Sunday, May 20, 2018

Housing: Part 298 - FICO Scores

There isn't much new here.  I was just putting together a chart from the New York Fed Household Debt and Credit Report, which tracks mortgage originations back to 1999, by FICO score.  It just still amazes me how little there is here.  How an entire, passionate point of view about the housing bubble grew out of a supposition that has no backing in the data.

There was a boost in mortgage refinancing in 2003 because households with strong credit tend to tactically refinance when rates are low.  For the entire rest of the housing boom, there was no shift in lending, by FICO scores.  The general rise in the value of originations followed along with rising home values, but then it leveled off.  So, not only was the private securitization boom not associated with a rise in lending to low-FICO scores, it wasn't associated with a rise in originations at all.   2018
Source: New York Federal Reserve
From the end of 2003 to the end of 2005, the value of residential real estate rose by about 40%.  We might expect mortgage originations to scale with aggregate value, even if it is rising value that is driving lending, not the other way around.  But, that didn't even happen.  While valuations increased by about 40%, originations remained flat.

There is a tiny bump up in originations to borrowers with FICO scores under 620 toward the end of the securitization boom.  The idea that this could form the basis for any noticeable shift in the aggregate market is a stretch, to say the least.   2018
Source: New York Federal Reserve
Sometimes you hear hand-waving about this.  One explanation is that rising home prices were falsely bloating  FICO scores.  The problem with that explanation is that prices in the Contagion cities tended not to rise until 2004, so this wasn't the case there.  And, the housing stock in the Closed Access cities is overwhelmingly owned by households with high incomes while households with lower incomes were moving away from those cities in droves.  The Closed Access housing markets are not a good example of markets driven by low credit quality borrower activity.

But, really, someday, I think people will look back and wonder how such widely held and extreme beliefs developed from empirical conclusions that were built entirely from modifications to data that, in its raw form, provided little or no basis for the conclusion.  This data is collected in a fairly timely fashion.  When the broad consensus formed in 2006 and 2007 that collapse was inevitable and curtailing lending at the margin was an important part of the process that we needed to enforce that collapse, this data was available.  Did anyone dare point that out at the time?

There is a lot of latent potential lending out there. (Averages are quarterly.)

 I am sure that many readers might think that lending was excessive throughout the 1999 to 2007 period, so that I can't really treat the average originations for that period as a normal baseline.  Let's say they are correct.  Then, my question for them is, what explanation do you have for borrowing that rose evenly across FICO scores from 1999 to 2007, but then only dropped for FICO scores under 720 after 2007?  Was lending too generous, and were prices too high, for all types of borrowers before 2008, but for some reason lending and relative prices only needed to decline for low FICO scores and low tier housing markets?  Can someone explain that to me?

Wednesday, May 16, 2018

Housing: Part 297 - A Review of the Soon-To-Be New View on Housing

As I prepare parts of this project for wider dissemination later this year, it is nice to see several schools of thought which inform this new view gaining favor. My project is the puzzle piece that solves some of the remaining mysteries and pulls these schools of thought into a coherent whole.

There are three movements or focal points of research that have become building blocks for this new view:
  • Market Monetarism:  This is a school of thought based on the idea that central banks should focus on stabilizing nominal incomes rather than focusing on inflation and unemployment. This seems to be gaining momentum, and it seems like it would lead to better central bank policy outcomes. The important point for my project is that, since market monetarists tend to measure de facto central bank outcomes with nominal income growth, they tend to conclude that the financial crisis was created by tight monetary policy in 2008, the crisis was not inevitable, and there was no direct, inevitable link between the housing bust that had been building in 2006 and 2007 and the recession in 2008 and 2009.

  • The Passive Credit School: Researchers like Demyanyk or Adelino, Schoar, & Severino, or Albanesi, De Giorgi, & Nosal, or Foote, Loewenstein, & Willen have been building a set of research that questions some of the presumptions of the popular accounts of the housing bubble. Borrowers during the boom didn't have particularly low incomes, low credit scores, or less education than usual, the crisis wasn't triggered by defaults that followed rate resets (as many had predicted), systemically destabilizing mortgage products were mostly being used by sophisticated borrowers who defaulted because home prices collapsed rather than because of affordability problems. Etc.

  • The New Urbanization:  Richard Florida has been describing this phenomenon for years. Hsieh & Moretti have done some interesting work. I would put the work of Autor, Dorn, & Hanson in this category. The YIMBY movement is building steam. Even though many urban housing activists tend to seek regulatory solutions rather than focusing on supply, there is a budding consensus that a lack of affordable urban housing is a really big problem

There are several blind spots and false premises which keep these movements from seeing that an endemic shortage of urban housing is the connective tissue that binds them all together.
The broad consensus that the housing boom was, fundamentally, a credit bubble prevents market monetarists from taking the leap to realizing that even the housing crisis was caused by destabilizing tight monetary and credit policies, which date back to as early as 2006 and continue in many ways to today. It's hard enough to try to claim that the housing bubble and bust didn't cause the recession. It would be crazy to try to argue that a recession caused the housing bust, but that is essentially what happened.

That broad consensus also prevents the passive credit school from pushing to a strong conclusion, because since they still tend to believe what happened can be described as a bubble, that there has to be some ad hoc explanation for why a bubble developed. This increases the confidence that the credit supply school has in the competing theory that unsustainable credit supply was the causal factor in the housing bubble and bust. The passive credit school would be on much firmer ground to conclude that there was no (or only an isolated) housing bubble. But, they cannot reach that conclusion based on currently accepted presumptions.

The new urban movement also is limited by the consensus presumptions about the housing boom. If your motivating principle is that we need more housing, it's a pretty big obstacle to have this idea that only a dozen years ago our big problem was that we had too much housing. So, again, their voices are weakened whenever policies that would solve the problem would seem, as a first order effect, to increase lending, home prices, or building development. All of their work is much more coherent once that false presumption is removed.

New evidence, which help to see that the consensus presumptions are wrong, include:
  • The flight from homeownership, and from living in the urban centers with constrained housing markets developed before the most aggressive price inflation happened, before the private securitization markets boomed, well before the CDO market that started the series of financial panics.  First time home buyers were declining as a portion of all households by 2005.  The private securitization boom was not associated with any increase in lending to first time buyers.
  • The peak bubble period was associated with a massive migration event from cities with high home prices to cities with lower home prices.
  • Taking all types of units into account, there was never an oversupply of housing in any city with a strong housing market. The rise in construction employment was not unsustainable.
  • The cities where low tier home prices rose more sharply than prices in high tier markets were an anomaly, and the source of that price differential was not credit supply.
  • The anomalous collapse in low tier home prices was universal across cities, and it happened after late 2008. It was not due to a supply overhang or to a lack of qualified borrowers. It was due to the regulatory imposition of extremely tight lending standards through the federally controlled GSEs and standards set by Dodd-Frank.
  • The time after the extreme tightening in credit standards is the time when the US market deviates from international comparisons. US-specific monetary and credit policies aren't likely explanations of boom period home prices because boom period prices followed international patterns.
  • The primary factor influencing home prices during the boom was location, and when comparing locations, changing rent levels explains nearly all rising prices.
In sum, rising prices during the boom were due to deprivation of supply, not excess credit and money. Once this realization is allowed to inform our presumptions about the market, the importance of the three schools of thought above, and the over-riding problem that connects them - an endemic shortage of housing - becomes clear.

Increased housing supply is what would have fixed the housing bubble. The myth that there was an oversupply overwhelmed our collective sense about what was happening. The Fed was never too accommodative. Home buyers, for the most part, were never too optimistic or speculative. There were never too many homes.

Once those conditions are accepted, the bold conclusions that the three movements above should lead to become obvious, and those seemingly unrelated movements reinforce each other.

Tuesday, May 15, 2018

Housing: Part 296 - Presumed bubbles are self-fulfilling prophecies

I recently saw this tweet by John Taylor, and for a moment, I thought, "Oh, no.  I've been scooped."

But, alas, would that it were so.  The article does get something right: "the Great Recession was not the inevitable consequence of unstable asset markets but followed, instead, from a series of unfortunate government policy mistakes."

But, of course, the first mistake they identify is that the Fed caused the housing bubble through loose monetary policy.  Now, one problem with this, as the authors point out, is:
Some economists question this interpretation of the data, arguing that the short-term interest rates under the Fed’s control have little connection to the longer-term mortgages that finance the purchase of new homes.  A 2010 New York Fed working paper, however, explains that banks and other mortgage providers borrow funds on a short-term basis to make longer-term loans.  Their activities open a channel through which policy-induced movements in short-term rates strongly affect the profitability of lending and thereby affect the mortgage and housing markets.
This leads to another problem, because the Fed was raising rates in 2004 and 2005 when the housing bubble peaked.  In order to solve this problem, the authors lag short term interest rates.  So, for instance, in a graph of home price changes compared to the Fed Funds rate, they lag the Fed Funds rate by two years.  So, the low Fed Funds rate in 2003 correlates with home prices in Phoenix in 2005 rising by 40%.

I can sort of meet the authors halfway here.  This is probably the most striking event that is visible in the moving chart I posted here.  Some combination of flexible mortgage credit markets, accommodative monetary policy, and real economic growth, fed a boom in Los Angeles housing markets in 2003 and early 2004.  Then, watching this in time-lapse, we can see that very soon after the Fed began raising rates in 2004, there was a sharp downshift in Los Angeles housing markets and a very sharp upshift in the Phoenix market.  This coincided with a massive migration event into Phoenix.

You can really see in this moving chart how the Phoenix and Los Angeles markets became tethered to a single extreme causal thread.  So, maybe some of that LA boom in 2003 was related to monetary policy.  And, maybe the pressure on the LA housing market that grew out of that boom was related to the 2005 Phoenix bubble.  But the factor that pulls those markets together isn't that there was an oversupply of housing or an unsustainable pop in real residential investment.  The cause was that there can't be a sustainable growth in Los Angeles residential investment.

The bubble in 2005, as is strikingly clear in this moving chart, was caused by a massive movement down-market from expensive LA homes to less expensive Phoenix homes.  By the end of 2005, the Fed had tightened enough that the entire national market drops together like a bag of bricks.  Watching this chart move, you really can almost feel your stomache rise at the beginning of 2006 like you're on a roller coaster drop.  So, to the extent that accommodative monetary policy in 2003 was a factor in rising prices in 2005, the rising rates in 2004 were a factor in the drop that began in 2006.

So, if monetary policy works with a two year lag, then it was too tight by 2004 or 2005. I'm willing to accept that there really isn't a lag, and that it was too tight by 2006.

The article includes the following chart, using a 1-year lag in the Fed Funds rate to support the statement that: "Other statistical indicators of housing-sector activity display strikingly strong correlations with the federal funds rate.  The first figure below shows that rapid growth in residential investment over the period from 2003 through 2005 was preceded by very low settings for the federal funds rate."

Their chart only goes back to 2000.  I have added a Fred chart of annual growth in real residential investment, back to 1967.

The idea that loose monetary policy created a housing bubble is entirely dependent on high prices.  And high prices were entirely dependent on the lack of real residential investment in specific localities.

So, the irony is that there is a dual claim here, involving public policy errors.

Add caption
1) The Fed erred by being too loose in 2003-2004.


2) The Fed erred by being too tight after the housing market collapsed.

The irony is that the second claim is absolutely correct, and that the reason the second claim came to be true is because so many people falsely believed claim number 1.

And, the problem is that it is claim number 1 that seems to motivate so much of the policy debate.  Claim number 1 is certainly the primary influence on public policy for the past decade.

It would be really nice if economists in general found something more useful to worry about than having too much real investment.

Monday, May 14, 2018

Upside Down CAPM, Part 4: National Debt

The basic premise of the Upside Down CAPM (comment if you have a better name for the concept) is that there is a pretty stable expected real rate of return on at-risk assets.  This is about 7%-8%.  The problem with at-risk investments isn't that the expected rate of return changes much over time.  It's that realized returns over short time frames are highly volatile.  (This is why NGDP level targeting would be so beneficial.  Those short term fluctuations are waste.)

My hypothesis is that the waste isn't expressed much in the rate of return on at-risk assets.  Held over long periods of time, real returns are somewhat stable.  There are some persistent real shocks that change long term returns, so long term returns aren't completely stable, but variance on total returns to equities starts high and then declines regularly as the holding period increases.

Any asset manager knows this, and so savers with longer holding periods are more likely to hold equity positions.

In the context of the Upside Down CAPM, my point is simply that the basket of total assets, accounting for some maintenance reinvestment, is basically a perpetuity.  Diversified equities, the proxy for that basket of assets, are a perpetuity.  This long-term stability and mean reversion means that expected returns of equities tends to remain around 7%-8%, and long-term investments reflect this long-term stability.  The sharp changes in valuation are mostly due to short term shocks, real and nominal, and the fickle nature of the valuation of a perpetuity with minor shifts in cash flow and long term growth expectations.  The portion of ownership we call debt is simply a subset of this basket where some capital, seeking shorter durations and more cash flow certainty, pays a fee for that certainty.

So, right now, highly rated corporate bonds pay a little less than 4%, or about 2% in real terms.  The Upside Down CAPM approach says the proper way to think about this is that some subset of the capital base is paying a 5% annual fee in order to receive 2% annually rather than receiving 7% annually with short term fluctuations.  Debt supply is mostly a transaction where savers are paying a convenience fee for keeping their capital safe for future consumption.  It just happens that in developed economies, the base return on capital - 7%-8% real - is high enough that the fee paid for certainty still leaves a residual return that is greater than zero....most of the time.  As we have seen recently, this doesn't have to be true.  Zero is not particularly important, especially in real terms.

Equity holders currently expect about 9% returns (roughly 2% inflationary capital gains + 2% dividends + 3% buybacks + 2% real growth).  The 7% + inflation figure is pretty stable.  There are some small shifts between growth expectations and capital payouts over time.  So, for instance, in the late 1990s, growth expectations were high.  Since the real return of 7-8% doesn't change much, that mostly meant that dividends and buybacks were lower, and PE ratios were higher.  Since those growth expectations are negatively correlated with risk aversion, the fee lenders required for capital protection at the time was very low - maybe 2%, so that bonds paid close to 5% real returns after the discount.

If we think of national public debt through this framework, I think this argues for (1) less concern about the level of debt outstanding and (2) a higher standard of returns on public investments.  As a first conceptual step, I don't think there is much difference between funding public spending with taxation or borrowing.  Either way, $x in capital is removed from the private stock of capital.  If spending is funded with borrowing, that is just a separate transaction where the government is providing the service of capital protection.  So, deficit spending is really a combination of two transactions.  First, taxation and spending.  Then, a transaction where the government accepts cash and promises to protect it, with some interest, and pay it back in the future.

Thinking of public debt in this way, I think the typical understanding of deficit financed spending being stimulative is overstated.  The spending part of the transaction is the same either way.  If there is anything stimulative about the deficit financing, it is just that the government has a competitive advantage in providing capital protection services.  Comparing treasury yields to investment grade corporate bonds, this amounts to a little more than 0.5% on average.  The reason deficit spending is useful in a contraction is if that spread rises, then that is an indication that the public service of providing capital protection is especially valuable.

So, it is stimulative.  But, only to the extent that it provides this service.  It is better to think of this stimulus in terms of the spread between AAA-rated private securities and treasuries than to think of it in terms of the government borrowing cheaply to inject spending into the economy.  There is no injection of capital here.  It is just a transfer between a saver and a lender.  And, if spreads are relatively low, then it is a service that can nearly as easily be provided in the private sector.  For a few months in late 2008 and early 2009, that spread was more than 3%.  The spread could have been brought down by more accommodative monetary policy that would stabilize nominal activity.  Eventually it did.  But, lacking that, massive public debt expansion was valuable then, including actions like guaranteeing GSE MBSs to reduce spreads.

As long as public debt levels are low enough that they don't induce a credit spread, then the public benefits from having the government provide this service.  Debt outstanding is just a measure of the extent to which there is demand for that service and the government is meeting it with a supply of capital protection.

But, this argues for a high required return for public investments.  In private markets, at-risk investments are expected to return 7%-8%.  The spread between private bonds and public bonds is only about 0.5%.  So, public spending has a small advantage over private spending because of the government's ability to provide this service.  But, in order for public spending to be more valuable than private spending, it still needs to return something like 6.5%-7.5% or more to justify taking that capital out of private markets, even with the public advantage in providing capital preservation services.

This also means that high real interest rates are probably not something that we need to fear in the context of the national budget.  High real long term interest rates will only happen if risk appetites and growth expectations rise.  As in the late 1990s, this would be associated with rising growth, innovative investments, and rising federal revenues.  In the late 1990s, the relative weights of these factors was so favorable, that federal officials feared a shortage of treasury securities might develop among institutions that utilize them.

Friday, May 11, 2018

California and solar panels

Apparently, California has passed a new law requiring homes to have solar panels.  Even if solar is becoming a viable energy source, I suspect that decentralized rooftop panels are not the optimal form of energy production.  Centralized, efficient solar farms are probably the long term form that will end up being the most productive.  This seems like the sort of thing that tends to be popular but doesn't work in practice, like Mao Zedong's backyard furnaces.  Maybe something like Tesla's solar tiles can become practical, since they serve a double purpose.  But, for the purposes of this post, I am agnostic about the idea, and I will argue that even if the solar panels are completely useless, they are still an improvement over the status quo in California housing.

Let's say that in a typical new development in California, the cost of building a new home is $150,000, but the market price is $400,000.  The gap between the cost and the market price will be filled.  It is filled by a high price for the land, the cost of meeting various local regulatory demands, developer fees and taxes, and the costs associated with waiting.  Given the cost and market value, these expenses that fill the gap must exist.  If they didn't exist, the market price would converge with the basic cost.  For instance, if long waiting times for permits were eliminated, more homes would be built, and the market price would decrease.  This is a sort of natural law.

The high price of the land is simply a transfer of economic rents to an unproductive owner.  It simply allows someone to claim some portion of the market's production from others without producing anything themselves.

Queuing is pure waste.

Taxes could be useful.  High property taxes, imposed fairly and universally, as they are in places like Texas, work pretty well.  In theory, it would reduce real housing consumption (reducing the average home's square footage, for instance).  But, when paired with elastic housing supply, as it is in Texas, the effect of supply outweighs the effect of the tax, and housing remains relatively inexpensive, in rental terms, and especially in price, since the government is essentially a silent owner in the property and claims a portion of the rent.  But, in California, property taxes are assessed unequally.  Long time owners pay very little tax and frequently new properties are assessed with various forms of taxes, fees, and payoffs to local municipal agencies.  Taxes assessed in this way increase the market value of all properties by limiting supply, but instead of capturing that value as public revenue, existing owners pocket it as economic rents, and so in California, development taxes also create poor social outcomes.

So, what about the solar panels?  Let's assume that they don't quite pay for themselves.  Let's say that they cost $10,000, but they only provide about $5,000 worth of electricity over their working lives.  So, on economic terms, new homeowners would not install them.  The market value of the house, without the panels is based on supply and demand.  The value of living in that location, given the quantity of homes available.  Adding $10,000 to the cost of building the house just changes the gap between cost and value.  So, now, the house costs $160,000 to build, but it still has a market value of $400,000.  Maybe, if buyers have the means to pay more, and they recognize the value of the solar panels, they will be willing now to pay $405,000 for the house.  But, the market value of the house will only rise to the extent that the buyers actually value the solar panels.  In this context, adding a cost to building the structure doesn't make much difference.  The market value of that home is unrelated to the cost of building it.

So, this means that the gap between the cost of the home and the market value has been reduced from $250,000 to $245,000.  Now, instead of transferring money to real estate owners, or wasting it in queuing, that money is wasted on the production of solar panels that aren't worth the cost of producing them.  To the extent that home values don't rise the full $5,000 or that there are some positive externalities from having solar panels, some of that wasteful gap between cost and market value gets filled with activity that is useful.

That is how messed up the California housing market is.  It is so bad that forcing home builders to spend $10,000 for solar panels that are worth $5,000 would be an improvement over the status quo.

Thursday, May 10, 2018

April 2018 CPI

The pattern is maintained this month.  Non-shelter core inflation was negative for the month, but the month that dropped off also had a negative reading, so trailing 12 month non-shelter core inflation remained about where it had been last month.  Core CPI inflation is 2.1%.  Shelter inflation is 3.4%. Non-shelter core is 1.2%.

There is little change in the Fed Funds futures market, but market expectations are below the Fed's stated expectations, so maybe this moves Fed policy down toward the market expectation.  It's been nice hearing some noise from the Fed about letting inflation move both above and below the target rate.  But, I still suspect that rate hikes will continue apace as long as core inflation remains near 2%.

Wednesday, May 9, 2018

Wages and unemployment

A few people have been talking about wage growth and unemployment lately.  I have put together a few posts on the Phillips Curve. (This was the latest.)  David Henderson has a couple of posts about wage growth, building on a post from Paul Krugman.

I have an old chart that I haven't updated in a while, so I thought I'd take a new look at it.  This is a chart comparing real wage growth to the unemployment rate.  (Here, real wages are measured with Average Hourly Earnings of Production and Nonsupervisory Employees, deflated with core PCE prices.)

Now, over the past few years, wage growth has been somewhat flat, which is why it has been a topic of conversation.  But, it seems to me that it was slightly above the norm a few years ago and has moved slightly below the norm now.  But, it really hasn't been out of the ordinary.

The big mystery in this cycle is why was wage growth so strong when unemployment was shooting up to 10%.  I think Extended Unemployment Insurance might have something to do with that.  Maybe the two minimum wage hikes in 2008 and 2009 might have had something to do with it, too.

But, there is one other adjustment we should make.  I know, readers will be shocked to hear this, but I think this has to do with the housing shortage.

I have argued that inflation is much lower than it is currently understood to be.  That is because most inflation is due to rent inflation.  Rent inflation isn't high because the Fed is printing too much money.  It is too high because there is a shortage of housing.  And, high rents have little effect on other spending, because most rent is "owner-equivalent imputed rent", which involves no cash.

Now, I think this is a reasonable measure to use for estimating the cost of living, but it doesn't really have anything to do with cash, so I think it is more accurate to remove shelter inflation from the basket of goods if we are talking about monetary policy.  And, I think it makes sense to do that when we look at real wage growth, because really, rising rents are a tax imposed on workers that is then transferred to real estate owners (who are frequently the workers themselves.)  There is no reason that these high rents should be associated with rising wages.

So, if we deflate wages with CPI inflation less food, energy, and shelter, the chart looks like this.  And, with this measure, wages have been moving right along the 2nd degree polynomial trendline.

Friday, May 4, 2018

April 2018 Employment Flows

Employment flows sure don't show any signs of weakness, either in gross or net terms.  Healthy flows from not-in-labor-force to employed, from unemployed to employed, etc.  Everything looks good.

No signs here of imminent contraction.

I have been prematurely looking for contraction from an overly hawkish Fed, but there certainly isn't much in labor markets to confirm that position.

Of course, labor markets tend to be lagging or coincident indicators, while equities and the yield curve tend to be more leading indicators.  But, things are looking good here.

Friday, April 27, 2018

Wage pressure is not inflationary.

The employment cost index for the first quarter continues to show some moderate strength.  This has led to new discussion about inflation, etc.

I have written a few posts about the Phillips Curve - the idea that wage growth and inflation are related, or that rising wages lead to rising inflation.  I don't think this relationship works the way it is generally described.  Monetary inflation should certainly cause wages to rise just as it should cause all price levels to rise.  Clearly there is causation going in that direction.  I think the apparent causation going in the other direction is misleading.  It is a matter of only feeling parts of the elephant.

One main piece of evidence that makes it look like rising wages lead to inflation is that firms report tight profit margins that are being squeezed by rising wages.  They either have to raise prices or reduce profits.  It seems likely that this would produce price pressure.  The idea of cost-push inflation is alluring, but not useful.

First, there are two potential sources of wage pressure.

1) Rising capacity utilization.

2) Fundamental productivity growth.

On point 1, as unemployed workers return to the labor force and the pool of potential workers declines, there are pressures on wages.  But, an economy running below capacity is not a productive economy.  In this context, both wages and profits should rise, but this should be more than compensated for by the boost in productivity caused by utilizing productive capacity.  Wage and profit growth should be real, in this context.  If anything, this sort of growth should be disinflationary as real growth would be strong.

On point 2, it is difficult to grasp in real time the full complement of mechanisms that are in play.  And, we will be more likely to see ailing, dying industries that we are familiar with than new, disruptive industries that are the source of new productivity.  Here, also, it will appear that rising wages are inflationary, but they are not.

Here, it might be useful to think of Amazon vs. brick and mortar book stores.  Wage growth was strong in the late 1990s, and it would have been tempting to look at rising wages at brick and mortar book stores, and to forecast inflation.  That is because those were mature businesses, so they had a very stable and understandable cost structure.  Wages were rising, and they either had to raise prices or lose profits.

But, what we were seeing there wasn't price pressure.  What we were seeing was productive transformation in an economy.  What we were seeing was the end of a business model that wasn't profitable any more.  When any business model comes to the end of its life because of new innovation and productivity, it will look like it is suffering from cost pressures.   But, to the extent that those cost pressures were acute, they simply led to the transformation to new, more productive business models.

Amazon, on the other hand, was hiring like mad.  And, nobody was looking at Amazon as a source of inflationary wages.  That's funny, really.  Because, since Amazon was young, they were not particularly profitable themselves.  But, nobody looks at a young, disruptive company and says, "Oh, labor costs are cutting into their profits, this could lead to inflation."  That's because Amazon wasn't trying to become profitable by cutting costs.  They were trying to become profitable by hiring and growing.

There was a lot of that going on in the late 1990s.  So, profits were low, wages were growing, and inflation was moderating.  And, the stock market didn't seem too put out by the whole state of affairs.

By the way, interest rates were also high at the time, but they weren't high because the Federal Reserve was trying to discipline risk-takers by sucking cash out of the economy.  They were high because investors were risk-takers, and so the safety of fixed income was not highly valued at the time.  The appetite for risk wasn't expressed through borrowing.  It was expressed through Amazon's rising stock price.  It was expressed through expanding equity, not debt.

Rising wages are a sign of progress.  They are something to be encouraged, not tempered.  When wage growth is strong, real interest rates might naturally rise, but there is no reason to try to force them to in order to stop the business cycle.

Thursday, April 26, 2018

An unleveraged banking experiment.

I have written previously about my own confusion regarding the issue of bank capital.  The issue seems largely rhetorical to me.  It comes down to whether you call deposits capital, in which case you're an unleveraged money market fund, or you call deposits liabilities, in which case you're a bank.  The difference seems to be that insuring deposits turns them into liabilities.

There are so many debates in finance that seem to me like they could be solved simply.  Too big to fail could be solved by using private deposit insurance instead of public insurance, which would lead to prices that reflect risk.  Even with public insurance, I'm not sure what's stopping us from simply pro-rating insurance fees to reflect changing capital levels or size.  Money market funds seem to do just fine.  To the extent that there is some risk in NAVs falling below $1, it seems to me that a standard contract for investors could have a clause that if NAV ever falls below $1, then withdrawals must pay an additional 1% fee.  This would be a fairly insignificant amount, it would reduce panic withdrawals, and to the extent that there were still withdrawals, they would naturally push NAV back above $1.  In the rare event that this happens, it seems like this would be a stabilizing policy with little cost to investors.

I am sure that I am naïve on these matters and there are good reasons why some of these ideas aren't used.

But, regarding bank deposits, I would like to imagine a system with 100% capital requirements.  Instead of making deposits, depositors would just buy shares in the bank.  The returns depositors earn would not change much, because today depositors make up a very large portion of the capital available to banks, so the returns that currently go to equity holders would be spread pretty thin when shared among the new depositor/shareholders.

But, depositors want certainty.  In this regime, they could get certainty by selling at-the-money puts on their shares.  Depositors would make deposits or withdrawals by buying or selling shares.  The bank would mediate their asset base by buying and selling shares on the open market.  So, sometimes, withdrawers would be selling shares to depositors and sometimes they would be selling to the bank.

This would be a 100% capitalized banking system.  The put sellers would basically be taking the role that today's equity holders take, but with much less volatility because even failed banks usually only have capital shortfalls of a few percentage points of their assets.  In today's system, equity in a failed bank would fall to $0 if the value of assets fell below the value of liabilities.  This system would be more like a money market fund.  A failing bank whose shares had sold at $100 might now sell for $98.  Depositor/shareholders would exercise their puts, and the put sellers would now be shareholders.  The depositor/shareholders wouldn't lose a penny, and they would be free to reinvest their $100 back into the same bank at $98 per share or into another bank.  The main factor determining that decision would be how high the put premium was.  If a lack of confidence led to a run on shares, the bank could recapitalize by buying shares at the market price if that price fell below NAV.  The only losers would be the put sellers.

There could even be a public agency through the Fed that was a major put seller.  This would create a natural method for recapitalizing banks during nominal financial crises, because depositors would buy shares in other banks, and when the Fed funded exercised puts, it would be a natural monetary injection into the system that was automatic and didn't require discretionary decisions about which institutions to support.  Of course, this whole system would work better with some moderate inflation so that share prices tended to have an upward trajectory and exercised puts weren't triggered frequently.

In a way, this wouldn't be much different than today, where the Fed owns a bunch of treasuries and also holds reserves that they pay interest on, and monetary policy comes from managing both of those quantities.  In this system, they would earn income on treasuries they own and on puts they sell, and they would manage the quantities of treasuries and bank shares that they own from exercised puts.  It would sort of be a nationalization of the commercial banking system, because as a put seller, the Fed would basically be taking the risks that current bank shareholders take.

Today, banks are induced to take risks because the upside flows to shareholders.  In this system, that upside would still exist, but it would have to be earned through put premiums as income.  Riskier banks could offer shareholders higher dividends, but it would come with higher put premiums.  Maybe seeing that bank share prices rarely declined by more than a couple percentage points, few depositor/shareholders would even bother buying puts.

Since upside profits would be retained by the depositor/shareholders, put sellers would have less potential upside than today's bank shareholders do, but that would also translate into less downside risk.  They would mainly be trading a regular income stream for the occasional shock.  The main regulatory issue there would be how much leverage put sellers would be allowed to utilize when they sold puts.

Anyway, this is all academic.  But, I like to think about these sorts of things using a different rhetorical framework to try to think more clearly about these issues in a way that separates rhetorical factors from real factors.  Limiting ourselves to the rhetorical frameworks we generally accept seems like it leads to limited solution sets and to solutions that solve rhetorical problems when really, what we need are solutions to real problems.

I hope you haven't found this brief post to be a waste of time.  I welcome comments that point out how ill informed this post is.