Groucho Marx: Now pay particular attention to this first clause, because it's most important. There's the party of the first part shall be known in this contract as the party of the first part. How do you like that, that's pretty neat eh?

Chico Marx: No, that's no good.

Groucho Marx: What's the matter with it?

 

Chico Marx: I don't know, let's hear it again.

Groucho Marx: So the party of the first part shall be known in this contract as the party of the first part.

Chico Marx: Well it sounds a little better this time.

Groucho Marx: Well, it grows on you. Would you like to hear it once more?

Chico Marx: Just the first part.

Groucho Marx: What do you mean, the party of the first part?

Chico Marx: No, the first part of the party, of the first part.

Groucho Marx: All right. It says the first part of the party of the first part shall be known in this contract as the first part of the party of the first part, shall be known in this contract - look, why should we quarrel about a thing like this, we'll take it right out, eh?

Chico Marx: Yes, it's too long anyhow. Now what have we got left?

Groucho Marx: Well I've got about a foot and a half.

"Night at the Opera"
Sam Wood (1935)

This week in The Institutional Risk Analyst, we feature a comment by our friend and former colleague at the FRBNY, Richard Alford, "Fiscal Policy and Fiscal Illusion." Dick provides a very revealing look into the brave new world of macro economics and how the members of the priesthood of imprecision see the "multiplier" associated with fiscal spending. When you realize just how poor is the methodology behind these economic debates, both in terms of the mathematical assumptions and the understanding of human action, the fact that these distinctions underpin fiscal policy is truly frightening.

But first we had to share some of the comments and insights we received since last week's little tutorial on the fraud called private mortgage insurance ('Triple Down: Fannie, Freddie, and the Triumph of the Corporate State', October 27, 2010). That's why we began this week's outburst with the scene from the Marx Brother's classic, Night at the Opera, to reflect our view on the quality of the contracts and diligence on completing same in the world of mortgage backed securities and structured finance more generally. One of the more striking responses was this note from Dave in Santa Maria, CA:

"Thank you for ring the alarm bell! As an appraiser of agricultural and rural property, let me tell you the banks are NOT doing any deals. Full-on collection mode. The really distressed banks are pushing forward on foreclosure and relief from stay in bankruptcy, even when they are adequately collateralized. One cynical view is the end-game appears to be acquisition of the loan collateral as an REO and that is followed by spinning the REO-asset to a favored group of insiders."

To the point about foreclosures, those generous souls at Bank of America (BAC/Q2 Bank Stress Rating: "C") just extended the warm blanket of "Too Big To Fail" (TBTF) to one of the largest mortgage insurers. News reports say that BAC indemnified Fidelity National Financial Inc. (FNF) against any losses that Fidelity might sustain in litigation over title insurance it writes on foreclosed homes - the same homes, coincidentally, that BAC wants to sell to new buyers. We asked Anthony Sanders at George Mason University for his take:

"This arrangement amounts to U.S. taxpayers, who are the ultimate backers of the Federal Deposit Insurance Corp. (FDIC), backstopping a giant, publicly held title-insurance company, which is backstopping a huge commercial bank, so that the bank can sell properties that it might not have proper title to."

Sanders also fondly recalled the days when zombie dance queens like Fannie Mae and Freddie Mac counted tax credits as capital.

In response to a discussion on the international mortgage thread, one veteran banker and trader said this when asked what in the world is going to happen to mortgage servicing rights (MSRs) given (1) the lower threshold for counting these ersatz assets as capital under the latest Basle bank capital framework and (2) the rising cost of mortgage servicing:

"Basle III limits total B/S value of MSRs to 10% of Tier I capital, which means they will be valued at very low levels. Non-Basle III institutions can hold more. This is NOT about leverage. MSRs are IOs, which have huge negative duration for their B/S impact. The best way to think of them is a permanently levered short on the 10yr. Since MSRs are also deferred tax assets, taxpaying institutions can hold them. They could end up being held by pawn-shop type companies."

Some of you may recall that we wrote earlier about our encounter with H. Rodgin Cohen of Sullivan and Cromwell, when this august American lawyer tried to convince us that core deposit intangibles were assets that ought be counted as capital. The willingness of regulators and accountants to accept the idiocy of valuing as assets things like MSRs and core deposits is part of a wider and natural tendency to over-leverage the enterprise. In simpler times, such intangible assets simply supported the enterprise invisibly, adding value to the concern without supporting leverage. Today we instead recognize what are essentially options on future cash flow to as to support ever greater leverage, making the financials of the enterprise overstate the actual solidity of the balance sheet.

We asked the same colleague about BAC indemnifying FNF and more generally about the issue of poor mortgage lien documentation and how this ultimately would affect the large banks.

"I would not make such a big deal about this. BAC probably has a pretty good idea about the liens on their REO as they were the servicer on the first, owned the second and were escrow agent and paid the taxes and insurance. Much better to indemnify the title company and continue sales than sit on a pile of REO. Bigger issue is that BAC has negotiated a much lower guarantee from FNMA, which stifles competition from the smaller banks. FNMA will accept the lower fee because (1) they still need the market share that BAC can offer (2) know that BAC will be around to accept loan putback because they are TBTF, and (3) they like working with the big banks, who have a tacit agreement to not complain about their Loan Level Pricing (LLPAs) in return for the GSEs not complaining about cartel pricing. The Treasury should be charging an extra tax on the TBTFs to recover this subsidy, then use the proceeds to subsidize the smaller banks securitization efforts. Where is the Justice Department's antitrust division?"

Where indeed. While the behavior of the TBTF banks with respect to the mortgage market may seem outrageous, and it is, there is a certain consistency in the behavior of the cartel. As much of the attention of the media is distracted by the mortgage fiasco, across town the TBTF banks are trying to convince the Commodity Futures Trading Commission that finance and commerce are the same thing for the purpose of regulating over-the-counter derivatives. The definition of "commercial risk" is relevant to both the determination of whether an entity is a "major swap participant" and whether a swap is exempt from the clearing requirement under the Dodd-Frank Act.

The Dodd-Frank Act defines a "major swap participant" to include any entity, other than a swaps dealer, that "maintains a substantial position in swaps for any of the major swap categories as determined by the Commission, excluding positions held for hedging or mitigating commercial risk." The definition also includes entities that engage in significant swaps trading and are systemically dangerous or highly leveraged financial entities. Institutions categorized as major swap participants under the Dodd-Frank Act are subject to registration, record-keeping requirements, business conduct and prudential requirements.

Financial industry lobbyists have argued that the Commission should adopt a broad definition of "commercial risk" to ensure that financial institutions using swaps to hedge financial risks are not subject regulated as major swap participants. It would be a terrible mistake for the CFTC to go down this road. Not only would accepting the industry's arguments provide the means whereby financial entities such as hedge funds and insurance companies could escape regulation as major swap participants, but it would also result in a broader exemption from centralized clearing.

The position taken by the financial industry stands the world on its head and is, in fact, contrary to established American legal and common law traditions separating financial and commercial activities. Neither Alexander Hamilton nor Chief Justice John Marshall invoked the commerce clause of the Constitution as giving the federal government the power to charter national banks or central banks or to regulate the interstate activities of banks. They clearly assumed these powers in Opinion on the Constitutionality of the National Bank (1791) and McCulloch v. Maryland (1819). But they relied on the doctrine of "implied powers" and the "general welfare" and "necessary and proper" clauses, not the commerce clause.

There is no legal basis for equating commerce and finance, as the lobbyists for the financial industry argue. The fact that Congress has largely repealed much of the later Glass-Steagall laws which divided commercial banking from investment banking does not alter the traditional division between finance and commerce in American economic and legal practice. The Commission should recognize these arguments for what they are, namely a cynical attempt to alter the historical division between finance and commerce that Congress and the Supreme Court long ago decided with finality and which Dodd-Frank does not alter.

But of course this is Washington, a city where people are paid to lie for a living. And now for something completely different.

Fiscal Policy and Fiscal Illusion

Richard Alford

With interest rates near zero and the ability of the Fed to furnish further economic stimulus in question, fiscal policy is returning to center stage. However, in the paper "Monetary Science, Fiscal Alchemy" by Eric Leeper, delivered at the recent Jackson Hole Symposium, the author argues that monetary theory and policymaking have become more scientific, while fiscal policy has not. Leeper equates fiscal policy with alchemy. He asserts: "Fiscal policy will shed its alchemy label when the question 'What is the fiscal multiplier?' is no longer asked."

The observation that fiscal policy debates are still concerned with answering the question "What is the fiscal multiplier?" is a telling one. Until recently, the two most prevalent approaches to the fiscal multiplier were: the Barro-Ricardo equivalence approach and, for the want of a more precise descriptive, the Keynesian approach. The Barro-Ricardo equivalence camp argues that the fiscal multiplier has a value of zero. The Keynesian camp(s) argue that the value of the fiscal multiplier is stable and can be estimated from past data, although estimates of its size vary. In short, both perspectives employ and make policy prescriptions based on a fixed or at least stable value for the fiscal multiplier.

However, the ground is shifting under both the Barro-Ricardo and Keynesian camps. There is a consensus emerging that fiscal stimulus can be stimulative at times--an implicit rejection of the Barro-Ricardo position. At the same time, the consensus position also argues that the ability of fiscal policy (and hence the value of the multiplier) to stimulate economic activity in the present depends in part upon a credible commitment to fiscal austerity in the future. This is an implicit rejection of the idea that the fiscal multiplier is invariant.

The consensus has been driven by real world developments and is not the result of model building or theorizing. Economists and policymakers have been forced to view fiscal policy in a broader context. The recent widening of sovereign interest rate differentials and the fact that the markets for some developed world sovereign debt have required supra-national support has raised the prospect that there are limits to fiscal policy that have been under-appreciated. Spikes in long-term rates paid by some sovereign issuers affirm that fiscal deficits cam contribute to higher long-term interest rates even during periods of unemployment. Increases in the expected size of the future debt and tax burden may also lower the fiscal multiplier as economic agents change behavior in order to maintain or achieve desired future asset levels.

The recognition of these developments implies acknowledgment of policy trade-offs: the use of stimulative fiscal policy in one period may come at the expense of a reduction of the ability to use or the none of the effectiveness of fiscal policy in the future. Policymakers are also confronted with the possibility that fiscal policy will be limited by a political constraint on the size of the outstanding debt. However, the consensus. the Barro-Ricardo nor the Keynesian formulations cannot explain why there would be a trade-off between the current and future value of the fiscal multiplier. Nor can they explain why political opposition to fiscal deficits should spike at this time as it apparently has.

There is one perspective on fiscal policy which may shed some light on the fiscal multiplier and the current issues surrounding it. It arose in the field of public choice. It provides a possible explanation of why the Barro-Ricardo hypothesis is deficient and at the same time provides a framework that can explain why the fiscal multiplier can be a function of the size of the fiscal debt and why it occasionally adjusts abruptly.

It is called the fiscal illusion hypothesis and dates back to the late 1890s. In the US, it has been associated with William Niskanen of CATO Institute, who served in the Reagan administration, but who is best known for having argued that the Bush tax cutting policy known as "starve the beast" was destined to produce wider fiscal deficits, not smaller ones.

The hypothesis argues that the economic agents systematically mis-estimate the costs and benefits of government programs. Given the high costs and low benefits accruing to an individual, economic agents have little or even no incentive for becoming fully informed about their present and future burden of government taxes or benefits accruing from expenditures. Given the complexity of the tax code, the inability to calculate and compensate for future tax burdens and the perceived ability to shift the burden of taxation to others or future generations, the degree of underestimation of tax liabilities is presumed to be higher than that of expenditures benefits. Consequently, this approach differs dramatically from the Barro-Ricardo approach which argues that the multiplier will be zero because the public will view increased expenditure as being exactly offset by increased current and future tax liabilities. It also differs from the Keynesian approach, which says that the fiscal multiplier may vary.

Fiscal illusion also allows for sharp adjustments in the expected tax burden, the net benefits arising from government expenditures, and hence the size of the fiscal multiplier. Given the cost, economic agents only revise their expectations of the costs and benefits of government expenditures and taxes when presented with overwhelming evidence that past expectations are decidedly incorrect. Hence, it is consistent with the discontinuous response of taxpayers and various governments across the developed world to the financial crisis. Given the increased domestic demands on governments stemming from the recent economic downturn, as well as the costs associated with debt crises, economic agents had reasons to significantly ratchet upward their infrequently adjusted expectations regarding the future size, cost, and riskiness of sovereign debt. As a result, political opposition to debt issuance increased, as did calls for future fiscal austerity. Furthermore, some economic agents will presumably alter their behavior in ways which would make the current value of the multiplier lower than estimates based on past behavior.

Is there proof that fiscal illusion exists or is presently at work? No. Is it a complete theory of the fiscal decision making? No. On the other hand, it is consistent with a non-zero fiscal multiplier, a fiscal multiplier that can vary with the size of outstanding debt, and discontinuous changes in taxpayer behavior towards additional debt issuance. If fiscal illusion or something akin to it is operative, there are implications for fiscal policy. It would imply that the US economy is less responsive to fiscal stimulus, dollar for dollar, than in the past. This would be particularly troubling given the state of the economy and the fact that monetary policy is close to the zero bound. This in turn implies that fiscal stimulus efforts should be finely crafted. The design of any fiscal stimulus effort should turn on more than just size (where bigger is always better) and sound-bite justifications. "Shovel ready" is not an adequate criteria by which to allocate scarce resources and draw down on the increasingly limited ability to stimulate the economy via deficit-financed expenditures.

Given the current focus on projected Federal debt levels, the balance sheet dimension of the recession, fiscal stimulus would be best concentrated in capital projects that will generate identifiable and quantifiable income streams that could be capitalized and would therefore reduce the expectation of increased future tax liabilities (e.g. build and lease a robust and redundant national power grid?). This would serve to limit any erosion of the fiscal multiplier due to increased future tax liabilities. The approach also suggests that at this time policy actions that encourage debt-fueled consumption, e.g. cash for clunkers, more quickly erode the ability of fiscal stimulus to affect the economy.

A fiscal illusion-type approach also speaks to the effectiveness of "pay-go" budget rules. The approach suggests that while conventional "pay go" budget rules may constrain the fiscal budget deficits, the approach also suggests that "pay-go" will not succeed in shrinking government. To reduce the size of government, fiscal illusion approach suggests that the opposite of "starve the beast" is required. To reduce the size of government a "pay go" type rule would have to mandate that any given increase in expenditures be offset by either a larger decline in expenditures elsewhere in the budget or a larger increase in taxes or some combination of tax increases and expenditure cuts larger than the expenditure increase. This will be a difficult hurdle to clear, but the essence of the fiscal illusion approach is that the current consumption of deficit-financed government-supplied goods "appears" to be a bargain and therefore society demands more of them. Given the pressures on real incomes already, it will be politically difficult to limit, let alone reduce, the supply of these "bargains".

Needless to say, the fiscal illusion approach will find few friends. Proponents of fiscal stimulus will find fault with the argument that the value of the multiplier is lower than in the past and that current stimulus comes at a price: less room to use fiscal policy in the future. Proponents of shrinking the budget deficit and the government sector will bridle at the implied difficulty of achieving their stated goals. However, if nothing else the fiscal illusion approach highlights the economic, financial, political and policy quagmire where the US now finds itself.

Questions? Comments? info@institutionalriskanalytics.com

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