Market Instability and Moral Hazard

With markets roiling, investors are trying to ascertain whether the Federal Reserve will intervene again to support the capital markets. Some economists name such market behavior as moral hazard "which refers to risky investing done in the hope that government will bail people out of any trouble they get into." The chart at left tracks investments made during the week of August 29th through September 2nd, 2011 and tends to show that investors are motivated to invest based on whether the government will guarantee risk-taking.

Moral hazard"was a big issue after the 2008 collapse of Lehman Brothers Holdings Inc., when the government bailed out several other banks. It created the idea that they were too big to fail and that their executives and bondholders would be protected from their own mistakes."

In recent weeks, it appears that investors have returned to risk-taking in hopes of government intervention. During the week tracked above, "the Dow Jones Industrial Average surged 503 points in the first three days of [the] week on hopes Mr. Bernanke would announce some kind of monetary stimulus in Friday's speech [delivered September 2, 2011] in Jackson Hole, Wyo. It fell 171 points Thursday on fears he wouldn't. Then it rose 134.72 points Friday on hopes that the Fed's decision to expand its September meeting to two days was a signal that it was preparing to discuss some kind of stimulus."

Dodd-Frank at One Year

Last month, the Dodd-Frank Wall Street Reform and Consumer Protection Act "celebrated" its one year anniversary. Thirteen months after passage, how is the legislation doing? Or how has Dodd-Frank impacted the financial industry? Has it turned out to be akin to "a nuclear bomb killing an ant" as Speaker Boehner proclaimed at passage? Or does it promise to end "Too Big To Fail" forevermore, as claimed by President Obama at signing?

According to the Wall Street Journal article The Truth (and Lies) About Financial Regulation it is too soon to tell. "Much of Dodd-Frank has yet to be implemented. More than 200 provisions of the law haven't been enacted, while 23 that should have been enacted are overdue and 121 changes to previous law are still in the proposal process. Just 38 rules have actually been implemented, according to Davis Polk, a law firm tracking the law."

One of the reasons that the rulemakers appear paralyzed is that since passage of Dodd-Frank, the lobbying of regulators responsible for implementing Dodd-Frank has skyrocketed. According to Forbes: "While regulators, responsible for designing rules to implement laws 'laid out in principle' only, struggle with insufficient budgets and political pressure from both sides of the aisle, lobbying has exploded. According to the Center for Responsive Politics, the CFTC, the Fed, the FDIC, and the Office of the Comptroller of the Currency (OCC) have seen more lobbying activity in the first quarter of 2011 than at any other moment since Obama became president. The SEC saw it’s second most active month."

Further, despite the too early to evaluate nature of Dodd-Frank, the political rhetoric remains heated. The Wall Street Journal reports on the following:

Will Dodd-Frank end Too Big To Fail? "For the bill's defenders, we have Sen. Sherrod Brown. The Ohio Democrat said last April that the bill would end 'too-big-to-fail.' Speaking for the opposition, there is Sen. Mitch McConnell. The Kentucky Republican said that Dodd-Frank 'actually guarantess future bailouts of Wall Street banks.' He said the bill sets up a '$50 billion slush fund.' PolitiFact scored Mr. Brown's statement as 'barely true' and Mr. McConnell's as 'false.'"

On "Cascading Default, Bank Runs and Catastrophic Risk"

When the depositors in a bank all want their money at once--due to a panic for example--no bank in the world can survive. The New Deal ushered in FDIC deposit insurance in 1934 to address this reality, by putting the full faith and credit of the US government behind every bank in the US. Legal infrastructure thereby vanquished bank runs. The rest of the developed world followed suit and the prospect of a bank run destabilizing global financial institutions leading to a general economic collapse faded from memory.

Well, this weekend we should all review the experience of Credit Anstalt in 1931. Today, Treasury Secretary Timothy Geithner speaking at the world conclave of financial leaders this weekend in Washington DC said this: "The threat of cascading default, bank runs, and catastrophic risk must be taken off the table, as otherwise it will undermine all other efforts, both within Europe and globally." As recently as ten days ago Geithner said there was "no chance" of a European Lehman moment. Now its on the table, he's talking about it, and he apparently cannot get Eurozone leaders to resolve it without a public scolding that actually enhances the risk he fears. Instead of taking the risk off the table, the Eurozone now seeks to contain the contagion of Greek default. They are playing with fire. That is the scary reality of this weekend.

This past week saw downgrades a-go-go: Moody's downgraded 8 Greek Banks due to their holdings of Greek Debt, including the four largest; S&P downgraded seven major Italian banks shortly after downgrading all of Italy's sovereign debt; Moody's downgraded Bank of America, Wells Fargo, and Citigroup; and, Fitch found Greece "likely to default." Meanwhile, Siemens, China and Lloyd's of London are all cutting their exposure to the Eurozone and pulling out their cash. Reports out of Europe now claim that authorities in Athens and the EU are planning for a Greek default.

So that begs the question: Can the system withstand a managed Greek default? I am very skeptical, for two reasons: human psychology suggests a large possibility for sheer panic; and, deposit insurance will not operate to protect banks from runs. Sovereigns no longer have the ability to back their largest banks--they are now too often too big to save. Deposit insurance only protects retail depositors. The world's megabanks need access to funding far beyond mere depositor funds. Also, the contagion has already cut off funding access to even the largest Italian banks. At this point in time only shock and awe will work. Will the German people pay trillions to bailout Spanish and French banks as well as the sovereign debt of Portugal and Spain and Italy? Will voters in the US and UK go along with more money for the IMF?

The news this weekend (in the European press) is that after months of denial, Greece will default, the Eurozone is insolvent if it does, and it will now take trillions to save European Banks and bailout Spain and Italy and Portugal. Oh, and by the way we need at least 17 national parliaments to approve this nightmare.

I see unlimited downside after this weekend.

ClassCrits IV: Criminalizing Economic Inequality

ClassCrits will hold its 2011 meeting at the American University Washington College of Law on Friday and Saturday, September 23-24, 2011. The conference theme is ClassCrits IV: Criminalizing Economic Inequality and features professors and practitioners from across the nation critically examining economic inequality in the United States. The event is free of charge and open to the public, though registration is required.

"ClassCrits are a network of scholars and activists interested in critical analysis of law and the economy. The global economic crisis, along with growing economic inequality and insecurity, suggests it is time to explore alternatives to the neoclassical or “free market” economic paradigm, often identified with the U.S. “Law and Economics” movement. ClassCrits aim to revive discussions of questions of class pushed to the margins or relegated to the shadowy past, considering the possible meaning and relevance of economic class to the contemporary context. We hope to better integrate the rich diversity of economic methods and theories into law by exploring and engaging non-neoclassical and heterodox economics.

The name “ClassCrits” reflects our interest in focusing on economics through the lens of critical legal scholarship movements, such as critical legal studies, critical feminist theory, critical race theory, LatCrit, and queer theory. That is, we start with the assumption that economics in law is inextricably political and fundamentally tied to questions of systemic status-based subordination."

The First Annual Investor Protection Institute Symposium

The Institute for Investor Protection at the Loyola University Chicago School of Law will host its first annual symposium on Thursday, September 22, 2011, beginning at 12:00 noon. This symposium will feature panelists and keynote speakers that will evaluate the Dodd-Frank Act from the perspective of investor protection and corporate governance. Introductory remarks will be provided by the Honorable William T. Hart, United States District Court for the Northern District of Illinois, and the Keynote Speaker is Phillip Swagel, Professor for International Economic Policy at the University of Maryland and a former Assistant Secretary for Economic Policy in the U.S. Department of Treasury.

Continuing Legal Education (CLE) credit is available for a fee. Otherwise, attendance at the event is free and the schedule can be viewed here.

"This half-day symposium will provide a forum for distinguished scholars and participants to debate and discuss the practical implications of the Dodd-Frank Wall Street Reform and Consumer Act from an array of vantage points. Appropriate for lawyers and other professionals involved in corporate governance, the program will seek to address how, if at all, Dodd-Frank will enhance public investor protection. In addition, the program will address the impact of Dodd-Frank on corporate governance practices."

"Greece's Imminent Default is Assured"

According to economist Carl B. Weinberg (via the New York Times) a Greek default is "imminent." Other commentators suggest a default as soon as Tuesday. The credit default swap market also points to an imminent default, as shown at right by the soaring cost of purchasing protection on Greek debt.

Events in Europe moved rapidly this weekend. First, the meeting of the finance ministers of the Eurozone accomplished nothing except a delay of the next tranche of the Greek bailout until October at earliest, and then only if the Greeks impose further austerity in a bid to get their budget deficit in the promised range. Second, the Greek Prime Minister cancelled a trip to the US (to meet with the IMF) and returned to Athens for an emergency cabinet meeting. Third, the emergency cabinet meeting ended earlier today with no new austerity measures announced.

This catastrophe will climax very soon. The bailout sentenced the Greeks to a fiscal contraction that led to economic contraction that fed further deficits through impaired revenues and higher expenditures. Expansionary fiscal contraction failed--austerity as a solution to high sovereign debt now lies thoroughly discredited. They cannot meet the deficit reduction targets required for the next tranche, even if the Greek people would go along which I doubt. The IMF and the Germans do not appear willing to modify the conditions to paying the next tranche. At some point the hole is too big and neither realistic Greek austerity nor realistic Eurozone resources can be mustered to fill it. Politically, averting a default may be impossible until the Greeks and other Europeans see the costs of a default. In short, leaders are as paralyzed now as they were on the eve of the Lehman catastrophe. Greece may be too big to save.

The consequences of this reality are deeply negative. Gordon Brown suggests the 1930s beckon. Will Hutton thinks capitalism itself is going down the tubes. Some suggest Armageddon. Simon Johnson, the former Chief Economist of the IMF, states that any "further adverse consequences will precipitate a run on Italy." If the contagion reaches Italy the losses would be so massive that banks would then topple like nine pins. So it is hard to overstate how ugly this could get.

Fannie and Freddie Acquitted (Again and Again)

The GSE Conservator just released its updated report to Congress for Q2 of 2011. One of its most intriguing findings is that the total losses from the GSE investment portfolio (that is purchases of private label MBS) have melted to a harmless $3 billion. The GSE investments were simply too small and too safe to generate much loss. Notably, notwithstanding the continuing malaise in the residential real estate market this loss declined dramatically over the past year. Indeed, Fannie's investment actually turned positive over the last year. Here is my initial post on this point, from September 21, 2010.

My last post proved that the GSEs acted as super-prime lenders through the performance of their loan portfolio which had far fewer delinquencies than private lenders who really dominated the risky subprime lending market. This post shows that they also acted as a super-prime investor losing only $3 billion from all their purchases of MBS. I confess it is getting harder and harder to see how the GSEs contributed at all to the subprime crisis.

Fannie and Freddie Acquitted (Again)

The chart at left shows that the total Fannie loan book outperformed prime loans generated by private lenders and greatly outperformed private subprime loans. In other words, Fannie was like a super prime lender.

Calculated Risk has been following this issue and they just put up a new post reporting that Fannie's delinquency rate today is 4.08% and Freddie's was 3.51%. The overall market is 7.72%. That means private loans suffer much greater delinquency than GSE loans. This is, of course, consistent with the long time position of this blog that Fannie and Freddie were bit players in the subprime debacle.

On the Efficacy of the Obama Stimulus

The chart at left represents the best non-partisan estimates of the impact of the Obama Stimulus (more formally the American Recovery and Reinvestment Act or ARRA) plan on the economy, based on data from the non-partisan Congressional Budget Office. The CBO has undertaken a series of studies of the stimulus package and continually updates their findings.

In the second quarter of 2011 alone, the

"CBO estimates that ARRA’s policies
had the following effects in the second quarter of calendar year 2011 compared with what would have occurred otherwise: 1) They raised real (inflation-adjusted) gross domestic product (GDP) by between 0.8 percent and 2.5 percent;
2) Lowered the unemployment rate by between 0.5 percentage points and 1.6 percentage points;
3) Increased the number of people employed by between 1.0 million and 2.9 million; and,
4) Increased the number of full-time-equivalent jobs by 1.4 million to 4.0 million."

For 2012, the "CBO estimates that, compared with what would have occurred otherwise, ARRA will raise real GDP in 2012 by between 0.3 percent and 0.8 percent and will increase the number of people employed in 2012 by between 0.4 million and 1.1 million."

Here is a summary graph of the CBO's findings:



The CBO analysis enjoys broad support from numerous economists that have studied the issue. Ezra Klein summarizes nine studies on the issue: six find that the stimulus was successful, and only two find it unsuccessful. Thus, the problem with the stimulus is that it was too small.

Of course, because we are dealing with counterfactuals here we will never achieve 100% proof that the stimulus saved us from a deep depression in 2009-2011. But that conclusion is clearly supported by the best evidence to date, as well as longstanding macroeconomic science.

It is also noteworthy, that once debt deflation takes hold and people begin to hoard cash rather than invest in growth, only massive fiscal stimulus (shock and awe) like World War II can shake the economy out of its doldrums.

UPDATE: Greek Debt Yields Blow Out

Almost 18 months ago, I warned of a coming debt crisis in Greece. At that point, Greek debt yields reached 14 percent--meaning that Greece had to pay a lot of extra interest to entice investors to purchase its debt. As a comparison, the US two year debt now yields 0.19.

Well, today yields on Greek debt really blew out--one year Greek bonds now yield 68 percent, and the two year is nearing 50 percent--quadrupling over the last year, as shown at right. These yields reflect the fact that the market now assumes the risk of some form of default on Greek sovereign debt.

While Greek adoption of the IMF's and Eurozone's austerity prescription averted a financial cataclysm in 2010, it backfired in 2011, causing a deeper recession, a widening Greek deficit and therefore a worsening not an improvement of the Greek debt crisis. The GOP Arson Squad should take note: the Greek experiment shows that austerity will only worsen a recession induced deficit. The only way to resolve a debt crisis is rapid growth in productive government investment, as I have argued since December of 2008. It is becoming increasingly unclear whether Greece will see further bail outs from the Eurozone.

The failure of austerity in Greece, seems destined to wreck havoc across global financial markets and exacerbate the US stagnation/recession, as well as threaten a wider conflagration in Italy and Spain. Indeed, combined with other issues threatening US bank capital, these Eurozone issues caused credit default swaps to increase yet again for the US financial sector evincing enhanced risk aversion here in the US.

The situation in Greece suggests a grimmer outlook for the global economy which necessarily means a grimmer outlook for the US.