Wednesday, 30 December 2009

The Decade's Most Influential Events and Trends

I thought this might be a good time to reflect on the past decade by reflecting on the events and trends that appear to have had the greatest impact.

  1. 9/11 -- Much has been written about the impact on attitudes and policy in the US, but the terrorist attacks that day have been wildly successful as an inspirational call to arms for many disaffected mulsims around the world.

  2. Supreme Court case Bush v Gore -- In deciding in favor of Bush, the Supreme Court set the US and the world on a trajectory that almost surely would otherwise have been radically different.

  3. Obama's election -- Though it's too soon to declare the election of 2008 a fundamental political realignment, already in its first year the administration has engineered dramatic shifts in policy, particularly in the areas of health care, financial regulation, autos, bankruptcy, private sector pay, the environment, taxation, the size of the federal government, and fiscal deficits.

  4. Western intelligence failings -- From the George Tenet's claim that weapons of mass destruction in Iraq were a 'slam dunk' to the National Intelligence Estimate in November 2007 that Iran had halted its nuclear weapons program in 2003 to the recent failure to adequately disseminate advance warnings of the Nigerian Christmas bomber, western intelligence has had some significant disappointments this decade.

  5. Palestinian elections -- Hamas' victory over Fatah in 2006 set the stage for the current split between Gaza and the West Bank, effectively preventing progress toward peace between the Palestinians and Israelis.

  6. An Inconvenient Truth -- With this documentary on global warming, Al Gore tipped the debate, with the result that climate change is now taken as an article of faith among opinion-leaders and decision-makers globally.

  7. Media fragmentation -- Radio and television stations now cater to every political view and cultural demographic, so that many people in the west go for days without hearing a contrary opinion that challenges their world view. The resulting political fragmentation makes good governance problematic.

  8. Inflation targeting -- The broad adoption of inflation targets as rigid policy goals has distorted monetary policies, particularly in small, open economies such as Sweden, Norway, and New Zealand. Even in the US, the risk of deflation in 2003 was cited as a reason for leaving the Fed Funds rate lower and for longer than it would have been otherwise -- a development that has been attributed by many as having contributed to the formation of housing bubbles in the US and elsewhere.

  9. Rise of China -- China has been on a course of rapid growth and global integration since the reforms of Deng Xiaoping in the late 1970s. But it was only in this decade that the Chinese economy became large enough to meaningfully influence economic developments in much larger economies. With its inexpensive labor and exports of inexpensive goods, China has exerted downward pressure on many inflation indices, but with its demand for commodities, it's at times exerted upward pressure on inflation measures -- with the net effect of widening the gap between headline and core measures of inflation in some countries. Though less discussed, China has also exported a very low intertemporal marginal rate of substitution (real interest rate), exerting additional downward pressure on both real and nominal bond yields globally.

  10. Momentum trading -- The tendency to chase bull markets was evidenced during the tech boom of the late 1990s, which burst ignominiously in 2000. Not dissuaded, the public hopped on the housing bandwagon as the next trend, driving house prices to levels that proved unsustainable. The subsequent downward correction resulted in huge losses for banks, many of whom kept many of the AAA tranches of the mortgages they had securitized.

Finally, I'll note two themes that characterize these events and trends. First, a number of these were not identified as critical developments at the time, highlighting the limits to our abilities to contemporaneously understand the eventual importance of events undolding around us. Second, many of these events and trends are still unfolding. As a result, it's still too early to judge their ultimate importance. In the end, as always, history will be the judge.

Thursday, 29 October 2009

More Rhetorical Artifice from Stliglitz

In a recent column for The Guardian, Joseph Stiglitz offers some peculiar comparisons between Wall Street Bankers and Norman Borlaug, father of the green revolution. In the midst of his all-too-familiar castigation of bankers, Stiglitz offers these insights on society.

"...our societies tolerate inequalities because they are viewed to be socially useful; they are the price we pay for having incentives that motivate people to act in ways that promote societal wellbeing. Neoclassical economic theory, which has dominated in the west for a century, holds that each individual's compensation reflects his marginal social contribution – what he adds to society. By doing well, it is argued, people do good."

The problem with these insights is that they simply aren't true. Yet again, Stiglitz is attempting to advance his agenda by redefining the debate. Consider his two propositions in turn.

In the US, inequality is not tolerated because it's viewed as being socially useful. Inequality is tolerated because property rights are guaranteed by the US Constitution, particularly Articles IV and V of the Bill of Rights. I realize it's terribly unfashionable these days to refer to the Constitution as a document with any relevance to passe issues such as freedom and property rights. But as a matter of history, Stiglitz is simply wrong.

Of course, we could ask whether the authors of the Constitution might not have been motivated to protect property rights in order to promote "incentives that motivate people to act in ways that promote societal wellbeing." But as a matter of history, inequalities of income and wealth were not issues that were of great concern to these men generally. We might argue that they should have been issues of concern. But the fact is that they weren't.

We might also ask whether the Constitution should be amended, perhaps subjecting property rights to consideration of inequality of wealth or income. But the fact is that it hasn't been subject to such amendments.

At least in the US then, Stiglitz is simply wrong when stating the reasons that inequality is tolerated.

How about the claim that neoclassical economic theory holds that the compensation of an individual reflects his marginal contribution to society? In reality, neoclassical economic theory holds nothing of the sort. Rather, it holds that the compensation of an individual reflects the supply and demand for the skills and experience of that individual. Under certain conditions, the supply and demand for these skills may result in an equilibrium in which the marginal cost of the employee (his compensation) is equal to the marginal revenue generated by the employee.

And under certain conditions, an equilibrium may result in which the marginal compensation of the employee is such that the employee can expect to earn a return on the investment he's made in his own human capital that in some sense is commensurate with the expected returns of other investments, with appropriate adjustments for risk. But neoclassical economic theory does not suggest that this compensation reflects the employee's marginal contribution to society.

In fact, neoclassical economic theory makes no claim even to be able to measure the marginal contribution of an individual to society. And even if we could measure the marginal contribution of an individual to society, we would need to make a whole set of heroic assumptions about labor markets in order to obtain a result linking compensation to marginal social contribution, such as the absence of externalities and free rider problems in the labor market.

Of course, the goal of Stiglitz isn't simply to use the occasion of Borlaug's death as an opportunity to heap further abuse on bankers. He's also attempting to re-frame the debate about the redistribution of income and wealth. Throughout most of our history, the debate about redistribution primarily has been framed around the issues of property rights vs social stability (riots, strikes, protests, acts of civil disobedience). In recent decades, advocates of redistribution have tried to re-frame the debate as one involving individual liberties vs social justice. As these efforts have experienced relatively modest success, Stliglitz would like to re-frame the debate yet again -- this time as an issue of social incentives.

If Stliglitz and his sympathizers are successful in re-framing the debate in this way, they can point to the recent financial crisis as evidence that bankers haven't responded appropriately to their financial incentives and that these incentives therefore can and should be dictated by regulatory fiat rather than determined in a free market for labor.

Of course, we live in a democracy, and Stliglitz is free to attempt to influence the outcomes of the current regulatory reform process. But Stliglitz misleads those whom he would persuade when he mischaracterizes such basic notions as the protection of property rights and the tenets of neoclassical economic theory. We would all be better served if Stiglitz would rely less on rhetorical artifice and more on a straightforward enunciation of the values he believes should be promoted in our society.

Tuesday, 28 April 2009

Because they can?

In a recent New York Times column headed Money For Nothing Paul Krugman ponders compensation in the banking sector and poses the question, "why did some bankers suddenly begin making vast fortunes?" In addressing this issue, not once does Krugman use the words supply or demand.

In fairness to Krugman, he does pay lip service to the issue in the current environment -- barely. In a single sentence, he both raises and dismisses arguments of supply and demand, writing, "Claims that firms have to pay these salaries to retain their best people aren’t plausible: with employment in the financial sector plunging, where are those people going to go?"

If Krugman doesn't believe supply and demand are playing a role in determining compensation, what wisdom does he have for us? What explanation can the 2008 Nobel laureate offer his readers? Krugman's insight: "The real reason financial firms are paying big again is simply because they can."

Because they can. This is Krugman's contribution to the debate? 

Compensation in the banking sector is an important topic being debated in the White House, on Capitol Hill, and in boardrooms across the US and Europe. Shouldn't we be able to expect a more serious analysis from one of our leading economists?

Thursday, 23 April 2009

How Easy is Quantitative Easing?

A question for my macroeconomist friends:

It seems reasonable to expect that a central bank would increase the measured inflation rate (or at least the price index) by dropping freshly-printed money on an unwitting public from the proverbial helicopter. On the other hand, it would be unreasonable to expect that a central bank would create inflation by exchanging two freshly-printed ten-dollar bills for existing twenty dollar bills. What then should we expect for the inflation rate when a central bank exchanges newly-created reserves for government bonds, as is presently occurring in a number of countries engaged in quantitative easing, including the US and the UK? Is this more like the metaphorical helicopter drop or more like the exchange of ten-dollar bills for twenty-dollar bills?

And the ancillary question: Are there any examples of quantitative easing resulting in an increase in the inflation rate? There appear to be plenty of examples of governments generating inflation by using newly-created reserves to buy proverbial guns and butter. And there appear to be various examples in which interest rates have been lowered via open market operations, resulting in an increase in economic activity and eventually in the inflation rate. But I'm wondering whether we have any examples in which quantitative easing has resulted in an increase in inflation.

Tuesday, 14 April 2009

The FT's Pot Shots at Chicago Economics

The op-ed page of yesterday's Financial Times contains not one but two pieces attacking the Chicago school of economics. As a Chicago alum, I'm quite happy to see critiques of the lessons taught at my alma mater, but these pieces strike me as unsubstantiated, lacking focus, and wildly idealistic.

In a piece titled, It is time to put finance back in its box, Philip Augar claims the Chicago school of free-market economics is "busted." And what evidence does he use to support this claim? Augar writes, "The big beasts of free-market economics, Britain and America, are more wounded than other species." That's it -- the sum total of Augar's claim that free-market economics is "busted."

Augar ignores countries that in many respects appear to be faring worse than the US and Britain. For example, industrial production in Japan has declined by almost 40% over the past year, and in Germany the decline has been just over 20%. In contrast, the declines in the US and the UK have been just over 10%, similar to the declines in Russia and South Korea.

And Augar appears to ignore the fact that London and New York would be expected to suffer disproportionately in a global financial crisis, given their roles as global banking centers.

But if the first half of Augar's piece suffers from being poorly-supported, the second half suffers from Augar's unbridled idealism, as evidenced by his final paragraph.

"But now is the time for change. Unless governments in America and Britain really open themselves up to new ideas, emerging economies in Asia and mainland Europe, places where alternative economic and corporate governance models do exist, will seize the initiative and redefine the global agenda. In parallel, academics need to recapture their heritage of creative, independent thinking and throw off the influence of finance. Wall Street and the City need to be grown up about this. They might not like the prospect of losing their grip on government and exposing themselves to new ideas. But unless they do, they might just find that the page has indeed been turned and they are no longer on it."

Augar's plea for governments to be open to new ideas is well and good, but Augar doesn't offer any ideas -- new or otherwise. What alternative economic and corporate governance models does Augar support, and why?

But if Augar's op-ed piece in yesterday's FT is naive, Phillip Blond's is downright fanciful, starting with its title, "Let us put markets to the service of the good society." Blond has just become the director of Demos' Progressive Conservatism Project, and this piece is part of the Tory effort to re-brand the party ahead of the next general election.

Using the language of George Soros, Blond derides "the now clearly bankrupt ideology of the free-market fundamentalists." Whereas Augar at least offered a single sentence in an effort to convince us of the failings of free-market economics, Blond dispenses with any such effort, perhaps believing that this statement is simply self-evident. But the advocates of free markets never claimed they would prevent financial crises or recessions, and critics like Blond should at least be expected to make their case.

Blond states the view that bank that are too-big-to-fail should be broken up -- a view that could be argued quite reasonably given recent events. But rather than arguing this view based on recent events --or on the basis of any events whatsoever -- Blond appeals to pure philosophy. In particular, he justifies the break-up of large banks because it would represent a rejection of "...the neo-liberal and Chicago school-inspired dictum that market-generated monopolies are the most efficient distributor of resources and price utility." Let's resist the temptation to discern some meaning from Blond's term "price utility." Let's ignore the fact that Blond resorts to the time-tested rhetorical artifice of creating a straw man by mischaracterizing the views of the Chicago school. The fact remains that Blond is advocating policy on the basis of philosophy - the very definition of an ideologue.

But as the piece wears on, Blond descends into a virtual jabberwocky of meandering claims for the philosophy of political economy supported by the more fanciful elements of today's Tory party. Consider a few chestnuts.

"If carried through, the new logic of British Conservatism requires a break-up of this cosy corporatist duopoly and its replacement by a decentralised civic economy that crafts together moral values and economic power to create the type of society that most people want to live in: empowered, secure and sustainable communities of shared virtue and prosperity."

What is a "civic economy?" What are "communities of shared virtues?" Who decides what is virtuous? How would we ensure that such virtues are shared? What would these communities of shared virtues be empowered to do?

With the reader still reeling, Blond moves to the topic of antitrust. With an enthusiasm that would have made Teddy Roosevelt proud, he argues for breaking up not only monopolies but also oligopolies, citing the retail food industry in Britain, apparently ignoring the many thousands of local grocers in the UK. In support of this proposition, Blond avoids such bland concepts as predatory pricing and tying, arguing instead, "Allowing more people to participate in markets will help to address rising inequalities of opportunity, character and capability." The concept of equal opportunity is widely-discussed and widely-understood. But what is an inequality of character or an inequality of capability? Could Blond be arguing for government policies that attempt to foster equivalent outcomes resulting from differences in personal character?

Blond unleashes the final salvo in the next paragraph. "A fully engaged economy requires new associative models of equity and ownership such as time banking, fractional ownership and social bonds to generate wealth and influence for all."

What is meant by the term "fully engaged economy?" What is an associative model of equity and ownership? And how is the Conservative Party allowing itself to be intellectually hijacked by such drivel? And finally, why is the FT printing this dross?

I believe the mainstream financial press has an obligation to exercise some discretion to ensure minimal standards when selecting opinion pieces for publication. Even if the pieces are poorly-supported by a reference to actual events or observations, they should at least have some readily-discernible meaning to a typical reader. To the extent that these pieces by Augar and Blond have any meaning, they appear to me as unfocused diatribes against free-market economics rather than clear expositions in favor of an alternative, and I believe the readers of the FT deserve better.

Saturday, 11 April 2009

Krugman Spins on Boring Banking

In a recent New York Times column titled Making Banking Boring, Paul Krugman points to evidence regarding financial regulation and Wall Street compensation that appears in a paper by Professors Thomas Philippon and Ariell Reshef. In particular, Philippon and Reshef find that the level of Wall Street compensation has been inversely correlated with the degree of financial regulation in the US from 1909-2006, with high compensation corresponding to the two periods of light regulation (pre 1930 and post 1980) and with lower compensation corresponding to the intervening period of greater regulation. 

Krugman spins this finding to support his own political narrative, ignoring the authors' conclusions, which in some cases run counter to Krugman's views. 

In brief, Krugman's argument is:
  1. More stringent financial regulation is required, since greater regulation would prevent future crises.
  2. But more stringent regulation would result in lower compensation for Wall Street.
  3. Therefore, Wall Street will try to use its friends in high places to block needed regulatory reform.
Krugman presents the findings of Philippon and Reshef to support point (2) in this political narrative. But he weaves the findings of these academics so tightly into his story that it's difficult to tell where the facts ends and Krugman's opinions begin.

Let's consider what Professors Philippon and Reshef actually conclude.

"Our investigation of the causes of this pattern reveals a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial sector in the wake of the Depression era regulations, and started flowing back precisely when these regulations were removed. This link holds both for finance as a whole, as well as for subsectors within finance. Along with our relative complexity indices, this suggests that regulation inhibits the ability to exploit the creativity and innovation of educated and skilled workers. Deregulation unleashes creativity and innovation and increases demand for skilled workers."

"Our research has two important implications for financial regulation. First, tighter regulation is likely to lead to an outflow of human capital out of the financial industry..."

"Our results have another important implication for regulation. Following the crisis of 1930-1933 and 2007-2008, regulators have been blamed for lax oversight. In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premia that we document, it was impossible for regulators to attract and retain highly-skilled financial workers, because they could not compete with private sector wages. Our approach therefore provides an explanation for regulatory failures."

Of course, Krugman is free to incorporate the factual findings of Philippon and Reshef in support of his political narrative. But he does his readers a disservice by failing to note that the authors reach very different conclusions from these findings than he does.

Thursday, 9 April 2009

Supply & Demand or Comparable Worth on Wall Street?

At a recent dinner party, a friend's wife remarked that she was grossly overpaid in the financial services industry. "Why do you say that?," I inquired. "Because so many well-educated people do more useful jobs than I do for less money," was her reply. When I reminded her of supply and demand, she agreed that these basic principles of economics should govern the determination of wages but that she still believed she was overpaid. Overpaid or not, she certainly appeared confused.

I was reminded of this conversation as I was reading Steven Pearlstein's column in yesterday's Washington Post.

Pearlstein's view is that overall pay on Wall Street " to be ridiculously out of line with that of similarly skilled and equally successful people in other industries." Of course, implicit in that statement is the view that pay for similarly skilled and equally successful people should be in line across industries. Like my recent dinner companion, Pearlstein appears to believe that wages should not be determined in a competitive market for labor governed by the principles of supply and demand.

Pearlstein goes on to list the pernicious effects of high pay. "No matter how it is structured, pay at such astronomical levels has a tendency to swell heads, inflate egos and tempt people to take undue risks of all sorts, ethical as well as financial."

Let's ignore Pearlstein's remarks about swollen head and inflated egos, since even if they tend to produce great bores, they would seem to pose no risk to the financial system. But what about Pearlstein's claims that high pay tempts people to take undue risks?

Well for every Ken Lay and Bernie Ebbers who exhibit risky behavior, there appear to be a Warren Buffet and Bill Gates, models of prudent behavior. And plenty of people with low pay have been tempted to take undue risks, as the subprime mortgage saga reminds us. As a purely empirical matter, I'm not aware of any correlation between pay and the adoption of risky behavior.

What do the critics of market-based compensation suggest for Wall Street? As it happens, Pearlstein appears no more able to offer a suitable alternative than was my dinner companion.

"The answer to that problem isn't for Congress to use the tax code to effectively legislate pay caps for Wall Street. In the current climate, however, the only way to beat back such bad ideas is to find some other ways of stopping and reversing the Wall Street arms race on pay."

At least Pearlstein recognizes that legislating pay caps is a bad idea. But he still believes there's an imperative to find some approach that would result in lower pay on Wall Street.

Pearlstein is no doubt aware of the hundreds of thousands of layoffs on Wall Street and in the City of London. And he must be aware that average pay in the financial services industry is now running significantly lower than it has in years. In other words, the principles of supply and demand are already resulting in the wage declines that Pearlstein advocates. Yet Pearlstein still feels the need for some other method to cap pay on Wall Street, presumably on a sustained basis.

I suspect Pearlstein's objections to the determination of wages via supply and demand is that these economic principles allowed Wall Street pay to get "ridiculously out of line with that of similarly skilled and equally successful people in other industries." But if pay on Wall Street was "ridiculously out of line" with pay in other sectors, it was not the result of pernicious Wall Street traders undermining the political process to forestall needed regulation, as Pearlstein claims. Rather, it was the result of prices adjusting to bring labor supply in line with labor demand on Wall Street.

If Pearlstein someday finds a better way to determine wages in the labor market, we'll look forward to the day when the allocation of resources is consistent with similar wages for equally-successful people with similar skills. But until then, and notwithstanding the current recession, Pearlstein's angst is a small price to pay for a system that has worked so well in so many countries for so many years.

The (partial) Redemption of LLoyd Blankfein

NPR aired an interview yesterday with Lloyd Blankfein, whom I had criticized for his remarks the previous day to the Council of Institutional Investors that bank employees should be paid mainly in the form of restricted stock. NPR's Robert Siegal asked Blankfein to respond to Steven Pearlstein's comments in the Washington Post that the real problem with Wall Street pay is not its structure but rather the overall level of pay. In his reply, Blankfein went some way toward redemption for his previous comments.

"In our system, there are markets for things. There are markets for talent. There are markets for people who can draw people into movies, work in theater, baseball players. As long as the markets are working correctly, and are not impeded, I’m generally agnostic on what the price is that gets in there. If [an employer] knows that this activity is only worth that much money and sets a price.... That’s generally not the way the system works."

To which Siegal replied, "There's an argument though that if compensation is so high -- as it has been -- that it might actually encourage risks that are imprudent."

Of course, this isn't an argument; it's a conclusion -- one we've heard many times. I only wish someone would make the effort to articulate this argument clearly so that the rest of us could either be persuaded by the argument or offer a critique of the argument.

As part of his response to Siegal's statement, Blankfein replied, "...if you depress prices, talent will flow away from that into something else."

Siegal jumped in: "A lot people hearing that now -- a lot of people who aren't in the financial sector -- are saying 'Where would it go? Where would the talent leave Wall Street for in today's market?'"

At that point, Blankfein offered a very useful reminder.

"I’ll accept the premise that the numbers with the benefit of hindsight of course look much too high because today they’d never be those numbers. Because today, people aren’t creating that kind of value, and so it’s almost a foreign thought that we ever could have been in that world. But let me transport you back to 2006 and 2005: In those years, Goldman Sachs actually had issues retaining our talent. And I think it's kind of well-known that a lot of the people who created private equity firms and hedge funds were people who were alumni of our firm. And they weren't alumni who necessarily ran through their whole careers and retired from Goldman Sachs. They were people who, in the prime of their careers, when they were still creating enormous value for the shareholders of Goldman Sachs, decided they had more lucrative alternatives outside the firm."

With these remarks, Blankfein reminded us that our current system for determining compensation is for employers and employees to freely contract in a market for labor governed by supply and demand for talent. With this system under populist attack, Blankfein's reminder is particularly timely and appreciated -- and it goes some way toward redemption for the populist comments he made the day before. If more business leaders would make the case for market-based compensation, we'd stand a greater chance that the current system will carry on into the future. Despite recent events in the economy and the financial markets, the use of markets to determine wages has proven better at allocating labor resources in an economy than any other system, and we should avoid the impulse to do away with this system in the current populist zeal for reform.

Tuesday, 7 April 2009

The Financial Illiteracy of Lloyd Blankfein

I listened to Lloyd Blankfein tell the Council of Institutional Investors today that compensation in the banking industry should contain a significant element of deferred compensation in the form of restricted stock in order to limit 'excessive' risk-taking by employees. I have three problems with Blankfein's suggestion.

First, Blankfein's recommendation would result in employees increasing their exposure to their employer. Not only would their employment be subject to the fortunes of the firm, but their investment holdings would be strongly correlated with the fortunes of the firm as well. If Blankfein provided this sort of financial advice to a private wealth client, he could be sued for abrogating his fiduciary responsibilities.

Second, the equity of the bank can be viewed as a call option on the net asset value of the bank. As such, its value is an increasing function of the volatility of this net asset value. Anyone who wants to increase the value of this stock has an incentive to increase the volatility of the net asset value of the bank. This is particularly true when the value of the equity is low relative to the net asset value of the firm, as is the case presently. If Blankfein really wanted to restrict the incentive for employees to take 'excessive' risks, he would prohibit employees from owning stock in the bank rather than requiring that they do so.

Third, employees will only be indifferent between being paid in cash and being paid in restricted stock of their employer in the event that the restricted stock is provided at a significant discount, in order to reflect their increased risk exposure to their employer and to compensate them for the restricted nature of the stock. Inevitably, this discount will be paid by the employer. As a practical matter, do the shareholders really want to be selling significantly discounted shares to anyone, including their employees?

By paying all compensation simply as cash, Blankfein would mitigate employee incentives for taking 'excessive' risks and reduce the labor cost paid by shareholders. I only hope his misguided recommendations are a bow toward political expediency in the current populist environment rather than a display of genuine financial illiteracy.

Thursday, 2 April 2009

Subsidies in the PPIP

The non-recourse loans available to investors as part of Geithner's Public Private Investment Program have been criticized as unnecessary subsidies by Paul Krugman in the New York Times, Jeffrey Sachs in the Financial Times, and today by Peyton Young in another op-ed piece in the Financial Times. A few thoughts:

First, all three authors identify these subsidies as put options, but all three provide simple two-state numerical examples to illustrate the nature and potential magnitudes of these subsidies. They would improve the quality of the debate by attempting to use more realistic examples.

For example, using a simple Black-Scholes model with an implied volatility of 50% per year, I estimate that the 6:1 non-recourse leverage in the Legacy Loan program might increase the value of the loans by a bit more than 10% in the case of a one-year guarantee and a bit more than 20% in the case of a three-year guarantee -- a far cry from Sachs' estimate that taxpayers will "...overpay for banks’ toxic assets, perhaps by a factor of two or more." Of course, there are better models for this purpose than the Black-Scholes model, and Professors Krugman, Sachs, and Young could contribute more to the debate by at least trying to provide more realistic assessments of the values of these subsidies.

Second, the authors don't incorporate the fees that investors will be paying to the FDIC, the Treasury, and the Federal Reserve in at least partial payment for these put options. According to the Treasury Fact Sheet, in the case of the Legacy Securities program “Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral.” In addition, “Lending rate, minimum loan sizes, and loan durations have not been determined.” In the case of the Legacy Loan program, according to the Treasury term sheet, “The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.”

Just as haircuts, fees, and loan rates for home mortgages reflect the non-recourse nature of a mortgage loan, the haircuts, fees, and loan rates in the Legacy Securities and Legacy Loans programs can be set to reflect the non-recourse nature of the loans that are part of these programs. Until we know more about these fees, any judgment about the net magnitude of these subsidies is premature.

Third, the authors fail to comment on an important characteristic of the program that appears to work toward lessening the eventual liquidity in the secondary market for these assets. The investors in the PPIP will receive two assets when they invest: 1) the legacy assets, and 2) the put options provided by the non-recourse nature of the loans from the FDIC, Treasury, and the Fed. But it appears they'll have to relinquish the put options if they later wish to sell these assets in the secondary market.

If the value of the assets increases, the put options will lessen in value anyway, so in this case the issue may not be relevant. But if the asset values don't increase, in which case the put options would still have value, the inability to transfer these put options to subsequent purchasers would be expected to lessen the liquidity that otherwise would exist in the secondary market. Rather than increasing the liquidity of these legacy assets, the subsidies in the PPIP appear as if they might succeed only in a one-time subsidized transfer. Of course, even a one-time transfer may improve matters, but it does run contrary to the stated goal to enhance liquidity for these assets.

Fourth, the embedded put options present an accounting issue for the banks and their regulators. In particular, if assets are transferred from banks to the PPIP at values that reflect the put options provided by the non-recourse loans, should banks be able to use these higher prices to mark the value of similar assets? If so, the banks may be overstating the market values of their assets, which don't contain similar embedded put options. If not, at what prices should these banks mark these assets in light of the PPIP purchases?

At this point, I believe we'd all be better served if the debate focused on: 1) providing more precise estimates of the value of the put options, including fees paid by the investors, 2) the medium-term prospects for liquidity in the secondary market for these assets; and 3) the accounting and capital implications of observed PPIP purchase prices, which include puts for the buyers but not for the selling banks, which are very likely to retain some of these assets.