Panel Discussion at Wharton

[Rashiminos]

I like this. We can debate the relative importance of each component, but there may be a valid causal chain among those events that lead to the housing crash in mid-2007.

I don't think it helps us understand the sudden crash in October 2008, but it can be useful for the first half of the recession.

Now to actually read the panel discussion. Thanks for the transcript/pointer, whomp!

Actually, I think if you add a few more pieces (most notably from March, August, and September 2008), then it will help to explain that sudden crash.

 

[I'm Cleo!]

Having given this some more thought, it is a problem that innovations are by default not regulated. The solution to that is to say that any innovation requires prior regulatory approval before it can be used. So, for example, instead of companies issuing Credit Default Swaps, something no sane an honest person would do, they would have to seek approval for it. They would have to prepare a proposal, submit it to the regulatory agency, have hearings, solicit public comments, and finally get a ruling. That could take a while. and reducing innovations would certainly draw some protests. However it would have stopped at least some of the worst aspects that caused the recent crisis.

That's not a bad idea. People would cry "foul" because it would stifle financial innovation to a tremendous degree, but honestly: what has "financial innovation" done? How has it made the world better? The point of finance is to allocate capital efficiently, but I don't think anyone can look at the world of finance from the last ten years or so and say with a straight face that it does a good job allocating capital. It's record probably compares unfavorably to that of the Soviet Union, and the Soviet Union didn't even believe in private property!

Cleo

 

[Cutlass]

The argument is that all these financial instruments increase the liquidity of the market. Making it faster and easier for money to flow from one use to another based on where it will get the greatest return for the lowest risk. (except that risk was not well understood, blowing the whole concept out of the water) But that begs the question: Is it really beneficial to the economy or country as a whole to have the money zipping from one place to another so rapidly? Or does that just fuel bubbles?

 

[Whomp]

I think this particular financial innovation has ended poorly. By packaging quality loans with low quality loans and then rating them high quality was a mistake on a lot of fronts. More specifically, their complexity. A simple GNMA is easy to evaluate. If these loans were separated into their respected categories (high quality/low quality) there would've been a lot less loans originated on the low quality side. Not much different than junk bonds versus high grade bonds.

Anytime something is new it should be viewed that seasoning is necessary to make it a valid investment option. Adding complexity should, by nature, create less activity and liquidity.

 

[Cutlass]

Should the rule say that no financial instrament may be used unless it passes a certain standard of transparency? It should be made clear what a derivative is really worth.

 

[Whomp]

Should the rule say that no financial instrament may be used unless it passes a certain standard of transparency? It should be made clear what a derivative is really worth.

Absolutely on transparency but what it's worth really comes down to what the market will bear.

Transparency was something I suggested back in December 2007...
http://forums.civfanatics.com/showpost.php?p=6221577&postcount=46

Anyhow, take the case of rating debt instruments. Changing how the pay scheme rating agencies charge for their information should be considered. For instance, CDOs carry the highest fees, ABS next, and then regular corporate ratings. The agencies argue that the more complex structures are more labor intensive to rate and therefore warrant higher charges. Remember Thain's comment that one CDO took 3 hours to rate on a high speed computer.

Question then becomes have the rating agencies developed an expertise in analyzing these structures? Maybe, but more importantly, they are the only ones who can evaluate them, because they are the only ones with the detailed information about the structures. In their evaluation of corporate credits, rating agencies are exempt from regulation FD. This means that they can receive confidential information not available to the market participants.

Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%, while a corporate bond’s default rate is 1.8%. An A rated municipality has the same chance of default as and AA rated corporate. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates. Explain how this makes sense when the outcomes are very different for a certain credit quality?

 

[Cutlass]

So what do the regulations concerning how the ratings agencies look like? Who does what?

 

[mrt144]

Absolutely on transparency but what it's worth really comes down to what the market will bear.

Transparency was something I suggested back in December 2007...
http://forums.civfanatics.com/showpost.php?p=6221577&postcount=46

Anyhow, take the case of rating debt instruments. Changing how the pay scheme rating agencies charge for their information should be considered. For instance, CDOs carry the highest fees, ABS next, and then regular corporate ratings. The agencies argue that the more complex structures are more labor intensive to rate and therefore warrant higher charges. Remember Thain's comment that one CDO took 3 hours to rate on a high speed computer.

Question then becomes have the rating agencies developed an expertise in analyzing these structures? Maybe, but more importantly, they are the only ones who can evaluate them, because they are the only ones with the detailed information about the structures. In their evaluation of corporate credits, rating agencies are exempt from regulation FD. This means that they can receive confidential information not available to the market participants.

Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%, while a corporate bond’s default rate is 1.8%. An A rated municipality has the same chance of default as and AA rated corporate. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates. Explain how this makes sense when the outcomes are very different for a certain credit quality?

This is a problem.

 

[Whomp]

So what do the regulations concerning how the ratings agencies look like? Who does what?

S&P, Moody’s and Fitch, all based in New York, got their official blessing from the SEC in 1975, when the regulator named them Nationally Recognized Statistical Ratings Organizations.

Conflict of Interest

Seven companies, along with the big three, now have SEC licensing. The regulator created the NRSRO designation after deciding to set capital requirements for broker-dealers. The SEC relies on ratings from the NRSROs to evaluate the bond holdings of those firms.

At the core of the rating system is an inherent conflict of interest, says Lawrence White, the Arthur E. Imperatore Professor of Economics at New York University in Manhattan. Credit raters are paid by the companies whose debt they analyze, so the ratings might reflect a bias, he says.

“So long as you are delegating these decisions to for- profit companies, inevitably there are going to be conflicts,” he says.

In a March 25 report, policy makers from the Group of 20 nations recommended that credit rating companies be supervised to provide more transparency, improve rating quality and avoid conflicts of interest. The G-20 didn’t offer specifics.

52 Percent Profit Margin

As lawmakers scratch their heads over how to come up with an alternative approach, the rating firms continue to pull in rich profits.

Moody’s, the only one of the three that stands alone as a publicly traded company, has averaged pretax profit margins of 52 percent over the past five years. It reported revenue of $1.76 billion -- earning a pretax margin of 41 percent -- even during the economic collapse in 2008.

S&P, Moody’s and Fitch control 98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to high fees, says SEC Commissioner Casey, 43, appointed by President George W. Bush in July 2006 to a five-year term. S&P, a unit of McGraw-Hill Cos., has profit margins similar to those at Moody’s, she says.

“They’ve benefited from the monopoly status that they’ve achieved with a tremendous amount of assistance from regulators,” Casey says.

http://www.bloomberg.com/apps/news?sid=au4oIx.judz4&pid=20601109

This is a problem.

The pay scheme should be just the opposite. The issuers should not have to pay for the service, it should be the buyers and let the buyers do their own due diligence as they do with stocks. I guarantee this would create more competition and reduce those outsized monopoly profit margins to boot.

 

[Cutlass]

Not certain if this is quite the place to add this. But I thought it interesting and somewhat relevant.

This Time is Different:
Eight Centuries of Financial Folly
Carmen M. Reinhart & Kenneth S. Rogoff


Throughout history, rich and poor countries alike have been lending, borrowing, crashing--and recovering--their way through an extraordinary range of financial crises. Each time, the experts have chimed, "this time is different"--claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. This book proves that premise wrong. Covering sixty-six countries across five continents, This Time Is Different presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes--from medieval currency debasements to today's subprime catastrophe. Carmen Reinhart and Kenneth Rogoff, leading economists whose work has been influential in the policy debate concerning the current financial crisis, provocatively argue that financial combustions are universal rites of passage for emerging and established market nations. The authors draw important lessons from history to show us how much--or how little--we have learned.

Using clear, sharp analysis and comprehensive data, Reinhart and Rogoff document that financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. They examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debts--as well as the cycles in housing and equity prices, capital flows, unemployment, and government revenues around these crises. While countries do weather their financial storms, Reinhart and Rogoff prove that short memories make it all too easy for crises to recur.

An important book that will affect policy discussions for a long time to come, This Time Is Different exposes centuries of financial missteps.

Carmen M. Reinhart is professor of economics at the University of Maryland. She recently coedited The First Global Financial Crisis of the 21st Century and is a regular lecturer at the International Monetary Fund and the World Bank. Kenneth S. Rogoff is the Thomas D. Cabot Professor of Public Policy and professor of economics at Harvard University. He is the coauthor of Foundations of International Macroeconomics, and a frequent commentator for NPR, the Wall Street Journal, and the Financial Times.

Reviews:

"The authors use copious amounts of data . . . to make the compelling case that any well-informed person should have seen the Great Recession coming. The essence of their book is that while financial crises come in different varieties, they are not mysteriously born of undersea earthquakes, but frequently occurring events that can be spotted and even controlled if politicians and regulators know what to look for."--Devin Leonard, New York Times

"Reinhart and Rogoff have compiled an impressive database, which covers eight centuries of government debt defaults from around the world. They have also collected statistics on inflation rates from every country where information is available and on banking crises and international capital flows over the past couple of centuries. This lengthy historical study gives what they call a 'panoramic view' of the unending cycle of boom and bust, showing how claims that 'this time is different' are invariably proven wrong. . . . This Time Is Different doesn't simply explain what went wrong in our most recent crisis. This book also provides a roadmap of how things are likely to pan out in the years to come. . . . This Time Is Different is an important addition to the literature of financial history."--Edward Chancellor, Wall Street Journal

"[E]ssential reading . . . both for its originality and for the sobering patterns of financial behaviour it reveals."--Economist

"The four most dangerous words in finance are 'this time is different.' Thanks to this masterpiece by Carmen Reinhart at the University of Maryland and Kenneth Rogoff of Harvard, no one can doubt this again. . . . The authors have put an immense amount of work into collecting the data financial institutions needed if they were to have any chance of making quantitative risk management work."--Martin Wolf, Financial Times

http://press.princeton.edu/titles/8973.html

Review
The authors use copious amounts of data . . . to make the compelling case that any well-informed person should have seen the Great Recession coming. The essence of their book is that while financial crises come in different varieties, they are not mysteriously born of undersea earthquakes, but frequently occurring events that can be spotted and even controlled if politicians and regulators know what to look for.
(Devin Leonard New York Times )

Reinhart and Rogoff have compiled an impressive database, which covers eight centuries of government debt defaults from around the world. They have also collected statistics on inflation rates from every country where information is available and on banking crises and international capital flows over the past couple of centuries. This lengthy historical study gives what they call a 'panoramic view' of the unending cycle of boom and bust, showing how claims that 'this time is different' are invariably proven wrong. . . . This Time Is Different doesn't simply explain what went wrong in our most recent crisis. This book also provides a roadmap of how things are likely to pan out in the years to come. . . . This Time Is Different is an important addition to the literature of financial history.
(Edward Chancellor Wall Street Journal )

Eight hundred years of financial folly

Carmen M. Reinhart
19 April 2008

In the context of the last thirty years, the present period appears to be unlikely to produce a wave of sovereign debt defaults. But a new database spanning eight centuries reveals that history has many lessons for those studying financial crises. Contrary to conventional wisdom, today may not be very different

...

http://www.voxeu.org/index.php?q=node/1067
http://www.amazon.com/This-Time-Dif...TF8&coliid=I3HK8M00R3HE9Z&colid=1P18OHMCNZYH0