Michael Kevane

In my macro class a student (Mark or Steve… whatever!) asked about the size of the MBS market relative to Federal Reserve holdings.  Here’s a nice description of the market:

Agency mortgage backed securities (henceforth “MBS”) are fixed income securities that entitle the owner to principal and interest payments on underlying residential mortgages that are guaranteed by Government Sponsored Enterprises (GSEs) such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Company (Freddie Mac), or government agencies such as the Government National Mortgage Association (Ginnie Mae). The MBS market is large, with over $7.5 trillion in outstanding debt at the end of 2013 according to the Financial Accounts of the United States. MBS fund residential investment and are used by a wide variety of market participants for investment and collateral purposes. A key feature of MBS is that the market is “liquid”. Specifically, market participants perceive that they are typically able to buy and sell significant quantities of MBS without difficulty and face relatively low transaction costs. Accordingly, many MBS investors hold these securities as a liquid investment that they expect can be quickly converted to cash at low cost when the need arises while earning a positive rate of return.

The Fed holds about $1.7 trillion of MBS, or about 23%.  Fed purchases are given in Excel spreadsheets here.

MBS trading volume is many times larger than that observed in the corporate bond market.  Daily MBS trading volume fluctuates between $10 and $80 billion per day while trading volume in a typical, U.S. corporate bond fluctuates between $15 and $40 million per day suggesting that MBS are much more liquid than U.S. corporate bonds. Finally, MBS and U.S. Treasury trading volumes are of a similar order of magnitude though MBS trading volumes are generally larger and somewhat more volatile.

Here is a nice powerpoint presentation overview of the market by Randy Appleyard of Citigroup back in 2005.  Here is a Fed overview from 2013.

Hi I would like to borrow some money from you and my contract says I do not have to repay you if it turns out that I can but do not want to.  Of course there is nuance, but the reporter should have covered that.

While Puerto Rico made some other bond payments that were due on Monday, attention in the financial markets was focused on the decision to skip the $58 million in payments due on about 20 so-called moral obligation bonds. Those bonds were issued by a subsidiary of the Government Development Bank for a variety of projects — including school construction and the creation of landfills.

The government bank initially financed the projects, then refinanced them through its subsidiary, the Public Finance Corporation. By tapping the municipal bond market in that way, the bank removed the liabilities from its own balance sheet.

Even though this particular type of bond does not carry with it a legal requirement for repayment, market experts said Puerto Rico’s decision not to pay amounted to a default and left them perplexed about the strategy of paying some bonds while letting others lapse.

via Puerto Rico Defaults on Bond Payment – The New York Times.

I have been doing a little extra reading for my MBA macroeconomics class, for the sections on the U.S. financial crisis.  Lehman Brothers’ actionable fraud (resulting in settlements by Ernst & Young, their accounting firm) was for a strategy they called repo 105 where they would, shortly before financial statements were due, enter into repo agreements, where they would borrow money and offer collateral equal to 105% of value of loan.  But for accounting purposes the repo agreement could (maybe!) be called a sale, and then the cash could be used to pay off liabilities, so assets and liabilities dropped and so leverage ratios improved.  After issuing the financial statement, the repo is concluded and Lehman once again had the asset and the leverage ratio went up.  To simplify, imagine Lehman had borrowed $100m to purchase bonds.  It now has a debt of $100m on its books (as well as the assets).  In the repo it “sells” the assets and repays the debt the day before the financial statement snapshot is due.  So now it looks less leveraged.  After the statement, it borrows $100m again and repurchases the assets. So it is right back where it started in terms of leverage.  Indeed, the repo was clearly intended purely to fake the leverage ratio (because it was quite costly apparently for Lehman to do this, and there is no upside in the transaction).

Here is a nice accounting article on the ethics and practice of the repo 105.  A gated article on the magnitudes and importance is here.  A good case writeup is here.

Anticipatory commentary on recent Fed interest rate decision

Fed implementation of capital surcharges on too big to fail firms

Fed FOMC press release July 29, 2015  “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”

The facts.  After hitting 0% nominal interest rates in the short term Federal Funds market, the Fed purchased almost $3 trillion longer-term assets (mortgage backed securities guaranteed by Fannie Mae and Freddie Mac, and longer-term Treasury bonds guaranteed by the Federal government) with newly created reserves.  The money supply (M1) did not increase with this huge program, nor did inflation.

The problems with the QE program, in order of seriousness and relevance:

• The program might eventually generate more inflation than would have happened.
• The Fed may be less able to implement a similar QE program in a future financial crisis.
• If the Fed decides to unwind the program, and sell the assets, that might produce financial instability.
• There is some probability that the assets will not yield the promised coupon payments and principal (i.e. MBS might default, and Fannie Mae might be insolvent and so not guarantee; or the U.S. Federal government might default, a la Greece).  The Fed itself would then not be solvent.
• The program may have contributed significantly to growing inequality “the greatest backdoor Wall Street bailout of all time.”
• There may be some appearance or reality of corruption, where assets of some sellers are treated preferentially and assets of other sellers are not purchased, in return for some implicit or explicit quid pro quo (revolving door, etc.)

Given the possible problems (costs) of the program, it is important to gauge the benefits of the program.  The rationales for the program were two-fold:

• Improve stability in the financial sector
• Lower long-term interest rate thus stimulating greater investment and consumer spending

The main alternatives to the program?

• Commit to zero short term interest rates for long time periods (i.e. five years) with gradual raises after that
• Shift existing assets to long term without adding assets
• Commit to a higher rate of inflation (say 4%)

So what were the effects of the program?  It has to be said that it is pretty much impossible to tell, since we have a sample of one country over one time period (the United States over the period 2006-2015) and the country was in a financial crisis and subsequent recession that was the whole reason for the program.  Hence there is no credible counterfactual of what would have happened to financial stability, interest rates and output/employment in the absence of the program. That is, there is no “control” sample to tell us what would have happened to a country like the U.S. facing a similar crisis that did not implement QE.  Pescatori and Turinen highlight another problem with research on the effects of QE, which is that long-term real interest rates appear to have been declining over time, and appear likely to continue to decline over time, so the counterfactual is even harder to know: the counterfactual is not a “return to normal” time period, rather it is a “never seen before” decade of negative real interest rates.

So studies of the effectiveness of the program have to focus on short-term effects (what if we purchase more assets this week compared with last week), or effects around the timing of major events in the program (what happens when program is announced or launched), or comparing with Eurozone (which is not that comparable to U.S. but is the only control possible), or effects generated by a simulation of an economy (of which there are dozens, each similarly implausible, each solving a difficult modeling problem, and each with different results), or effects estimated with econometrics that non-specialists have a lot of difficulty evaluating.  Moreover, we have to recognize that there is a selection bias in the results that get publicized or become part of the conventional wisdom in economics.  Economists value “clean” over “messy,” “innovative” over “standard” and “name” over “who?”  Moreover, much of the research on this question will come from Fed researchers, who have perhaps unconscious biases in deciding what lines of inquiry to pursue.

The Wall Street Journal has a nice roundup of research conclusions.  The roundup suggests maybe there were significant and sizable effect for mortgage rates, but not much else.  Daniel Thornton of the St. Louis Fed finds no effects of the QE program on yields or other outcomes.  Engen, Laubach,and Reifschneider find modest effects of the program (perhaps a change in unemployment of one percentage point), given its magnitude.  Here is a recent (and inconclusive) discussion by Jim Hamilton of Econbrowser (and an older discussion here) with lots of links.  Overall, as George Bernard Shaw (I think?) quipped, “You can lay all the economists end to end and never reach a conclusion.”

Bank of America has had to pay a lot of legal settlements and fines since 2009.  The New York Times has a timeline.   Here are the highlights, adding up to about $48 billion:

• June 7, 2008 $108 Million Settlement on Countrywide Fee Complaint
• Feb. 22, 2010 $150 Million Settlement With S.E.C. on Merrill Deal
• Aug. 2, 2010 $600 Million Settlement of Class-Action Suits Against Countrywide
• June 28, 2011 $8.5 Billion Deal in Investor Suit on Mortgage Debt
• Dec. 21, 2011 $335 Million Settlement in Justice Department’s Bias Suit
• Feb. 8, 2012 $11.8 Billion Settlement on Foreclosure Abuses
• The bank also agrees to a $1 billion settlement with the federal government over Countrywide loans awarded to “unqualified” borrowers and insured by the Federal Housing Administration.
• Sept. 28, 2012  $2.43 Billion Shareholder Settlement Over Merrill
• March 26, 2014  $6.3 Billion Settlement of F.H.F.A.’s Mortgage Lawsuit
• July 30, 2014  $1.3 Billion Penalty in Federal Mortgage Case
• Aug. 21, 2014  $16.65 Billion Mortgage Settlement

What happened to Bank of America’s share price before, during, and after the crisis?  Remarkable really how short-lived the deep stock price downturn was.  In the first three months of 2009 the price hit the low of just over $3, but rebounded quickly to about $12.  Bank of America bought Countrywide and Merrill Lynch in 2008 (the Merrill deal closed on January 1, 2009), and the stock plummeted partially because of fears and information that Merrill Lynch was vastly more exposed to mortgage lending and derivatives than Bank of America had thought.  Over the longer term, the stock basically went from $50 to $20.  Anyone who thinks bankers made a killing because of the crisis has to reconcile that basic fact.  If you bought shares in Bank of America in 2005, anticipating the crisis, assuming that this bank, along with Chase, was going to emerge as the undisputed winner, and so you, as an owner, were going to really do well… you were wrong.

Nevertheless, there is still time to profit from the financial crisis. Analyst consensus is that Bank of America is going up, because profits are going to rise dramatically in 2015 and 2016.  So again, if you think the big banks profited handsomely from the crisis, then step up and become a part owner. Use the resulting tainted (your words not mine) profits to fund Friends of African Village Libraries.

Here is his conclusion:

For now, the Greek government has capitulated. Perhaps, as the lost half decade becomes the lost decade, as the politics get uglier, as the evidence mounts that these policies have failed, the troika will come to its senses. Greece needs debt restructuring, better structural reforms and more reasonable primary budget surplus targets. More likely than not, though, the troika will do what it has done for the last five years: Blame the victim.

His opinion is that the agreement will be very bad for Greece.  No duh.  But the right oped would make the case for what is better, and why the creditors will be better off with that alternative.  Instead, Stiglitz slouches off, rambling.

He never offers specifics about those “better structural reforms.”  So we have no idea what he prefers for Greece.

On the primary surplus, he is also silent.  Given the likely reality that Greece really will only have a 1% primary surplus (presumably Stiglitz has read all those analyses about how countries repeatedly “agree” to immense structural reforms as conditions of IMF loans and then just go ahead and delay and ignore until the next loan negotiation comes around and they promise to be better next time) is Stiglitz saying 1% is good, or is he saying that an agreement for 1% would enable the Greek government to actually run a deficit of -1%?  Is that his preferred alternative?

On debt restructuring, he surprisingly has nothing to say in the oped.  I assume he thinks the eurozone countries should take a $200 billion haircut.  That is a big number.  More than 1% of eurozone GDP.  About the same size as a full year of eurozone military spending.  But spread out over 20 years, with a suitable discount rate, it is doable and the rise in Greek and neighboring GDP will make some of it worthwhile in the long run.

So his oped has little positive content.  Instead, it offers a smattering of conspiracy theory, innuendo, “I told you so,” and “it obviously must be true” rhetoric.  The beginning of the oped warns, like Marvin Gaye, that “we shouldn’t lose sight of what is really going on.” But what is going on?  Marvin Gaye never answered the question, and neither does Stiglitz.

The only clear thing going on, Stiglitz offers, is that Dutch milk producers will get to sell more milk in Greece. Really, that is what is going on?  I always thought the Netherlands had comparative advantage in milk and Greece in feta.  Take a look at Greek trade.  $350m in cheese exports, and $506m in cheese imports.  Seems like standard intra-industry trade with lots of specialization, branding, and niche economies of scale.  In fact, I might even venture that Greece imports milk and exports cheese, just like it does for petroleum?

Even if there were 20 “things going on” like this, the total value of the benefit to European producers could not be more than $5b.  (Outside of petroleum, Greece top 20 imports are valued at maybe $20 billion a year; assuming a 25% markup, doubling that would increase profits by the firms exporting to Greece by $5b).  Do those dispersed European exporters really exert that much leverage over the concentrated power of hedge funds, banks and European treasury departments, who presumably would be quite willing to accept a $50b haircut?  Tell, us, Joe, if they do!  May I rephrase?  Stiglitz seems to be arguing that the eurozone is refusing restructuring in order to open up the Greek market to European exporters, even though eurozone creditors are then losing far more than eurozone exporters could gain.  To me, it does not add up as a theory of “what’s going on.”  Maybe my math is wrong?

The other thing going on, Stiglitz suggests, is that the troika is going to ruin Greece just like they ruined Indonesia in 1998.  OK, here is Indonesia’s GDP per capita:

Greece should be so lucky.  In the two decades since the Asian crisis, real GDP more than doubled. But if you read Stiglitz, you would think Indonesian GDP had declined for a decade after 1998.

Even if the secret intent of the troika is to “ruin” Greece, to what end, one might ask?  Is this a Naomi Klein conspiracy?  Ruin them so we can buy up their assets cheap?  It could be true.  Yanis Varoufakis thought so.  In one blog post he cogently (well, almost) summarized exactly that in the case of Eurobank, though how the Greek oligarchs profited from the mess he never quite made clear.  I would have appreciated an assessment from Stiglitz of how much looting has been going on.

Aside: Well, what did happen to Eurobank’s shares?  They went from about 23 cents in May 2014 when Varoufakis was sure that the hedge funds were making a killing, to 6 cents today.  Some killing.  And by the way, if you truly believe that they are indeed going to make a killing, then absolutely nothing prevents you too from sharing in the profits of their risky bet, by buying shares now at a price much lower than they bought theirs. How well you will sleep at night, knowing that you are going to make an even higher return than John Paulson!

Stiglitz then hints darkly that this is about teaching left-wing politicians a lesson.  That argument to me is implausible: “Let’s impose vicious austerity so that a left-wing backlash ensues, and a super left-wing government gets elected, and then we’ll make them accept the same conditions they campaigned against, so that way no left-wing movements will arise anywhere else.”  How do the oligarchs stay in power with such fiendish thinking!

So in the end we learn little from Stiglitz’ oped.  A pity, because there is probably a lot of merit to his position that European political parties (Merkel’s in particular) would do better in the long-run with a rhetoric and policy of European solidarity and sacrifice.  So would ordinary citizens of Greece, who are Europeans too. And policies that reduce wealth disparities at the very high end indeed are my political preference too.  But I don’t think those policies will be hastened by writing ten bad opeds a day, as Stiglitz seems to do.

A clearer oped would have indicated how Indonesia returned quickly to growth.  One factor was the huge devaluation, then float and depreciation, of the rupiah.

Yikes!  Without a large depreciation in Greece, a depression for another five years seems likely, regardless of whether the Dutch do not get to sell more milk, or bank shares are distributed to “the people” in a gesture towards inclusive capitalism, or the primary surplus target is reduced to .5%.

I am totally sympathetic to Stiglitz’ argument.  I wish he had taken the time to write more coherently.

via Greece, the Sacrificial Lamb – The New York Times.

Even the New York Times cannot escape absurd reporting on absurd discourses.  The discourse, dear reader, is to name something with a label so broad and amorphous that everyone can interpret in any old convenient way, where convenient means “mystify.”  The Church, capital C, is an expert at mystifying.  The problem is that when people do not fully comprehend the mystification, they run right into contradiction and inconsistency.  So here is the New York Times.  Watch closely at the end of the second paragraph:

ASUNCIÓN, Paraguay — His speeches can blend biblical fury with apocalyptic doom. Pope Francis does not just criticize the excesses of global capitalism. He compares them to the “dung of the devil.” He does not simply argue that systemic “greed for money” is a bad thing. He calls it a “subtle dictatorship” that “condemns and enslaves men and women.”

Having returned to his native Latin America, Francis has renewed his left-leaning critiques on the inequalities of capitalism, describing it as an underlying cause of global injustice, and a prime cause of climate change. Francis escalated that line last week when he made a historic apology for the crimes of the Roman Catholic Church during the period of Spanish colonialism — even as he called for a global movement against a “new colonialism” rooted in an inequitable economic order.

Somehow the old Roman Catholic Church during the period of Spanish colonialism has something to do with “global capitalism” and so was also a victim of the “subtle dictatorship” and so therefore can apologize without taking responsibility (it’s The Mission redux).  What would responsibility involve?  See, er,  Harvey Keitel, Bad Lieutenant?

via In Fiery Speeches, Francis Excoriates Global Capitalism – The New York Times.