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July 25, 2009

The Minsky Watch

There has been a lot of public discourse over the last year of systemic risk without any real systemic re-pricing of risk in my neighborhood, which would have a deflationary affect. Now my home is located within a few blocks of some famous people, like Joe Mauer and Garrison Keiller. From my own research, the homes around here have barely budged in valuation over the past year. Home now selling for $575,000 that would not have brought $325,000 since the time I moved into the neighborhood in the 1990s. In times when the financial system economy was not overlooking the precipice, trapped in a classic debt-deflation cycle as it seemed now in which falling asset prices and declining consumer demand transmit deflation through the economy. It had not really happened much yet in my neighborhood.

A number of publications have referred to real unemployment to be near 20%, despite the $787 billion stimulus package. State budgets are drowning in red ink, soon to deepen with jobless claims and Medicaid bills, hesitant to spend consumers as paychecks shrink and jobs disappear. I would not be buying stocks with this kind of economic forecast, yet this week the indexes on Wall Street sprouted up like Iowa corn.

The speculators still abound. People who are gambling with their money in these times, as they had gambled turning real estate in this decade. In May 2009, Paul McCulley of PIMCO wrote, “The longer people make money by taking risk, the more imprudent they become in risk-taking. While they’re doing that, it’s self-fulfilling on the way up. If everybody is simultaneously becoming more risk-seeking, that brings in risk premiums, drives up the value of collateral, increases the ability to lever and the game keeps going. Human nature is inherently pro-cyclical, and that’s essentially what the Minsky thesis is all about.”

Hyman Minsky is an economist who has gained a lot of disciples over the past few years. He wrote about bubbles that occur in an economy. He theorized that a bubble begins with displacement caused by a significant invention like the internet. A displacement creates profitable opportunities in any given affected sector but, rather than invention alone, financial innovation is necessary for access to cheap credit before a kick-off to an over-trading phase. Euphoria ensues as people pile into the sector, with a driving demand to affect higher prices, often with borrowed money. Ponzi’ investors join in speculation that someone will buy their assets at higher prices. But markets eventually, whether due to lenders tightening lending criteria or insiders selling out, hit a peak. Panic then sets in. With a stampede out of the market, bankruptcies ensue.

James Fallow’s opening paragraph in this months Atlantic Monthly is: “On March 28, 2007, Federal Reserve Chairman Ben Bernanke appeared before the congressional Joint Economic Committee to discuss trends in the U.S. economy. Everyone was concerned about the ‘substantial correction in the housing market,’ he noted in his prepared remarks. Fortunately, ‘the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.’ Better still, ‘the weakness in housing and in some parts of manufacturing does not appear to have spilled over to any significant extent to other sectors of the economy.’ On that day, the Dow Jones industrial average was above 12,000, the S&P 500 was above 1,400, and the U.S. unemployment rate was 4.4 percent. That assurance looks bad in retrospect, as do many of Bernanke’s claims through the rest of the year: that the real-estate crisis was working itself out and that its problems would likely remain ‘niche’ issues. If experts can be this wrong—within two years, unemployment had nearly doubled, and financial markets had lost roughly half their value—what good is their expertise? And of course it wasn’t just Bernanke, though presumably he had the most authoritative data to draw on. Through the markets’ rise to their peak late in 2007 and for many months into their precipitous fall, the dominant voices from the government, financial journalism, and the business and financial establishment under- rather than overplayed the scope of the current disaster.”

Paul McCulley delivered a speech to the 17th Annual Hyman Minsky Conference on April 17, 2008. He stated, “Since August 2007, the shadow banking system – defined as any levered lender who does not have access to (1) deposit insurance and/or (2) the Fed’s discount window – experienced a modern-day run, with asset-backed commercial paper holders refusing to roll over their paper. It has not been fun. It has not been pretty.” And he saw that it was not over, as the ensuing 15 months proved. Whereas James Fallow cited Federal Reserve Chairman Ben Bernanke discussion of trends in the U.S. economy on March 28, 2007, Paul McCulley of PIMCO on April 17, 2008, 25 weeks before the Lehman Brother collapse, talked about a lot of things that Bernanke publicly was oblivious to.

Paul McCulley of PIMCO wrote on April 17, 2008: “Which brings us back to where I began: Minsky’s insight that financial capitalism is inherently and endogenously given to bubbles and busts is not just right, but spectacularly right. And when the financial regulators are not only asleep but actively cheerleading financial innovation outside their direct purview, a disaster is in the making, as the last year has taught us. We have much to learn and relearn from the great man as we collectively restore prudential common sense to bank regulation – both for conventional banks and shadow banks.

In May 2009, Paul McCulley wrote, “Human nature is inherently pro-cyclical, and that’s essentially what the Minsky thesis is all about. He says ‘from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system’s reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt-deflation feeds upon debt-deflation.'”

Paul McCulley on April 17, 2008: “Whatever moment you pick for the Moment, we have since been traveling the reverse Minsky journey: moving backward through the three-part progression, with asset prices falling, risk premiums moving higher, leverage getting scaled back and economic growth getting squeezed. Minsky’s Ponzi debt units are only viable as long as the levered assets appreciate in price. But when the price of the assets decline, as we’ve seen in the U.S. housing market, Minsky tells us we must go through the process of increasing risk-taking in reverse – with all its consequences.

“The recent Minsky moment comprised three bubbles bursting: in property valuation in the U.S., in mortgage creation, again, principally in the U.S., and in the shadow banking system, not just in the U.S. but around the world. The blowing up of these three bubbles demanded a systemic re-pricing of all risk, which was deflationary for all risk asset prices. These developments are, as Minsky declared, a prescription for an unstable system – to wit, a system in which the purging of capitalist excesses is not a self-correcting therapeutic process, but a self-feeding contagion: debt deflation.

“Fittingly, the last debt unit on the forward Minsky journey is called a Ponzi unit, defined as a borrower who has insufficient cash flow to even pay the full interest on a loan, much less pay down the principal over time. Now, how and why would such a borrower ever find a lender to make him a loan? Simple: as long as home prices are universally expected to continue rising indefinitely, lenders come out of the woodwork offering loans with what is called negative amortization, meaning that if you can’t pay the full interest charge, that’s okay; they’ll just tack the unpaid amount on to your principal. At the maturity of the loan, of course, the balloon payment will be bigger than the original loan.

“As long as lenders made loans available on virtually non-existent terms, the price didn’t really matter all that much to borrowers; after all, housing prices were going up so fast that a point or two either way on the mortgage rate didn’t really matter. The availability of credit trumped the price of credit. Such is always the case in manias. It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policymakers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.

“Clearly the explosion of exotic mortgages in recent years have been textbook examples of Minsky’s speculative and Ponzi units. But they seemed okay, as long as expectations of stably rising home prices were realized. Except, of course they cannot forever be realized. At some point, valuation does matter! How could lenders ignore this obvious truth? Because while it was going on, they were making tons of money. Tons of money does serious damage to the eyesight. And our industry’s moral equivalent of optometrists, the regulators and the rating agencies, are humans too.

“As long as the forward Minsky journey was unfolding, rising house prices covered all shameful underwriting sins. Essentially, the mortgage arena began lending against asset value only, rather than asset value plus the borrowers’ income. The mortgage originators, who were operating on the originate-to-distribute model, had no skin in the game – no active interest – because they simply originated the loans and then repackaged them.
But who they distributed these packages to, interestingly enough, were the shadow banks. So we had an originate-to-distribute model and no skin in the game for the originator, and the guy in the middle was being asked to create product for the shadow banking system.

“The system was demanding product. Well, if you’ve got to feed the beast that wants product, how do you do it? You have a systematic degradation in underwriting standards so that you can originate more. But as you originate more, you bid up the price of property, and therefore you say, “These junk borrowers really aren’t junk borrowers. They’re not defaulting.” So you drop your standards once again. And you take prices up. And you still don’t get a high default rate. The reason this system works is that you, as the guy in the middle, had somebody bless it: the credit rating agencies. A key part of keeping the three bubbles (property valuation, mortgage finance and the shadow banking system) going was that the rating agencies thought the default rates were low because they were low. But they were low because the degradation of underwriting standards was driving up asset prices.

“Both regulators and rating agencies were beguiled by very low default rates during the period of soaring home prices. It all went swimmingly, dampening volatility in a self-reinforcing way, until the bubbles created by financial alchemy hit the fundamental wall of housing affordability.

“Ultimately, fundamentals do matter! We have a day of reckoning, the day the balloon comes due, the margin call, the Minsky Moment.

“If the value of the house hasn’t gone up, then Ponzi units, particularly those with negatively-amortizing loans, are toast. And if the price of the house has fallen, speculative units are toast still in the toaster. Ponzi borrowers are forced to “make position by selling out position,” frequently by stopping (or not even beginning!) monthly mortgage payments, the prelude to eventual default or jingle mail. Ponzi lenders dramatically tighten underwriting standards, at least back to Minsky’s speculative units – loans that may not be self-amortizing, but at least are underwritten on evidence that borrowers can pay the required interest, not just the teaser rate, but the fully-indexed rate on ARMs.
From a microeconomic point of view, such a tightening of underwriting standards is a good thing, albeit belated. But from a macroeconomic point of view, it is a deflationary turn of events, as serial refinancers, riding the back of presumed perpetual home price appreciation, are trapped long and wrong. And in this cycle, it’s not just the first-time homebuyer that is trapped, but also the speculative Ponzi long: borrowers who weren’t covering a natural short – remember, you are born short a roof over your head, and must cover, either by renting or buying – but rather betting on a bigger fool to take them out (“make book”, in Minsky’s words). The property bubble stops bubbling and when it does, both the property market and the shadow banking system go bust.

“The asset class imploded violently, when the conventional basis of valuation was undermined for the originate-to-distribute (to the shadow banking system) business model.

“And the implosion was on Wall Street and next on Main Street, with debt-deflation accelerating in the wake of a mushrooming mortgage credit crunch, notably in the subprime sector, but also up the quality ladder. Yes, we are now experiencing a reverse Minsky journey, where instability will, in the fullness of time, restore stability, as Ponzi debt units evaporate, speculative debt units morph after the fact into Ponzi units and are severely disciplined if not destroyed, and even hedge units take a beating. The shadow banking system contracts implosively as a run on its assets forces it to delever, driving down asset prices, eroding equity – and forcing it to delever again. The shadow banking system is particularly vulnerable to runs – commercial paper investors refusing to re-up when their paper matures, leaving the shadow banks with a liquidity crisis – a need to tap their back-up lines of credit with real banks or to liquidate assets at fire sale prices. Real banks are in a risk-averse state of mind when it comes to lending to shadow banks, lending when required by backup lines but not seeking to proactively increase their footings to the shadow banking system but, if anything, reduce them. Thus, the mighty gulf between the Fed’s liquidity cup and the shadow banking system’s parched liquidity lips.

“The entire progression self-feeds on the way down, just like it self-feeds on the way up. It’s incredibly pro-cyclical. The regulatory response is also incredibly pro-cyclical. You have a rush to laxity on the way up, and you have a rush to the opposite on the way back down. And essentially, on the way down, you have the equivalent of Keynes’s paradox of thrift – the paradox of delevering. It can make sense for each individual institution, for a shadow bank or even a real bank, to delever, but collectively, they can’t all delever at the same time.

“Along the way, policymakers slowly have recognized the Minsky Moment followed by the unfolding reverse Minsky journey. But I want to emphasize “slowly,” as policymakers, collectively, tend to suffer from more than a thermos full of denial. Part of the reason is human nature: to acknowledge a reverse Minsky journey, it is first necessary to acknowledge a preceding forward Minsky journey – a bubble in asset and debt prices – as the marginal unit of debt creation morphed from hedge to speculative to Ponzi. That is difficult for policymakers to do, especially ones who claim an inability to recognize bubbles while they are forming and, therefore, don’t believe that prophylactic action against them is appropriate. But framing policies to mitigate the damage of a reverse Minsky journey requires that policymakers openly acknowledge that we are where we are because they let the invisible, if not crooked, hand of financial capitalism go precisely where Professor Minsky said it would go, unless checked by the visible fist of counter-cyclical, rather than pro-cyclical, regulatory policy.

“That’s not to say that Minsky had confidence that regulators could stay out in front of short-term profit-driven innovation in financial arrangements. Indeed, he believed precisely the opposite. Minsky wrote these words in 1986:

“In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy.”

Three years later, we can only bemoan that his sensible counsel was ignored and the economy experienced the explosive growth of the shadow banking system, or what Minsky cleverly called “fringe banks and other financial institutions.”
Minsky’s insight that financial capitalism is inherently and endogenously given to bubbles and busts is not just right, but spectacularly right. We have much to learn and relearn from the great man as we collectively restore prudential common sense to bank regulation – both for conventional banks and shadow banks.

“Meantime, we’ve got a problem: we’re on a reverse Minsky journey. The private sector wants to shrink and de-risk its balance sheet, so someone has to take the other side of the trade to avoid a depression – the sovereign. We pretend that the Fed’s balance sheet and Uncle Sam’s balance sheet are in entirely separate orbits because of the whole notion of the political independence of the central bank in making monetary policy. But when you think about it, not from the standpoint of making monetary policy but of providing balance sheet support to buffer a reverse Minsky journey, there’s no difference between Uncle Sam’s balance sheet and the Fed’s balance sheet. Economically speaking, they’re one and the same.

“I think we’re pretty well advanced along this reverse Minsky journey, and it’s a lot quicker than the forward journey for a very simple reason. The forward journey is essentially momentum-driven; there is a systematic relaxation of underwriting standards and all that sort of thing, but it doesn’t create any pain for anybody. The reverse journey, however, does create pain, otherwise known as one giant margin call. The reverse journey comes to an end when the full faith and credit of the sovereign’s balance sheet is brought into play to effectively take the other side of the trade. No, I’m not a socialist; I’m just a practical person. You’ve got to have somebody on the other side of the trade. The government not only steps up to the risk-taking and spending that the private sector is shirking, but goes further, stepping up with even more vigor, providing a meaningful reflationary thrust to both private sector risk assets and aggregate demand for goods and services.

Thus, policymakers have a tricky balancing act: let the deflationary pain unfold, as it’s the only way to find a bottom of undervalued asset prices from presently overvalued asset prices, while providing sufficient monetary and fiscal policy safety nets to keep the deflationary process from spinning out of control. Debt deflation is a beast of burden that capitalism cannot bear alone. It ain’t rich enough, it ain’t tough enough.

“Capitalism’s prosperity is hostage to the hope that policymakers are not simply too blind to see.

“As long as we have reasonably deregulated markets and a complex and innovative financial system, we will have Minsky journeys, forward and reverse, punctuated by Minsky Moments. That is reality. You can’t eliminate the Minsky journeys. It’s a matter of having the good sense to have in place a counter-cyclical regulatory policy to help modulate human nature.

“Not to say that Minsky had confidence that regulators could stay out in front of short-term profit-driven innovation in financial arrangements. Indeed, he believed precisely the opposite:

“In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy.”

“While asset prices, and notably property prices, were soaring, it was all quite dandy. Which, of course, propelled the Forward Minsky Journey. There were no regulatory cops on the beat, only regulatory czars in corner offices, actively accommodating growth in the shadow banking system. Most fundamentally, regulatory authorities ignored the systemic liquidity risk imposed by the shadow banking system versus the conventional banking system: without access to either deposit insurance or the Fed’s discount window, and mostly void of any meaningful term financing, the shadow was a sitting duck for a classic run on liquidity. And ever since last August, that has been precisely what has unfolded, punctuated by the run on Bear Stearns last month.

“Along the way, the Fed has taken gallant and bold steps to inject liquidity into the markets, creating lending facility after lending facility. But up until last month, when the Fed opened the discount window to investment banks, who are the largest shadow banks of all, the Fed’s role as liquidity provider of last resort was simply not effective, however valiant it may have been. Channeling liquidity to conventional banks, in hopes that they would pass it along to shadow banks, simply did not work very well, though it did have the salutatory effect of allowing some banks to (reluctantly) expand their balance sheets so as to absorb assets being disgorged by shadow banks.

“As the Bear Stearns rescue forcefully demonstrated, the Fed had no choice but to open the discount window to investment banks, to facilitate the takeover of Bear in particular and even more importantly, to prevent a cascading of runs. This was a moment of truth and clarity, if there ever was one. I applaud the Fed for doing what it had but no choice to do. At the same time, the Fed’s action demands a complete re-think of the bifurcated regulatory regime for conventional banks and investment banks.

James Fallow: “The difference was partly ‘debt versus equity.’ That is, a loss of stock-market value is damaging, but defaults on loans which put banks themselves in trouble had a ‘multiplier’ effect. The difference between this crash and others, Nouriel Roubini said, was that the speculative bubble involved so much more of the economy than the term ‘subprime’ could suggest. ‘It was subprime, it was near-prime, it was prime mortgages. It was home-equity-loan lines. It was commercial real estate, it was credit cards, and it was auto loans. When there’s a credit crunch, for every dollar of capital the financial institution loses, the contraction of credit has to be 10 times bigger.’

“‘Bernanke should have known better. But it’s not really about him. It’s in everybody’s interest to let the bubble go on. Instead of the wisdom of the crowd, we got the madness of the crowd. So when the proverbial stuff hit the fan in the summer of 2007, the Fed and the Bush administration were initially taken by surprise,’ Nouriel Roubini concluded. ‘Their analysis had been wrong. And they didn’t understand the severity of what was to come. And all along, their policy was two steps behind the curve. We’ve had a model of growth in which over the last 15 or 20 years, too much human capital went into finance rather than more-productive activities. It was a growth model where we over-invested in housing, the most unproductive form of capital. We have been in a growth model based on bubbles, and the model has broken down, because we borrowed too much. The only time we are growing fast enough is when there is a big bubble.

And so the government now more than doubled note and bond offerings to $963 billion in the first half of 2009 as it tries to end the recession. It may sell another $1.1 trillion by year-end, according to Barclays. The second-half sales would be more than the amount sold in all of 2008.

“Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth,” Fed Chairman Ben Bernanke said this week in semi-annual testimony before the House Financial Services Committee. Bernanke said “limited inflation pressures” will allow policy makers to keep interest rates near zero for an “extended period.”

“‘The Fed is now embarked on a policy,’ Nouriel Roubini said, ‘in which they are in effect directly monetizing about half of the budget deficit. The public debt is going up, and the federal government is covering about half of that total by printing new money and sending it to banks. In the short run, that monetization is not inflationary.” But banks are holding much of the money themselves. ‘They are not re-lending it. So that money is not going anywhere and is becoming inflationary.’”

But at some point the recession will end—Roubini’s guess is 2011–and banks will want to lend the money. People and businesses will want to borrow and spend it, James Fallow’s piece concludes.

Writes Alan Blinder, a Princeton University professor of economics and public affairs, in the Wall Street Journal: “Economic conditions are dreadful at the bottom of a deep recession. Jobs are scarce. Layoffs abound. Businesses scramble for penurious customers. Companies go bankrupt. Banks suffer loan losses. Tax receipts plunge. Government budget deficits balloon. All this and more in what now looks to be the country’s worst recession since 1938. So why is everyone so blue when the U.S. economy is hitting bottom. The good news also is the bad news. As the economy hits bottom, it’s a long uphill climb to get out.

Paul McCulley of PIMCO and Bill Gross of PIMCO and Mohamed El-Erian at PIMCO have had a better public perspective than Mr. Bernanke has over the past two years. As did Nouriel Roubini. It is hard to believe his name will be put in nomination at the soon to end current term as Fed chief, no matter his performance since September 2008. Even though the real-estate crisis was working itself out and its problems likely remained ‘niche’ issues, and had not approached my neighborhood.

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1 Comment »

  1. Comment by baseball91 — May 30, 2015 @ 2:12 PM | Reply

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