Must Read of the Week

Great lineup of papers from the Russell Sage Foundation and Century Foundation conference on the financial crisis on Friday.

Behavioral finance, efficient market theory revisited ... your inner finance wonk will rejoice. (The only one so far that I've found head-wagging is "Shadow Finance" and its theory of "cream skimming," which seems way out in left field -- more on that later, I hope.)

The "talker" of the set is this paper that, fundamentally, questions the intrinsic value of financial innovation by showing that, over the last century and a half, the industry has become more inefficient at its core role of intermediation, not less. Yes, there are numbers and charts.

In brief:

The finance industry that sustained the expansion of railroads, steel and chemical industries, and the electricity and automobile revolutions was more efficient than the current finance industry.

The conclusion:

In the absence of evidence that increased trading led to either better prices or better risk sharing, we would have to conclude that the finance industry's share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billions for the U.S. alone.

Ben Bernanke's Great Delusion?

Ben Bernanke made a speech Friday in which he made a couple of curious comments about the financial crisis.

First (my bold):

The multiple instances of run-like behavior during the crisis, together with the associated sharp increases in liquidity premiums and dysfunction in many markets, motivated much of the Federal Reserve's policy response. Bagehot advised central banks--the only institutions that have the power to increase the aggregate liquidity in the system--to respond to panics by lending freely against sound collateral.

And then:

The Federal Reserve's responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options, given the absence of a legal framework for winding down such firms in an orderly way in the midst of a crisis--a framework that we now have. However, those actions were, again, consistent with the Bagehot approach of lending against collateral to illiquid but solvent firms.

Really?

Was the Fed really lending against sound collateral, or was it more the fact that, whatever it chose to lend against became, ipso facto, "sound collateral."

And were these really "illiquid but solvent firms" or "illiquid and insolvent firms" that the Fed, through a bevy of support programs, succeeded in reviving?

I can't tell if Bernanke really believes what he's saying or, deep inside, realizes it's a necessary intellectual cover for a spate of unprecedented Fed activism.

More Games Played by Ratings Agencies With Securitizations

I found this paper this morning: "Ratings, Mortgage Securitizations and the Apparent Creation of Value."

Some excerpts below (my bold):

Structured products are designed to produce desired ratings. The company issuing a bond has no easy way of restructuring itself to change the rating assigned to a bond if it does not like the rating.

Yup.

The apparent creation of value happens when any portfolio of debt-like assets is securitized. It is therefore a potential explanation for popularity of re-securitization and re-re-securitization.

Double yup.

On to the summary:

The creation of tranches with AAA ratings was the key to the success of the securitization of subprime mortgages during the 2000 to 2006 period. Indeed, the profitability of a securitization to the structurer depended critically [on] the volume of AAA-rated tranches that were created ...

Pension funds, endowments and other large investors often establish rules governing how their assets can be invested. These rules often specify that the credit rating of instruments must be above a certain level, and sometimes that the credit rating must be AAA. There is a limited supply of AAA-rated corporate and sovereign bonds in the world ...

Was a AAA-rated tranche equivalent to a AAA-rated bond? The answer ... should be clear from our analysis ... If the rating agencies applied their criteria appropriately, one dimension of the loss distribution of a AAA-rated tranche was the same as that of a AAA-rated corporate bond, but other aspects of the loss distribution were liable to be quite different ...

Consider a bond and a thin tranche, both rated BBB by S&P or Fitch. They will have approximately the same probability of default. However, in the case of the bond, the expected loss in the event of default is about 60% whereas, in the case of the tranche, it is almost 100%.

There are other reasons why investors should have been wary ... regarding a AAA bond as equivalent to a AAA tranche. As pointed out by Coval et al. (2009), AAA-rated tranches have high systematic [sic, should be "systemic"] or market risk. They tend to lose money when the market as a whole performs very poorly and there are many defaults. AAA-rated bonds do not have as much systematic risk.

Another difference concerns the probability of downgrade. As explained earlier, structurers knew the models used by rating agencies and were able to show proposed structures to rating agencies before creating them. As a result, it is likely that AAA-rated tranches had just made it to the AAA category.

I won't even comment on the unmentioned here, regarding systemic risk -- that these instruments that are likely to perform more poorly during periods of systemic risk are themselves, with their shiny AAA veneers, contributors to the eventual appearance of that systemic risk.

So those are some of the games. Investors, note well.

Are We Finally Ready to Do Something Meaningful About Shadow Banking?

I've been heartened by a growing number of news stories that pose the question: "What to do about shadow banking?". Here's the latest, from the New York Times, to pop up on my screen (though this piece isn't very substantive).

Barry Ritholtz shows us with this graphic from the Wall Street Journal that shadow banking never went away after the big financial crisis; the Fed and Treasury just stepped in to pick up the slack.

Finally: Be very, very wary of people peddling solutions that make the world's central banks the shadow bankers of last resort.

Why You Should Be Very Depressed About Climate Change

This is a bit off topic, but for years I've been following the climate change debate. Today I came across this terrific list of "myths vs. what the science says". There are 173, total.

So that's 173 myths that nothing's really wrong, debunked.

Still, part of me wanted to cry at the earnest thoroughness of the debunkers. They even break down their answers into basic/intermediate/advanced, to suit everyone from pea-brained U.S. Senators (doesn't Jim Inhofe actually, physically look like a dinosaur?) to climate scientists who can handle advanced formulas and charts.

But it's all just spitting into the wind.

Even if the science were agreed upon by 100 percent of the population -- yes, climate change is coming if we don't restrain levels of carbon dioxide -- does anyone really think anything would change in any significant way?

One problem is, we all live on one planet, share the same air, but are governed by hundreds of different political systems. And we can't compel global cooperation. So there's a huge incentive for any one country to cheat while others cleave to aggressive carbon-dioxide lowering rules -- and that's if we ever got close to agreeing on anything substantial globally, which we won't.

Another problem is, in the U.S. (the worst of the carbon-spewers per capita), we don't do pain. We don't want our lifestyle threatened. Just look at the federal gas tax. It's been frozen at 18.4 cents per gallon for almost two decades. If you double, triple, quadruple (or more) that tax, that will change driving habits and fill up some of those one-person cars you see everywhere zooming down the freeways.

There are lots of great reasons to do this -- reduce pollution, encourage energy independence, generate revenue for a cash-strapped budget, fight global warming. Conservative economists like Greg Mankiw have gotten behind this proposal. But the average American hates the idea, so don't hold your breath.

One last problem (though there are many; this is the short list): To combat global warming, we would be asked to make real, immediate sacrifices for a hypothetical, distant problem. That just won't happen.

So what now?

If we wait too long, and the effects of global warming are as serious as we've been told, we'll just find a way to cope. If half of New York City winds up under water, we'll just adjust. Highways on stilts. Floating homes. Water taxis.

On global warming, I'm sorry: I just don't think there's anything to be optimistic about.