Thursday, January 14, 2010

Academic vs. Wall Street Economists

The WSJ recently asked a number of economists whether they thought the Fed's low interest rates in the early-to-mid 2000s were an important contributor to the credit and housing boom. What the WSJ found was interesting: most business and Wall Street economists (78%) answered yes while just less than half of the academic economists (48%) said yes. One way to interpret this difference is that economists who are closer to the actual financial system may sometimes see better how the low rates actually influence it. Take, for example, the difference between the academic economist Richardo Caballero and the Wall Street economist Barry Ritholtz on what drove the demand for the riskier assets during the boom. Richardo Cabaello's story is a structural one dealing with a shortage of safe assets relative to the global demand for them:
By 2001, as the demand for safe assets began to rise above what the U.S. corporate world and safe mortgage‐ borrowers naturally could provide, financial institutions began to search for mechanisms to generate triple‐A assets from previously untapped and riskier sources. Subprime borrowers were next in line, but in order to produce safe assets from their loans, “banks” had to create complex instruments and conduits that relied on the law of large numbers and tranching of their liabilities. Similar instruments were created from securitization of all sorts of payment streams, ranging from auto to student loans... Along the way, and reflecting the value associated with creating financial instruments from them, the price of real estate and other assets in short supply rose sharply. A positive feedback loop was created, as the rapid appreciation of the underlying assets seemed to justify a large triple‐A tranche for derivative CDOs and related products.
What is interesting about Cabellero's story is that there is not one mention of how incentives created by the low interest rates may have contributed to this process. Barry Ritholtz, on the other hand, sees a big role for the low interest rates in creating demand for riskier assets:
What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

Now Ritzholtz acknowledges regulatory failures were important as well, but the fact that he sees a role for distorted incentives created by the low federal funds rate in creating demand for riskier assets while Cabellero does not may speak to the fact that Ritzholtz is on the ground at Wall Street. Now their two views may actually complement each other. However, one is left wondering whether their differences and that between academic and Wall Street economists more generally on the importance of the Fed's low interest rates can arise based on proximity to the action in financial markets.

6 comments:

  1. It depends how far you want to take it back, right ? I think in the "Trillion dollar meltdown" Morris begins his story with the financial liberalization and freeing of capital flows in the 1970s!! History is a flowing process, with as someone once said "one damn thing leading to another". Fed interest rate policy played a role, but we have to see it in a wider, longer historical context.
    Something similar is true of our understanding of the Depression. The Friedman & Schwartz view was tempered by the Gold Standard research of Eichengreen, Sachs and Temin. These historians see World War I as a key event for understanding the global depression -talk about long and variable lags!

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  2. FYI, Barry Ritholtz is not an economist.
    http://www.ritholtz.com/blog/barry-ritholtz-curriculum-vitae/

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  3. Anonymous, did you read your own link?

    "Previously, Mr. Ritholtz was Chief Market Strategist for Maxim Group a New York Investment bank, managing over $5 Billion in clients assets. Applying his model to the broader investing environment, Mr. Ritholtz wrote weekly Market Commentary for the firm’s brokers and institutional clientele.

    ...

    Hailed as a “bright and savvy fellow” by Alan Abelson’s Up and Down Wall Street column (Barron’s), he is one of handful of Strategists who participate in BusinessWeek’s annual market forecast. He has taught The Economy of America for New York University’s School of Continuing & Professional Studies.

    Mr. Ritholtz performed his graduate studies at Yeshiva University’s Benjamin N. Cardozo School of Law in New York, where he focused on Economics, Anti-Trust and Corporate Law. He was a member of the Law Review, and graduated Cum Laude with a 3.56 GPA."

    He may not have the PhD, but he has the experience.

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  4. So it's
    Wall St. economists 78
    Acedemic Economists 48
    Ben Bernanke 0

    Way to go, Man of the Year!

    Cheers!
    JzB

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  5. jdvn1,

    I doubt he has the technical expertise necessary to understand the models that the academics are using. Unless you can converse with the broader profession I don't think he qualifies.

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  6. Judging by the appallingly ill-informed and crude comments by Mr. Ritholz on the Boskin commission (see his blog 19 Jan) I am not sure I would be enlisting him as an aide to any economic argument.

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