May 16th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the May 2013 Longbrake Letter. To read the letter in its entirety, click here.
Much ink has been spilled in recent weeks about computational errors, which have been acknowledged, and methodological errors, which have been disputed, embodied in a paper published, “Growth in a Time of Debt” by Carmen Reinhart and Kenneth Rogoff.¹ The latest round of controversy was ignited by a paper published by Thomas Herndon, Michael Ash and Robert Pollin.² The controversy has been heated because it is more than an esoteric intellectual debate among economists.
Reinhart and Rogoff’s research finds that economic growth declines as the government-debt-to-GDP ratio increases. Specifically, when the ratio eclipses 90%, economic growth drops sharply. The computational error had to do with the importance of the 90% cliff. Reinhart and Rogoff have acknowledged this error and agree that there is not a cliff effect, but argue vehemently that economic growth declines, nonetheless, as the government-debt-to-GDP ratio rises.
Reinhart and Rogoff’s research, and especially the so-called 90% cliff effect, has been cited by some as justification for curtailing government deficits. The name for the fiscal policy that focuses on driving down government deficits is referred to as “austerity.” Austerity can involve spending cuts or tax increases or both. In the U.S. austerity policy has been championed by Republicans and is expressly embedded in Paul Ryan’s House of Representatives version of the 10-year federal budget. Ryan’s austerity plan encompasses only spending cuts.
European Union (EU) fiscal policy is decidedly focused on austerity but encompasses spending cuts, tax increases and other kinds of economic reforms. The EU has set a 3% annual budget deficit target and member countries are expected to adopt policies to attain that level within a relatively short period of time, generally two years.
Critics of austerity argue that withdrawing fiscal stimulus through spending cuts and tax increases will depress GDP growth and could decrease growth to such an extent that the debt-to-GDP ratio would rise, rather than fall, because the denominator falls faster than the numerator.
To put this debate into perspective requires a discussion of macroeconomic theory.
1. Keynesian Macroeconomic Policy
There has been an ongoing policy debate among economists and policy makers about the conduct of fiscal policy in times of economic duress. The Keynesian response is that when private aggregate demand declines government must intervene and replace the lost spending power. Then, as private sector demand improves, government stimulus can gradually be withdrawn. Keynesians view fiscal policy as a macroeconomic stabilization instrument. Government stimulus should be added when the economy is at less than full employment but be withdrawn when the economy is at full employment. Government fiscal policy should be neutral over the entire cycle.
Keynesians further argue that without government stimulus there is no assurance that an economy operating at less than full employment will be able to return to full employment on its own. The economy can get caught in a liquidity trap or worse in which a negative reinforcing downward spiral takes hold. The famous economist, Irving Fisher, described this phenomenon in a seminal paper published during the Great Depression which described the debt-deflation process.
Politicians, being the people who they are, especially in democracies, have difficulty withdrawing government stimulus when the economy is strong with the result that a permanent structural budget deficit tends to become embedded. Then, when the economy falters and the budget deficit explodes, the government-debt-to-GDP ratio spirals out of control. And, as Reinhart and Rogoff argue, economic growth may be permanently depressed.
2. Austerity Macroeconomic Policy
Those who espouse a policy of austerity generally are skeptical of government interference in the marketplace. They argue that government intervention is inefficient and messes things up. Worse, those who promote government intervention seek to reallocate resources in ways that diminish aggregate social welfare. In other words, proponents of intervention sponsor income transfer programs that may increase opportunity for those who are less well situated but that reduce opportunity in the aggregate for everyone – that is, total potential GDP contracts.
Thus, those who favor austerity tend to be advocates of the view that government is better when it is small than large and, thus, a policy of “starve the beast” should be pursued. This interconnects with a bias to minimize deficits even in a time of economic duress. In this context evidence that growth is slower as deficits pile up is taken as direct proof that deficit reduction needs to be pursued vigorously.
3. Good Deficits and Bad Deficits – Fiscal Multipliers
There is plenty of evidence that government replacement of lost spending power in an economic downturn is essential to interdict the vicious circle inherent in a liquidity trap and to prime a virtuous circle. In other words, government deficits are an essential ingredient in arresting an economic decline and initiating recovery.
But not all forms of government fiscal policy intervention have the same impact dollar for dollar. The important aspect of stimulus is that it leads to spending that creates jobs. If the stimulus goes into the bank without being spent its impact on economic activity will be limited. The relationship between a type of government stimulus and its longer-term impact on economic activity is measured by the fiscal multiplier. If a dollar of stimulus stimulates a dollar of economic activity, the multiplier is equal to one. Multipliers greater than one are highly desirable while multipliers less than one are not.
When the EU reinforced discipline to reduce budget deficits a couple of years ago it believed fiscal multipliers were less than one. Were this actually true, then debt-to-GDP ratios would have contracted even as GDP declined. In addition, per Reinhart and Rogoff, future GDP growth potential would rise as deficits fell.
Unfortunately, we know from the experience of the last two years that the belief that multipliers were less than one was false. European countries forced to adopt stringent austerity measures have seen their economies collapse with limited if any improvement in their debt-to-GDP ratios. The International Monetary Fund (IMF) owned up to this outcome in research published last year which concluded that fiscal multipliers in times of enormous economic slack are much greater than one.
What all of this means is that when there is a large output gap fiscal policy should focus first on boosting aggregate demand but the mix of fiscal policy programs should emphasize high-multiplier initiatives. Then, only as economic recovery gains traction should deficit reduction rise to the fore.
4. U.S. and European Experiences
Europe has pursued austerity aggressively and has limited its use of monetary policy. Many European countries are still mired in recession and prospects for imminent turnaround are doubtful. Little progress has been achieved in addressing government deficits and high levels of debt. In the meantime social unrest is building and political stability is slowly unraveling.
In contrast, the U.S. initially pursued a traditional Keynesian stimulative fiscal policy. However, many argue that the policy was deficient both in scope and also in composition as the program did not allocate significant resources to high multiplier programs such as investment in infrastructure, education and research.
The U.S. emerged from recession nearly four years ago, but growth has been disappointingly slow since then. Could the recovery have progressed more rapidly in the U.S.? Keynesians argue in the affirmative, but that would have required greater amounts of stimulus.
Now U.S. policy has switched from stimulus toward austerity while the output gap remains extremely large. In the short run this will slow growth. What is important is whether the slowdown is temporary or protracted. My sense is that the negative consequences will linger and the expected strong bounce back in GDP growth that most expect may not materialize. I continue to be concerned about a sustained decrease in productivity growth because of insufficient investment. When deficit reduction is the policy of choice government investment suffers along with other forms of government spending. Reduced investment spending will depress productivity growth and that will decrease potential GDP growth.
5. Does a High Debt-to-GDP Ratio Cause Slow Growth or Does Slow Growth Cause a High Debt-to-GDP Ratio?
Although Reinhart and Rogoff’s 90% cliff finding that economic growth drops dramatically after the government-debt-to-GDP ratio reachs that level has been discredited, GDP growth is still negatively correlated with that ratio. Critics have correctly pointed out that the statistical analysis merely reveals that a correlation exists but does not prove that high debt ratios cause slower growth. The reverse could be true – lower growth leads to higher debt ratios. This debate will continue and I cannot shed any light on the issue of causality.
However, from my own statistical analysis I can corroborate Reinhart and Rogoff’s finding that there is a strong negative correlation. Reinhart and Rogoff analyzed three data sets. The data set that Reinhart and Rogoff (RR) and their critics, Herndon, Ash and Pollin (HAP) focused on covers 20 advanced economies over the period 1945 to 2009. Data were grouped by ranges of debt-to-GDP ratio and the arithmetic mean and median were provided for each range. Table 4 shows the results of both RR’s and HAP’s calculation based on this data set.
Because RR and HAP used the same data set the differences in medians has to do with HAP’s and RR’s disagreement about calculation methodology. To my way of thinking the differences are not particularly material. The negative correlation is apparent and that correlation is monotonic, which means that growth steadily declines as the debt ratio rises. Clearly, there is no 90% cliff effect and RR acknowledged that fact when they corrected their data.
Table 4
GDP Growth for Developed Countries Covering the Period from 1949 to 2009 Classified by the Size of the Government-Debt-to-GDP Ratio
*Originally reported by RR as -0.1%; this was the errant calculation that led to the assertion that there is a 90% cliff effect
#Bill’s analysis is a statistical correlation for the U.S. only covering the time period from 1971 to 2013; debt/GDP ratio is public debt only rather than total debt
Also shown in the last column of Table 4 are the results of statistical analysis I conducted on U.S. GDP and the U.S. public-debt-to-GDP ratio for the period 1971 to 2013. For a lot of reasons my analysis is not strictly comparable to that of RR and HAP. However, the direction of correlation and the general order of magnitude among all of these results are similar.
6. Conclusion
Whether high debt-to-GDP ratios lead to slower GDP growth will continue to be debated. However, what is clear from the analyses is that neither low growth nor high debt ratios is a desirable place to be. However, driving down debt ratios without understanding the transitional impacts on GDP growth can have disastrous consequences. Austerity entails high risks. Outcomes for countries that have pursued austerity are discouraging. Keynesian stimulus appears to achieve better outcomes but a Keynesian fiscal policy, too, can be designed poorly and produce troublesome results.
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1 Carmen Reinhart and Kenneth Rogoff. “Growth in a Time of Debt,” American Economic Review” Papers and Proceedings, May 2010.
2 Thomas Herndon, Michael Ash and Robert Pollin. “Does High Public Debt Consistently Stifle Economic Growth?” PERI Working Paper 322, April 2013.
Tags:austerity, debt-to-GDP, fiscal policy, GDP, longbrake, stimulus.
May 15th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
This is an excerpt from CFP Academic Fellow Phillip L. Swagel’s testimony before the U.S. Senate’s Committee on Banking, Housing, and Urban Affairs on May 14, 2013. Click here for the full transcript.
Bringing private capital back to fund mortgages and take on credit risk is an essential element of housing finance reform, particularly with respect to reform of the government-sponsored enterprises (GSEs) of Fannie Mae and Freddie Mac. Housing finance reform should ensure that mortgages are available across economic conditions, while shielding taxpayers from taking on uncompensated risk and protecting the broader economy from the systemic risks that arose in the previous system. Bringing about increased private capital as part of housing finance reform will help protect taxpayers and improve incentives for prudent mortgage origination by lenders and investors with their own resources at risk.
The situation in housing finance today is that taxpayers fund or guarantee more than 90 percent of new mortgages through the GSEs and through government agencies such as the Federal Housing administration (FHA). Fannie Mae and Freddie Mac stand behind virtually all new conforming mortgages through the two firms’ guarantees on the mortgage-backed securities (MBS) into which the two firms bundle the home loans they purchase from originators. There is loan-level capital to absorb losses in the form of homeowner down payments and private mortgage insurance (PMI), but no private capital at the level of the mortgage-backed security (MBS) ahead of the financial resources of Fannie and Freddie. With the U.S. Treasury committed to ensuring that Fannie and Freddie remain solvent, the U.S. government effectively backstops conforming loans, leaving taxpayers exposed to considerable losses in the event of another housing downturn—and this risk remains even while the two firms are now profitable. Taxpayers further take on credit risk in housing through the government backstop on the Federal Home Loan Bank (FHLB) system, and through guaranteed mortgages supported by the Federal Housing Administration (FHA) and other federal agencies. I have previously testified on reforms to the FHA that would better protect taxpayers while focusing the agency on its mission to expand access to mortgage financing for low- and moderate income families who have the financial wherewithal to become homeowners.¹ I thus focus here on GSE reform.
Bringing back private capital into housing finance would mean that private investors would absorb losses as some mortgage loans inevitably are not repaid. In some instances, this could involve mortgage loans with no government guarantee, while in others there could be a secondary government guarantee that kicks in only after private capital absorbs losses (or the guarantee could be alongside private capital, with losses shared). Private investors would be compensated for taking on housing credit risk, so that it should be expected that mortgage interest rates will increase as housing finance reform proceeds. This interest rate impact reflects the facts that the previous system was undercapitalized and provided inadequate protection for taxpayers.
It would be useful for reform to allow for a diversity of sources of funding for housing, and for private capital to come in a number of forms and through a variety of mechanisms. This will help make the future housing finance system more resilient to economic and market events that affect particular parts of financial markets and thus impinge on the availability of funds for housing.
At the level of the individual loan, capital for conforming mortgages will continue to be present from a combination of homeowner down payments, private mortgage insurance, and the capital of originators that carry out balance sheet lending. The recent housing bubble and foreclosure crisis highlighted the importance of homeowner equity as a factor in avoiding foreclosures, as foreclosure rates were especially elevated for underwater borrowers—those who owed more on their mortgages than the value of their home. As reform proceeds, it is vital to ensure that meaningful down payments remain a central aspect of underwriting and a requirement for mortgages to qualify for inclusion in MBS that benefit from a government guarantee. Similarly, regulators must ensure that private mortgage insurers have adequate levels of their own high-quality capital to participate in mortgages that receive a government guarantee.
The larger changes involved with the return of private capital to mortgage origination will come at the level of the mortgage-backed security. With nearly all securitization of conforming mortgages going through the GSEs, there is essentially no capital at the MBS level. The so-called profit sweep agreement between the Treasury Department and the two GSEs prevents Fannie and Freddie from building up the capital that would be the norm for an insurer.
Fannie and Freddie are setting up risk-sharing mechanisms to allow private investors to invest in securities that will take losses ahead of the firms’ guarantee (that is, ahead of the taxpayer guarantee). There is still little securitization of mortgages taking place without a guarantee (private label securitization of non-conforming loans), and firms other than Fannie and Freddie are not allowed to compete in the business of securitization of conforming mortgages with a government guarantee.Housing finance reform should involve changes on all of these dimensions so that private capital is present at the MBS-level.
¹February 28, 2013, Senate Banking Committee hearing on “Addressing FHA’s Financial Condition and Program Challenges, Part II.”
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Tags:GSE, housing finance, mortgage-backed securities, swagel.
April 19th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the April 2013 Longbrake Letter. To read the letter in its entirety, click here.
Most analysts expect the European Union (EU) and the Eurozone (EZ) to return to growth by the second half of 2013. This belief appears to be based upon the quiet that has prevailed in financial markets since last August when president of the European Central Bank (ECB), Mario Draghi, announced that the ECB would “do whatever it takes” to preserve the euro. It is also based on modest improvements in economic performance in northern EU countries with the exceptions of France and the Netherlands.
I think this expectation will turn out to be optimistic. As I have mentioned repeatedly, European policy makers have been effective in stabilizing financial markets through a variety of initiatives, but none of these has addressed effectively fundamental political and economic reforms which are necessary in the long run to assure the viability of the EU and the common currency, the euro, used in EZ countries. And, as feared, stabilization of financial markets since last August has reduced the sense of urgency on the part of policymakers to pursue essential reforms.
Political risks are rising. The outcome of the recent Italian election in which the populist Five Stars party garnered 25% of the vote made that risk abundantly clear. Nearly two months after the Italian election a new Italian government has yet to be formed. When one is formed it is expected to be weak and new elections are expected within a year.
Cyprus was bailed out and bailed in. Although the market reaction subsequent to this crisis has been muted, details of the resolution sowed poisonous seeds that are likely to come back to haunt policymakers in the future.
Next up for bailout and, perhaps, bail-in is Slovenia.
Euro-skeptic parties, while still far distant from obtaining real political power, are growing in many EU countries. The slow unraveling of the European Project is continuing. A majority of Italians voted for euro-skeptic parties. In Greece, polls indicate that the euro-skeptic party, Syriza, which is not part of the current governing coalition, commands a majority of popular support. A new political party, Alternative for Germany, has formed in Germany. This party is a collection of elites and not populists, as in other EU countries. Alternative for Germany’s principal policy position is to terminate the European currency union. Polls indicate that as much as 25% of the German electorate is sympathetic to the new party’s policy position, but whether that will translate into a significant number of votes in the September German parliamentary elections remains to be seen.
Social unrest continues to escalate in peripheral countries like Portugal and Greece.
Current Economic Situation
Recent data tell a story of a struggling economy – one that generally is not getting worse, but isn’t signaling the kind of turn around that most expect. Confidence fell more than expected in February, implying that economic recovery is falling short of expectations. Retail sales year-over-year, as of February, were down -1.4%. While this was an improvement from January’s -1.9% it was worse than the expectation of -1.2%. Industrial production rose 0.4% in February; however, January data was revised down from -0.4% to -0.6%. Year over year, industrial production fell -3.1% in February compared to -2.4% in January. The March composite purchasing managers index fell to 46.5 in March from 47.9 in February. A value below 50 means that industrial production is contracting. Auto sales continued to decline in March and are down approximately 30% from post-Great Recession highs.
As might be expected, economic performance in peripheral countries generally is worsening. Greece’s industrial production continues to decline and is now 40% below the pre-Great Recession level. Spain’s industrial production is down -6.5% over the last year and retail sales have fallen -7.8%.
Data reports in Germany and France were both weaker than expected in March. Germany’s purchasing managers index slipped to 48.9 from 50.3 in February, suggesting that the incipient German economic recovery may be stalling. In France, the economic situation continues to deteriorate. The composite purchasing managers index, which includes both manufacturing and services, fell to 42.1 in March from 43.1 in February.
Optimism about Europe’s ability to emerge from recession has been based on two considerations. First, slowly improving global growth will be positive for European exports. Recent evidence indicates that global growth is not improving but is trending at 2012 levels, but with growing downside risks. However, because of aggressively easy monetary policy in the U.S. and now in Japan, the value of the euro is appreciating. If this appreciation is not contained or reversed it will negatively impact European exports. Germany’s manufacturing-export-based economy is particularly vulnerable to an extended strengthening of the euro. The ECB does not appear inclined to engage in policies, specifically quantitative easing, aimed at decreasing the value of the euro. At best these developments will delay Europe’s emergence from recession; at worst they will contribute to deepening and extending the recession.
Second, there is a presumption that the banking and sovereign debt crises are slowly being resolved. As the recent events in Cyprus clearly demonstrate, this presumption is not soundly based. Abatement of turmoil in financial markets is not an indicator that the underlying problems have been addressed and resolved. Provision of unlimited amounts of liquidity, which is what the principal remedy has been to date, can treat the symptoms but cannot cure the disease. The disease is deeply rooted in balance of payments mismatches among members of the EU and EZ, differences in competitiveness among countries and the absence of effective economic and political governance mechanisms. Can Europe emerge from recession when these fundamental problems remain unresolved? Perhaps, but a return to normal growth seems to be a real stretch of the imagination. The European financial system remains deeply dysfunctional and like the Japanese financial system of the 1990’s will not be in a position anytime soon to facilitate the kind of credit creation essential to promote economic growth.
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Tags:Europe, Europe Debt Crisis, longbrake, recession.
April 17th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Laurent Frésard, Assistant Professor of Finance
This post is based on a paper co-authored by Michel Dubois, University of Neuchatel – Institute of Financial Analysis; Laurent Frésard, University of Maryland – Robert H. Smith School of Business; and Pascal Dumontier, University of Grenoble; French National Center for Scientific Research (CNRS)
Over the past decades, securities firms and their analysts have often been accused of producing overly optimistic research to attract and retain investment banking clients. Given the central role that analysts play in disseminating information across market participants and guiding investment decisions, regulatory agencies have taken corrective actions. As part of a large effort to better protect consumers and to restore trust in financial markets, several national regulators have designed new rules aiming to curb conflicted equity research and improve the overall quality of analysts’ output. As with any new law the effectiveness of security regulations depends on how the new rules are designed, but also crucially on the associated legal sanctions and their practical enforcement. In a period characterized by increasing pressure to regulate the financial system, better understanding the real consequences of regulatory changes and the role played by legal sanctions and their enforcement turns out to be of paramount importance.
In a recent study conducted with Michel Dubois (University of Neuchatel) and Pascal Dumontier (University of Grenoble) that is forthcoming in the Review of Finance, we shed new light on this question by analyzing an important regulatory change in the European Community (EC). In 2003, the European regulators decided to enact the Market Abuse Directive (MAD). Aiming to reorganize and increase confidence in European financial markets, this regulation includes several provisions targeted to curb conflicts of interest in equity research. Similarly to U.S. rules (e.g. RegFD, NASD Rule 2711, NYSE Rule 472 and SOX501), MAD limits the relationship between research and investment banking departments, and creates stringent disclosure requirements on the nature of such relationships (Directive 2003/125). These changes in the European regulatory landscape allow us to provide novel evidence on the interplay between the severity of legal sanctions, enforcement and the behavior of financial analysts. Indeed, due to the absence of full legal harmonization across European countries, the enforcement of MAD’s provisions and the sanctions in case of violations remain ultimately in the hands of national authorities. Hence, while the new rules apply equally in all Member States, the penalties and the actual enforcement vary across countries. In addition, while all EC Member States were required to adopt MAD, they did so at different points in time. For instance, Germany implemented MAD in October 2004, the U.K did it in July 2005 but Portugal only enacted it in March 2006. We use this heterogeneity to empirically separate the role of sanctions and enforcement from the change in rules.
To evaluate the impact of the new European regulation on the nature and magnitude of conflicted equity research we focus on the dynamics of stock recommendations issued by brokerage houses around the European regulatory change. To identify the presence of conflicts of interest, we rely on the exact provision of the European Directive that states that any recommendation made by (an analyst working for) a broker on a firm for which it has acted as underwriter or adviser over the last twelve months is considered as being exposed to conflicts of interest. Across a large sample of recommendations made on stocks listed in thirteen European countries between 1997 and 2007 (261,260 recommendations), we estimate that conflicted brokers issued recommendations that were on average more optimistic than their peers in the pre-regulation period. While “Sell” and “Strong Sell” investment recommendations account for 18% of non-conflicted recommendations before MAD, they only represent 7% of the recommendations issued by conflicted brokers. Likewise, the proportion of “Buy” and “Strong Buy” is significantly larger for conflicted (60%) than for non-conflicted (46%). Similarly to what has been documented in the U.S., these descriptive results indicate that recommendations issued by certain brokers on European companies were severely tainted by conflicts of interest before the adoption of MAD.
Overall the passage of the Directive was successful. The enactment of MAD significantly mitigated the effect of conflicts of interest on equity research. After MAD, the distribution of recommendations issued by conflicted brokers is much less skewed towards favorable recommendations. The proportion of “Sell” and “Strong Sell” from conflicted brokers increases to 10%, while the proportion of “Buy” and “Strong Buy” decreases to 51%. In contrast, we observe virtually no change in the recommendations of non-conflicted brokers.
Strikingly, the magnitude of the conflicted brokers’ bias varies considerably across countries in the pre-MAD period. For instance, while conflicted brokers exhibit almost no sign of over-optimism in Belgium, the bias appears particularly strong in Austria and the U.K. In addition, we observe an important heterogeneity in the mitigating impact of MAD among European countries. The reduction of the over-optimism bias of conflicted brokers ranges from 50% in Sweden to more than 100% in Portugal, where conflicted brokers became slightly (over-) pessimistic.
Further analyses reveal that this heterogeneity is related to the severity of the legal sanctions that are specifically applicable in cases of violations of MAD. A recent report by The Committee of European Securities Regulators (CSER) highlights substantial differences in administrative and penal sanctions across countries. The European Commission considered that “…there are significant differences and a lack of convergence across the EU in terms of the sanctions available for market abuse as well as the application of those sanctions. At present sanctions are simply too weak in some Member States and lead to the risk of weak enforcement and even regulatory arbitrage”.
To measure sanction severity, we gather specific information on the potential sanctions brokers face in each country in cases of violations of MAD articles. For each country, we aggregate the relevant pecuniary administrative sanctions and criminal sanctions, including imprisonment and fines, to construct an index of sanction “severity” that goes along with the implementation of MAD. We document that the effect of MAD is significantly stronger in countries where MAD’s sanctions are strong. After MAD, the over-optimism of conflicted brokers is virtually eliminated in countries equipped with severe sanctions (e.g. Ireland or France) but only decreased by around 70% in the countries where sanctions are milder (e.g. Scandinavian countries).
The strength with which each country enforces its securities laws also appear to play an important role in shaping brokers’ incentives. In sharp contrast with the U.S., European countries almost exclusively rely on public enforcement. We show that the reduction of conflicts of interest in the aftermath of MAD is much larger when countries allocate more resources to their financial supervisors. This is true when we consider the budget countries dedicate to financial supervision or the size of the staff working for supervisors.
Overall, our study underscores the need to distinguish between new rules, the associated sanctions and their practical enforcement, to properly understand the outcomes of financial regulations. Even though the provisions of MAD apply similarly to each European country, our results suggest that affiliated brokers perceive the effective risk associated with a violation to vary from one country to another, and adjust their behavior accordingly. Our cross-country analysis indicates that the efficacy of imposing new rules to tackle conflicts of interest rests on the severity of the sanctions imposed in case of violations and the power with which regulators enforce the rules.
These results have important implications for the expected outcomes of future regulatory reforms and the efforts to harmonize regulation across countries. Fostering harmonization and improving the cooperation and coordination among national regulatory agencies remain a top priority and challenge for the European Union and the stability of European financial markets.
Given the richness of the European setting and the heterogeneity that exists between Member States, studying regulatory changes in Europe appears to be a promising laboratory to better understand what shapes regulatory outcomes more generally. For instance, the provisions of MAD encompass a broad spectrum of actors, including firms and their executives, financial institutions, investors, stock exchanges, auditors, and regulators. While our study focuses on brokers and their conflicted incentives, the enactment of MAD can be used to examine how regulatory events affect different actors and more generally how they modify the functioning of (European) financial markets. There is some valuable early evidence on some of these issues. For instance, Christensen, Leuz, and Hail (2011) report that the implementation of MAD and the later adoption of the European Transparency Directive in 2007 triggered a significant increase in liquidity across European markets.
A copy of the paper is available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1786523
Tags:corporate finance, Europe, Financial Regulation.
April 10th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
This is an excerpt from Executive-in-Residence and Tyser Teaching Fellow Cliff Rossi’s testimony before the United States House of Representatives’s Subcommittee on Housing and Insurance Of the Committee on Financial Services on April 10, 2013. Click here for the full transcript. Click here for an archived webcast of the testimony.
Unquestionably, FHA has served a critical role in our nation’s housing market by providing affordable credit to over 40 million first-time homebuyers and other borrowers with limited resources that would otherwise have difficulty obtaining access to credit through more traditional private sector sources. The recent financial crisis and its aftermath underscored the importance of FHA’s countercyclical role in providing much needed liquidity and credit to mortgage markets reeling from the withdrawal of private capital during this period. At the same time, FHA in its capacity as public steward of the $1 trillion plus Mutual Mortgage Insurance Fund (MMIF) has responsibility for maintaining the financial integrity of that fund which according to recent actuary analyses has lately experienced considerable stress.
The current state of the MMIF can be directly attributed to a lack of clarity in the scope of its programs, mission conflict between maintaining actuarial soundness of the MMIF and advancing homeownership opportunities to prospective borrowers, a lack of resources to effectively identify, measure and manage risk consistent with an insurance fund of the scale and complexity of the MMIF and a lack of systematic and proactive countercyclical policy mechanisms to guide the agency as economic circumstances change. The question for policymakers is what changes should be made to FHA that provide the agency with the best opportunity to fulfill its critical mission to housing while also protecting the taxpayer?
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View webcast of testimony
Tags:fha, housing finance, MMIF, reform, Rossi.
March 25th, 2013 by Michelle Lui under Faculty Commentary. No Comments.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
This is an excerpt of the March 2013 Longbrake Letter. To read the letter in its entirety, click here.
Stock prices are posting new highs on a regular basis. Employment is improving more rapidly than expected with the unemployment rate hitting a new post-Great Recession low of 7.7% in February. Manufacturing has accelerated in spite of a stronger dollar. Businesses and consumers are a bit more optimistic. In the face of tax increases, consumer spending is holding up surprising well. Housing prices are rising at an accelerating rate.
After four years of feeble recovery, in the words of Goldman Sachs, “Are We Already over the Hump?”
What about all the gloom and doom about the consequences of higher taxes and automatic across-the-board federal spending cuts (sequestration)?
Experience strongly indicates that it is too early to conclude that the recovery is gathering momentum. Data reports lag events and are often revised. Tax increases have only been in place for two months and the sequester became effective at the beginning of March and probably won’t have much impact until April. It is generally agreed that the negative impact of fiscal policy will amount to about 2.0% of real GDP in 2013. This is significant. For the economy to gain momentum at this juncture requires growth in other sectors of the economy to be great enough to offset negative fiscal policy. That seems to be a very tall order.
Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) believes the U.S. is entering a recession. He points out that key data have been weakening since the middle of last year. Real GDP growth and production have been slowing. Courtesy of austere fiscal policy, consumption is about to slow significantly. And, growth in corporate profits has disappeared.
Supportive of ECRI’s pessimism is the Chicago Fed National Activity index, which posted a negative value in January for the first time since October. This measure implies that growth is below trend, but it is not negative.
What seems most probable is that 2013 will be a year of slow growth in the U.S. with improving momentum as the year progresses and the near-term negative impact of higher federal taxes and reduced spending unwinds. The trend in global economic activity should be moderately supportive of growth.
However, when growth is weak, it wouldn’t take much to push it down or even trigger recession. With the exception of natural disasters, most potential downside risks can be identified, but whether or when they might erupt and impact the economy is impossible to forecast unless you believe in soothsayers.
In December I listed six risks. The status of each risk is summarized in the Appendix at the end of this month’s letter. To these six must be added a new one involving the growing possibility of hostilities on the Korean peninsula. North Korea just annulled the 1953 armistice and has threatened to attack a South Korean island. Although some might dismiss this as “posturing”, foreign policy analysts are worried and U.S. military planners are beefing up missile defense systems.
In the longer run, significant challenges face the U.S. economy, but whether and how they are resolved will have little impact on the economy in 2013.
Perhaps the single greatest challenge facing the U.S. economy over the longer run is the trend in potential structural real GDP growth, which has plummeted in recent years, largely due to a decline in productivity, but also partially due to slowing population growth.
While most economists expect productivity to be near the long-term historical average in coming years, this expectation seems to be more one of simplistic extrapolation of past experience than one of critical analysis. A sustained decline in productivity growth, should it occur, is important because it would result in slower growth in potential GDP. Slower growth in potential GDP means it will be harder and take longer to reduce the burden of federal debt, it will make it harder to finance social programs and it could exacerbate the problem of growing income inequality.
Better focused government policies, which encourage private sector investment and target direct government investment in infrastructure, research and education, have the potential to lift productivity significantly over time. Such policies generally have much higher multipliers than the kinds of transfer payments that have predominantly comprised fiscal policy in recent years. But such policies also take longer to produce results.
My point is that government policy should not be focused exclusively on increasing consumption spending and reducing unemployment. It also needs to focus on lifting the structural potential real rate of GDP growth. Effective policy would have the dual benefits of raising the rate of growth, thus reducing the debt burden more rapidly, but very importantly it would raise the standard of living for Americans to a greater extent.
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Tags:economic growth, economic recovery, GDP, Housing, longbrake, unemployment.
March 1st, 2013 by Michelle Lui under Faculty Commentary. No Comments.
This is an excerpt from CFP Academic Fellow Phillip L. Swagel’s testimony before the U.S. Senate’s Committee on Banking, Housing, and Urban Affairs on February 28, 2013. Click here for the full transcript.
More needs to be done to safeguard the financial stability of the FHA and thus to ensure that it carries out its mission; to protect taxpayers against even greater losses and the possibility of a future bailout; and to boost overall U.S. economic growth by ensuring that the private sector and not the government plays the leading role in allocating capital. I focus below on policy measures that would achieve these goals while better targeting government resources that are deployed in the form of support for homeownership through the FHA to families who most need assistance to become homeowners.
To be sure, the unwelcome financial condition of the FHA reflects the effects of the collapse of the housing bubble, ensuing recession, and subpar growth of jobs and incomes over the past four years. The combination of these developments led to elevated losses on FHA – guaranteed mortgages originated from 2000 to 2009, and especially on loans made starting in 2007 when the shutdown of subprime lending led riskier borrowers to migrate toward FHA – backed loans. The effects of these loan guarantees are still felt, as indicated in the most recent figures for the National Delinquency Survey released by the Mortgage Bankers Association that show a slight increase in delinquencies for FHA – backed loans at the end of 2012 when delinquency rates for other types of loans continued to decline.
These various factors affecting FHA – backed loans provide an explanation of the FHA’s situation but not an excuse. Indeed, the negative value of the MMIF came about because the underwriting standards, insurance pricing, and other practices of the FHA have taxpayers provide an underpriced guarantee with 100 percent coverage of the mortgages taken out by risky borrowers, many with scanty down payments and thus little protection against home price declines.
Some of the practices which brought about the FHA’s problems have changed, with an end to seller – funded down payments, some changes to practices for home equity conversion mortgages (HECM; so – called reverse mortgages), and increased actions to address problematic originators and underperforming servicers. But more needs to be done to protect taxpayers, to target FHA
activities more effectively, and to ensure that the costs, risks, and benefits of FHA activities are transparent,accurately accounted for in government books, and understood by policymakers and the general public. In doing so, the FHA should return to its traditional share of about 10 to 15 percent of the housing finance market so that government does not take on an inappropriately high level of risk and distort the housing market.
In considering reforms, it is important both to address the present solvency concern and to ensure that the FHA is focused on its core mission while avoiding risks that pose a threat to its future solvency. Maintaining an oversized FHA is not the best approach to addressing solvency either today or into the future. With insurance premiums that appear still to underprice risk, a continued large footprint for the FHA compounds the solvency risks rather than addresses them. Moreover, maintaining an outsized role for the FHA means increased distortions in the broad housing market as the government seeks to artificially boost demand for housing — an approach that in the past led to considerable suffering for borrowers who prematurely attempted to take on the financial responsibilities of homeownership. It is intrinsically pro-consumer to strengthen underwriting standards to ensure that borrowers are capable of staying in their homes. The FHA Emergency Fiscal Solvency Act considered by the Committee in 2012 is a useful starting point for reform but is not enough. Additional measures are needed to ensure the solvency of the FHA, reduce its market share, and improve its efficiency, effectiveness, and ability to manage risk.
Measures that should be taken as part of FHA reform include:
1.Improve the pricing of FHA insurance. As was included in the FHA Solvency Act, it would be useful to increase both the minimum and maximum annual premiums on FHA loans and to utilize the scope for pricing insurance in line with risks. In the meantime, the FHA should use its existing authorities to tighten its insurance pricing. These steps will mean higher costs for homebuyers, but this reflects the risks borne by taxpayers. At the very least, the FHA should use its existing scope to raise annual insurance premiums until the MMIF regains its minimum required 2 percent capital ratio.
An important consideration is that Fannie Mae and Freddie Mac are taking steps to increase the pricing of the insurance they offer on mortgages and also eventually to require private capital in a first – loss position ahead of the government guarantee. Absent corresponding action by the FHA, borrowers who might otherwise qualify for conforming loans backed by Fannie and Freddie will migrate toward the FHA and its less stringent underwriting standards. This could lead to increased risk for the FHA and thus greater net exposure for taxpayers since loans backed by the FHA are riskier than those backed by Fannie and Freddie. This concern is illustrated by the experience starting in 2006 when the shutdown of subprime origination resulted in borrowers turning to FHA -backed loans for mortgages, with dire consequences for the financial condition of the FHA.
2.Require higher down payments for additional categories of relatively risky borrowers. The FHA is unusual in allowing borrowers to have relatively modest downpayments. While this helps first-time homeowners who have not accumulated the resources for larger downpayments, a lesson of the recent crisis is that housing prices go down as well as up, and that ensuring that borrowers have equity in their home is vital to avoid foreclosures and to safeguard the stability of the housing market. As noted above, it is intrinsically pro-consumer to ensure that homebuyers get into houses and mortgages that they can sustain. The FHA now requires 10 percent downpayments for borrowers with FICO scores below 580. It would be useful to add a tier with a required downpayment of 5 percent for borrowers with FICO scores from 580 to around 620 (with the precise cutoff depending on an evaluation of risk factors). As an alternative, borrowers could be offered a choice of retaining the lower downpayment with a shorter loan term such as 20 rather than 30 years. The goal is to ensure that risky borrowers build up an sizable equity stake in their homes relatively quickly. The Committee should also consider whether borrowers with very low FICO scores such as 500 to 580 should be eligible for FHA-backed loans in the first place.
3.Reduce FHA loan limits in order to shrink the FHA market share and focus government assistance on homebuyers who most need assistance. The current loan limit of up to $729,000 means that the FHA is serving a population far outside of its mission, and this would still be the case if the FHA loan limit is allowed to revert to $629,500. It is misguided to assert that the FHA should continue to insure these high-dollar loans because they are profitable and will help to recapitalize the MMIF. As discussed below, the FHA books profits under government accounting procedures that understate the risks of its activities. Indeed, the FHA loan limit exceeds that for mortgages guaranteed by the U.S. government through support for Fannie Mae and Freddie Mac, even though the underwriting requirements for those two firms are more conservative than those of the FHA. Moreover, the FHA activity displaces the private sector to the detriment of the overall U.S. economy. Even if jumbo loans above the GSE conforming loan limits were profitable for the FHA, it would be better to allow the private sector to gauge the creditworthiness of people seeking to buy homes of three-quarters of a million dollars or more (including the down payment on top of the maximum loan amount). It is noteworthy that the recent report from the Bipartisan Policy Center’s (BPC) Housing Commission calls for loan limits for government-backed loans to be set at $275,000 in order to focus public support on families most in need (and then would accompany this with increased spending to support affordable housing for both owner-occupied and rentals).
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Tags:fha, Housing, reform, swagel.
by Bill Longbrake, Executive-in-Residence, Center for Financial Policy
