research out there, please let us know.

* Yes, that post is by Felix, not by Ryan Avent, who replaced him at Portfolio earlier this year. In an impressive display of technical incompetence, Portfolio has not figured out how to show that some posts have one author and other posts have another offer. I know that they are going through hard times, but this can’t be that difficult.

By James Kwak