Greenspan Endorses Contingent Capital

Alan Greenspan has lost a little of his mystique since McCain said he continue as Fed Chairman after death, but he’s still one of the most knowledgable people out there.

He has delivered a speech at the Brookings Institute that is of great interest.

I can’t find a copyable paper (update: Dealbreaker has one), so you’ll just have to read the speech yourselves or rely on my paraphrases!

He notes that not a single hedge fund has defaulted on debt throughout the crisis, though many have suffered large losses and been forced to liquidate.

The crash of 1987 and the dotcom bubble bursting led the Fed to believe that financial bubbles had disengaged from the real economy.

He strongly doubts that stability can be achieved in the context of a competitive economy.

Capital and liquidity address all the regulatory shortcomings that were exposed by the crisis. Capital has the advantage that it is not necessary to identify which part of the financial structure is most at risk.

The behaviour of CDS spreads in the wake of the Lehman default and TARP imply that the “well capitalized” requirement for total bank capital should be 14%, not 10%, subject to some Herculean assumptions. This will allow bank equity to earn a competitive return while not constricting credit.

The solution, in my judgment, that has at least a reasonable chance of reversing the extraordinarily large “moral hazard” that has arisen over the past year is to require banks and possibly all financial intermediaries to hold contingent capital bonds, that is, debt which is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures, but its existence could materially reduce moral hazard.

The global housing bubble was driven by lower long-term rates, not policy rates. Home mortgage 30-year rates led the Case-Shiller index by 11 months with R-squared of 0.511, compared with Fed Funds, R-squared = 0.216 and and eight-month lead. This makes sense because housing is a long-term asset.

Some people (silly people) get this muddled because the correlation between Fed Funds and 30-year mortgages is 0.83 (until 2002). But the relationship delinked, which was the Greenspan Conundrum, so up yours.

Taylor’s wrong. He equates housing starts (supply) with demand. But starts don’t drive prices, it’s the other way ’round. Builders look at housing prices, not the Fed Funds rate. What’s more the correlation between house prices and consumer prices is small to negative.

Some people (silly people) believe that low Fed Fund rates lowered ARM teaser rates and led to increased demand. But the balance of probabilities is that the decision to buy preceded the decision on financing. Anyway, the correlation of Taylor rule deviations with house prices is statistically insignificant (Dokko, Jane, et al., “Monetary Policy and the Housing Bubble”, Finance & Economics Discussion Series, Federal Reserve Board, Dec. 22, 2009)

Any attempt to instigate a “Systemic Regulator” is ill-advised and doomed to fail. Their models and forecasting ain’t gonna be any better than anybody else’s.

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