Coyote Blog

I am not sure I understand Kevin Drum's argument for capital controls.  He seems to be arguing that these controls are a sort of financial speed limit and making an awkward analogy to highway speed limits to justify them.

In a world where I as a taxpayer have to bail out banks, I don't have a huge problem with capital requirements for banks, though this seemingly simply topic is rife with unintended consequences -- I have seen it argued persuasively that the pre-2008 Basil capital requirements helped fuel the housing bubble by giving special preference to MBS in computing capital.  In fact, one might argue the same for the sovereign debt crisis, that by creating a huge demand for sovereign debt for bank balance sheets it fueled an unsustainable expansion in such debt.

Anyway, the point of this post was capital controls.  Drum quotes this from an IMF report:

19. Indeed, as the recent global financial crisis has shown, large and volatile capital flows can pose risks even for countries that have long been open and drawn benefits from capital flows and that have highly developed financial markets. For example, in several advanced economies, financial supervision and regulation failed to prevent unsustainable asset bubbles and booms in domestic demand from developing that were partly fueled by cheap external financing. Rather than favoring closed capital accounts, these experiences highlight the need for policymakers to remain vigilant to the risks. In particular, there is a constant need for sound prudential frameworks to manage the risks that capital inflows can give rise to, which may be exacerbated by financial innovation.

The logic, then, is that bubbles are exacerbated by inflows of foreign capital so capital controls can keep bubbles from getting worse.  I have very little knowledge of international finance, but let me test three thoughts I have on this:

1. Doesn't this cut both ways?  If bubbles can be inflated by capital inflows, can't they also be deflated by capital outflows?  Presumably, if people domestically see the bubble, they would logically look for other places to invest their money.  International investments outside of the overheated domestic market are a logical alternative, and such capital flows would act a s a safety valve to reduce pressure on the bubble.  So wouldn't capital controls just as likely make bubbles worse, by confining capital within the bubble, as make them better by preventing new capital from outside the country flowing in?
2. The implication here is that the controls would be dynamic.  In other words, some smart person in government would close the gates when a bubble starts to build and open them at other times.  But does that not presupposed the ability to see the bubble when one is in it?  Certainly there were a few who pointed out the housing bubble before 2008, but few in power did so.  And even if they had seen it, what is the likelihood that they would have pointed it out or taken action?  Who wants to be the politician who pops the bubble?  Remember the grief Greenspan got for pointing to an earlier bubble?
3. Controls on capital inflows tend to be anti-consumer.  Yeah, I know, no one in government ever seems to care when they pass protectionist laws that protect 100 tire workers at the cost of higher tires for 100 million drivers.  But limiting capital inflows would reduce the value of the dollar, and make anything imported (or made from imported parts or materials) more expensive.

A guest blogger on Megan McArdle's blog writes:

Here's my first such idea:

Abolish Mortgage-Backed Securities (and Offspring)

CDOs and credit default swaps don't kill financial systems, mortgages kill financial systems. There has been altogether too much opproprium directed at CDOs, credit default swaps and other structuring techniques that spread financial contagion, and not enough directed at the underlying collateral. The record seems to be, however, that Dick Pratt was correct when he called the mortgage "the neutron bomb of financial products."

This makes no sense.  I don't have time for a comprehensive argument, so here are a few bullet points:

• His argument rests on the fact that mortgages have inherently hard-to-quantify risks.  I don't believe that, given how long the financial system worked just fine writing mortgages, but if this is really the case, shouldn't he be proposing to ban mortgages, not just mortgage-backed securities?
• Holding the higher-quality tranches of an MBS simply cannot, by any mechanism I can fathom, be more risky than holding a lot of individual mortgages.  In fact, for a given bank, it should spread the risk geographically and to a larger number of mortgages.
• The first actual problem with MBS's is that the default risks were under-estimated by those packaging the securities.  Basically, the top AAA tranches were too large (or too wide, I think the term is).  This is correctable, and likely already has been corrected (In fact it had more to do with the actions of the government-enforced credit rating oligopoly than with actions of bankers).
• The second actual problem with MBS's is that the default risks were under-estimated by government regulators world-wide when in Basil II and the equivalent US law changes c. 1991, MBS's were given very preferential capital requirement treatment.  Basically, MBS were treated, for capital requirements, as if they were nearly as risk-free as US treasuries, providing incentives for banks to over-weight in them.
• The largest problem was the reduction in credit requirements for mortgages.  Increasing LTV from 80% to 97% or 100% or even 100%+ hugely increased the risk of default, and no one really took that into account in MBS packaging or bank capital requirements.  Bank capital requirements for mortgages and MBS were set as if they were European style recourse loans with 80% LTV.  But the same regulations and requirements applied to MBS built on US-style non-recourse loans with 97% LTV, which is crazy.

Here is a better plan:

1. Narrow the AAA tranches of MBS
2. Fix bank capital requirements vis a vis mortgages and MBS
3. Stop encouraging high loan to values on mortgages

I thought Dale Franks has a really good post on why the bailout is a crock.  Its quite long, but here is one excerpt:

Banks that made bad mortgage choices get a buttload of money for their
bad MBS paper. Banks that charted a more reasonable course"”and yes,
there are quite a few"”get no reward.

In a real free market, of
course, the banks that made bad decision would have to take the hit.
They'd auction them off at whatever price the market would bear, and
they'd have to suck up the losses on the difference between face value
and sale value, even if that meant driving them out of business.
Meanwhile, the more rational banks would be able to pick up the MBS
paper at a discount, and make some cash off of the distress sale from
the incompetent banks.

And, of course, the incompetent banks would probably be driven out of business.  Which, after all, is how it is supposed
to work. But, the government seems entirely uninterested in letting the
market work this out, which brings me to my next point....

I keep hearing over and over again"”and I've even said it"”that no one
knows what these mortgage backed securities are worth. But let's be
clear here: the reason we don't isn't because the price is mystifyingly
unknowable. It's because they haven't even tried to sell them off yet.
We already know it's possible to find out what the price is, simply by
offering them up for sale. Indeed, we did it in July when Merril Lynch sold off its entire MBS portfolio.

The reason we're not doing it now is because the holders of MBS paper expect a government bailout, and they expect to
receive through it a price significantly higher than they would in the
secondary market. If it were otherwise, they'd already be auctioning
them off.

After all, we're talking about securities based on the
value of mortgage repayments. We already know that the default rate on
most of the MBS paper will be around 5%, with a maximum of probably no
more than 10%. Everybody already knows this. Now, just to turn the
screw, a buyer might want a discount of over"”perhaps well over"”50%.
after all, it's a fire sale, and everybody wants a bargain, right.

But there is a market-clearing price for these securities, and everybody on the street knows it.
What they also know is that they have an excellent chance of receiving
a much better price from the Feds, and that waiting for the bailout
gives them a better chance to stay in business, even if the Treasury is
a large shareholder in the company. And, after all, if the Treasury is
a shareholder, how likely is it that the government will let them fail, losing all that equity?

The
bailout doesn't solve the problem. It keeps the bad banks in business,
lets them escape the worst consequences of their malfeasance, and
prevents the better run banks from taking up the reins that would be
otherwise dropped when the bad banks went out of business.