Dollars and Jens
Saturday, March 25, 2023
Swiss coco

Financial and economic wealth are largely a function of expectations. A factory is valuable because I expect that it will help produce something that people want; a house is valuable because I expect that it will be a place people want to live. If people suddenly stop wanting to buy what the factory produces — or if they stop wanting to live in that house — then the factory or house loses its value, even if it is physically unchanged.

The size of a bank's liabilities to depositors is pretty clear in dollar terms, at least in principle; the bank owes a precise amount of dollars to depositors, and it owes it to them now. In a practical sense the liability is somewhat lower; the depositors won't all ask for their money right away, even if the bank charges fees. If the bank pays a low enough interest rate and charges fees, then, even with the costs of maintaining the bank accounts, the deposits provide the bank with a cheap source of funding that, in a true economic sense, reduces the size of the liability. Even in that sense, though, the true economic size of the deposits owed to customers is probably not a lot lower than the nominal size.

The asset side of the bank is murkier. If the bank has made a ten-year loan, the value of being entitled to that money depends on how things go over the next ten years; it depends on the ability of the bank to fund itself more cheaply than the interest rate on the loan,[1] and it depends on the ability (and sometimes willingness) of the borrower to actually pay it. The bank may even have investments in companies or real estate, and their value depends on the ability of those assets to provide things people want in the future. There are accounting rules about how we're supposed to guess at the value of these things, but these are merely conventional guesses.

These accounting guesses have some real force insofar as banking regulators impose solvency requirements on banks; the regulators want the bank's assets to be worth more than the liabilities, and use accounting guesses for at least some of those requirements.[2] The regulator's primary purpose is to protect the payment system, and particularly to protect the depositors' ability to get and use their deposits. The solvency requirements serve this in two ways: in the short run, if a bank is low on actual cash but has a lot of assets, it can sell assets or put assets up as collateral to borrow money to give to depositors. To the extent that this is our primary concern, the value of the assets should be reckoned based on the amount of money that could be acquired somewhat quickly by selling or borrowing against them. The primary purpose of the solvency requirement, however, is long-run: if the cash flows from the assets are anticipated to be reliably lower than the cash flows being paid on the liabilities, then eventually the bank will run out of cash, even if the depositors don't do anything weird. A regulation that is only worried about this concern is only worried about cash flows, not how much the asset could be sold for today.

There is an important sense in which, if the market value of your assets is lower than your liabilities, the market is saying that its best guess is that your cash flows in will not ultimately keep up with your cash flows out, but there is a fair amount of wiggle-room here. Market prices of assets bounce around a bit, and if the assets of a bank have gone down in the past three months, the bankers could well say, well, perhaps they will go back up in the next three months. Within certain constraints, the ability of the bank to hold onto cheap deposits does become important; even if the markets imply that funding costs over the life of the asset will eat up cash flows, if the bank can effectively borrow from depositors more cheaply, it may be able to survive. There are accounting rules that codify in certain ways how banks can get away with this; in particular, they can declare that they don't intend to sell certain assets, and if the market price changes they can ignore that change.[3] To some degree this feels like wishful thinking to me, but there's an element of wishful thinking in a well-capitalized bank as well; in one case you're hoping that the market is right, and that the cash flows in will be larger than the cash flows out, while in the other case you're hoping that the market is wrong. Even if we made banks use the market value for all of their assets,[4] the difference between a bank that is solvent and one that is insolvent is not a crisp one; there is a continuum, which is just one reason that the requirement is not just that assets exceed liabilities, but that they do so by some margin.

One new way to evade insolvency was introduced after the 2007–2009 financial crisis: the contingent convertible bond. "Bond" here is something of a misnomer, but they look like bonds in that they typically pay out a fixed interest rate and can be called in after a period of time, much like paying off a bond. Their key feature, though, is that they don't pay out if the bank's assets don't exceed the bank's liabilities by more than a certain specified margin. These "cocos" are designed to be liabilities as long as the bank can afford them, but to go away if liabilities are too large as a fraction of assets; if assets lose value, the cocos take the hit, and the depositors and other claimants on the bank are protected.

Different cocos work in different ways, perhaps in part with different purposes in mind. Most notably, some of them convert into stock or something similar when the asset-to-liability ratio gets too low. (These are the ones that are best called "contingent convertible bonds", though the term "coco" includes other securities that work rather differently.) Some of them convert into ... nothing. They go away. In each of these cases, though, they cease being liabilities, and thereby help restore the asset-to-liability ratio. If their purpose is to deal with long-term sustainability, rather than short-term sustainability (which is the purpose of liquidity regulations rather than capital regulations), then what matters about these things is their cash flow. A lot of them don't convert; they stop paying interest while the bank is in violation of its asset-to-liability requirements, but continue to sit around waiting to pay out again if the bank's situation improves. If the problem is a temporary market dip, or the bank has enough going-concern value that it can ultimately make it, these bonds don't get wiped out; they will lose some value when things look dicey, but it does relatively little harm to let them sit there dormant if the bank gets into trouble, only coming back if the bank's problems turn out to be temporary. It makes a lot of sense to me that they would largely work this way. Even from a short-term standpoint, a bond that works this way is a relatively small encumberance to selling or borrowing against assets, as the liability in practice remains small as long as there's much question of the bank's being able to repay secured loans.

The big exception, though — the point at which it seems like you have to make the coco's impairment final — is when the bank is being sold, especially if it's being sold as a matter of distress. In theory it might make a kind of sense to have the cocos paid off based on a sort of option value, but I can see why, as a practical matter, you might prefer that they be redeemed at par or zero. There's no longer an actual bank here (whose assets and liabilities could be assessed), so the best you could imagine is that it somehow continues to hedge the value of the assets the bank had when it was sold. Prospective buyers may well be averse to carrying around this strange option, and if the assets of the old bank are being folded into those of the purchasing bank, determining whether they recovered or not becomes onerous. Situations like this are usually messy and difficult as things are, and the value of being able to write this liability to zero in these situations seems compelling.

A week ago, the largest bank in Switzerland (UBS) acquired the second-largest bank in Switzerland (Credit Suisse). Both banks did the deal under duress from their primary regulator; Credit Suisse was on the brink of failure, but wanted to keep trying to recover, while UBS saw the balance sheet of Credit Suisse as unsafe at any price. Credit Suisse had some cocos that explicitly provided that they could be converted into nothing in a situation like this, and a lot of the holders of the cocos were disappointed to learn this. Cocos issued by banks in the European Union tend not to have such a provision. The Swiss cocos, indeed, had the provision that they would convert into nothing if the asset-to-liability ratio, as determined by accountants, were breached, even if the bank continued as a going concern. In actual fact, it is clear that UBS (and other potential suitors) thought that Credit Suisse's assets were worth a lot less than their accounting value; perhaps they should have been written down shortly before the takeover, anyway. After the fact, the fact that it was in the provisions of the bond (and was well within the spirit of how the bonds were intended to behave) means, of course, that they could do this; my assertion in this post is that such bonds should be written to be zero-able in this sort of situation, but that, outside of such forced-sale situations, the way the rest of Europe does things — with payments suspended, but the bond still sitting there, dormant, to potentially claim upside surprises if the bank recovers — makes more sense to me.

[1] This is especially important if the loan is a fixed-rate loan, i.e. the amount of dollars that are to be paid along the way is set when the loan is made. A lot of business loans have interest rates that adjust with time, which reduces this problem.

[2] There are in fact a number of requirements, and especially large banks these days are in trouble with the regulator if traditional accounting measures of assets aren't enough above liabilities, but also if other measures of assets aren't enough above other measures of liabilities.

[3] Again, this doesn't apply to all of the requirements that the largest banks face.

[4] And, to be clear, banks often have some assets that don't really have clear market values; if nothing else, traditional banks have office furniture, and any guess as to how much it could be sold or pawned for in an emergency is going to be pretty imprecise.

Sunday, April 03, 2022
price controls and rationing

 There's been inflation, and there have been calls for price controls, and so I've been reading a bit about price controls in history.  Pretty much every time price controls with substantial bite[1] are implemented, you get shortages and black markets; additionally, I had failed to consider how expensive enforcement costs frequently are.  Usually the government gives up on price controls fairly quickly as it becomes clear that the problems created are worse than any mitigation; exceptions seem to be in cases where there is some other form of rationing taking place, typically in war time.

There may be a semantic argument whether rationing avoids shortages or repackages them, and they certainly don't avoid the black markets or enforcement costs, but they do create a little bit more reliability; sometimes consumers are unable to buy as much as the rationing system entitles them to, but it will be less common that they will be unable to buy anything than it will if there is not rationing and similar price controls are enforced.  This made me wonder whether, if price controls did gain political popularity now, we could mitigate some of their effects by implementing a rationing program as well.  After a bit more thought, though, it occured to me that this is a bit redundant; if you impose and enforce a rationing program, that should bring down market demand and reduce prices.  If the rationing is tight enough to bring prices to where you would "control" them, the control becomes superfluous; if it is not, then it isn't enough to restore the sort of reliability being sought with the controls in place, either.

As a political matter, perhaps the price controls would not be superfluous; the price controls may be the popular part, at least to the extent that people don't realize that it will amount to stochastic rationing.  The implementation cost, even if greater than many people appreciate, may also be less than that of a rationing system, and it would certainly tend not to fall directly on individual consumers to the same degree; carrying around ration coupons would be less convenient than heading to the store and seeing what they have in stock.  It would, however, keep prices "controlled" while substantially mitigating the biggest problem simple dictated price controls present — and you wouldn't even need the price controls themselves to do it.

[1] If the price is set at $5, and the market price would be $5.10, effects will naturally be minimal; if the price is set at $5 and the market price would be $20, but only for a couple of weeks, some of the effects won't have time to develop.  I'm mostly considering settings where the price is kept well away from the free price for a substantial period of time.

Saturday, April 25, 2020
reopening the economy
Most of the cost-benefit analysis I've seen of non-medical measures to reduce the contagion of covid have been treating them as an all-or-nothing deal.[1]  I want to think more granularly: independent of why a particular level of contact takes place, consider the incremental cost of a small change in contact.  What are the costs of higher contact?

And the answer leans heavily on the nature of exponential processes, with which people may be more familiar than a month and a half ago.  First, note that the reproduction number of the virus depends on the amount of time an infected person is contagious, in addition to other stuff.[2]  In the fastest exponential growth phase of this disease, cases seemed to increase by a factor of the basic reproduction number about twice per week; I'm going to use "half a week" as the effective infectious time here.  Okay, then, consider some scenario as a baseline, and let's consider a small change from it.  If we eliminate 1% of contacts in a half-week period, and other than that half-week change nothing — go back to the baseline — then in expectation we should have 1% fewer people infected than we would otherwise.  Forever.  Whatever your exponential growth and decrease do after that period, that 1% is locked in.  [3]

Let's suppose the optimal number of QALY that we expect to lose from covid is 2 million; this proceeds from an estimate I've seen of 8.6 per fatality (because they skew older), a guess that we're aiming at close to 100,000 deaths, and a rough factor of a bit over 2 to account for morbidity injuries to patients who recover.  Let's call that $400 billion.  Note that, as opponents of shut-downs like to observe, this is much smaller than the economic costs incurred from shut-downs, but note, as they do not like to observe, that that fact is basically irrelevant because the correct comparison is how much worse things would be, health-wise, if we relax restrictions, compared to how much better the economy would be doing.[4]  So if opening up restaurants of a certain type in a certain manner increases "contacts" by 1%, the cost isn't $4 billion — it's $8 billion per week.  In recent years, the United States economy has produced about $400 billion per week, so if those contacts represent more than 2% of the US productive economy, we should do them; if they represent less, they aren't worth the added health risks.

That first $400 billion number is very rough; you could reasonably suppose that the mortality/morbidity cost is $700 billion or $250 billion.  The other numbers are more reasonably precise, though, and the primary point I want to make is that the optimal response will be one with a lot more economic costs than health outcome costs.

[1] The most egregious versions seem to assume, in fact, that if there is no government response, individuals will blithely behave as usual; in fact, restaurant attendance seems to have dropped about 70% before government action took place, so many of the costs and benefits of "closing down the economy" are independent of government policy actions.  It won't matter whether changes considered here are driven by policy or not.

[2] If you're more infectious at some times than others, we're going to end up with an average of sorts.

[3] This supposes that we aren't going to end up acquiring herd immunity by burning through a large fraction of the population.  If that is in fact what we're going to do, then things change a lot; in fact, the benefit of shutting down is very small once we keep the disease from overwhelming the health care system, and possibly even then if treatment doesn't actually do very much good.

[4] The ratio between "cost/benefit" and "change in cost/change in benefit" is what we call, in economics, an "elasticity", and in most contexts it's on the order of 1 or 2, but boy is it not in this context.

Wednesday, April 01, 2020
total stimulus
The recent COVID relief bill that passed congress has been reported, variously, as being $2.2 trillion in size, or, in some cases, as being $6 trillion, as part of the money is to be leveraged by borrowing $4 trillion from the federal reserve.  There are various people who want to report a big number — journalists like a big number in a headline because it gets attention, some politicians like it because it looks like they're doing a lot, and some populist opponents of the bill trumpet it as an enormity, another massive debt that we are thrusting on the shoulders of future generations.

I view it as a bunch of numbers that are added together.

There are three different kinds of things in the bill, and I would really like to see them broken out separately.  Now, there are two kinds of people these days: people with more free time than a month ago, and people with less.  I'm in the latter camp, so this will not be particularly researched or detailed, but here's a taxonomy of dollar figures:

Finally, I'll note that I've largely joined some prominent economists in avoiding calling it a "stimulus" bill; to the extent that it has similar goals to a stimulus bill, it actually feels more to me like a monetary stimulus than a fiscal stimulus.  The loans in particular have that feel; they're intended not to affect wealth distribution, but to get literal cash to economic agents who suddenly need more cash than they had provisioned for.  This is less true, but still fairly true, of the cash being handed out to individuals; of course, this does involve some wealth redistribution, but the scale of the cash payments is a couple of weeks' spending for many people without savings, or a modest increase in savings for those who suddenly wish they'd been saving more; it is on the scale of short-term spending needs, not on the scale of life-time income or wealth, and is much more attuned to alleviating financing constraints than solvency constraints on economic decision-makers.

Wednesday, July 11, 2018
Roth vs. traditional retirement plans
I have a lot of work I should be doing, but someone is wrong on the internet:
The chart makes a lot of assumptions, including that each investor contributes $1,000 to either the Roth or traditional IRA, that they are in the 25 percent tax bracket and that there is a seven percent annualized return. And in almost every case, the Roth does better than the traditional, even for older workers.
Okay, this is correct: if you give up $1,000 per year now to put into a retirement account that won't be taxed in the future, you will have more retirement savings than if you give up $750 per year now to put $1,000 into a retirement account that will be taxed in the future, at least if you assume the growth rate of the money exceeds the rate at which you discount your marginal consumption spending. (And boy do they seem to assume that, but that's a harder quibble than the apples-to-oranges comparison they're making here.)

They would be on somewhat firmer ground if, instead of supposing each investor contributed $1,000, they supposed that each investor contributed $5,500: because the dollar amounts of the contribution caps are the same, the effective cap on the Roth is higher than the traditional IRA: you can forego up to $5,500 to a Roth, versus (using the 25% rate) $4,125 for a traditional IRA.  Similarly, if you're going to max out a 401(k), even if you think your tax rate in retirement will be somewhat lower than it is now, it may be worth paying the extra taxes now to avoid not just taxes in retirement but compounding taxes along the way.  Furthermore, if you are likely to save more money using one kind of account than the other (perhaps because of the salience of taxes), there may be behavioral reasons to use the one that will incline you toward better behavior.  If you aren't hitting the caps, though, and you think your tax rate in retirement will be lower than today's, and you compare apples to apples, the Roth is your better bet.

Thursday, February 09, 2017
game theory
This might be in part because I'm teaching game theory this semester, but I look at this working paper suggesting that investment has gone down in industries that have become less competitive, and I'm struck by the idea that not only does the optimal level of capital go down if a tacit cartel forms (as production goes down), but that publicly maintaining a low level of capital could be useful in keeping a tacit cartel together; underinvesting is a commitment device, making it hard and costly to ramp up production should there be an otherwise profitable opportunity to deviate from the arrangement.

Friday, June 10, 2016
If you don't read Matt Levine, I don't understand why not; if you do, then you probably have some awareness of Saudi Arabia's build-up to doing an IPO on its massive state oil company, even if you haven't yet read today's column.
A $150 billion initial public offering would be by far the biggest ever; Bloomberg's league tables show about $176 billion in total global equity offerings so far in 2016. And if Saudi Arabia is selling oil shares, who is buying? "There is no guarantee there will be sufficient demand from investors to soak up all the shares," and messing this one up would be many times more embarrassing than messing up, say, the Facebook IPO.
Note that the $150 billion figure itself is only for 5% of the company; the expectation is that Saudi Arabia could retain a 95% share and get $150 billion for the rest of it.  The purpose of the funds is diversification; the plan is to take the $150 billion and turn around and invest it in like Baidu or niobium mines or Caterpillar or something.

I expect that the plan would also be to later sell more of the company, and I kind of wonder whether they picked 5% because $150 billion is the very largest initial deal they think could get pulled off.  I kind of think, though, that they ought to halve it, or maybe even go to 1% or something.  You really only need it to be large enough to create a liquid market in the shares, at which point you can sell more shares into that market later or even directly swap shares for other investments.  You want the initial float to be big enough that you can do those later deals (and maybe $30 billion would leave the market too thin to absorb what you're planning to do later), but it seems like trying to find that much cash among IPO investors when you're not really looking for cash so much as to create your own currency (viz. the shares with which you will purchase other investments) creates a difficulty that at least in principle could be avoided.

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