An impish grin spreads across [Goldman CEO Lloyd] Blankfein’s face. Call him a fat cat who mocks the public. Call him wicked. Call him what you will. He is, he says, just a banker “doing God’s work” — The Sunday Times, November 8, 2009

Goldman Sachs is in the headlines again, this time for a transaction that helped the Greek government report artifically low debt. When you ponder this case, it is hard not to think about Enron.

In 2003, Citigroup and JP Morgan Chase paid a combined $236 million fine to the SEC for allegedly having helped Enron mislead investors. Enron had undertaken a series of complicated swap transactions. When the smoke cleared, these transactions were loans,but Enron reported the results as income instead of debt. The SEC complaint against Chase contains tidbits such as this e-mail excerpt from a Chase executive: “WE ARE MAKING DISGUISED LOANS … WITH AFEW [sic] EXCEPTIONS, THEY ARE UNDERSTOOD TO BE DISGUISED LOANS AND APPROVED AS SUCH.”

This is appalling, but in the end, neither Citi nor Chase admitted the SEC’s allegations. Both paid large fines and agreed in writing not to violate the antifraud provisions of the securities laws. Apart from the allegation that the banks helped Enron to mislead investors it’s not clear to me that either bank broke any additional laws. (Misleading investors is illegal but probably the banks would have fought hard in court had it come to that.) From the perspective of the banks, the SEC fine has to be like being sent to the principal’s office: They suffered humiliation, but not much harm. (Not being a lawyer, I am baffled that the SEC made the banks promise not to break securities laws. Can’t we take that for granted?)

Goldman appears to have done something similar in its deals with Greece. Details are scarce so I am making educated guesses. The best account I have seen is by Nicholas Dunbar writing in Risk Magazine in 2003. Prior to adopting the Euro as its currency in 2001, Greece had issued bonds denominated in yen and dollars. Greece and Goldman entered into swaps that converted these payments into Euros. This is a completely standard and common use of swaps.

However, the swaps were reportedly undertaken at “off-market” terms. Translation: Greece entered into swaps at disadvantageous future prices and made up the difference by immediately receiving money from Goldman. This was a loan from Goldman to Greece, but under European government accounting rules Greece was not required to report that it had borrowed money because the loan was embedded in a derivatives transaction.

For all the headlines about this story, it isn’t clear that the transactions had much effect. The Risk story stated: “There is no doubt that Goldman Sachs’ deal with Greece was a completely
legitimate transaction under Eurostat rules.” The reductions in Greek debt seem not to have been large. Goldman Sachs earned big fees, of course. In the end, it appears that Goldman did the same thing as Citi and Chase — helping an entity to disguise debt — but they (so far) haven’t received a timeout or been sent to the principal’s office.

Presume that Goldman violated no regulations. Nevertheless, isn’t it obvious that we don’t want banks to make profits by helping companies and countries to lie to investors and taxpayers? But the banks are unable to stop themselves. They are not charged with acting ethically, they are charged with making profits. If we expect them to voluntarily walk away from huge commissions we will be disappointed. (One report said that the Greek deal earned Goldman $300 million.) If we try to write highly specific regulations to stop them, we will be disappointed (“You said I couldn’t dip Little Suzy’s pigtails in the inkwell, but you didn’t say anything about the gluepot!”). We’re not going to outlaw swaps and other derivatives, because legitimate risk management has value.

Big banks will behave better when their customers are made to behave better. In the case of Greece, this means that accounting rules should have required Greece to report debt as debt, whether incorporated in a swap or not. Any why shouldn’t a government, of all entities, simply disclose these deals completely? If disclosure and better accounting had been in place, there would be no headlines today. Derivatives are at the center of many brouhahas because accounting for derivatives is complicated and sometimes inconsistent.

For better or worse, banking is amoral. Last November Blankfein said that Goldman was doing “God’s work”. He never said which deity he had in mind. Maybe Zeus?

Where do we go from here?

“You never want a serious crisis to go to waste.  And what I mean by that is an opportunity to do things you think you could not do before.”  Rahm Emanuel, Feb. 2009

I would like to touch briefly on two issues in answer to the question posed for this session:  first, the integration of housing finance into the financial and regulatory mainstream; and second, the need to modernize budgetary and regulatory accounting.   I chose these topics for several reasons: they are important; they get less attention than is deserved; and I have thought quite a bit about them from both an academic and policy perspective.

For those of us who have long worried about Fannie and Freddie – their spectacular political and market power; lack of transparency; and the costs and risks to taxpayers associated with their implicit guarantee – the crisis has opened up the tantalizing possibility of rationalizing the structure and regulation of housing finance.

Yet, although it is widely agreed that the housing bubble precipitated the financial crisis and that Fannie and Freddie as too-big-to-fail institutions posed a serious systemic risk, there is still not an official, articulated, vision for how housing finance will be structured and regulated in the future.  When these issues are mentioned at all, it is outside of the broader context of any regulatory restructuring of banking and financial markets.  The omission can be seen, for instance, in a series of Treasury proposals for restructuring the financial system — both under the previous administration and this one — that are largely silent on the regulation of housing finance.  Avoidance is also evident in the current state of the Federal Housing Finance Agency (FHFA):  It has been left with the peculiar task of regulating Fannie and Freddie, now effectively themselves federal entities; and regulating the Federal Home Loan Banks, institutions that serve as wholesale liquidity providers to financial institutions (Ashcraft et. al., 2009) but that have only an indirect effect on housing finance. [1]

There are of course many proposals for housing finance reform that have been put forward by researchers working in academia, government agencies, think tanks and advocacy groups.  But the ghosts of Fannie and Freddie, and the legacy of regulatory segregation, seem to constrain the set of possibilities that are seriously under consideration. The proposals often presume a continuation of the pre-crisis model of a small number of dedicated conforming mortgage securitizers, guarantors and regulators (e.g., Government Accountability Office (2009), and Mortgage Bankers Association (2009)).  Policy options are taken to be the extent of government backing for mortgage-backed securities, with options ranging from total privatization to full federal guarantees.

A priority I would suggest going forward then, is a fundamental rethinking of the structure and regulation of housing finance, both the primary and secondary mortgages markets, including consideration of to what it extent it can be integrated into the financial and regulatory mainstream.  To quote recent comments by James Lockhart that were made in reaction to a GAO options paper, we “should consider what the secondary market should look like before considering specific institutions.”  He goes on to suggest that “one such possibility would be a market characterized by many privately owned issuers of MBS with the government providing insurance against catastrophic losses, either directly or in partnership with private companies.”

Certainly there are industrial organization and political economy reasons to favor solutions like the one Lockhart sketches that reduce market concentration and make explicit the extent of government backing.  And if that were to occur, a case can be made (although the Fed has argued against it in the past and Mr. Lockhart certainly didn’t suggest it in his comments) for reassigning the oversight responsibilities of the FHFA to a regulator with broader safety and soundness responsibilities, perhaps avoiding some of the vulnerability to political interference of a dedicated housing regulator.

Turning to my second suggestion for what urgently needs to come next, it is to modernize budgetary and regulatory accounting.  I realize this is not on everyone’s top ten fix-it list, and although it would be a stretch to claim that ill-conceived accounting rules are largely to blame for the financial crisis, I believe they have significantly exacerbated it.  Going forward, failure to correct the structural flaws in government accounting will make it more difficult for the federal government to understand, and to extricate itself from, the extensive credit market obligations it has recently assumed.  Regulatory reforms also will be less effective than they otherwise might be.

I want to elaborate on these assertions by way of several specific examples:

First, accounting rules determine the budget cost of federal financial obligations.  If budget rules cause the cost of a policy to be understated, there will be a tendency to over-rely on that policy.  An obvious example was the implicit guarantee of Fannie, Freddie and the Federal Home Loan Banks, which allowed housing policy to be executed through these entities at a zero budget cost but with a substantial hidden cost to taxpayers.  In fact this is often emphasized as contributing to the lack of political will to control their growth.

Although not as dramatic as for implicit guarantees, the rules of budget accounting cause the cost of all federal credit assistance to be systematically understated in the budget relative to the market value of those commitments (Lucas and Phaup, 2008).  By law, loans and loan guarantees are valued without any adjustment for a market risk premium, in other words, they are discounted at too low an interest rate.  The discrepancies between budget cost and economic value can be large.  For instance, in the case of student loans, our recent estimates suggest that inclusion of a risk premium increases the subsidy rate by more than 20 cents per dollar of loans originated (Lucas and Moore, 2009).

Interestingly, recognition that complying with the normal budget rules for credit would result in a severe understatement of the economic cost of the TARP led to an exemption in that legislation that allowed it to be accounted for using risk-adjusted discount rates.  Similarly, CBO reports on the cost of Fannie and Freddie adjusting for the cost of risk.  Had they not done so, the eventual transfer of the activities of Fannie and Freddie back to the private sector would likely appear to come at a significant cost to the government, making a difficult separation even more problematic. Still, this accounting bias remains in place for most credit activities, including the much expanded guarantee obligations of the FHA going forward.

A second, distinct, reason to be concerned with accounting conventions is that regulations are communicated in terms of accounting numbers, and compliance is measured against them.  Hedge accounting can be particularly problematic in this regard.  Anecdotal evidence suggests that when the two are at odds, financial institutions choose to hedge regulatory risk, not economic risk.  This results in greater risk and expenses for institutions and taxpayers than if accounting conventions were more closely aligned with economic principles.

A final example arises from the acrimonious debate over mark-to-market or fair value accounting rules.  Before the crisis, FASB rules and international accounting authorities were marching steadily towards a greater embrace of fair value concepts, and recent reports suggest that trend will likely resume.  These developments are welcomed by many economists including myself: market prices are generally the best available measure of economic value, they are forward looking and aggregate private information, and they are reasonably hard to manipulate in active securities markets.

The crisis brought a plunge in market values, a disappearance of market prices for many securities, and angry calls from bankers to abandon ruinous fair value rules.  Like many of my academic peers, my initial reaction was dismissive:  If bankers had accepted the high valuations on the upside, why the uproar on the downside?  Upon further reflection, and in a recent Carnegie Rochester paper written with John Heaton and Bob McDonald, we suggest that placing blame on fair value accounting is misplaced, but that real costs are incurred when these accounting rules interact with regulatory capital requirements.  It is the static nature of regulatory capital requirements that have not responded to the greater earnings volatility that accompanies fair value accounting, however, that may deserve the blame.  Over time capital requirements are periodically revised by bank regulators, as is FASB’s definition of capital, but the two types of regulatory actions are not coordinated.  A sensible solution to the problems caused by the interaction of more volatile market-based capital measures and a static capital requirement would be for regulators to periodically redefine the capital requirements to neutralize unwanted side effects of changes in financial accounting standards, and allow them to continue to evolve in a direction that provides better information to markets and to regulators.

References

Ashcraft, A., M. Bech and S. Frame, 2009, The Federal Home Loan Bank System: The Lender of Next–to-Last Resort?,” manuscript, Federal Reserve Bank of Atlanta

Government Accountability Office, 2009, “Fannie Mae and Freddie Mac, Analysis of Options for Revising the Housing Enterprises’ Long-term Structures.”

Heaton, J., Lucas, D. and R. McDonald, “Is Mark-to-Market Accounting Destabilizing? Analysis and Implications for Policy,” Journal of Monetary Economics., forthcoming. [Working paper version]

Lucas, D. and M. Phaup, 2008, “Reforming Credit Reform,” Public Budgeting and Finance, Winter.

Lucas, D. and D. Moore, “Guaranteed vs. Direct Lending: The Case of Student Loans,” in Measuring and Managing Federal Financial Risk, University of Chicago Press, forthcoming

Mortgage Bankers’ Association, 2009, “MBA’s Recommendations for the Future Government Role in the Core Secondary Mortgage Market”

U.S. Dept. of Treasury, “Financial Regulatory Reform, a New Foundation” <http://www.treasury.gov/initiatives/regulatoryreform/>

We learn today from the New York Times that the FDIC — the independent government agency that insures your bank accounts — is effectively insolvent. It is going to ask insured banks to prepay three years worth of deposit insurance premiums in order to raise $45 billion to replenish the FDIC insurance fund.

What makes this interesting is that the FDIC is backed by the “full faith and credit” of the US government. In other words, as long as the US government is solvent, your bank accounts are safe. There was no need for Sheila Bair, the head of the FDIC, to ask banks for funds. The notion that the banks will rescue the FDIC is pure theatrics.

There is apparently no interest cost to the loans (details are here), so to the extent the banks forego interest one could say they are subsidizing the FDIC. However,  the notion that this borrowing is not public debt is ludicrous, and it is exactly the sort of accounting fiction that helped cause the crisis. Because the Treasury backstops the FDIC,  prepaid assessments from the banks represent public debt, even if it is off the official balance sheet.

I can’t resist including one other quote from the New York Times article: “Borrowing from healthy banks, instead of the Treasury, has the advantage of keeping this in the family.  It is much better for perceptions than having the fund borrow from somewhere else.” Karen M. Thomas, executive vice president of government relations at the Independent Community Bankers of America. (emphasis added)

You can be forgiven for thinking that I’ve just described Bernie Madoff’s investment fund. In fact, I’ve described the operation of money market mutual funds in the U.S. (Note that these are mutual funds, not insured “money market accounts” offered by banks.) A year ago there was a run on these funds. Over the span of a week, investors  withdrew almost $170 billion after the Reserve Fund “broke the buck”, i.e., announced that it’s shares were worth less than $1. This announcement caused investors to flee other funds because of a fear that those other funds would also break the buck. Investors wanted to exit at $1, before the buck-breaking. In the end, the Treasury staunched the outflows by temporarily insuring money market funds. This insurance expired last week.

There was a run because money market funds routinely lie about their value, which the SEC permits them to do. (If you are interested, the details are in Rule 2a-7; the quick summary is that funds can do “penny-rounding”, meaning that a fund worth $0.995 can report itself worth $1 as long as “The board of directors of the money market fund shall determine, in good faith, that it is in the best interests of the fund and its shareholders to maintain a stable net asset value per share or stable price per share … and that the board of directors believes that it fairly reflects the market-based net asset value per share”. Huh?)

As a result of the run last fall, the SEC is in the process of revising the rules for money market funds. In a rational world, money market funds would behave just like all other funds: every night they would report to investors their true net asset value, which might differ from $1. Investors would then be able to choose money market funds as they do stock funds, investing in a riskier fund if they wanted higher returns, accepting that the net asset value might fluctuate more. Just as stock fund investors have no incentive to run, money fund investors would have no incentive to run. In any event, money funds would have small price fluctuations if they invested in high quality, short duration assets.

Unfortunately, rather than simply requiring funds to tell the truth, the SEC is proposing new and more elaborate rules that will restrict the behavior of money market funds and possibly leave money market fund investors unable to withdraw in a crisis. The proposed rules would include

1. New restrictions on the assets in which funds can invest. The assets must be “liquid” (of course we have seen that liquidity vanishes in a crisis), rated in the highest credit category (we have seen that ratings are not reliable ina crisis), and funds must hold a reserve in cash or T-bills
2. The ability of the fund to suspend redemptions
3. A “know your investor” requirement in which “funds would develop procedures to identify investors whose redemption requests may pose risks for funds.” (It would be exciting to be labeled a “flight risk”!)
4. Funds must have the ability to redeem at other than $1 per share

The important thing to notice is that these rules mostly do nothing to prevent investors fleeing funds in a panic. The SEC will try to convince investors that money funds are safer than ever. However, if there is a crisis, investors will still try to exit before redemptions are suspended. The SEC is avoiding the simple alternative, with funds just telling the truth.

The SEC’s approach to money market funds is discouraging because it is emblematic of the approach to other financial reforms in the wake of the crisis. The administration has a unique opportunity to simplify and rationalize regulation. Instead they are crafting a Rube-Goldberg machine.

There is one unexpected twist if money funds were to routinely break the buck. Once funds report their true value, investors will buy and sell fund shares at a floating price, and would therefore be obligated to report as income any resulting capital gains (as with any other mutual fund). These gains would almost always be very small, and the money funds could surely calculate taxable income as a service for investors. But there would be reportable capital gains.

On the other hand, is it a surprise that you can simplify your tax calculations if you lie about your income?

In May, Treasury Secretary Geithner outlined a plan for regulating the over-the-counter derivatives market. Today (June 4), the Chairman of the Commodity Futures Trading Commission, Gary Gensler, provided a more detailed proposal.  The Gensler proposal basically says that if a financial contract walks and quacks like a standardized OTC derivatives contract, it will have to be cleared through a central clearinghouse, just like a standard exchange-traded contract (think wheat and pork bellies).

The (over-simplified) notion of a clearinghouse is that after A and B trade a contract, the clearinghouse steps into the middle, becoming the buyer to the seller and the seller to the buyer. Derivatives wonks call this process “novation”. Gensler proposes to extend the clearing model of the Chicago Mercantile Exchange to most contracts that are now traded over the counter, i.e. directly dealer-to-dealer or dealer-to-customer.

The banking industry (AKA “The Empire”, in case you were wondering) is not happy and has been preparing for a fight since last Fall. In Monday’s New York Times, Gretchen Morgenson and Don van Natta Jr., in a terrific piece of reporting, discuss the Wall Street lobbying efforts to forestall Geithner’s proposed regulation. On a related front, the Wall Street Journal reveals that banks are fighting efforts to change accounting rules so that off-balance-sheet entities will be put back on balance sheet. Recall that off-balance-sheet structures permitted banks to effectively own risky loans without holding any capital.

I will offer a few brief observations here. I hope to say more in the future:

1. Once the government mandates central clearing, there will be a powerful implicit commitment to prop up the clearinghouse. Thus, if the Geithner/Gensler proposal goes through, the government will have created a new too-big-to-fail entity, most likely the Chicago Mercantile Exchange clearinghouse. Probably the CME Clearinghouse is already too big to fail, but is this really how we want to fix the problem?
2. Once the CME (or some other clearinghouse) is too big to fail, it will also be subject to even more intense political pressure than it is now. Farmers are complaining that wheat prices are too volatile and margins are too great? Watch for congress to pressure the CME to change its business practices. (This already happens, by the way.)
3. The Gensler testimony lays out criteria that “could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms.” Wall Street is expert at constructing new vehicles that skirt rules. You think you’ve seen tweaking? You ain’t seen nothin’.
4. Wall Street is most profitable when transactions are non-standard and non-transparent, exactly what Gensler is trying to stop. Thus, Congress will be trying to enact rules that destroy multi-million dollar bonuses. Would you bet on regulators or on Wall Street?
5. There is a wild card in all of this. Congress will hold hearings. Who knows what stories will emerge that might outrage the public and catalyze the movement for serious changes in regulation? The Pecora hearings in 1933 unearthed testimony that induced Congress to create the SEC. Who knows what stories are waiting to be told?

Finally, throughout the public policy discussion, there is a presumption that financial institutions have a fundamental right to privacy. If JP Morgan Chase acquires a $10 billion credit exposure to Goldman, the regulators will in theory know, but the investing public and other banks will not.Why? Shouldn’t investors have a right to know about material credit exposures? If AIG had been forced to reveal the extent and nature of its credit exposures, perhaps the AIG fiasco would never have occurred. (AIG’s counterparties might have balked at dealing with an entity with AIG’s risk profile.) Why do we permit and encourage all-encompassing secrecy? Shouldn’t the presumption of privacy at least be part of the public policy discussion?

To quote Ferdinand Pecora: “Had there been full disclosure of what was being done in furtherance of these schemes, they could not long have survived the fierce light of publicity and criticism. Legal chicanery and pitch darkness were the banker’s stoutest allies.”

Some things never change.

Whatever you think about the wisdom of these interventions, one fact is indisputable: The government is not saying how much it expects all of this to cost us. The dearth of official estimates has, on one hand, led to Pollyannaish claims like “taxpayers could actually make money on this.”. On the other hand, it has stoked fears that taxpayers may be on the hook for trillions of dollars in losses.

More worrisome: Without hard numbers, not only is the initial cost of these interventions obscured, but it will be nearly impossible to assess the government’s performance as it manages these huge new commitments going forward.

Producing credible cost estimates is not easy, but it is necessary. Private-sector entities have to comply with strict and often frustrating accounting standards so that investors can make informed decisions. Taxpayers and policymakers need just as good data if they are to be equally well equipped.

What is insufficiently appreciated is that the government holds itself to a much less stringent accounting standard that what it imposes on the private sector. Importantly, the principles of fair value accounting are largely absent from federal budgeting for risk.  I would single out two accounting rules that create serious distortions in accounting for federal ownership of financial securities.

The first is in the treatment of the market price of credit risk, which is omitted from the pricing of federal credit obligations. By law, projected net cash flows must be discounted at maturity-matched Treasury rates.  This causes the value to the government of a loan to risky borrowers like Ford Motor Co., AIG or Morgan Stanley to be systematically overstated.  Thankfully, this byzantine rule was waived temporarily for the $700 billion bailout bill, but it remains a problem for most security purchases.

The second is that the value of equity investments, like the recent purchases of preferred bank stock, are systematically understated initially because these are accounted for on a cash basis, which means the full purchase price of stock is counted as an outlay, with no offset for the value of the claim received. In later years any positive cash flows from dividends and principal repayments reduce the reported budget deficit, even if the recoveries fall far short, in present value terms, of the initial value expended.

Some might argue that in the middle of a crisis the last thing we have to worry about is bean counting. But we should remember that lax government accounting rules—such as those that kept Fannie and Freddie off the federal budget despite their longstanding federal ties—are among the culprits responsible for getting us into the current mess, and failing to strengthen them will make it harder to get out of it.  Just imagine how difficult it will be in a few years for the government to re-privatize banks if, because of accounting distortions, it looks like they are making money for taxpayers instead of losing it.

Note: This is an expanded version of my editorial that appeared last week in Crain’s Chicago Business.

“Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”—Winston Churchill, November 10, 1942

When Churchill made his famous statement following the allied victory at El Alamein in North Africa, he was warning the public not to be too optimistic, and to expect the war to continue for a long time. It now seems clear that the financial crisis will last a long time. I want to suggest here that we are at the “end of the beginning” of the financial crisis, about to enter a new phase. Unfortunately, this is not an optimistic statement, merely an assessment. The government is fast running out of policy options that bear any resemblance to “free market” policies. What remains is for the federal government to run everything. And this is what is gradually occurring. The challenge will then be for the government to undo all of its intervention as quickly as possible.

Consider (if you can bear it) the situation this week:

• Banks have stopped dealing with each other, with the Fed serving as primary lender to banks.
• Financial firms are not making loans.
• Credit default swap (CDS) prices for financial firms remain at record levels. (Corresponding to the high CDS quotes, the debt of these firms is trading at very low prices.)
• Commercial paper outstanding is falling and the bulk of issuance is at very short maturities.
• California, unable to borrow in municipal markets, may ask to borrow $7 billion from the federal government. Massachusetts also faces borrowing difficulties, as presumably do other states.
• AIG was granted an additional $37.8 billion to stave off default.
• European governments are now facing similar situations, increasing insurance on bank accounts, rescuing financial institutions, and (in the case of Iceland) trying to stave off national bankruptcy..

You’ll notice that I didn’t even mention the stock market.

Two other news items in the last week make me think we have finally reached the end of the beginning.

First, the Federal Reserve has created a facility to buy 3-month commercial paper (short-term bonds issued by firms). The fed will essentially swap Treasury bills for commercial paper (CP), doing exactly what my colleague Arvind Krishnamurthy described in his blog entries (here and here). Firms issue commercial paper and the government buys it, effectively replacing the commercial paper with government bonds. Most importantly, this will prevent a major firm from going bankrupt simply because it cannot issue CP to pay off CP coming due. General Electric, for example, had $63 billion of commercial paper outstanding in June. As that paper comes due, GE must issue new paper (or sell assets) to pay it off. The government will have to do whatever is necessary to keep the CP market running.

Second, the Treasury is seriously considering taking ownership stakes in banks, which it is permitted to do under the bailout bill. The purpose will be to provide capital to weak institutions, and the Treasury will presumably then be in a position to urge these banks to resume lending.

The executive summary is this: the federal government is taking over US credit markets. We are no longer talking about technical hacks and tweaks such as lowering the discount rate, the Fed accepting risky collateral when lending to banks, or the Treasury buying mortgage-backed securities. We are talking about direct federal intervention, with the government buying and selling assets and taking ownership. What else is left? We have to hope that once the government has fully intervened, stabilized the situation, and can do no more, then capital markets will start working again.

There is an irony and a danger here. At this time, the government is the only agent in a position to intervene, but the government is also part of the problem. No private solution will emerge with the government hovering in the background, making decisions on the fly (will a particular institution be rescued or abandoned?) and essentially commandeering markets. This is not to criticize the Fed and the Treasury, but we must recognize that commitments of private capital will require clear ground rules. At the moment, with the situation fluid and constantly changing, only the government can act. Having acted, the government will then quickly need to stabilize the rules that enable and encourage private action.

[Update: Mitsubishi UFJ Financial Group has reached agreement to invest $9 billion in Morgan Stanley. In order for the deal to go through, US government officials had to assure Mitsubishi that their interest would be protected in the event of a future Morgan Stanley bailout. I’ll emphasize two points here: first, fear of government action almost prevented a deal, and second, the US government is now a contingent equity holder in Morgan Stanley. ]

Now I am certainly not advising you to panic (in fact, I am not advising you at all, because I am a mere finance professor, not a certified investment advisor).  But it does seem like a good time to revisit what we know (and don’t know) about personal investments and asset allocation, and to try to reassure you that there is no dishonor in prudence.

There is no formula that can tell you the right way to allocate your savings. There is a risk-return tradeoff.  Investing in risky securities, like stocks, increases your expected returns, but at the cost of higher risk exposure.  Advice like, “put a percentage of your savings equal to 100 minus your age into the stock market” are marketing prescriptions that are absent from the pages of reputable finance texts.

Where you draw the line on risk and return is a personal choice.  And you can change your mind.  It is not your patriotic duty to invest in the stock market, and it does not make you a fool not to. I cringed the other day listening to Terry Savage, a well-respected investment adviser and national commentator, talking about how everyone needs some “chicken money.”  While acknowledging that safe investments help investors sleep better at night and might even be useful beyond that, she not so subtly uses this pejorative to generically mock conservative investment strategies.  Well, all I can say is “pluck.”

Market volatility varies over time. Right now it is extraordinarily high.  Presumably prices have adjusted to reward investors for bearing this volatility.  In other words, part of the fall in stock prices can be seen as compensation for the increased risk, and a sign of higher expected returns going forward.  But we all have to decide whether the collective view of risk and return that is reflected in current prices makes personal sense.  If you have a stomach for volatility, this may look like an attractive buying opportunity and it may be a good time to increase your allocation to stocks.  If roller coasters are not your thing, a move to a more conservative asset allocation may be in order.
Stock prices are not mean-reverting. The catch-phrase “stocks are for the long run” unfortunately seems to suggest that if stock prices drop, it doesn’t really matter because they will catch back up.  That is not what the statistics of stock returns imply. As a first approximation, stock prices are best described as a random walk with positive drift.  When a stock’s price falls, that is its new and permanently lower starting point.  Over time returns will be positive on average, but there is no force that erases past loses.

Also, the long-run can be very long indeed.  Today the Dow Jones is back to where it was almost a decade ago, in the spring of 1999.  Had you put $100 in stocks, you’d have $100 today.  Had you put it in a “chicken money” bank account earning 2% after inflation, you’d have about $120.  And I have been wondering, when did commentators start confusing bank accounts with mattresses?

Asset allocation is reversible. It is true that if you pull back from the market you lose the opportunity for gains as well as losses.  Moving to a more conservative asset allocation is a way to avoid risk, and there is no telling if by so doing you also avoid the next big run-up.  If you do decide to back off, it is better to think of it as a time out than as a permanent retreat.  Remember that if you exchange $1 of stocks for $1 of bonds, what you have in either case is a dollar of value today.

Diversification is critical for reducing risk, but it does not eliminate it. You can avoid a lot of risk by holding a diversified portfolio of risky assets, rather than individual stocks.  Investing in funds like Vanguard’s 500 Index allow you to get broad stock market exposure while incurring low transaction costs, even with a relatively small investment.

Once you get rid of the risk of individual stocks, lots of risk remains.  Unfortunately, a quick glance at the markets in the last few months confirms this fact.

A final thought on investing and the greater good. I expect to get some major pushback for having written this, if for no other reason than that if everyone sits on their money and reduces their investments in stocks, a decline in market prices becomes a self-fulfilling prophecy.  While I agree that the world would be a happier place if everyone settled down and resumed investing as usual, I don’t think the common investor should have to bear the burden of being the first to make it happen.

On September 18, Bernanke and Paulson met with Congressional leaders in the office of House Speaker Nancy Pelosi. The headline in the New York Times described the attendees as “stunned”. Sen. Christopher Dodd afterwards said “Somber doesn’t begin to justify the words. We have never heard language like this.”

Subsequently, Bernanke and Paulson have not been publicly forthcoming about what they know. The original proposed Treasury rescue plan was politically clumsy, and generated a lot of criticism (including a petition that I signed).  All along I’ve been wondering what was said to Congressional leaders. Exactly what were they told and why haven’t we been told? It’s hard to assess the plan if you don’t know what’s wrong. I think there’s a good reason for the secrecy.

First, what is it that we do know? Credit has dried up: banks and other financial institutions are afraid to deal with one another. There is a lot of “toxic waste”—-mortgage-related assets—-sitting on balance sheets. There is no active trading in these assets and no readily ascertainable market value. We also know that banks have large exposures to the credit risk of other banks stemming from a variety of assets, including credit default swaps. Some banks are insolvent, others are not. You and I have no way to know which banks are solvent, but the Fed must have a pretty good idea.

The plan permits the Treasury to buy troubled assets from banks. Much of the commentary has revolved around the fact that if a bank is insolvent, buying its assets for a fair price will not make it solvent. This has lead to speculation that the Treasury plans to overpay for assets in order to rescue bad banks. There is another possibility, however, which is that the Treasury will not buy assets from insolvent banks, but rather intends to let them fail.

In this interpretation, the plan is not intended to prevent bad banks from failing, but rather to increase confidence in good banks. By identifying the good banks and shoring up their assets, those banks will be able to start lending again and dealing with other good banks. Regulators will be able to close insolvent banks quickly without starting a chain reaction. If a good bank is rumored to be in trouble, the Treasury can buy assets from it. If a bank is truly in trouble, it can be quickly closed. Thus, the plan may have a secret component, namely the pending closure of numerous financial institutions.

This would account for the credit market symptoms we’re seeing (there really are insolvent financial institutions), make sense out of the original version of the rescue plan, and explain the secrecy surrounding the diagnosis. This also explains one curious omission in the original rescue plan: The government was not planning to receive ownership interest in rescued banks because there was no intention of bailing out failed banks. Rather, the plan’s purpose was to liquify good bank balance sheets.

If the intent is what I’ve described, then it’s obvious why Bernanke and Paulson could not explain everything. We still have to be afraid of widespread runs on financial institutions. Bernanke and Paulson wouldn’t announce that the financial system is insolvent for fear of inciting just such a run. Despite deposit insurance, we still have to fear bank runs (the Flow of Funds Account published by the Fed shows $2.4 trillion in time deposits exceeding $100,000 as of June—- this is almost 30% of deposits). There was a run on money market funds earlier this month, stemmed by Paulson’s pledge of $50 billion in insurance. However, there are $3.3 trillion in assets in money market funds, so $50 billion of insurance could be used up in a flash. Widespread runs would be a disaster.

If this analysis is correct, the next few months will be very hard, very expensive, and very disruptive. But it won’t be expensive because we’re rescuing the failures, it will be expensive because we’re doing the right thing and shutting them down.

Will the Treasury’s buying distressed assets reassure investors that the financial institutions are creditworthy?  I don’t see how it could, unless the intention is to overpay massively for mortgages.  How is the public to know that enough of its problem assets have been sold for a bank or brokerage to be viable?  And if institutions are not selling now because they don’t want to fess up and mark to market, why will they want sell assets at a fair price to the Treasury?  Sure they will be motivated if Treasury offers such a large premium over fair value that big losses are written down as little losses.  But the administration claims this will not happen, that taxpayers are to be protected.  So we’re back to square one – how can this solve the trust problem?

What would seem to be much less expensive for taxpayers, and ultimately less intrusive, would be for the government to address the transparency problem directly.  Instead of legislating a bailout, compel companies to open their books to government auditors.  Authorize Treasury and/or the Fed to muster up a sophisticated crew of experts to examine the books of financial institutions and report on which are fundamentally solvent, which are close enough to be viable with just a shoring up of capital, and which need to be dissolved or reorganized.  Some kind of certification or temporary guarantee could follow for institutions deemed reasonably sound, or the government could even choose to make targeted capital infusions based on this information.  Done properly, this would reveal very little proprietary information.  In economist speak, the government would be creating a “positive information externality,” an idea that should have some appeal across party lines. Granted this sounds intrusive, but it pales in comparison to counter-proposals to the Administration’s plan that call for the government taking large equity stakes in the companies they purchase assets from.

Also problematic is what will happen to the mortgage assets once the government owns them.  Pundits have been throwing around comparisons to the RTC.  The RTC bought the assets of failed S&Ls, but the RTC had an infinitely easier job.  What brought down the S&Ls was interest rate risk, not credit risk.  The RTC bought good mortgages, not distressed ones, so reselling them posed no special challenges.  This is not the case here.  Will private buyers be interested in what will surely continue to be opaque assets?  And in the mean time, what is the Treasury supposed to do with distressed mortgages?  Evict delinquent homeowners?  It is one thing for banks to try to enforce their contractual rights, but quite another for the government after they have already broken all the rules by bailing out Wall St. to be taking away people’s homes.  All of this is to say that one way or another, it will likely turn out to be extremely expensive for taxpayers if the government becomes the direct owner of distressed mortgages.