Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Friday, June 15, 2012

European Bond Yields

It is a fascinating picture (h/t Frances Wooley at WCI):

Frances asks "what were they thinking?" It seems clear enough that with the introduction of the Euro, bond traders came to view the debt of several European sovereigns as very close substitutes--a perception that seems to have vanished since the beginning of the financial crisis.

The better question, as Frances points out, is why were they thinking that? Actually, the "they" in this question should probably be replaced with a more uncomfortable "we." Yes, what were we thinking--if we were thinking anything at all. (If you were thinking otherwise, I presume you were holding significant short positions throughout the episode?)

I remember what I was thinking when I was teaching my section on International Monetary Systems years ago. After discussing the benefits of a common currency (or multilateral fixed exchange rate agreement), I'd turn to the evidence and discuss why the experiment seems to have worked in some cases and not others. A recurring theme for success appeared to be (among other things) some notion of "fiscal coordination" among potentially disparate regions of the union. I came to view this conclusion as a "duh, kinda obvious" sort of lesson that any future monetary union would surely respect and deal with accordingly.

Oops. So maybe I was being unduly naive in this respect. But is it reasonable to suppose that agents managing large bond portfolios were equally naive?

Anyway, if you have an interesting take on the picture above, please comment below.

In the meantime, you may be interested in this piece by my colleagues Fernando Martin and Chris Waller: Sovereign Debt: A Modern Greek Tragedy, and by my colleague Silvio Contessi: An Application of Conventional Sovereign Debt Sustainability Analysis to the Current Debt Crisis.

And here's a piece by Ferguson and Roubini in Der Spiegel: This Time, Europe Really is on the Brink.

Interesting times...


  1. What if the bonds weren't viewed as close substitutes so much as bond investors thought (correctly, for now) that the EU countries would work hard to bail out countries that looked like they might default? Wouldn't that have the same effect on the yields?

    1. Well, yes, I suppose an implicit guarantee of that sort would support the view that the assets were close substitutes. Not sure if it explains the relatively low yields though.

    2. The low yields may be because of the low rates set by the ECB:

      The bond yields tend to follow the ECB deposit rate trend.

  2. in my mind this is a good example of misaligned incentives.

    If you look at ECB target2 balances (Germany's portion), the current account balance, etc etc, Germany is already on the hook for something like 20% of GDP based on estimates i have seen (of course, a lot depends on how the Euro breaks, what the losses on the sov defaults are etc etc). If the Euro breaks, Germany will get a doozy of a recession and bank collapses.

    Its probably in Germany's overall interest to keep the Euro alive and proceed to the next stage (political + fiscal union). Indeed Merkel is moving in that direction.

    But this is something they should have planned for 5 years ago (Jens Weidmann is talking about referendums!)

    Now, its it Merkels own self interest to postpone and procrastinate (till after German elections sept 2013 i think). She will probably have to either choose the Euro and ram through some stuff at the last minute (ah, which is now), or choose to let it die (or let Greece go and risk a meltdown in order to sell the bigger union). Of course the issue for the voters, one with which i sympathize, is that Germany is being asked to underwrite French pensions where you can retire at 60, without a vote on it.

    what do we call this... the principal-agent problem? Merkel is just the steward of German interests, but her own objective function is very different.

    yes, very often markets do a poor job sizing the effects of moral hazard, etc etc. witness: subprime. In this case, the stewards of the EU plodded along ignoring the warnings people wrote about eons ago.

    1. dwb,

      I think you were doing fine until I got to the last paragraph. Free markets usually do a good job dealing with moral hazard. The subprime problem was created by the gub'ment.

    2. just want to clarify: yes, i think market participants were assuming (i was) that the Euro was but stage 1 of a step towards true fiscal/political union. It was believed that political leaders would "make the right decisions" when it was time, however the political leaders incentives were never particularly aligned with that goal.

      When i think of "fiscal coordination" i.e. taxes and transfers, its important to include common EU inflation on that menu of choices (inflation is just a different tax, a different way of socializing losses). The ECB essentially has the power to tax and transfer and therefore alleviate the mess. why dont they? well, because EU did sign up for a political union and if they put more ECB capital at risk Germany bears 28% share of the losses. which they just are now realizing...

      nothing like getting cold feet at the altar!

  3. "Free markets usually do a good job dealing with moral hazard. "

    heh, i guess you have no banking experience.

    1. I do. I also realize banking is the most regulated market in the U.S., and in other countries. As long as there is a central bank it will not be a free market.

    2. great. next time I see Santa Claus I'll ask him to eliminate the Fed, and for a new boat.

    3. sorry to be so glib in the above comment but ending the Fed and blaming the gub'ment for subprime are fantasies (if your history is cloudy, go find the FDIC manual and read about Penn Square and Continental Illinois and those correspondent oil and gas loans).

      The fundamenal issue that 2000 Dodd-Frank and umpteen BASEL, SEC, OCC regs to not address is management incentives and compensation. As long as management/trader comp is heads-I-win-tails-you-lose, markets will never do a good job with moral hazard. I am pretty use that has something to do with why many people looked away while loan docs were misstated. I am pretty sure that J Dimon had no idea how risky the London Whale's trades were (they restated their risk metrics, oops!). If he did not know, how could the shareholders? I am personally familiar with traders mismarking thier curves to hide the sausage and endless accounting memos that deem the impact "not material" so it does not need to be disclosed in the 10-K.

      Will compensation/bonuses at the CIO unit of JP Morgan be clawed back, or will the former head just get a nice retirement package. She made 15 MM per year, do you really think she was in it for the money at that point, where calwing back a little bit, if they even can, affects behavior? Traders who fail ofter go on to other jobs leaving destruction behind.

      Yes, i know you willl say "let em fail." I agree 100% with that sentiment, however i have three problems with that argument.
      1) we live in a probabilistic world full of uncertainty and nonlinearity, how can i distunguish ex-post a bad draw from bad behavior??

      2)JP Morgan (for example) employs 200k people, yet less than 1000 were responsible for the bad trades. Everyone gets punished for a few? You can't even say "peer pressure" if everyone suffers would be effective since most times these things are kept compartmentalized and confidential for good reasons.

      Also, politically, its impossible to do since politicians are sensitive to job losses in their district.

      3)even at small firms, traders and management resposible for fiascos go on to work as analysts, on boards, and find great ways to move on. If you dont believe me, look at what Greg Parsegian is doing these days (Not that Freddie Mac was a small company). But its hard to find these examples, because the details are often deemed confidential, not material, not disclosed, and the company and the trader part ways agreeing not to tell.

    4. and maybe BASEL MCMXLVII will get around to fixing this. someday. not in my lifetime i think.

    5. On some things we agree, and on others we do not. Also, I'm deaf to calls to 'learn more history' when there is no specific suggestion of what the suggester has in mind. So, if you have some books or articles that are good reads then by all means, share.

      For my part, I am convinced of my position from reading the following: Financing Failure (Vern McKinley), which showed that the Continental Illinois, Brady Bonds, and S&L fiascos codified "Too Big Too Fail." TBTF is the driving incentive to become a large bank, since only the small ones are allowed to fail.

      On the subprime issue, I recommend Russ Roberts "Gambling with Other People's Money" and Horwitz-Boettke "The House that Uncle Sam Built." Both of these documents make the strong case that Fannie and Freddie, in addition to the Boston Fed and the FHA, were really to blame for expanding mortgages to individuals who could not afford it. Furthermore, by maintaining the market for low-rate fixed rate mortgages, these organizations induced people into buying more house than they would have otherwise. All of these actions conspired to misprice the market for real estate.

      The existence of the Fed and FDIC further reduce the incentive to closely monitor banks and their trading behavior. If depositors' money was at risk, I guarantee they'd watch the banks much more closely, in the same way that institutional investors monitor management at industrial firms.

      I haven't seen much research on how the traders' incentives are affected by the compensation structure, so can't speak to that. Why don't the losing traders get fired? Among hedge fund managers, there are ways of identifying luck and skill (such as regularly having high alpha) - why can't these techniques be applied to the traders?

      I do know that the main cause of higher compensation in general, for executives, is the sharp increase in the average firm size. Big firms have more political clout so the incentive to get big is always there. I can't see what to do about this, other than eliminate the benefit of political connectedness.

      I do not believe any regulation that we might expect from the federal government of this country or European countries would do much to fix any of these problems. Deregulation and competition are the answer.

    6. In your ideal world of ending the Fed, FDIC, and the GSEs, be sure to make debt contracts indexed to nominal gdp so that i can tell ex-post who was really irresponsible.

      and really, who was originating and buying this crap (stated income and no documentation loans)?

      Fannie and Freddie, ironically, were too tied up with restatement and other issues so they never got involved in subprime until late in the game. I don't buy that the GSEs caused this because at any point Greenspan could have raised rates more.

      Seriously, there are 527 billion reasons to get rid Fannie and Freddie, but blaming them for subprime is overly simplistic. There is enough blame to go around: politicians, the Fed, the FOMC (for not tightening earlier), management compensation structure (how about "risk based pricing" for subprime that was basically "we need to set rates at x to hit our origination target of y" yep i saw that -lets just lend until we get a great big bonus!).

      Subprime has been around since humans invented lending.

      "I haven't seen much research on how the traders' incentives are affected by the compensation structure, so can't speak to that. Why don't the losing traders get fired? "

      Traders do get fired, all the time, so what? First, they sign non-disclosure agreements as part of severance, and the details are only disclosed if the losses meet accounting materiality tests. Second, management (e.g. risk, audit) looks just as idiotic disclosing the loss (were they unaware or did they know and were just stupid?). Third, clawback provisions are not as easy to enforce as is assumed when both sides have an $825/hour lawyer and a 20 page compensation agreement (I can see JP Morgan and the trader arguing about whether he would have lost the money were it not for the hedge fund counterparties complaining to FT Alphaville), so everybody settles and moves on. Fourth, you cannot prevent someone from earning a living and traders move on to other nice jobs.

      so basically compensation is: heads i win tails you lose. and their is plenty of complicity to go around so its rarely just the traders problem.

      we had plenty of banking panics before the Fed and FDIC, so i do not think deregulation is the answer either. Anyway: i know a lot of people at banks whose opinion is that with 12 different regulators that can be played off each other and vague rules, what we have now is only the illusion of regulation anyway. did i say that out loud?

    7. If you are saying the Fed set the fed funds rate too low, then I agree. In fact, this is the source of the business cycle in general.

      Pre-Fed and FDIC was not a good system, but that doesn't mean it was worse than post-Fed. On this, see Selgin, Lastrapes, and White, 2012, in the Journal of Macroeconomics. Essentially they show that the Fed has created more volatility in the banking sector.

      The main arguments for (relative) deregulation are Canada and 19th century Scotland, and Hong Kong (though to a lesser extent). Canada doesn't have Fannie and Freddie sorts of agencies, and also never had a subprime loan problem. They do have an FHA-like agency, called the Canada Mortgage and Housing Corporation but they didn't become as loose in their guarantees as FHA.

      And high-risk lending is fine if you price is correctly. The problem is there was no incentive to price the mortgage correctly since the bank wasn't going to hold it.

      I agree with you about the state of regulation. It is a snake nest designed to create work for lawyers, not to provide simple rules to guide best practices or protect consumers.

      My point remains though - banking is the most officially regulated industry and also the most fragile. That's a curious coincidence isn't it? The presence of implicit bailouts (as you put it heads I win tails you lose) is institutional and a huge problem that I don't see going away anytime soon.

    8. Oh, and please explain what you mean in the first paragraph. On the free market, people could index debt contracts to anything they wanted, but why NGDP in particular? Is this related to David's OLG model?

    9. DWB and ProfJ -- I have been following your excellent discussion with much interest -- thanks, I am loving the debate.

      I share ProfJ's sentiment that banking (along with pharmaceuticals) is among the most heavily regulated of all industries. In fact, I suggested this way back here:

      My reading of history suggests it is a mistake to think of any period in banking history to be "unregulated." But the so-called "free-banking" era in the US (1836-63) was less regulated than today. And Art Rolnick and Warren Weber argue, based on new evidence, that the US Free Banking Era was "not as chaotic as many people believe." (The alleged chaos of this period evidently served as fodder for those who wanted to argue for more regulation.)

    10. my point about debt contracts (love how we get back to this?) is that they are a function of the price level (perhaps the asset price level), which is endogenous to the path of nominal gdp. Take Penn Square and Continential Illinois. Yes, Penn Square was originating lots of correspondent loans and oil and gas leases blah blah blah so mgmt would get big bonuses. Then Volcker comes along and decides to wring inflation out of the economy. Now, who do i blame for a bad banking book - the FOMC or the managers at Penn Square? well, both i think. Did Volcker just precipitate an event that was inevitable? we will never know.

      Back to mortgages and the FHA. Underwriting standards assume a whole bunch of things wrapped up into the model. A prime loan with a 30% downpayment and mortgage/income of 25% appears pretty safe, unless Bernanke gets a bug up his butt and decides to cut nominal gdp growth 9% by hiking rates to 15% (I'm making up numbers to make the point). yay deflation! But seriously, now that mortgage ex-post is in default because the FOMC went psycho. Perhaps credit models should assign a higher probability to "Fed regime change" or "FOMC stupidity", or whatever, well now they do.

      However, it does not matter either way: in a world where debt contracts are nominal, i cannot objectively distinguish. The "safety" of a (nominal) debt contract is inextricable from monetary policy. Anyting that assigns blame to this or that is all monday morning armchair quarterbacking. Anyone who says they can tell which loans originated in 2006 are ok and which were "irresponsible" are just making stuff up.

      That's why banking crises are often very much intertwined with monetary policy, and why its very hard to assign blame definitively. Managers at Penn Square can just blame Volcker, and the Spaniards can just blame the ECB for tight money. So in addition to unregulating the banking system, you also need to make sure that debt contracts are not functions of the past asset price level, i.e. fully flexible.

    11. because debt contracts are nominal, and nominal asset prices are endogenous to the path of ngdp growth, lending standards themselves (and bank capital levels) are endogenous to the level of ngdp volatility (in other words, a 95% LTV loan is safe in a low ngdp volatility world, whereas a 80% ltv is risky in a high ngdp volatility world).

      changing the regulatory scheme without solving this problem fixes nothing.

    12. dwb,

      I see your point. I need to think about it some more, but on the face of it I think the problem is tied to inflation, which is tied to having a money monopolist.

      To be clear, if we are talking about nominal price shocks, then it's not clear that this is something that can be addressed by regulation, whether more or less. Further, bond investors do try to price in shocks (like default) into corporate and municipal bonds, so in a a free mortgage market, I would think the same thing could be done. But not with a central bank committed to steady, low inflation. The inflation risk just doesn't get priced into the asset (I know because I've done some work on this with stock prices).

    13. Oh, and regarding the no-doc loans, etc. that you (DWB) linked to at Alpine. Note they all say that the less documentation you provide the higher the rate you have to pay. Seems fine to me - higher risk = higher interest rate.

    14. yes, do tell me how to price those loans. think about it: why would someone be unable to provide income verification (such their W-2, tax returns)?

      I state that i make 1,000,000 per year from my small business. now give me money.

      no one said it better...

    15. just to be clear: i am fine with stated income loans, as long as there is no taxpayer money at risk.

      when you open your hedge fund offering these again. i state that i make 1,000,000 and i intend to buy a nice house in, just outside Barcelona. pay you back tomorrow. promise. i will pay 30 points over prime.

    16. "as long as there is no taxpayer money at risk."

      That's the crux of the matter and why I argue for a free market in banking. Moreover, why I argue that there should not have been any bailouts of any firms, including GM and Chrysler for a second time.

    17. David,

      Finally I read the Rolnick paper. It's a nice paper and I was happy to see mainstream researchers picking up on the free banking scene way back when. I remember a book you recommended way back in your Money&Banking class at SFU - Vera Smith's book "Rationale of Central Banking and the Free Banking Alternative." That is a nice little book. I think she was Hayek's student at LSE - too bad she didn't go on in the academic world.

      As you probably know, the Austrian economists are very big on free banking. I would recommend Rothbard's "Origins of the Federal Reserve" for an 'in the trenches' look at the actual creation of the current Fed system. Eye-opening - puts the 'political' into 'political economy.'

      Btw, I met Art Rolnick couple years ago at the MEA conference. He's really on this early-education kick now. Nice guy, though.

  4. Didn't Basel II designate them all risk-free? In that environment, any risk spread would be arbitraged away by the worst managed bank.

    1. Basel II didn't come in until June 2004. But, even under Basel I (1988), sovereign debt was supposed to be credit-risk free. That didn't change, so likely isn't driving this effect.

  5. David, do not overestimate the skill of bond traders. Even those deemed sophisticated (e.g. PIMCO) only follow the herd. That is how one makes money, by the way.

    1. Only too true. Pimco is a good publicity machine driven by Bill Gross, but at the end of the day they are also following what others are doing as well.

  6. Is it reasonable to suppose that agents managing large bond portfolios were equally naive?

    1. Anon-thanks! I just put it on my course reading list.

    2. consider, for the macro part of any course

      in conjunction with the paper above, you might also what to consider Bhide's HBR paper, Hustle as Strategy, asking students whether economic models can capture such business models and actions?

    3. Like so many critics, Gordon comes off as being out of touch with a large segment of the macro literature that has for years emphasized credit market frictions, liquidity, banking,etc. And I'm afraid I don't understand your last sentence at all. Please feel free to elaborate.

  7. A tremendous chart!
    If I may add another convincing graph in order to emphasize the central problem:
    The dramatic course of the divergence in unit labor costs.

  8. "if you have an interesting take on the picture above, please comment below."

    Key point: "As it may not be optimal ex post, the no bail-out rule is not credible ex-ante." And therefore...

    1. Anonymous...thanks for the link! I will put that paper on my graduate course reading list.

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