http://www.nytimes.com/2010/06/20/business/20view.html?emc=eta1
Robert J. Shiller (the Yale professor and co-founder of the Case-Shiller home price index), a noted financial economist and a supporter of the behavioral finance school of thought, noted in the NY Times on 6/18 that Congress will not be addressing the underlying financial crisis issues when a House/Senate compromise reform bill is passed. The versions of the current efforts to get a bill out wouldn't "... prevent a repeat of this mess."
As Shiller says, he's been working with a nationwide group of 15 professors of financial economics on recommendations that might improve our chances of better regulation. Named for the New Hampshire lake where the group first got together in 2008, the group looked to pool their expertise.
The group made extensive use of what they considered to be an important economic theory: people respond to incentives, but the incentives embedded in government regulations often don't have the desired effects. They presented their findings on June 16th at Columbia University where Ben Bernanke introduced their book: "The Squam Lake Report: Fixing the Financial System (Princeton University Press). He said he agreed with the principle that "the stakeholders in financial firms - including shareholders, managers, creditors and counterparties - must bear the costs of excessive risk-taking or poor business decisions, not the public."
The article's attachment does a nice job of outlining the various categories where the group feels a better focus could be made on issues that would impact a better result. One of our favorites is executive compensation. There's no question that the wrong incentives were in place at all levels but, then, what are the right ones? The Working Paper argues that governments should generally not regulate the level of executive compensation at financial firms. Instead, a fraction of compensation should be held back for several years to reduce employees' incentives to take extra risk. The "say on pay" provision in the proposed legislation gives stockholders a chance to whine about pay levels being too high, but so what. Good point for the Squam Lake Group.
The Senate bill does have "clawback provisions" that might take back an executive's compensation at a later date, under special circumstances. But, these provisions wouldn't have the likely effect of a "holdback."
This group has done good work on all aspects of financial regulation. It's worth reading.
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"the stakeholders in financial firms - including shareholders, managers, creditors and counterparties - must bear the costs of excessive risk-taking or poor business decisions, not the public."
ReplyDeleteIt simply can't be put any better.
Craig: Thank you! The incentive plans in all of those institutions are out of whack. Those plans are short term and cash (or deferred cash) oriented. And, our accounting rules (and I use the term "rules" advisedly) encourage "profit management".
ReplyDeleteExecutive compensation; so what!
ReplyDeleteAll of this, to me, is merely fiddling as Rome burns. Until Fannie Mae and Freddie Mac can no longer underwrite bad housing loans, which they are still doing so today at a similar rate to the height of the bubble, this fiscal irresponsibility will continue.
A loan officer, mortgage company, or even a bank will never care about the underlying qualifications of the borrower, as long as Fannie Mae & Freddie Mac will purchase those loans unquestionably (as they still do).
Why are Fannie Mae & Freddie Mac so off-limits to regulation? Because, these organizations allow many minorities (including illegals) to purchase homes, which they would not be able to do so under standard lending practices of most financial institutions, i.e. 20% down plus an income appropriate to cover the mortgage. Also, for now, such loose lending practices are keeping the housing market from totally collapsing.
Now, this is not a finger pointed at any single party. Democrats, led by Bill Clinton and Barney Frank, passed legislation in the late-1990s directing Fannie Mae & Freddie Mac to loosen their standards for purchasing of mortgages.
Republicans, led by George Bush, ordered Fannie Mae & Freddie Mac to expand the kind of mortgages that are purchasable. This resulted in the infamous "ninja" loans widely prevalent at the height of the bubble: No Income, No Job nor Assets.
Why oh why such madness? Simple, it is all about votes; or, more precisely, enough votes until a person leaves office. The bad risk people get a house that they would normally not be able to afford (nor should); they are happy and vote for those they figure got them their happiness. Those who can afford loans and already have a home sell their house at a above-normal-market profit; they are happy and vote for those they figure got them their happiness. Happy people equals happy voters.
Madness, yes. Simple. very much so.
The flipside, however, isn't really a solution either, is it?
ReplyDeleteAs reported here:
http://www.fivethirtyeight.com/2010/06/closer-look-at-housing.html
The summary:
1.) The existing home sales market has farther to fall. There is simply far too much inventory on the market for prices to remain stable.
2.) During the recession, the economy lost a total of 7,281,000 million jobs. Of these, 2,102,000 or 28% were construction workers. Given the massive inventory overhang in the existing home sales market it is highly doubtful that we'll see large construction employment gains in the near future.
3.) Housing wealth is one determinant of consumer behavior. If housing prices continue to move lower, expect lower consumer spending to follow.
So, bottom line: If, for example, the suggestion made is implemented (i.e. tighten Fannie and Freddie) it doesn't take a lot of guesswork to imagine what the net result would be:
Economic apocalypse.
While I don't disagree with some of your points (although I strongly disagree with your specific characterization of Fannie and Freddie's policies only being popular because they help minorities), I can't help but wonder what your solution would be, and if that solution would be worse than the problem in the first place.
Ezra Klein in the Washington Post had a good point as well.
http://voices.washingtonpost.com/ezra-klein/2010/05/why_arent_fannie_and_freddie_i.html
"You're talking about taking a massive -- albeit somewhat opaque -- subsidy to the middle class and eliminating it."
Yeah. That's exactly what we need. An even steeper imbalance in wealth than our current historic high.
Gentlemen: Great points! As we said back in 2008, the massive inventory overhang in housing will have to correct before unemployment, consumer demand or anything else can improve substantially. We worry that, as Krugman opines in today's Times, this may be a double dip that looks more like the Great D than Great R. Oh, and the Group of 20's resolve to cut back spending looks just like the mistake the U.S. made in the 30s. In the worldwide situation, we are cutting back just at the time we should be spending. Nobody (except Warren Buffet, Krugman, and a few others) will understand that until it's too late. Maybe we could throw in a Smoot-Hawley tariff act, just like we did during the Depression, so that we can assure no trade at a time when it needs to be encouraged. The difference between the real unemployment rate right now (17%) and the actual unemployment rate during the Depression (25%) is not that far to travel.
ReplyDelete@ Craig
ReplyDeleteI don't understand your position: You want "the stakeholders in financial firms - including shareholders, managers, creditors and counterparties - must bear the costs of excessive risk-taking or poor business decisions, not the public."
Yet you support the bailout of organizations that took excessive risk-taking and made poor business decisions. GM, AIG, Fannie and Freddie all made mistakes and the government's bailout of them put their costs onto the public.
Also, the worst organizations regarding incentives are the GSEs as they were privately owned and government guaranteed, meaning they were set up in order for the private sector to earn profits while the government bears the costs.
Aaron: Welcome back! Great points!
ReplyDelete