PANEL 3: TRANSITION TO A NEW MONETARY REGIME

Moderator: Steve H. Hanke
Professor of Economics, Johns Hopkins University

DM: Steve Hanke was a professor of mine when I went to Hopkins.

Targeting NGDP — Cato Institute — 2003 — Nominal Gross Domestic purchases or final sales

Richard H. Timberlake
Emeritus Professor of Economics, University of Georgia

Why did we go off the gold standard?

Dual Mandate is the main problem at the Fed.

Fed very different animal than at its inception.

Legal tender laws — goes back to the Civil war, 2.5x inflation afterward.  Debts paid off with depreciated greenbacks.  Tested by Supreme Court — Salmon Chase, Lincoln’s Treasury Secretary in 1864, was the Chief Justice at the time in 1869, and he changed his mind, on the ability to pay off pre-1862 debts with the greenbacks.

Rankled Grant administration — appointed 2 new justices, and a new case reversed the ruling. 1871

1884 — Congress can issue any currency it likes because it has sovereignty.

1913 — System needed a lender of last resort, thus Fed creation.

1922-1929 — Stabilized the price level, amid a gold standard…

Benjamin Strong dies, and power shifts from the NY Fed to the Board.  New leader opposes speculation; banks needing liquidity could not get it if they had been lending to the stock market. 1929-1933 huge contractions and bank failures.

FDR abandons the gold standard; devalues; collects gold; eliminates gold clauses.

Supreme Court relies on legal tender laws saying that Congress could define money as it chose.  He thinks the precedents should have been re-argued.

Judy Shelton
Author, Money Meltdown

Ruble collapse — Why back to gold standard?

Thinks all candidates should be talking about monetary reforms.

Money should be a stable unit of account and should be liquid.  It should allow us measure value well.  Convey the price signals of the market accurately.

Jefferson wanted a hard currency defined in terms of precious metals.

Offer Treasury Trust Bonds with a an optional conversion feature to gold.  Would receive par back or an ounce of gold.  Priced initially with par of an ounce of gold, no interest paid.

Argues for a balanced budget amendment.

Thinks other nations would mimic the ideas if a US Government gold bond would be issued.

Greenspan proposed this idea 40 years ago.

Lawrence H. White
Professor of Economics, George Mason University

How to go back to the gold standard?

A lot is calculating the proper initial parity with gold.

Treasury owns enough gold to re-establish a gold standard at $1600/ounce.

“At least I assume it is there, Fort Knox hasn’t been audited in a while.”

1) Eliminate excess reserve by eliminating interest paid on reserves.

2) Redeem reserves at Fed with gold.

Back M1 100% with gold — $8000/oz, Inflationary, reduction in wealth, etc.  Warehouse notes w/storage fees.

Central bank?  No monetary policy needed.  People would buy and sell gold daily.

Single mandate has not worked well for the ECB.  Inflation there running at 4% or so.

Competing private banks worked better than with central banks.

Or, the Fed could become a currency board in the short run.

Q&A

Taxation of Tsy Trust Bonds?

Shelton: Would confuse some of the issues.  Just get this out there so it can be tried.

Will the gov’t take action?  Guesses as to when?

Shelton, White: No idea.

Would would trust the Treasury w/Treasury Trust bonds?

Shelton: They would be collateralized.

Why is monetary reform important?

Hanke: because the Fed ran a reckless monetary policy, and did not regulate leverage of banks well.

PANEL 2: FED POLICY AND THE ALLOCATION OF CREDIT

Moderator: Mark A. Calabria
Director of Financial Regulation Studies, Cato Institute

Malinvestment vs capital flowing to most productive sectors of the economy.

Jeffrey M. Lacker
President, Federal Reserve Bank of Richmond

Fed’s response led to misallocation of capital.

Monetary expansion was needed to prevent a collapse.

Initial Fed lending was sterilized — equivalent to issuing Treasuries, and lending the proceeds.

Fed could have just bought Treasuries, and not MBS or other securities.  To do otherwise distorts credit incentives.  It creates an appearance of unfairness.

Many contend as a result that credit allocation should not be an aspect of Fed policy. May compromise the independence of the Fed to do so.

Cornerstone of CB independence is control of liabilities.  Assets are more open to choice.  Thus it becomes a path of least resistance in a crisis.  Creates moral hazard, and probabilities of future economic distress.  Threatens CB independence.

Contain the willingness to intervene either by CB habit or law.  Would conflict with lender of last resort, which was more a product of a commodity money era.  Not elastic credit needed but elastic currency.

CB asset policy is an unfinished aspect of Central Banking.  This should be a top priority for action.

Allan H. Meltzer
University Professor of Economics, Carnegie-Mellon University,
and Distinguished Visiting Scholar, Hoover Institution.

Bailing out Bear Stearns was a mistake, and other non-commercial banks, including AIG.  Added to uncertainty of the situation, Fed then increased supply of credit, bought MBS and long-term Treasuries.  Fed acted too soon, if they had waited, they might have been able to do less.

Speculators front-run the Fed.

Fed doesn’t care about exchange rates except in a crisis — US Dollar down 15% recently.

Operation Twist not needed because they acted too soon, economy expanding rapidly now (?!)

Fed is too short-term oriented.

Believes that things will only normalize when housing values fall to their eventual equilibrium levels.

Chart on base velocity vs LT AAA Corp Bond yields.  Current conditions consistent w/ ’20s and ’60s.  Here’s my version, really only consistent with 1932-33 at present.

Greater centralization of the Fed and US Government control over the Fed.

Thinks higher future inflation is highly likely.

Fed has done well when it has followed the Taylor Rule.  Flip-flopping from one aspect of the dual mandate to another has not worked well.

Phillips Curve does not work, and the present Fed uses it for erroneous forecasts.

Fed kept monetary policy too low for too long and created the crisis.

Fed needs to be more accountable for its actions.

George Selgin
Professor of Economics, University of Georgia

Jokes that the Federal Reserve should be done away with, or that it should be significantly modified.

Describes how monetary policy works.  Little need for a discount window a common topic before.

Fed channels liquidity through soundest counterparties — primary dealers.  But if primary dealers are impaired, they become liquidity sponges.  Happened in 2008, so they worked to rescue primary dealers, excluding Lehman. [PDCF?]

Discount window didn’t help because of stigma, and thus the TAF was created.

1) End primary dealer system.  Not needed anymore with modern technology for auctions.

2) End Treasuries only.  Original Fed was not that way; avoid monetization of US debt. Let many parties bid for credit from the FOMC.

Eventual disbanding of FOMC, let a computer do it.

Roger Garrison
Professor of Economics, Auburn University

Natural rates of Interest and Economic Growth

The Fed attempts to expand growth beyond the natural rate of growth, and accelerates it beyond, setting up the conditions for a slump.

FOMC actions every eight weeks; learns once a decade when a crisis occurs.

Taylor Rule has no concept of the natural rate of interest.

Concludes that the Fed oversupplied credit, creating a boom and then the bust we are currently in.

Q&A

Opinions on Nominal GDP targeting?

Meltzer: easy to say, hard to do.  Follow Taylor Rule.  Lacker agrees.

Selgin thinks it is a much better idea.

Garrison: target a zero growth rate. Prices would fall.

PANEL 1: RETHINKING THE GLOBAL FIAT MONEY SYSTEM

Moderator: Mary Anastasia O’Grady
Member, Editorial Board, Wall Street Journal

Comments that the Fed buying MBS reminds her of the Latin American countries that she covers.

Benn Steil
Director of International Economics
Council on Foreign Relations

Central bankers as Churchillian war leaders, rather than dull technocrats.

Y = C + I + G  Economists treat C, I, and G as easy substitutes but they have different effects over time.

Krugman advocated creating a housing bubble, to replace the NASDAQ bubble.  (DM: They are trying to create new bubbles now via QE.)

Sweden and Australian central banks sold foreign assets to buy dollars and euros during their financial crises.

Central banking effective when governments can borrow near the policy rate of the central bank w/a tight correlation.  Implies that the ECB is no longer an effective CB for the fringe.

Central Bankers not particularly effective with fiscal policy.

Can Central Banks act without capital?  Will German taxpayers recapitalize the ECB? Doubtful.

On the Fed:

If the Fed got into trouble (negative net worth), the Treasury would back up, recapitalize it.

Suggests that the Fed should exchange MBS with the US Treasury for Treasuries.  Suggests that MBS will produce significant losses.

George Melloan
Former Deputy Editor, Wall Street Journal

Jokes about what a nickel could buy during the (big Baby Ruth bar) Depression and now (a jellybean).

Talks about post-WWII monetary policy in Britain, and how British Socialism led them astray.  War in Vietnam did much the same thing in the US, leading Nixon to end Bretton Woods.

Dollar’s primacy increasingly questioned.

Inflation coming as the Fed creates credit to fund the US government.

Doubts that multilateral currencies like the SDRs of the IMF would work. The Euro proves that.

The US needs monetary reform, but we might need to fail before that comes.  Gold, bitcoins, scrips, barter if things break down.  Fiat currencies are liquid, barter is inefficient.

If the US dollar goes, a lot else will go down as well. (DM: think about Chinese banks.)

Gerald P. O’Driscoll Jr.
Senior Fellow, Cato Institute

Gold standards can be done if the currencies reflect the fair values of the currencies.  I.e. France made its currency too cheap post-WWI, and Britain too expensive.

Gold standards are not always associated with deflationary periods with low growth.

No monetary system survives big wars.

Nixon went off the gold standard when the CPI was at a high 4.2%.  Monetary policy run by the seat of the pants then.

Argues that classical liberalism requires a gold standard.

Q&A

Fiat currencies even larger proportionately in Africa.  Give seniorage as foreign aid to Africa?

O’Driscoll: dollarization is faux gold.  Gold would be better.  Seniorage can’t be given away.  We need it.

Steil: Helps the African countries get along fine.  Dollarization of Panama has not hurt them; they know the US won’t send help.

O’Grady: Argentines tried to find a way to use US Dollars, but wanted seniorage, thus but devalued instead.

Question to Steil on Operation Twist, duration risk to Fed?

Steil: Operation Twist worked for several nations.  40 bp move would wipe out Fed capital.  ECB purchases of PIIGS debt an alternative to Eurobonds, bailouts, etc.

Isn’t fractional reserve lending the problem?

O’Driscoll: leverage would come from other sources.  MMMFs?

Melloan: Politicization of monetary policy is the problem.

DM: misses the concept that asset-liability mismatches with leverage produces failures.

O’Grady: Wouldn’t a single mandate solve things?

All of the panel expressed doubts on this point.  The Fed needs it to hide, but they would find other ways to do it.

This is the first book that I have reviewed twice.  I reviewed the third edition of the book previously, but I am reviewing the sixth edition now.

Kindleberger places the manias, panics, and crashes on a common grid, to see their similarities,  In it he draws on a number of common factors:

• Loose monetary policy
• People chase the performance of the speculative asset
• Speculators make fixed commitments buying the speculative asset
• The speculative asset’s price gets bid up to the point where it costs money to hold the positions
• A shock hits the system, a default occurs, or monetary policy starts contracting
• The system unwinds, and the price of the speculative asset falls leading to
• Insolvencies with those that borrowed to finance the assets
• A lender of last resort appears to end the cycle

The advantage over the third edition is that you get to hear about the Asian crisis LTCM, the tech bubble, Madoff, and the present crisis (banking & housing, soon to be sovereigns).

The main point for readers is to beware when monetary policy is easy, banking regulation is lax, and many seem to favor buying the asset du jour, often with leverage.  What is self-reinforcing on the way up will be self-reinforcing on the way down, but with greater speed and ferocity, as bad debts have to be liquidated.

Quibbles

Hindsight is 20-20.  If the US Government had rescued Lehman, something else might have proven to be “too big to rescue,” that the government might allow to fail, but miss the connectedness of the institution.  I do think the US Government should have been a DIP lender to troubled firms, but not a buyer of equity.

Who would benefit from this book: Most investors would benefit from this book.  It will make you more skeptical of assets that seems to be doing unnaturally well; it will also make you more skeptical about catching falling knives in the market.  If you want to, you can buy it here: Manias, Panics and Crashes: A History of Financial Crises.

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Bubbles are easy to spot.  Wait, don’t most people say that bubbles are impossible to spot?

I’ll say that again: bubbles are easy to spot.  Why?  People have the wrong theory on bubbles.  They listen to those that don’t understand the efficient markets hypothesis, and think, “Prices are always fair predictors of the future.  I don’t have to think about the future as a result.” (It would be better to say that current prices are the short-term neutral line against which bets are placed.)

Don’t listen to academics on bubbles.  There have been booms and busts as far back as we can see.  If markets tend toward equilibrium, that is very well hidden — please require economists to take courses in history.  I mean this; I am not joking.  Neoclassical economics is not  a science; it is a religion, and with much less historical evidence to support it than Christianity has to support the historicity of the resurrection.

Why do I write on this? Partly because of Jason Zweig’s piece in the WSJ.  I ordinarily like what Jason writes; this is a rare exception.

Spotting bubbles gets easier when you don’t simply look at rising prices.  It is better to look at what is driving the rising prices.  How are players financing the purchase of assets is more important to view than even price trends.

It is hard to get a bubble without having an increase in debt-finance.  Financing with debt is cheaper, and riskier than financing with equity.  Financing long-term assets with short-term debt is even cheaper and riskier than financing with debt that matches the term of the asset.  Most bubbles end with some sort of financing time-mismatch, where the inability to renew short-term indebtedness in order to hold the asset leads to a panic, which leads some to say, “This is a liquidity crisis, not a solvency crisis.”  When you hear that leaden phrase, ordinarily, it is a solvency crisis, with long-dated assets of uncertain worth, and near-term liabilities requiring cash.

This is why the simplest way of looking for bubbles is to look for where debt is increasing most rapidily, and where the terms and conditions of lending have deteriorated.

But where do we have these issues today?  Let me offer a few areas:

• We have a chain of financing arrangements in the Eurozone where many banks might have a hard time surviving the failure of Greece, Italy, Portugal, and perhaps some other nations as well.  Failure of those banks might lead to bailouts by national governments and/or a significant recession.  Anytime financial firms as a group would have a hard time with the failure of a company, industry, government, etc., that is a sign of a lending bubble.
• There is a major imbalance in the world.  China trades goods to the US in exchange for promises to pay later.  Creditor-debtor relationships are meant to be temporary, not permanent as far as governments are concerned.  There may never be a panic here, but so long as the US retains control of its own currency, it is safe to say that they will never get paid back in equivalent purchasing power terms as when they exported the goods.
• China itself, though opaque, has a great deal of lending going on internally through its banks, pseudo-banks, and municipalities, a decent amount of which seems to be for dubious purpose at the behest of party members.  The government of China has always been able in the past to socialize those credit losses.  The question is whether covering those losses could be so large that the government follows an inflationary policy to eliminate the debts amid public discomfort.
• AAA and near-AAA government debt has been the most rapidly growing class of debt of late.  Maybe AAA governments that are unwilling to cut spending or raise taxes are a bubble all their own.  Remember, when you are AAA, the rating agencies let you make tons of financial promises — think of MBIA, Ambac, FGIC, AIG, etc.  Only when its is dreadfully obvious do the rating agencies cut a AAA rating, but once they do, it is often followed by many more cuts as the leverage collapses.

Now, my view here is both qualitative and quantitative.  To find bubbles there are indicators to watch, such as:

• Low credit spreads and equity volatility
• Low TED spreads
• High explicit/implicit leverage at the banks
• High levels of short term lending/borrowing (asset/liability term mismatches)
• Credit complexity and interconnectedness
• Poor Credit Underwriting
• Carry trades are common (many seek free money through seemingly riskless abritrages)
• Accommodative monetary/credit policy

All manner of things showing that caution has been thrown to the winds and lending is done on an expedited/casual basis is a sign that a bubble may be present.  Kick the tires, look around, analyze the psychology to see if you can find a self-reinforcing cycle of debt  that is forcing the prices of a group of assets above where they would normally be priced without such favorable terms.

Not that this analysis is perfect, but it follows the broad outlines of Kindleberger and Chancellor.  Speculative manias are normal to capitalism; don’t be surprised that they show up.  Rather, be of sane mind, and learn to avoid participating in manias, long before they become panics or crashes.

This book grew on me. Think of it as “How I hit a home run in investing.”  Who are the sluggers that earned outsized returns?

But, there is a problem here, and the book would have been better if it had recognized the problem.  In a few cases, the “greatest” made one (or a few) good decisions.  In more cases, they made many good decisions that compounded over time.

Was the first group lucky? Maybe, but when things work out for the reasons that you specify in advance, I think not.  The problem of the first group is repeatability, which for John Paulson, is proving to be an issue for his asset management shop at present.

The investment markets are cruel.  No matter what you have done in the past, the question comes, “What have you done for me lately?” The pressure is high, so no wonder that one of the investors that the book mentioned has gone into hiding.

There are two more dimensions here.  Imagine an investor that made some amazing gains , but then craters.  There are some brilliant investors for which that has been true: Livermore, Niederhoffer, Keynes, and more… how much credit should we give to the gains, if the price is flameouts?

Second, imagine someone who is the best in class at a low-return area of the asset markets, like Jim Chanos in short-selling, or Bill Gross at Pimco.  They may not earn that much, but the skill level is really high.  But is the skill level so high when they chose areas of the market to work in that are low -return?

Maybe the book should have featured private equity players, or real estate investors, or those that have managed university endowments well… there are other investors that would be comparable or better to the returns of some in this book.

Or ask, where is Buffett?  He would deserve a spot here, not for any one trade, but for the multitude of clever trades and mergers he has done over the years.

Quibbles

The book needed a better editor.  Information on Templeton is repeated.  Beyond that, most of the ideas on how an average investor could try to replicate the strategies of the great investors are akin to drinking near-beer.  They are too weak, but on the other hand, without the brilliance of the investors, an average person would not know when to but and sell.

With those caveats, I recommend the book highly.  It is well-written, and it will fill out knowledge gaps in amateur investors.

Who would benefit from this book: Most investors would benefit from this book.  If you want to, you can buy it here: The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today (Wiley Trading).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Comments

• This release of the FOMC statement was really kind of a nothing-burger, aside from the hawks going with the majority, and Evans arguing for looser policy.
• The main shift in the FOMC’s economic reasoning is that GDP growth is improving.  One quarter on the GDP data should not get us that definite.
• In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
• The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
• The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

• Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
• Why will reinvestment in Agency MBS help the economy significantly?  Doesn’t that only help solvent borrowers on the low end of housing, who don’t really need the help?
• Couldn’t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
• Isn’t stagflation a possibility here?  I mean, no one expected it in the ‘70s either.
• Could we end up with another debt bubble from keeping short rates so low?
• If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
• Is it possible that you don’t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?

When I was a kid, I liked to set up large arrays of dominoes so that I could watch them fall.  Early on, I realized the errors in setup were frequent enough that I left gaps such that if I accidentally knocked down a domino, it wouldn’t destroy all of the work.  I usually put in a number of gaps close to the square root of the dominoes.  Once complete, I would fill in the gaps, and after that would come the show.

When the dominoes are set up, there is an unstable equilibrium.  Any jolt to the system will topple most or all of them.  Now, some would say the jolt causes the toppling of the dominoes, but the dominoes were arranged in order to make them all fall at once.  Whether the designer topples the first domino, or a marble from a kid brother rolls into the room, or there is a small earthquake, the array of dominoes was designed to fall.

So it was for the financial crisis.  These thoughts are my own, though others have uttered them as well.   In order for there to be a panic that destroys a large portion of the financial system, there has to be:

• High levels of leverage.
• Leverage that is layered, where many parties are lending, and carry trades are common.  Parties borrow to lend more aggressively.
• Collateralized lending — financial entities lend far more when lending is collateralized.  Most of the time, the existence of collateral prevents defaults.  But when things get really bad there is no protection with most collateral.
• Problems with highly rated debt.  When debts are highly rated, in order to get high returns out of them, there must be a high degree of leverage applied.
• There must also be general confidence that it is highly unlikely that there would be significant losses associated with the asset class.
• Regulators must be similarly blind, and assume that risks are low in that set of assets.

So when the crisis struck it started in real estate lending, moving from Subprime, to Alt-A, to Prime, each one in turn more leveraged, and less likely to be prone to a crisis.  That’s why the crisis was so large.

The system had been optimized across many asset subclasses where many borrowers were trying to achieve equity-like returns through borrowing.  Thus when the overlevered previously safe asset classes began to fail, the failure was large, and had second-order effects that extended to lenders.

No one should say the current financial crisis was an accident; yes, no one aimed for it, but no, it was preventable.  It occurred from human activity that was left unchecked, building up leverage in safe asset classes, and pushing up the trading value of those assets to unsustainable levels.  Regulators had the power to bring it all to a halt, but they were complicit with the bankers.

That’s what you need to have a real crisis, and that ‘s why we still suffer from it.  The crisis will continue until enough of the safe debts have been rationalized, and the total level of debt gets paid down enough for the average borrower to borrow once again on a basis that has significant provision against adverse deviations.  Maybe we’ll get there in another 2-3 years.

Comments

• Announces an operation to twist the yield curve, sending the long bond up almost 3% in price.  Also announces the reinvestment of proceeds from Agency Bonds and MBS into more Agency MBS.
• In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government.
• Still engages in wishful thinking regarding inflation, thinking that it is declining.  Points at energy and commodities, but that’s not the largest part of what drives inflation.
• The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
• Difficult to tell how much the hawks disagreed with the new “easing tools.”
• The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

• Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
• Why will reinvestment in Agency MBS help the economy significantly?  Doesn’t that only help solvent borrowers on the low end of housing, who don’t really need the help?
• Couldn’t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
• Isn’t stagflation a possibility here?  I mean, no one expected it in the ‘70s either.
• Could we end up with another debt bubble from keeping short rates so low?
• If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
• Is it possible that you don’t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?
• How big is the effect on employment from higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan?

I’m not an expert on game theory, but the rule of thumb I have run across is to win in games with more than two parties, you must assemble a coalition that has more than 51% of the aggregate power within the game.

Practical rule number two is that the one on the winning side that arranges/controls the communications/relationships tends to walk off with a larger proportion of the stakes won in the game.

I learned this early as a young actuary working on my pricing models, and noted that those that really made out well in insurance were the successful agents.  They brought two parties, insured and insurer together, who most of the time would not have found each other.  Then, they did policyholder service for the company and the customer controlling the flow of information in the process.  There were times when I thought it would be useful for the company to talk more directly to the insured, but marketing sometimes objected, and so we didn’t.  The agents owned all the loyalty in the transactions.

As an older actuary, I saw this writ large when I was running an annuity division.  Using regression, I did what I think was one of the industry’s most advanced studies of deferred annuity withdrawal.  The Society of Actuaries produced a similar (but broader) study roughly one year behind me.  One of the main results of the study was that withdrawal rates spike when the surrender charge ends.  The reason is because most agents try to roll the business to a new product so that they can earn another commission.  (Trivia note: I learned that those policyholders that did not roll along with the agent were very sticky business.)

Multiparty transactions exist because there is something complex going on, and the multiple parties each serve a need, providing a service, or eliminating a risk.  Let’s move to the concept of buying a house.  Here is my informal list of all of the parties:

1. Buyer
2. Seller
3. Realtor for the Seller — helps convince the buyer to buy.
4. Realtor for the Buyer, or, sub-agent for the seller — helps the buyer find a good property to buy.
5. Title insurer — assures that there are no mistakes in the transfer of title.
6. Mortgage insurer — insures mortgage lender against default when there is little equity for the buyer.
7. Property & Casualty insurer — protects the lender and buyer against losses from property damage, or injury to people on the property.
8. Mortgage lender (first lien) — provides most of the money for the purchase
9. Mortgage lender (second lien and beyond) — provides some money for the purchase, but in foreclosure gets paid after the first lien lender.
10. Appraiser — gives an estimate of the value of the property so that the first lien lender does not lend too much.
11. Home Inspector — finds defects in the property so that the buyer can adjust his price down.
12. Taxation authorities — collect taxes, so that services that make the community livable are provided.
13. Community Association — enforces neighborhood standards, so that property values are enhanced.
14. There are more, but I can’t think of them…

Note: I did the “smiley-face” version of the roles parties play in the process.  I could have done the cynical version, but didn’t.  Also note that not all of the parties are needed on a given transaction.  The complexity erupts because the buyer needs to borrow to complete the transaction, and the lender wants protection.

Now, going back to my earlier thoughts, in this case, the first-lien mortgage lender has things set up to his advantage.  Many of the parties to the sale of a house exist to protect his interests.  It is the dominant party in this sort of transaction.  This leads to two current problems:

• Mortgage reinsurance captives owned by banks originating the loans.
• P&C Insurance that is forcibly placed by the lender when the buyer does not make P&C insurance payments.

On the first point there was an article today that I found surprising because it is so late to the game.  Don’t get me wrong, it is a good article, but for an insurance analyst that spent time analyzing the mortgage insurers, it is old news.  As I wrote back in 2003 (and published in 2010):

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

It got worse from there, with more mortgage insurers giving in, and lenders demanding a larger proportion of the profits.  Nominally they were reinsurance premiums, but for the most part they were closer to being commissions.  Why did the mortgage insurers go along with this?  Because the first-lien lenders were the dominant party in the transactions, controlling most of the other parties.  As a result, borrowers putting small amounts of money down ended up paying more for their mortgage insurance because of the pseudo-commission paid to the mortgage lender because of the captive reinsurer.  As I have sometimes said, “Reinsurance is the ultimate derivative; it can obscure almost any transaction.”

On force-placed insurance I have written as well, and it sounds a lot like this post.  The similarity is that the insurance is primarily designed to protect the mortgage lender, and the mortgage lender again collects a commission in the process because it is at the hub of communications.  The mortgage agreements give them discretionary power.

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My simple rule to average people when involved in complex transactions is this: be cynical.  No one is interested in your well-being, and most of the transactional terms are skewed against you.  To the extent that you can borrow less, and eliminate some of the parties that would be a part of the transaction, it is to your good that you do so.  The best situation is that you buy for cash, if you have it.

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Now, this same sort of analysis can be applied to securitizations, and other multiparty transactions.  Watch for who has control; it is a valuable option to have.  But that is an essay for another day.