Before I put my buzz saw to work, let me make a few things clear. First, I have a good deal of respect for Robert Shiller’s work. Anyone who was willing to tell Greenspan in 1996 that he ought to be worried about asset bubbles has a good deal of foresight. Second, I am a fan of Project Syndicate; I’ve featured many of its articles. Third, I am not opposed to financial innovation per se (although that term is so all-encompassing as to get in the way of useful discussion, and the term “innovation” has such positive connotations as to put critics on the back foot).
However, Robert Shiller’s Project Syndicate article, “Has Financial Innovation Been Discredited?” can only charitably be interpreted as incredibly sloppy, but since this is an area where he claims expertise, it must be deemed to be intellectually dishonest.
Let’s go through it:
Skeptics of financial liberalization and innovation have been emboldened by the crisis in the world’s credit markets that erupted in mid-2007, when the problems with sub-prime mortgages first appeared in the United States. Are these skeptics right?….
The entire sub-prime market is largely a decade-old innovation – the word “sub-prime” did not exist in any language before 1994 – built on such things as option adjustable-rate mortgages (option-ARM’s), new kinds of collateralized debt obligations, and structured investment vehicles. Previously, private investors in the US simply did not lend to mortgage seekers whose credit history was below prime.
First, option ARMs are not a subprime product; they were targeted to prime borrowers (see here and here from the esteemed Tanta). This is a striking error from a supposed expert on housing markets. Second, financial innovation does not equal “securitization of subprimes” which is what his second paragraph implies. CDOs frequently contain heterogeneous assets; many CDOs contain only corporate bond exposures.
Back to Shiller:
But, while it does sometimes appear that the current crisis is due, at least in part, to financial innovation, financial-market liberalization has been shown to be a good thing overall.
A study published in 2005 by economists Geert Bekaert, Campbell Harvey, and Christian Lundblad found that when countries liberalize their stock markets, allowing them to operate freely without government intervention, economic growth rises by an average of one percentage point annually. The higher growth tends to be associated with an investment boom, which in turn seems to be propelled by the lower cost of capital for firms.
This is a misrepresentation of the Bekaert, Harvey, and Lundblad paper. I am pretty certain the article in question is “Growth Volatility and Financial Liberalization.” I will be generous and assume that he did not get past the abstract, which uses the term “equity market liberalization.” However, when you read the paper, it analyzes opening financial markets in a development economic context, and the primary focus is on increasing receptivity to international capital, not on lowering regulatory standards. This is the question the paper is seeking to answer:
Is the cost to a country for opening its financial markets to foreign portfolio investment increased economic volatility?
Other quotes to show its emphasis and conclusions diverge from what Shiller implies:
.
…there is an extensive literature on the benefits of international risk sharing. This literature explicitly recognizes that open capital markets lead to international risk sharing, which should improve welfare….Our study contributes to this debate by testing directly whether consumption growth volatility changes after financial liberalization. If there are genuine benefits to international risk sharing, we expect to observe reduced consumption growth volatility….
And consider this:
A substantial interaction analysis shows that countries with relatively large government sectors and developed banking sectors experience significant reductions in volatility but countries with poor investor protection experience significant increases in volatility (boldface ours).
So to the extent this article discusses regulation of markets in the manner Shiller implied, it found that greater investor protection, i.e., regulation, was beneficial.
Note also that per our post earlier today, Dani Rodrik disputes the conclusions of this paper, that financial liberalization is good for developing countries.
And in any event, extending conclusions from equity markets, which by nature are speculative, to credit markets, where investors expect to get their principal back, is also quite a stretch. Ditto applying work on developing markets to mature economies.
Back to Shiller:
…..The US is one of the world’s most financially liberal countries. Its financial markets’ high quality must be an important reason for America’s relatively strong economic growth. Indeed, given a very low savings rate and high fiscal deficit over the past few decades, the US might otherwise have faced economic disaster.
This discussion is pretty confused. “Markets” covers a multitude of sins. Public equities and bonds are in fact highly regulated, as are exchange traded derivatives. It’s when you get into certain OTC markets that things can get wild and woolly. And the notion that US financial markets are “high quality” is no longer widely accepted. Foreign buyers have compared our mortgage products to China’s toxic toys.
Although the SEC’s enforcement isn’t what it used to be, the basic framework of regulations hasn’t changed dramatically; indeed, measures like Rule FD and decimalization were forced on the industry. A 1993 Harvard Business Review article by Amar Bhide, “Efficient Markets, Deficient Governance,” makes observations that still ring true:
Without a doubt, the US stock markets are the envy of the world. In contrast to markets in countries such as Germany, Japan, and Switzerland, which are fragmented, illiquid, and vulnerable to manipulation. US equity markets are widely respected as being the broadest, most active, and fairest anywhere. The Securities and Exchange Commission strives mightily to keep it that way…..
US rules protecting investors are the most comprehensive and well enforced in the world….Prior to the 1930s, the traditional response to panics had been to let investors bear the consequences……The new legislation was based on a different premise: the acts [the Securities Act of 1933 and the Securities and Exchange Act of 1934] sought to protect investors before they incurred losses.
Bhide describes the three main approaches: detailed description of the company, its financial performance, and the securities offered, with requirement for extensive periodic disclosure; measures to bar insider trading; rules against market manipulation.
Bhide discusses at some length that extensive regulations are needed to trade a promise as ambiguous as an equity on an arm’s length, anonymous basis. In hindsight, it may be that the halo effect of America’s successful equity markets facilitated the sale of dodgy debt instruments.
To Shiller again:
In 2000, Stewart Mayhew, Assistant Chief Economist at the US Securities and Exchange Commission’s Office of Economic Analysis, surveyed the extensive literature on this topic. Mayhew concluded that it is rather difficult to tell whether derivative markets worsen financial-market volatility, because their creation tends to come when existing financial markets already are more volatile, or can be predicted to become so. Moreover, he found that there is no evidence that derivative markets create volatility in underlying cash markets; in fact, they may even reduce it.
The effect on underlying financial markets’ volatility may not even be the right question to consider in deciding whether to permit new derivative products. The right question is whether these products are conducive to economic success and growth.
Here, Mayhew concludes that new derivative markets clearly increase the liquidity and quality of information in existing financial markets. And it is this liquidity and quality of information that ultimately propels economic growth.
First, it’s revealing that Shiller cites a dated paper to support his position. Mahew’s paper did indeed look at research on options and futures markets to a wide variety of cash markets. However, these were all exchange traded markets.
Shiller conveniently ignores the elephant in the room: the systemic risk posed by OTC derivatives. We have a $45 trillion credit default swaps market, for instance, which has the potential for large-scale counterparty failure. Indeed, some observers think that the risk of cascading CDS losses was the reason the Fed rescued Bear Stearns and was willing to pony up such a large credit facility (Bear was a large CDS protection writer, the side of the transaction susceptible to default).
And his comment that ” liquidity and quality of information that ultimately propels economic growth” is unadulterated financial services industry bullshit. Economic growth is a function of demographic growth and productivity growth. Perhaps Shiller can make a case that liquidity and high quality financial market information produce higher productivity growth. Merely asserting it doesn’t make it so.
Shiller again:
The sub-prime crisis has exposed serious problems that we must address. For example, we need stronger consumer protection for retail financial products, stricter disclosure requirements for new securities, and better-designed vehicles for hedging risks.
Some of the innovations associated with the sub-prime crisis – notably option-ARM’s, when extended to borrowers who couldn’t handle them – seem to have little redeeming value. But others – those involved with the securitization of mortgages – were clearly important long-run innovations, because they can help spread risks better around the world.
The first paragraph is more or less motherhood and apple pie, although it isn’t clear what he means by “better designed vehicles for hedging risk”
In the second, he gets it wrong again on option ARMs. They were around long before subprimes, and they are a perfectly fine mortgage when sold to its proper market, which is fairly narrow. Some private banks offered them in the 1980s, if not sooner, to investment bankers. They are perfect for people who have low salaries and high bonuses. The product fits their cash flows: low monthly commitment with discretionary additional paydowns when the big money arrives. Those users don’t suffer the negative amortization that can make the product so damaging.
Shiller once more:
So, we should not slow down financial innovation in general. On the contrary, some of the fixes that result from the sub-prime crisis will probably take the form of still more innovation, further increasing the sophistication of our financial markets.
This gets back to the disingenuous idea that regulation is tantamount to stifling innovation. But now distrust of opaque structures, poor underwriting standards, and unreliable credit ratings is so high that it is naive to think that many investors will have appetite for complexity absent tougher regulation. Preserving innovation is far down the list of concerns these days. Merely keeping the wheels from coming off the financial system will be a considerable accomplishment.
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God help us should the financial markets become more “sophisticated.”
You were saying?
– – >
Fed Actions Defuse Subprime ARM Rate Reset Bomb: John M. Berry
March 27 (Bloomberg) — Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners’ monthly payments jumped when interest rates reset to a higher level.
Not only is that unlikely to happen, this year’s resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007.
The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level.
The Federal Reserve’s cuts in its target for the overnight lending rate — the last to 2.25 percent on March 18 — from 5.25 percent in mid-September, plus actions to increase liquidity in the inter-bank lending market, have caused the Libor to fall.
Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven’t been due to resets so far. Many borrowers simply bought a house or condo they couldn’t afford unless bailed out by rising prices, and lower rates alone won’t help them much.
Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been.
Much of the discussion about the danger of resets has focused on the initial interest rate, or “teaser rate,” that ARMs carried. That left the impression it was a very low rate that would adjust up a lot. Most of the initial rates were 8.5 percent or above, and now many are set to adjust hardly at all.
New Subprime Report
A new report, “Understanding the Securitization of Subprime Mortgage Credit,” by economists Adam B. Ashcraft and Til Schuermann of the New York Federal Reserve Bank, published this month, provides a wealth of detail about subprime mortgages. Much of its information is based on a pool of such mortgage-backed securities issued by New Century Financial in June 2006.
All but 12 percent of the loans in the pool were ARMs, either the so-called 2/28 or 3/27 variety. That is, they carried a fixed-initial rate for two or three years, respectively, so the former will first reset in June.
The average initial rate for the loans was 8.64 percent, set when the six-month Libor was 5.31 percent, according to the report. It was a teaser rate in the sense that once resets began, the interest rate would be based on Libor plus a spread of 6.22 percentage points.
Rate Changes
Thus the initial rate was 2.89 percentage points lower than the full rate of 11.53 percent. Had Libor not come down, the reset in June would have raised the monthly rate to 10.13 percent, and the second, in December, would have lifted it to 11.53.
The lifetime cap on the mortgages averaged 15.62 percent, while the floor was 8.62 percent, only 2 basis points lower than the initial rate.
Now, if six-month Libor remains close to its recent level of about 2.6 percent, the June reset would be less than a quarter-percentage point. If the Fed’s lending rate target is lowered again, as many investors expect, the loans’ interest rate might dip a couple of basis points to the floor of 8.62 percent.
Equally important, 2/28 loans originated in 2005 or earlier whose rates reset to a higher level last year may now be coming down if they are tied to the same Libor index and the spread is similar to those in the pool described in the New York Fed paper.
Ashcraft and Schuermann calculate that if the Libor index had remained unchanged, the monthly payment on a $225,000, 2/28 ARM would increase by 14 percent in the 25th month and another 12 percent in the 31st month.
Less Payment Shock
However, the payment shock would have been greater for a majority of the borrowers, because many loans were 30-year loans to be repaid on a 40-year amortization schedule, while others had an interest-only option for the first five years. In both cases, the unpaid balance was always higher than if the principal was to be repaid over 30 years.
If a borrower’s initial monthly payment on a $225,000, 2/28 loan was equal to 40 percent of his income — and six-month Libor hadn’t come down — resets would have raised the debt service ratio to almost 53 percent in the 31st month.
On an interest-only loan, it would exceed 58 percent at that point, the paper said.
“Without significant income growth over the first two years of the loan, it seems reasonable to expect that borrowers will struggle to make these higher payments,” the two economists wrote, assuming no decline in Libor. “It begs the question why such a loan was made in the first place.”
The Question
In all probability, the lenders expected that the borrower would be able to refinance before it was time for the payment to reset, they said.
Refinancing, of course, presupposed that housing values would rise, or at the least not fall a lot, and that’s not what has happened.
The question now is how many borrowers can afford to keep making their payments even in the absence of resets, and how many will be willing to do so if the mortgage balance is much greater than the current value of their home.
Deregulation of banking is the most liberal policy a government can adopt. As we are currently witnessing, deregulated banking (along with a dearth of oversight and enforcement), is a breeding ground for fraud, embezzlement, criminality, and outright financial chicanery.
Never be liberal with money.
Never.
Also, never walk through a run-down neighborhood with money hanging from your pockets or while wearing a nice watch. It’s an open invitation to a mugging.
I’ve worked with Schiller’s information for housing since 1993 or 94 and I also have a great deal of respect for his work. But it seems more than just sloppy for him to suggest that sub-prime is only a decade old seems to be a manipulation of the facts to suit his argument. Numerous lenders, including Household, Long Beach and Guardian S&L had securitized sub-prime mortgages prior to that point, some with success and some not. The mortgage market had already experienced significant turmoil on bank balance sheets and in securitized transactions prior to 1994, and many of the underlying loans were innovative products such as COFI 40 year negative amortization loans, 7/23 loans, graduated payment loans and balloon loans. Some of these “innovative” products were washed away for the next 10 years because of their poor performance. To some of us who follow this market, the return of these products was a sign of a coming market crisis and of the market’s short memory, rather than a sign of new innovation.
Today, as in the RTC days, a substantial part of the problems in the market came from the failure to enforce existing rules and standards, including those of the rating agencies themselves. Financial innovation either happens or it doesn’t, depending on market conditions and economic incentives. “we” can’t really slow it or speed it up by government fiat. however, successful innovation depends on a legal and regulatory framework that is maintained and enforced. If these are neglected, innovation will be replaced by scamming, corner cutting and fraud.
Shiller’s piece sounds like a political defense of one of the core attributes of capitalism. Back in 1939, when innovation was out of fashion, Schumpeter wrote this defense:
“It is one of
the most characteristic features of the financial side of capitalist evolution so to ‘mobilize’ all, even the longest, maturities as to make any commitment to a promise of future balances amenable to being in turn financed by any sort of funds and especially by funds available for short time, even overnight, only. This is not mere technique. This is part of the core of the capitalist process.”
Also, Minsky noted in 1957 that financial innovations allow asset prices to rise against the tightening effect of rising interest rates – until the Minsky moment arrives, of course.
“The compounded changes will result in an inherently unstable money market so that a slight reversal of prosperity can trigger a financial crisis.”
An option ARM with its potential for negative amortization is also a great tool for sophisticated borrowers due to the tax arbitrages they provide.
Excellent analysis Yves. I am surprised that Schiller would demonstrate such flawed reasoning and provide such a lack of substantiation. I am not impressed at all.
It’s just shocking that someone as high-profile as Schiller can be so dead wrong as to his notion of Option-ARMs being a subprime product. I would love to know where he got that idea.
I know most will disagree, but I’ve always thought he was a bit overrated; you didn’t need to blow him any kisses before pulling out the buzzsaw. When you’re wrong, you’re wrong – it doesn’t matter who you are.
I enjoyed your analysis of this article, which is (I think) sloppy or ill thought out, not dishonest. However, I would take issue with part of your final point.
“But now distrust of opaque structures, poor underwriting standards, and unreliable credit ratings is so high that it is naive to think that many investors will have appetite for complexity absent tougher regulation.”
Much of the financial press and commentary seems fixated on the impact of the blow-up of certain sectors (monolines, subprime etc) as if they (and their investor base) represent the whole of securitised / structured products, and I read this comment in the same light. For the record, there are many of us working in the industry who didn’t buy the subprime bullshit, and who still have confidence in our portfolio! In particular, the assertion that structures are opaque is simply not true – the problem is that people forgot about credit fundamentals when doing investment work, and are paying for that now. When a deal goes from first marketing to launch in 24-48 hours (as many US RMBS deals did), you have to ask yourself why. Was it well understood? Given some of the investors to come out of the woodwork, clearly not!
Does that mean that the rest of us (prudent) investors hate structured credit? Actually, no. Will we continue buying? Well, it certainly meets our spread targets(!), and now the idiots have left / are leaving the room, maybe we won’t have to worry so much about not getting paid enough for the risk.
Re: lower interest rates bailing out homeowners.
Lower interest rates only postpone the problem–unless you think incomes are going to soar, or you think that home prices are going to zoom back up and allow for refinancing or sales at the level of the mortgage debt. When interest rates go up in a year, or two years, or whenever, these “homeowners” will have their rates reset higher, and they will default. We are thus hostage to this debt, because it requires that interest rates stay very low forever, or at least a long, long time.
As a quick note – I have not finished reading the blog post but I would guess that Shiller is referring to this paper:
http://faculty.fuqua.duke.edu/~charvey/Research/Working_Papers/W56_Does_financial_liberalization.pdf
Titled: Does financial liberalization spur growth
Not the volatility paper
Anon of 8:29 AM,
I find it rather remarkable that Fed economists who ought to know better based an entire paper on one pool of MBS issued by one issuer in one month when there are vastly more comprehensive data sources available.
The American CoreLogic databases as of March 2007 contained 38 million mortgages. Their extraordinarily detailed analysis of 8.4 million ARMS originated between 2004 and 2006 showed only 9.1 % with initial interest rates of 8.5% or higher (note that the paper claims an average of 8.64%)
There were more mortgages ate 2% and below (1,1 million) than above 8.5% (770 thousand). Without throwing in the intermediate levels, it’s obvious that the weighted average is well below 8.64%
So that paper was a garbage-in, garbage out exercise, and it appears designed to forestall criticism of the Fed.
I must also note that delinquencies on some pools are running at unheard-of rates before reset, as high as 3-4% per month.
John Berry is tight with the Fed guys, so it doesn’t surprise me that he is acting as a shill for the Fed (hey don’t worry about all those resets!).
Yves,
If anyone is to be filleted here, it should be Berry, not Ashcraft and Schuermann(aka. The Fed).
Berry is taking generous liberties using the single pool data presented in the Ashcraft/Schuermann paper as representative of the entire market.
The authors make it clear that the single pool data used is nothing more than an example used to facilitate the (little better than) cursory analysis of the securitization process.
Frankly, it appears that Berry cherry picked an example and leveraged the author(s) credibility to make an appeal to authority.
To me, the sloppiness of Shiller’s argument, and it is extremely sloppy, looks like a function of haste and hidden motives: his goal, which he specifies most of the way through the article, is to preserve the securitization of mortgages, and presumably secondarily the continuation of regulated derivative exchanges dealing in such instruments. It looks clearly like his buddies in the mortgage and financial world asked him to put his credibility on the line to preserve their most profitable products. Shiller would also like to see the industry remain free to scheme, slice, and shape their products to their own advantage, free of any new public regulator’s oversight, i.e. ‘unfettered innovation [sic].’
Now, I think there may be a real case to be made that securitization of mortgage pools is a public good—if these securities are transparent, properly written, against soundly issue mortgages, with recourse for their unwinding if and as they go bad. I say that as no friend to the industries involved, nor do I deal in or even have a mortgage (I rent). But the ‘solutions’ Shiller proposes to ‘lax issuing standards to “undesirable” borrowers’ [my paraphrase] are clearly designed to prevent recourse _against underwriters_ for badly performing securities and retain for them the ability to shave the system with any scheme they can think up to inflate their profits. *blecchh*
We should more nearly have a system for mortgage securities where the underwriters are libable for the first X% or losses in a pool, where they have to post collateral against that liability at the time of issue, and where X at the very least equals their total profit on the deal. This is the kind of requirement that _will_ get us better paper, and actually maintain liquity for the mortgage market. Forget about outside ratings: nothing clears the mind like liablity and escrow.
As for other issues in Shiller’s article, they do him more harm then good. His contention that derivatives exchanges ‘have improved the quality of information’ is totally risable: they have actively done the reverse. Due to their complexity, diffuse structure, size, and closely held inside information by issuers, these instruments are among the most confusing and opaque ever designed—deliberately. The industry doesn’t want you to see them making sausage, particularly since they are skimming out far more meat from skein than you or they would be comfortable for you to know. Shiller must know this, and he becomes Shill-er by touting the benefits and staying silent on the costs of these products.
If that wasn’t enough, his failure to acknowledge the complicty of the industry in creating and trading the ultra-speculative and unstable OTC derivative instruments in his call not to ‘over-regulate’ [the profits] of his buddies, the ‘heroic innovators’ [naked speculators more like] expends at the outset all the credibility he had and more.
There is a good point to be make in his article, but the way he tried to make it is underhanded and intellectually discreditable, and in my view speaks to his real goals, presumably to save his friends profits.
The ultra-high deliquincy prior to reset rates on some of these MBS pools are a shocking phenomenon, and one that I don’t think has been adequately discussed yet. To the extent these kinds of numbers are mentioned, ‘fraud’ is often posited. There is another view that folks who just took out these mortgages are ‘walking away’ because they ‘can’t afford them,’ based on very little real evidence to that effect.
I have a suspicion, no more, that these defaults are a function of _speculative purchases_ by small scale operators. At the top of the boom, folks who had bought and flipped a house or two, made a bundle, and thought they knew what they were doing took on two or three at once, intending to float the extras for fat money before their total payments even began to bite let alone the ARMS reset; in ‘a few months’ was likely the idea. This isn’t fraud per se, just small time operators being stupid. Then the market locked up, their potential buyers couldn’t get a mortgage, the value of the properties plunged enough overnight to make refinancing impossible, and omigod, there they were . . . dead broke in the headlights. Of course they stopped paying on the total loss properties immediately; I mean, most folks like wouldn’t even have the dough to make multiple simultaneous mortgage payments for even six months.
The ‘quick washout’ is likely a function of small speculators nailed at the market top. As such, though, it may not be indicative of the actual weakness or strength of comparable mortgages overall. —But I’ve yet to see the issue sized up this way by those competent to read the tea leaves (which I am not).
Thanks for this. When I read that Shiller article, I was flabbergasted – it was so manifestly dishonest. I wasn’t expecting that from Shiller.
Hopefully, someone will alert him to your buzz sawing of his article, and he’ll back off his more absurd claims. On the other hand, this bodes badly for a Democratic administration really coming to grips with regulating the financial industry – Shiller, I imagine, would be a powerful influence on either Clinton or Obama.