Working Papers

2011 03

Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance

The financial crisis has generated hundreds of wise-after-the-fact, morality play and melodrama books on the subject, almost all of which have been completely beside the point. Until now. James Pressley reviews Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance:

Fannie Mae and Freddie Mac’s growth reflected astonishing advantages they had over private rivals. They paid lower taxes, could borrow at cheaper rates and were required to hold less capital. How much less? When they guaranteed the credit risk of mortgage-backed securities, or MBS, the capital requirement was 0.45 percent—just 45 cents per $100 of guarantees, the authors say; when they invested such securities, the buffer was 2.5 percent, or $2.50 per $100.

A federally insured bank, by contrast, faced a capital requirement of 4 percent for holding residential mortgages—unless it held GSE MBS. In that case, the requirement fell to 1.6 percent, creating perverse incentives for banks to originate mortgages, sell them to the GSEs for securitization and buy them back as GSE MBS. Same risk, less capital.

A race to the bottom was on—a competition to churn out increasingly dicey mortgages—only now it pitted Godzilla Fannie Mae and Freddie Mac against King Kong banks deemed to have “a too-big-to-fail government guarantee,” the authors say. Here was “a highly leveraged bet on the mortgage market by firms that were implicitly backed by the government with artificially low funding rates.” America, the bastion of free markets, became anything but when it came to mortgages.

You can read Chapter One here.

posted on 31 March 2011 by skirchner in Economics, Financial Markets

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Greenspan on Dodd-Frank

Greenspan in the FT on the Dodd-Frank Act:

the largest regulatory-induced market distortion since America’s ill-fated imposition of wage and price controls in 1971.

posted on 30 March 2011 by skirchner in Economics, Financial Markets

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John Edwards Tipped for the RBA Board

John Edwards has been tipped as an appointment to the RBA Board. John’s Lowy Institute monograph Quiet Boom gives a good insight into the thinking he would bring to monetary policy decision-making. He is critical of the conduct of monetary policy in the late 1980s and early 1990s and directly challenges former RBA Governor Ian Macfarlane’s attempts to re-write the history of this episode. I review Edwards’ and Macfarlane’s interpretations of this episode in this essay.

As I have suggested previously, if the government is not going to re-appoint McKibbin, it could at least give thought to appointing an overseas economist to the Board. Here is an interview with Adam Posen, a US economist appointed to the Bank of England’s Monetary Policy Committee. He takes his job very seriously:

“If I have made the wrong call, not only will I switch my vote, I would not pursue a second term. They should have somebody who gets it right and not me. I am accountable for my performance.”

Meanwhile, Peter Diamond’s nomination to the Fed is being held up by Senate Republicans, revenge for the Democrats blocking Bush nominee Randall Kroszner. As Hassett notes:

This is what we have come to: In the minds of our politicians, partisan manoeuvring and score-settling far outweigh the desire to populate government with skilled individuals.

posted on 29 March 2011 by skirchner in Economics, Monetary Policy

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When the Guano Runs Out

A RBA research paper obtained through FOI advocates an offshore sovereign wealth fund, although the story seems to contain some editorialising by Paul Cleary, who thinks Australia is just a bigger version of Timor Leste. Liberal MP Paul Fletcher seems to think Australia is just a bigger version of Naru:

More fundamentally, natural resources are finite. When they run out, the money will stop flowing. So we should make sure we put some of the money aside – rather than spending it all now.

In our own region, the micro-state of Nauru offers a sobering example of the folly of assuming that the good times will last forever. It used to have large reserves of guano, used to make fertiliser.  With only a few thousand people and a steady flow of mining royalties, it was in a fortunate position.

But the money was largely frittered away. Then the guano ran out – and Nauru had little to show for decades of mining.

Resources are not finite in any economically meaningful sense. The Coalition seems to think that SWFs are a great idea once government debt is paid off (they set up the Future Fund after all). I make the case against further use of SWFs in this op-ed. Governments that are not prepared to commit to binding fiscal responsibility legislation cannot be trusted with SWFs.

posted on 28 March 2011 by skirchner in Economics, Fiscal Policy

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RBA Drags the Chain on Transparency

Fed Chair Bernanke joins overseas counterparts in holding post-FOMC meeting press conferences:

Chairman Ben S. Bernanke will hold press briefings four times per year to present the Federal Open Market Committee’s current economic projections and to provide additional context for the FOMC’s policy decisions.

In 2011, the Chairman’s press briefings will be held at 2:15 p.m. following FOMC decisions scheduled on April 27, June 22 and November 2. The briefings will be broadcast live on the Federal Reserve’s website. For these meetings, the FOMC statement is expected to be released at around 12:30 p.m., one hour and forty-five minutes earlier than for other FOMC meetings.

The introduction of regular press briefings is intended to further enhance the clarity and timeliness of the Federal Reserve’s monetary policy communication. The Federal Reserve will continue to review its communications practices in the interest of ensuring accountability and increasing public understanding.

In this op-ed, I made the case for the RBA Governor to hold a press conference following each Board meeting and CPI release. Apart from the gains to monetary policy transparency, this would serve to reduce politicians’ media space in public debates over interest rates and inflation.

posted on 25 March 2011 by skirchner in Economics, Financial Markets, Monetary Policy

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Sovereign Fiscal Responsibility Index

Australia is number one (meaning we hit the wall only after 40 years, as opposed to being broke right now). The United States sits between Italy and Hungary.

These are the variables:

Fiscal Space: An analysis of the additional amount of debt a country could issue before it is likely to face a fiscal crisis. Compares a country’s weighted-average debt level to the estimated maximum debt level a country could carry.

Fiscal Path: A projection of a country’s future levels of debt. The measure uses a projection of a country’s weighted-average debt level every year until 2050, using those figures to then calculate how long it takes a country to meet its maximum debt level.

Fiscal Governance: A rating of a country’s spending rules, transparency about fiscal policy making, and whether those rules are actually enforceable.

posted on 24 March 2011 by skirchner in Economics, Fiscal Policy

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Go Canada, Go Australia

Substitute ‘Australia’ for ‘Canada’ in this story for no loss of generality.

posted on 22 March 2011 by skirchner in Economics, Financial Markets

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Offshore Perceptions of Australia: A Failure of Leadership

The WSJ on the failure of the federal government and opposition to provide leadership on the SGX-ASX takeover:

Ms. Gillard professes to understand the general principle involved, having said that “An open economy has been in Australia’s interest.” So the failure by her and Mr. Swan to more aggressively support lifting the ownership cap to open the economy further is puzzling.

She may feel politically constrained as the head of a minority government beholden to a small band of Greens and independents. But that’s all the more reason to mount an aggressive persuasion campaign. Equally disappointing is the reaction—ranging from silence to outright hostility—from members of the ostensibly more free market opposition.

On this issue, the federal opposition is not even ostensibly free market.

Jennifer Hewett argues the government won’t risk defeat on something it doesn’t care about anyway:

It would be hard enough to muster political energy and risk defeat for something the government strongly supported, but Labor doesn’t really like this deal one bit. That is even though it knows blocking it on national interest grounds would be awkward for a government already regarded with suspicion by the international investment community. It’s why the Treasurer is sounding so cautious.

posted on 22 March 2011 by skirchner in Economics, Financial Markets, Foreign Investment, Rule of Law

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Fed Bloggers

The Federal Reserve Bank of New York has launched a new blog, Liberty Street Economics, following in the footsteps of the Atlanta Fed’s Macroblog. From their introductory post:

We have created this blog to augment our existing publications by providing a way for our economists to engage with the public about economic issues quickly and frequently. Further, the less technical style that we are striving for in the blog posts should make the insights from our research informative to a broader audience…

There are some topics that you will not find in the Liberty Street Economicsblog. We will not be blogging on the next policy move of the Federal Open Market Committee (FOMC) or other issues that only the FOMC or other policymakers could know. And the blog posts will not necessarily reflect the official opinion of the Federal Reserve Bank of New York or the Federal Reserve System.

I wouldn’t hold your breath waiting for the RBA to start blogging.

posted on 22 March 2011 by skirchner in Economics, Monetary Policy

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‘If the FIRB Doesn’t Kill It, We Will’

The FIRB is nothing more than a fig-leaf for political decisions that have already been made:

A senior source told the Herald that the government’s disposition was to reject the [SGX-ASX] merger, despite what the board recommended. ‘‘If [the board] doesn’t kill it, we will.’‘

posted on 19 March 2011 by skirchner in Economics, Financial Markets, Foreign Investment, Rule of Law

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How Big Are Fiscal Multipliers?

For an open economy with a flexible exchange rate, zero to negative. (HT: Scott Sumner).

posted on 17 March 2011 by skirchner in Economics, Fiscal Policy

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ERA and Economic Papers

A letter to contributors from the editor of Economics Papers, Harry Clarke, can be found below the fold.

continue reading

posted on 17 March 2011 by skirchner in Economics

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A Forgotten Financial Failure

I have an article in Online Opinion questioning the dominant narrative of the recent financial crisis and its role in conditioning regulatory responses to the crisis:

Perhaps the most pernicious myth about the crisis is that it was the failure of the US government to rescue Lehman Brothers that precipitated these events. Indeed, it has become common practice to date the crisis from 15 September 2008 when Lehman Brothers was allowed to fail. Yet trouble had been brewing in credit markets for more than 12 months before.

The failure of Lehman Brothers was a trivial event compared to a much bigger but largely ignored financial failure that took place one week before when the two US mortgage giants Freddie Mac and Fannie Mae were put into conservatorship by the US government. These Congressionally-mandated, government-sponsored enterprises (GSEs) either owned or guaranteed two-thirds of the bad mortgages in the US financial system. They were far more highly leveraged than the private US or European investment banks. They will also ultimately cost US taxpayers more than all the other bail-outs of private financial institutions combined…

The failure of Lehman Brothers was merely a symptom rather than a cause of the crisis and the unwillingness of the US authorities to rescue Lehman was perhaps the one good US policy decision made through this episode. Federal Reserve Chairman Ben Bernanke conceded as much recently, when he tried to defend the decision as a necessary one, but then undercut his own argument by maintaining that the decision also had disastrous consequences. What Bernanke should have argued was that the winding up of Lehman Brothers was fairly orderly as far as these things go and not a source of major systemic problems in the financial system.

Other contributions in this series can be found here.

posted on 16 March 2011 by skirchner in Economics, Financial Markets

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Bernanke is Not a ‘Money Printer’

Frederic Mishkin is in Australia and will be presenting at the Reserve Bank on Thursday. He was interviewed by Alan Kohler for Inside Business:

ALAN KOHLER: So therefore do you join those who call Ben Bernanke a money printer?

PROFESSOR RICK MISHKIN: No, so… I don’t at all. The purpose here is not to print money and to just not worry about future inflationary consequences.

There is, however, an issue that when you have a balance sheet which is this large - and particularly in long-term assets and even more so in housing assets - the Fed is now involved in the most politicised of all financial markets in the US. The Federal Reserve and also the government has been involved in very large transactions to help the economy and bail outs.

The government’s not going to lose a penny on everything but one - the Fannie and Freddie, a couple [sic] of hundred billion dollars. So again, this is an indication of how crazy some of our policies have been.

Economists didn’t get - we missed a lot of things in this crisis, we got a lot of things wrong. Much to trusting for example of the quality of prudential supervision, which by the way in your country was done much, much better than in many other places, so you know, I don’t know whether you’re just lucky or good but…


posted on 14 March 2011 by skirchner in Economics, Financial Markets, Monetary Policy

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Government Activism Hindering Recovery: Greenspan

Alan Greenspan, writing in International Finance, highlights the role of government activism in undermining economic recovery in the US:

What is most notable in sifting through the variables that might conceivably account for the lacklustre rebound in GDP growth and the persistence of high unemployment is the unusually low level of corporate illiquid long-term fixed asset investment. As a share of corporate liquid cash flow, it is at its lowest level since 1940. This contrasts starkly with the robust recovery in the markets for liquid corporate securities. What, then, accounts for this exceptionally elevated level of illiquidity aversion? I break down the broad potential sources, and analyse them with standard regression techniques. I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism.

posted on 06 March 2011 by skirchner in Economics, Financial Markets

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John Taylor versus Bernanke and Greenspan

John Taylor has accused Ben Bernanke of mis-representing him in testimony before Congress over Taylor’s preferred version of his eponymous rule. This is a rather bizarre dispute, because naming rights aside, there can never be a definitive formulation of the Taylor rule. The Taylor rule depends on assumptions about unobservable variables such as the equilibrium real interest rate and potential output. There are dozens of methodologies for recovering these latent variables, all of which have strengths and weakness, but none of which yield definitive answers, especially not in the real time setting in which monetary policy is actually made. Alan Greenspan was always very careful to highlight the implications of uncertainty in relation to these variables, whereas Taylor seems untroubled by this issue in his recent commentary on Fed policy.

The Taylor rule can also be given a backward or forward-looking specification. Monetary policy is supposed to be forward-looking, so forecasts for inflation and the output gap are more relevant to judging the appropriateness of policy than contemporaneous or lagged values. Again, these forecasts are necessarily subject to considerable uncertainty. Insert the Federal Reserve Board’s staff forecast for inflation and the output gap circa 2003 into a reasonably parameterised Taylor rule and you will get different implied policy settings than if you use historical data, not least because the historical values will have been influenced by the stance of policy, which in turn was influenced by the forecast.

Taylor’s 1993 rule was an outstanding contribution and most economists have embraced it, but they have also significantly improved upon it. John Taylor’s 1993 specification may be his own, but it is far from definitive and may not be the optimal or efficient rule. Taylor should concede this much at least.

posted on 03 March 2011 by skirchner in Economics, Monetary Policy

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WikiLeaks Blows the Whistle on Australian FDI Policy

WikiLeaks confirms what many have long suspected. The Australian government runs a secretly discriminatory policy on foreign direct investment by China:

The Foreign Investment Review Board told US diplomats that new investment guidelines signalled “a stricter policy aimed squarely at China’s growing influence in Australia’s resources sector”.

The anti-China rationale was set out in confidential discussions with US embassy officers in late September 2009 by the head of the Treasury Foreign Investment Division, Patrick Colmer, who is also an executive member of the Foreign Investment Review Board.

The embassy report on MrColmer’s remarks, titled “New Foreign Investment guidelines target China” and classified “sensitive”, is among US embassy cables leaked to WikiLeaks and provided to the Herald.

Based on Mr Colmer’s briefing, US diplomats reported that the Australian government privately wished to “pose new disincentives for larger-scale Chinese investments”.

The documents also confirm that the recent liberalisation of FIRB review thresholds was designed to alleviate the administrative burden on an over-worked FIRB that has increasingly sought to micro-manage high-profile FDI transactions.

My own whistle blowing efforts in relation to Australian FDI policy can be found here, although I obtained the document legally through the Freedom of Information Act.

posted on 03 March 2011 by skirchner in Economics, Foreign Investment

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Time to Dump Australia’s Anti-Dumping Laws

I have an op-ed in today’s Australian arguing against the campaign by the Australian Workers’ Union and the federal opposition to strengthen Australia’s anti-dumping regime:

The AWU has dressed up its anti-dumping campaign in the language of free trade and adherence to World Trade Organisation rules. But there is nothing in the WTO rules that prohibits dumping and WTO members are not required to maintain an anti-dumping system…

It is far more likely that Australian consumers and producers will end up paying more because of misplaced fears about foreign predation than due to the acquisition of international monopoly power by foreign producers. Anti-dumping measures bring about the very outcome they are designed to prevent.

The Productivity Commission has recommended the introduction of a public interest test, which would improve the operation of our anti-dumping system by allowing greater consideration of the economy-wide implications of dumping.

But a simpler reform that would have greater benefits for Australian consumers and the majority of producers would be for Australia to dump its anti-dumping system. This was one of the recommendations of the 1989 Garnaut Report. It shows just how little progress has been made in this area that we have still not acted on Garnaut’s recommendation two decades later.

posted on 02 March 2011 by skirchner in Economics, Free Trade & Protectionism

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The Irrelevance of Fed Policy to House Prices

In my CIS Policy Monograph Bubble Poppers, I was dismissive of the notion that Fed policy had anything to do with the US house price boom and bust of last decade. The Reinharts take this Fed irrelevance proposition much further in a new NBER Working Paper:

We take a close look at the responses of asset markets to changes in the short-term policy interest rate since the founding of the Fed in 1914. Changes in the federal funds rate have no systematic effect on either long-term interest rates or housing prices over nearly a century. Indeed, since the mid-1990s the policy rate had a negative relationship with long-term interest rates. This is consistent with a global view of capital markets where massive cross-border flows shape the availability of domestic credit and asset prices. The evidence casts doubts on arguments that a moderately different monetary policy path might have mattered.

I tried telling the same story to John Taylor once, without much success. Maybe the Reinharts will be more convincing.

posted on 02 March 2011 by skirchner in Economics, Financial Markets, House Prices, Monetary Policy

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