Liquidity and Debt

The empirical evidence shows that throughout history, money (broadly defined to constitute assets that circulate widely as media of exchange) takes the form of debt. In the past we saw banknotes redeemable in coin with senior claim to bank assets. Today we have government-insured demandable bank liabilities redeemable in government fiat. More broadly, it is notable that the collateral objects that "circulated" in the repo market were debt instruments (e.g., US treasuries and AAA rated MBS).

Why do we pay for things using bank debt rather than bank equity? To put things another way, why is debt more "liquid" than equity? What is the link between liquidity and the optimality of debt?

There is, of course, a literature that explains the optimality of debt (e.g., Townsend, Hart and Moore). The focus of this literature, however, is on the primary market and not on the secondary market; that is, they do not link the optimality of debt to liquidity. There is also a literature that studies liquidity provision, but simply assumes the optimality of debt (e.g., Diamond and Dybvig).

Some good news: there is now a nice paper that makes some progress in linking liquidity and debt. The paper is by Tri Vi Dang, Gary Gorton, and Bengt Holmstrom: Opacity and the Optimality of Debt for Liquidity Provision.

I am not an expert in corporate finance, but the theory of debt laid out in this paper seems somewhat different from, say, Townsend's costly state verification model. In Townsend, the security issuer has private information over the realization of the project. The security purchaser has an ability to discover this information at some cost. Costly audits are a social waste, so it is desirable to minimize this expense. Equity finance is terrible in this regard because the purchaser must audit all the time. Debt, on the other hand, triggers an audit only when the security issuer reports terrible outcomes.

Dang, Gorton and Holmstrom (henceforth DGH) have a setup where project realizations are publicly verifiable ex post. The twist in their setup is that prior to exchange, agents have an opportunity to discover the true project realization at some fixed cost. Consider two extremes: the audit cost is zero or infinity. Question: which world would agents rather live in? Answer: ex ante welfare is maximized under ignorance. The intuition for this is similar to Hirchleifer's (AER 1971) classic result; although agents in DGH are risk-neutral.

So their first result is that symmetric ignorance dominates symmetric information (even if such information is costless). Imagine that the security issuer and purchaser both face the same cost (k) of discovery. Is it possible to design a security that gives both agents the incentive not to acquire private information?

Let x denote the project outcome, distributed according to cdf F(x). Let s(x) denote the security's promised payout in state x, and let p denote the price of the security. Since the purchaser is risk-neutral, he is willing to purchase the security (without scrutiny) if p = E[s(x)].

The problem here is that the purchaser will view himself as having "overpaid" for the security in bad states of the world; i.e., for all x such that p - s(x) > 0. The expected cost of overpaying in this manner is given by v = E[max{p-s(x),0}]. DGH show that v is the value of information to the purchaser (they also show that the corresponding value for the seller is always smaller, so we may, without loss focus on the buyer). If v < k, then no party has an incentive to acquire information (preserving symmetric ignorance).

Note to reader: this program does not seem to handle mathematical formulae well. After several attempts at editing without the desired result, I will try to explain as much as possible in words only.

DGH demonstrate that because debt is senior, it reduces the probability that one will overpay (ex post) for the asset, hence it reduces the incentive to acquire information to make sure that one is not overpaying.

If v(debt) < k < v(equity), then the existence of leverage will support trades that would not otherwise have occurred. Leverage lifts the economy higher. But of course, when something is created, one automatically creates the risk that it might collapse. DGH have in mind the arrival of bad news in the form of a public signal (e.g., declining real estate prices). The effect of such a shock may be to render k < v(debt); which is to say, it suddenly pays to acquire information on debt. Such information acquisition, while privately optimal, is socially suboptimal -- it has the effect of generating asymmetric information and adverse selection -- which further hampers the liquidity of debt beyond the effect of the fundamental shock (the bad news). It is in this sense that a fundamental shock can lead to a systemic event.

If you are motivated to read the paper, please let me know what you think about it. I think that the authors are on to something; but I'm not absolutely sure whether the details all hang together. I'd also appreciate references to related literature.

Fed Makes $47.4B Profit for U.S. Taxpayers

The Federal Reserve System on Wednesday released the 2009 annual comparative financial statements for the Reserve Banks, the limited liability companies (LLCs) that were created to respond to strains in financial markets, and the Board of Governors; see here.

In a remark that may have been directed to those concerned about "transparency" at the Fed, Chairman Ben Bernanke said:

"I am pleased that an independent auditor has found that our financial statements present fairly, in all material respects, the financial position of the Federal Reserve. The information disclosed in the 2009 financial statements reaffirms our commitment to transparency and to the responsible stewardship of public resources."

The annual financial statements include information about the assets held by each of the consolidated LLCs (limited liability companies, known as Maiden Lane I, II, and III). The statements also contain summaries of the associated credit and market risk for each significant holding.

The Reserve Banks’ comprehensive income increased $17.9 billion over the previous year to $53.4 billion….The increase was primarily attributable to interest earnings on the Federal agency and GSE MBS holdings (and was) partially offset by a decrease of $3.8 billion in realized gains on the sale of Treasury securities and a decrease of $2.8 billion in interest income on loans to depository institutions.

The Reserve Banks transferred $47.4 billion of their $53.4 billion in comprehensive income to the U.S. Treasury in 2009, a $15.7 billion or 50 percent increase from the amount transferred in 2008.

Here is an excerpt from a related NY Times article:

Along with financial statements for the Fed’s board of governors in Washington and the 12 Fed district banks, the Fed released details about the assets held by five limited liability companies that were created by the Federal Reserve Bank of New York in response to the crisis.

Three of those companies, known as Maiden Lane I, II and III, were created to hold troubled assets, including mortgage-backed securities and collateralized debt obligations, acquired as a result of the government-brokered sale of Bear Stearns to JPMorgan Chase in March 2008 and the takeover of the American International Group, the stricken insurance giant, that September.

The Fed expects to recover the full value of the loans made to those special entities and does not expect any loss to taxpayers from them, senior Fed officials said in a conference call.

If the Fed does end up avoiding losses on these enterprises, then perhaps there is something to be said about the desirability of having a central bank operate as lender of last resort. (I would not have thought so even a year ago).

Did the Fed Fail as a Financial Supervisor?

No need to remind dear reader that the Fed is certainly under attack from all sides these days. Ben Bernanke recently gave testimony in the House Financial Services committee, explaining how the Fed had no idea about what was going on at Lehman's; see Fed Had Limited Oversight on Lehman.

What is going on here? Is the Fed really this clueless? Can we really trust the Fed in its proposed supervisory role, given its pathetic record in this regard?

Well, I'm not sure. But let me share with you a few things that I do know (or think I know).

THE FED AND BANKING SUPERVISION

[1] The U.S. has a primary regulator system for the nation's 8000+ commercial banks and thrifts; the primary regulator has the key authority for the regulation of the bank in question.
[2] Before the crisis (as of Jan 2007), the Fed had primary regulator responsibility for about 12% of all banks (14% by assets).

In other words: more than 85% of banks and bank assets had non-Fed primary regulators.

THE FED AND THE FINANCIAL LANDSCAPE

[1] Banks are only one part of the financial landscape. As the crisis began, 20 firms accounted for about 80% of S&P financial sector assets in the U.S.
[2] About 1/3 of this total was in banks; about 2/3 of this total was in non-bank financial firms, including government-sponsored-agencies (Fannie Mae and Freddie Mac), investment banks, insurance companies, and thrifts.
[3] Non-bank financial firms turned out to the most troubled entities in the crisis.

The Fed had no supervisory authority over these entities, including

• Investment banks, like Goldman Sachs and Bear Stearns
• Insurance companies, like Prudential and AIG
• Financial hybrids, like GE Capital and GMAC

And so, whether by accident or design, the Fed in fact had authority over only a very small segment of the financial market. Nevertheless, when the crisis hit, the Fed was widely expected to act quickly in its role as lender-of-last-resort. Many of the Fed's decisions, subject to great criticism today, involved "bailing out" non-bank firms like Bear Stearns and AIG -- firms for which the Fed had no supervisory authority.

THINK ABOUT IT

Imagine putting yourself in this situation. You are legally prohibited from supervising the vast majority of financial sector actors. You are not privy to any of their financial information. But when a crisis hits a group of these firms, you are asked to supply emergency loans...today...not next week, or one month from now. You are told, and you may even suspect it a possibility, that the entire financial system may collapse if you do not provide this emergency lending. So, what do you do?

Personally, I think I would not have done it (though this is easy to say from my office chair). But the Fed did it. Can you really blame them? And the lending had to be extended to agencies not even under the Fed's supervision. Are we to be surprised if "mistakes" were made? Who is to blame for all this? The Fed?

Make no mistake. The Fed, like any institution, should be subject to criticism and review. At the same time, any such criticism should be fair and balanced (especially if one expects enlightened legislation to emerge from the impending Dodd Bill).

Information Disclosure Policy for the Fed

This constitutes a bit of a follow-up on my earlier post "Will Federal Reserve Secrecy Conceal Incompetence and Corruption "; see here.

Judging by the people I talk to, not many appear to have an accurate knowledge of what exactly the Federal Reserve Bank is, what it does, or what it is supposed to to. These same people, however, appear fairly certain that the Fed has secretly bailed out privileged groups with its extraordinary power of printing money. No doubt about, the Fed should be audited; it is an outrage that it is not.

Let's all calm down a bit and get some facts straight first.

The first thing that the general public should know is that the Fed is, in fact, audited. It is audited extensively and frequently at many different levels and by different agencies. One of my colleagues has estimated that more than 425,000 manhours are devoted to auditing the Fed every year (I do not know exactly how he came up with this number, but suffice it to say that no matter how you slice it, the number is large).

Each of the 12 Federal Reserve Banks have their own internal auditor, who reports to the audit committee of each regional Fed's Board of Directors. This is, I think, analogous to the manner in which any public corporation is audited.

Each regional Fed is also subject to oversight from the Board of Governors (I think from the Division of Bank Operations). On top of this, there is an external auditor (Deloitte). And last, but certainly not least, the Fed is subject to auditing by the U.S. Government Accountability Office (GOA), an agency of the U.S. Congress.

Of course, this does not mean that all aspects of Fed policy are made public. For example, it has been a matter of standard practice not to disclose the identity of those agencies making use of the Fed's discount window (Fed lending to banks with liquidity problems). The Fed, and other federal agencies like the OCC and the FDIC do not disclose their assessments of the financial health of private banks under supervision (CAMELS ratings).

The stated justification for these types of nondisclosure policies is that it encourages liquidity constrained banks to use the discount window (they avoid the apparent stigma associated with using the discount window). This policy has been, as far as I can tell, rather noncontroversial...at least up to the recent crisis.

During the crisis, the Fed opened up a number of additional emergency lending facilities. I don't want to get into the details here but very quickly: the Fed made emergency loans backed by what it considered to be high-quality collateral. The loans have all now been repaid, the emergency programs have almost completely shut down, and the Fed, apparently, has made a handsome profit.

In the middle of the financial crisis, the Fed was challenged by Bloomberg concerning the details of these transactions. The Fed refuses to make these details public. Here is a recent update "Fed Shouldn't Reveal Crisis Loans, Banks Vow to Tell High Courts."

Conspiracy and cover up...right? Possibly. But let's not get too carried away just yet. The most telling sentence in the piece is this:

“Our member banks are very concerned about real-time disclosure of information that could cause a run on the banks,” said Paul Saltzman, the group’s general counsel, in an interview yesterday.

The concern here appears not to be with respect to disclosure per se; but rather, with real time disclosure.

This suggests that a happy medium might be struck. Of course, the Fed should reveal the details concerning its emergency lending practices. But only with a sufficient time-lag. The exact length of this time-lag is something that can be debated. Does 5 years sound reasonable?

Are Mortgage Defaults Driving Consumer Demand?

Came across this "funny" story: Mortgage Defaults May be Driving Consumer Spending.
You've got to like this one:

First he describes a case study of someone who applied for the government's Home Affordable Modification Program. The person had an $1,880.00 monthly mortgage payment on which they'd defaulted, but said person's monthly bank statement showed payments to a tanning salon, nail spa, liquor stores, DirecTV bill with premium charges, and $1,700.00 in retail purchases from The Gap, Old Navy, Home Depot, Sears, etc.

The article does not say whether this person was ultimately given government assistance. What would you guess?

Some Interesting Tax Facts (US Style)

Canadians (yes, I am one of them) are sometimes led to believe that the Canadidan tax system is much more redistributive than in the U.S. I am not sure whether this is true or not, but I came across this article today that made me reflect on this: Nearly Half of U.S. Households Escape Fed Tax.

Some interesting tidbits:

[1] About 47% of Americans will pay no federal income tax in 2009
[2] The top 10% of earners pay about 73% of all income tax collected by the federal government
[3] The bottom 40% of earners will (on average) pay negative taxes (are net recipients of transfer income)

Steve Williamson's New Monetarist Blogspot

Check out Steve Williamson's new blog site here. (I especially like his review of the Krugman interview...what a hoot).