P Problem Set 8 - Solution
P.1 Readings - Monetary Policy
Michael J. Burry, “I Saw the Crisis Coming. Why Didn’t the Fed?”, The New York Times, April 4, 2010. Q: According to Michael Burry, how could the Federal Reserve have seen the crisis coming? A: According to Michael Burry (the real one, not Christian Bale), there were many signs that the housing boom in the early 2000s was unsustainable. First, mortgages were offered to the riskier borrowers (called subprime), who did not have good credit. Instead of being born by the lenders, these risks were packaged into mortgage-backed securities, and sold to other investors for fees. Therefore, the incentives of the lenders were not to make loans of high quality, but rather to make more of these loans. Second, homebuyers were really optimistic about house prices (extrapolating past trends into the future), and so they wanted to get the biggest possible loan to afford the biggest possible house. Third, rating agencies were giving good ratings to mortgage-backed securities containing subprime loans, showing they were not paying much attention to the build up of risk. Fourth, the Federal Reserve Chairman was telling Americans they should get adjustable-rate mortgages as an alternative to traditional, fixed-rate mortgages. Later, pay-option adjustable rate mortgages, which allowed borrowers to make partial monthly payments and have the remainder added to the loan balance, were becoming available. All of these substantially increased the possibility of borrowing, which was only possible because of rising house prices. (see the article on Hyman Minsky in the chapter on theoretical controversies for more on this type of financing)
“Two out of three ain’t bad.” The Economist, August 27, 2016. Q: Under Keynes’ plan at Bretton Woods, how would “creditor adjustment” work? A: According to J.M. Keynes, the problem of fixed exchange rates such as a Gold Standard was that it forced the adjustment of balance of trade imbalances onto deficit countries. As a consequence, deficit countries were forced to respond to an outflow of gold by curbing the demand for imports, and cutting wages to restore export competitiveness. Instead, J.M. Keynes was proposing that creditor countries would share symmetric blame for trade imbalances. There would both be penalties for being overly lax, just as there would be penalties for having too large a trade surplus. However, Keynes was not able to get enough support for such creditor adjustment. The United States (dominating power at Bretton Woods) opposed the idea for the same reason Germany resists it today: it was a country with a big surplus on its balance of trade. Note: This adjustment is reminiscent of austerity policies which were implemented in Europe after 2011, following the Greek debt crisis. An alternative adjustment would have been to have Germany and the rest of Europe increase their aggregate demand, to boost Greece’s exports and help pay for imports (instead of forcing it to engage in costly import compression through tax increases and spending cuts, which also hurt internal demand a lot).
“Should egalitarians fear low interest rates?”, The Economist, July 11, 2019. Q: Why was J.M. Keynes potentially wrong about the “euthanasia of the rentier”? A: J.M. Keynes thought that a “savings glut” would lead to lower rates of return on capital, and erode investors’ bargaining power. According to him, the end result should be the “euthanasia of the rentier”. The recent episode of low interest rates suggests that in fact, they lead to soaring stock and real estate markets, thereby exacerbating wealth inequality. Therefore, when interest rates go down, the return on existing assets potentially goes up. J.M. Keynes was indeed missing the potential for “rational bubbles”: as interest rates would become lower than \(g\), asset prices and real estate prices could potentially become overvalued, maintaining and even boosting the returns of the investor class, even as interest rates stayed low. As The Economist explains, the corresponding boost in house prices has also added to substantial intergenerational tension, as this corresponds to a transfer from the “young” to the “old” generation (“ok boomer”). Note: In this article, The Economist magazine does not explicitely relate the failure of the “euthanasia of the rentier” to the existence of a savings glut and the corresponding overvaluation of asset prices. However, we have seen during the lecture on overlapping-generations models that this is a possibility when interest rates are low.
P.2 Readings - Theoretical Controversies
“Minsky’s moment”, The Economist, July 30, 2016. Q: List the 3 different types of financing according to Hyman Minsky. How was the financial crisis an example of Ponzi financing? (this question is related to The Big Short movie you will watch this week) The three different types of financing according to Hyman Minsky are “hedge financing”, “speculative financing”, and “Ponzi financing”. Under “hedge financing”, borrowers rely on future cash flows to repay interest and principal. Under “speculative financing”, future cash flows allow to repay interest on borrowing, but not the principal, which needs to be rolled over. Under “Ponzi financing”, cashflows repay neither the principal, nor the interest: borrowers assume that they will be able to repay both using the capital gain on their investment. During the run up to the 2007-09 financial crisis, many borrowers were indeed able to refinance their mortgages, and delay even the payment of interest, using the capital gains from rising home values.
“Where does the buck stop?”, The Economist, August 11, 2016. Q: Why did the Keynesian consensus fracture in the 1970s? What are the main beliefs of the “freshwater” and the “saltwater” school of macroeconomics? A: The Keynesian consensus fractured in the 1970s, as monetarism convinced many economists that the business cycle was caused by fluctuations in the money supply, so that monetary policy was enough to stabilize the economy (fiscal policy was not needed). According to the “rational expectations” school of macroeconomics, fiscal stimulus in the form of tax cuts was ineffective, as it was entirely offset by increased private saving (we learned in the class that this would correspond to “Ricardian equivalence”). Moreover, accommodative fiscal and monetary policies were attempted in the 1970s to remedy high unemployment, and only led to more inflation, as unemployment remained high. This appeared to be inconsistent with the “Phillips curve” view according to which there was a trade-off between inflation and unemployment. Freshwater economists were generally very skeptical of Keynesian principles. In contrast, “saltwater” economists borrowed insights from Keynesianism, as well as from the freshwater school, trying to build a “centrist” view of Keynesianism. According to them, central banks should do most of the job of macroeconomic management. This belief was however contradicted by the crisis in Japan in the 1990s, or the 2007-09 U.S. financial crisis, where fiscal policy was used very heavily.
“Central bankers’ holy grail: The natural rate of unemployment.”, The Economist, August 26, 2017. Q: What is the Phillips curve? What is the natural rate of unemployment? A: The Phillips curve was not part of Keynes’ thought initially. (“Inflation, for instance, barely entered his analysis of unemployment.”) It was proposed by Paul Samuelson and Robert Solow in the 1960s as a correlation between inflation and unemployment, following William Phillips who showed there existed such a relationship in the U.K.: according to them, this relationship between inflation and unemployment should be thought of as a “menu”, and the job of Keynesian policymarkers was to pick a point on the curve that best aligned with their preferences. Later, it was thought that the Phillips curve actually was more a relation between accelerating inflation and unemployment, and that the level of unemployment such that inflation would not accelerate was the NAIRU (“Non Accelerating Inflation Rate of Unemployment”), also known as the natural rate of unemployment. Whenever policymakers tried to have less unemployment than that, there would be rising inflation. Whenever there would be more unemployment, there would be a deceleration in inflation. Note: As I told you during class, I do not believe in the Phillips curve, but it is still an important part of the macroeconomics curriculum; you can see that journalists at The Economist are having doubts too, in the last article from this section: “The world economy’s strange new rules.”, The Economist, October 10, 2019.
“The bull market in everything. Asset prices are high across the board. Is it time to worry?”, The Economist, October 7, 2017. A: What are the arguments in favor, and the arguments against putting your money in risky assets (stocks, property, bonds) versus in cash? What are the driving forces behind the bull market in everything? Q: The arguments in favor of putting your money in risky assets are that the world economy is improving, real interest rates keep declining, which is a sign of a widening “savings glut”. Behind this “savings glut” there exists a longer-run trend, coming from populations’ increased desire to save, ageing populations wanting to save a larger share of income for their retirement, and stagnant wages which lead to a rise in the rate of profit. The arguments against are that monetary policy has been particularly expansionary lately, which should not last. Moreover, good times are typically followed by bad times, and there is no reason to believe that “this time is different”. Debt is at particularly high levels already, so that governments will be reluctant to use fiscal policy when the next recession comes.
“Why is macroeconomics so hard to teach?” The Economist, August 9, 2018. A: Why is macroeconomics hard to teach? Q: Macroeconomics is difficult to teach because (as we saw during this class) macroeconomic theorists disagree about so much. It is also difficult because macroeconomics textbooks give a false sense of consensus. To reach the widest possible audience, they present a miscellany of models that are not always consistent with each other or with themselves.
“The world economy’s strange new rules.”, The Economist, October 10, 2019. A: What are the most important recent failures of the Phillips curve? Q: Over the past decade, the Phillips curve has failed “at both ends”. First came the “missing deflation”: despite unprecedently high unemployment, there was no prolonged slump in inflation. Now, we are experiencing the opposite puzzle: despite very low unemployment, we have not seen any inflation lately.
P.3 The Big Short (1/6) - Michael Burry analyzes Subprime MBSs
What’s Michael Burry’s hedge fund typically invested in? Michael Burry’s hedge fund, Scion Capital, was typically invested in stocks. (not in Credit Default Swaps, or even in bonds)
What was the fee on MBSs typically? The fees on Mortgage Backed Securities were approximately equal to 2%.
Why did they start lending to riskier borrowers? They ran out of mortgages to put into the Mortgage Backed Securities. After all, they aren’t so many homes and so many people with good enough jobs to buy them. (this again, confirms the idea of a general “savings glut”) So they started to lend to riskier and riskier borrowers.
What did Michael Burry do to assess the quality of mortgage bonds? He looked at each and every mortgage in MBSs, even though they were filled with thousands of them. He read the documentation underlying these MBSs, and computed a number of statistics (we can see him look at the Loan To Value (LTV), number of days late). He also noticed that many Subprime Adjustable Rate Mortgages were supposed to reset in 2007.
What’s the main obstacle to shorting housing? How is Michael Burry going to short housing? The bonds are too stable, so there are no instrument to short mortgage bonds (which are basically given by options). Michael Burry intends to ask an investment bank to create an option for him. (in finance, this is called a “market maker”: someone who makes market for a particular financial product)
P.4 The Big Short (2/6) - Burry buys CDSs from Goldman
Why do people at Goldman Sachs think CDSs are a “foolish investment”? The bonds only fail if millions of Americans don’t pay their mortgages, which has never happened in history. This view of banks conforms also with popular culture, according to which housing is a rather safe investment.
What is Michael Burry worried about when he invests in CDSs? Michael Burry is concerned that when the bonds fail, the bank (Goldman Sachs, here) could at the same time be facing solvency issues, so that even though they owe him money due to the bonds’ default, they cannot honor their obligations.
Which agreement is put in place between Michael Burry and Goldman Sachs to take care of this problem? They put in place a pay-as-you-go structure which would pay out if the bonds fail. It applies also to his payments if the value of the mortgage bonds go up, he would have to pay them monthly premiums.
How much MBS does Michael Burry insure from Goldman Sachs? Initially, Goldman Sachs offers to insure 5 million in Credit Default Swaps on these mortgage bonds. However, Michael Burry asks if they can insure 100 million instead.
Why do you think Michael Burry went to many different banks for these contracts? Despite the pay-as-you-go structure, he was still worried about the looming financial crisis, and he therefore wanted to reduce the exposure to any one individual bank.
P.5 The Big Short (3/6) - Vennett & Field learn about the CDS deal
How much is the size of Michael Burry’s insuring of CDS in total? Michael Burry had 1.3 billion dollars of exposure in total: 200 million from Deutsche Bank, 200 million from Goldman Sachs, etc.
Why can’t Lawrence Field prevent Michael Burry from investing so much in MBS, even though he runs the fund? They have an inception agreement that Michael Burry has full autonomy when it comes to investment strategy.
Who’s writing angry emails to Michael Burry? The investors in the hedge fund are writing angry emails to Michael Burry, because they do not understand why he wants to short the housing market. They however cannot withdraw their money whenever they want: they have entrusted the fund manager with their money, and the fund manager has some autonomy to invest the money as he wants, without too much pressure from his investors. This allows him to lose funds for a while, and to invest for the longer term.
P.6 The Big Short (4/6) - Vennett’s Pitch to Front Point Partners
Compare the original mortgage bonds to the new ones. Original mortgage bonds were simple: they were just bundles of AAA mortgages guaranteed by the U.S. government. The modern ones are private.
What’s the difference between B tranches and AAA tranches? B are a little riskier, they take on defaults before AAA tranches. If you buy more Bs, you can make more money but sometimes, they fail (so in expectation, you are roughly even).
What makes B and BB tranches increasingly vulnerable? Somewhere along the line, Bs and BBs went to a little risky to being much riskier: low (“rock bottom”) FICO scores, no income verification, adjustable rate mortgages.
What are Credit Default Swaps? The CDS is like an insurance on the bond: it pays if the bond fails. (if the value of the bond drops to zero, and you are insured for 100 million, then you earn 100 million)
What are their potential returns? They mention 10 to 1, 20 to 1 return: the “1” represents how much money you put in up front (you need to pay the premiums), versus how much you expect to gain “20”.
How are CDS in 2006 and fire insurance on a burning house comparable? According to Jared Vennett, the housing market is about to crash, and therefore mortgage bonds are about to drop in value substantially. Therefore, Jared Vennett is selling insurance on something which, to his mind, is already “slowly going bust”: “I’m standing in front of a burning house. And I’m offering you fire insurance on it!”
What is a Colletaralized Debt Obligation? A Collateralized Debt Obligation (CDO) is a repackaging of Bs, BBs, and BBBs that have not sold. The whole bond is then considered diversified. Rating agencies then rate these bonds highly: a good portion of it is even triple A-rated.
P.7 The Big Short (5/6) - Meeting with a CDO manager
Why is the CDO manager not worried about the rise in default rates? The CDO manager is not worried about the rise in default rates, because he assumes no risk for the product himself. Note that this is contradictory with his previous statement, that he puts together the CDOs of the highest possible quality.
Why are the CDO manager’s incentives more aligned with that of JP Morgan than with that of the investors he’s supposed to represent? Merill Lynch sends him customers, only if he puts Merill Lynch’s bonds in his CDO. Therefore, although CDO manager is supposed to put together the bonds with the highest possible quality, his incentives are clearly aligned with that of Merill Lynch. They even give him money to run his business, and give him “fat fees” for doing so.
(not in the video) Why is that not a fully satisfactory explanation for the bad quality of CDOs? Asymmetry in incentives does not alone explain why investors went buying the securities that the CDO manager was offering. Investors should have known that the incentives of the CDO manager were not aligned with their own, and therefore been extra-careful, unless they did not know about the links between the CDO manager and Merill Lynch. (but then, this would perhaps have been considered fraudulent?)
What is the “hot hand fallacy”? Why is that a potential explanation for “real estate bubbles”? The “hot hand fallacy” in basketball is the fact that after a basketball player has made a bunch of shots in a row, he is typically expected to make the next one (as if he had a “hot hand”). More generally, it refers to the behavioral tendancy for investors to extrapolate: most people tend to think that whatever is happening now, will happen in the future. During the real estate boom, people became more optimistic about the housing market, as the housing market was rising in value: for them, this implied that housing was indeed a good investment. Real estate is dominated by rather “unsophisticated” investors, so are perhaps more prone to these types of “irrational exuberance”, as Robert Shiller (an economist at Yale) calls them.
Explain what a synthetic CDO is. A synthetic CDO corresponds to the opposite side of the bet which is made when buying swaps: the counterparty to someone who is insuring mortgage bonds is de facto, long mortgage bonds.
P.8 The Big Short (6/6) - General Questions
Explain how the Fed raising interest rates leads to a fall in disposable income for homeowners with Adjustable Rate Mortgages. With Adjustable Rate Mortgages, a homeowner can end up paying whatever interest rate is applicable after the “teaser-rate” period. This interest rate typically depends on the interest rate which is set by the Federal Reserve. As a consequence, raising interest rates leads to homeowners’ mortgage payments to rise, and therefore to a fall in their disposable income (available for purchases). In terms of the lecture on redistributive policies, this represents a zero-sum transfer from borrowers to creditors, who typically have a much lower propensity to consume. (typically, the ultimate investors in mortgage bonds are pension funds or other types of institutional investors) Moreover, rising mortgage payments tend to lower house prices, as they increase the total cost of owning a home, and make owning relatively less attractive. During the boom, homeowners were able to “refinance”, that is to lower their mortgage payments using the increase in home value, after the teaser rate expired. This was not possible anymore when house prices started to decline.
Explain through the Keynesian multiplier how the crisis was self-reinforcing, and how a small initial shock could have led to so many homeless people. The fall in disposable income, triggered by a rise in the federal funds rate (and probably by other factors as well), led to rising unemployment, as aggregate demand was falling. As a result, there was a further fall in disposable income for those unemployed (mitigated by the existence of unemployment benefits), which led to falling home values, and a rising inability for homeowners to refinance (or engage in equity extraction) - therefore, some homeowners had to default. Note: If you want to know how the financial crisis actually started, Margin Call is a very good movie to understand how the value of Mortgage Backed Securities started to fall, when an investment bank started to sell everything (“fire sales”): https://www.youtube.com/watch?v=7prnY2FOxns.
Why was it so hard to bet against the housing market? Give at least two reasons for this. It was hard to bet against the housing market for many reasons. First, before Michael Burry asked banks to “make markets” for him, there were no options or derivatives instruments for mortgage bonds. Second, even after these became available, one needed an “ISDA” (named after the International Swaps and Derivatives Association) in order to be allowed to trade these complex securities. Getting an ISDA was only reserved for people who worked in major investment banks or funds. Third, mortgage bonds are traded only by a handful of people, who could manipulate markets in order to prevent insurance contracts from rising too much in value (this is what happens at the end). Finally, one needed to “time it right”: Michael Burry, even though he was right in the end, almost lost everything, as for a while the prices of MBSs CDOs were rising in value: it is not enough to be right in the long run, you need to short in a timely way. (similarly, many people shorted the Dot Com bubble in 1999, way too early, and ended up losing everything)
What were the main contributing factors to the financial crisis, according to The Big Short? How can you make sense of it in terms of a fundamental excess of saving over investment? According to The Big Short, distorted incentives (in the case of the CDO manager), inattention (“people care about the ball game.”, “they care about which actressed went into rehab”, etc.), “stupidity” (Jared Vennett mentions this several times) and even sometimes dishonesty all were contributing factors to the financial crisis. At the same time, The Big Short repeatedly refers to the notion that investors really were looking for stores of value, that there was an underlying force behind (what appeared to be with hindsight) imprudent lending. Again, this could refer to the fact that there exists a fundamental excess of saving over investment at the world level, which explains why banks wanted to lend so much in the first place.