Topic: Finance, Banking & Monetary Policy

Yet Another Greek Secret: The Case of Phantom Assets

When banks are in distress, it is important to assess how easily the bank’s capital cushion can absorb potential losses from troubled assets. To do this, I performed an analysis using Texas Ratios for Greece’s four largest banks, which control 88% of total assets in the banking system.

We use a little known, but very useful formula to determine the health of the Big Four. It is called the Texas Ratio. It was used during the U.S. Savings and Loan Crisis, which was centered in Texas. The Texas Ratio is the book value of all non-performing assets divided by equity capital plus loan loss reserves. Only tangible equity capital is included in the denominator. Intangible capital — like goodwill — is excluded.

Despite the already worry-some numbers, the actual situation is far worse than even I had initially deduced. A deeper analysis of the numbers reveals that Greece’s largest banks include deferred tax assets as part of total equity in their financial statements. Deferred tax assets are created when banks are allowed to declare their losses at a later time, thereby reducing tax liabilities. This is problematic because these deferred tax assets are really just “phantom assets” in the sense that these credits cannot be used (read: worthless) if the Greek banks continue to operate at a pretax loss.

Contra Shiller: Stock P/E Ratio Depends on Bond Yields, Not Historical Averages

The Wall Street Journal just offered two articles in one day touting Robert Shiller’s cyclically adjusted price/earnings ratio (CAPE).  One of then, “Smart Moves in a Pricey Stock Market” by Jonathan Clements, concludes that, “U.S. shares arguably have been overpriced for much of the past 25 years.” Identical warnings keep appearing, year after year, despite being endlessly wrong.  

The Shiller CAPE assumes the P/E ratio must revert to some heroic 1881-2014 average of 16.6 (or, in Clements’ account, a 1946-1990 average of 15).  That assumption is completely inconsistent with the so-called “Fed model” observation that the inverted P/E ratio (the E/P ratio or earnings yield) normally tracks the 10 year bond yield surprisingly closely.  From 1970 to 2014, the average E/P ratio was 6.62 and the average 10-Year bond yield was 6.77.  

When I first introduced this “Fed Model” relationship to Wall Street consulting clients in “The Stock Market Like Bonds,” March 1991, I suggested bonds yields were about to fall because a falling E/P commonly preceded falling bond yields. And when the E/P turned up in 1993, bond yield obligingly jumped in 1994.

Since 2010, the E/P ratio has been unusually high relative to bond yields, which means the P/E ratio has been unusually low.  The gap between the earnings yield and bond yield rose from 2.8 percentage points in 2010 to a peak of 4.4 in 2012.  Recylcing my 1991 analysis, the wide 2012 gap suggested the stock market thought bond yields would rise, as they did –from 1.8% in in 2012 to 2.35% in 2013 and 2.54% in 2014.

On May 1, the trailing P/E ratio for the S&P 500 was 20.61, which translates into an E/P ratio of 4.85 (1 divided by 20.61). That is still high relative to a 10-year bond yield of 2.12%.   If the P/E fell to 15, as Shiller fans always predict, the E/P ratio would be 6.7 which would indeed get us close to the Shiller “buy” signal of 6.47 in 1990.  But the 10-year bond yield in 1990 was 8.4%.  And the P/E ratio was so depressed because Texas crude jumped from $16 in late June 1990 to nearly $40 after Iraq invaded Kuwait. Oil price spikes always end in recession, including 2008.

Today’s wide 2.7 point gap between the high E/P ratio and low bond yield will not be closed by shoving the P/E ratio back down to Mr. Shiller’s idyllic level of the 1990 recession.  It is far more likely that the gap will be narrowed by bond yields rising. 

None of the Fed’s Business

The latest Commerce Department report and FOMC press release have, as usual, led to a flood of commentary concerning the various economic indicators that the Fed committee must have mulled over in reaching its decision to put off somewhat longer its plan to start selling off assets it accumulated during the course of several rounds of Quantitative Easing.

Those indicators also inspire me to put in my own two cents concerning things that should, and things that should not, bear on the FOMC’s monetary policy decisions. My thoughts, I hasten to say, pay no heed to the Fed’s dual mandate, which is itself deeply flawed. But then again, since that mandate allows the FOMC all sorts of leeway in making its decisions, I doubt that it would prevent that body from following my advice, assuming it had the least desire to do so.

I have a simple–some may call it quaint–way of deciding whether some information supplies reason for the Fed to either sell off or buy more assets. Here it is: does the information offer reliable evidence of either a shortage or a surplus of nominal money balances?

More Proof of Math Gone Mad

Last September Kevin Dowd authored a dandy Policy Analysis called “Math Gone Mad: Regulatory Risk Modeling by the Federal Reserve.” In it Kevin pointed to the dangers inherent in the Federal Reserve’s “stress tests,” and the mathematical risk models on which those tests are often based, as devices for determining whether banks are holding enough capital or not.

Recently my Cato colleague Jeff Miron, who edits Cato’s Research Briefs in Economic Policy, alerted us to a new working paper, entitled “The Limits of Model-Based Regulation,” that independently reaches conclusions very similar to Kevin’s. The study, by Markus Behn, Rainer Haselmann, and Vikrant Vig, is summarized in this month’s Research Brief.

The authors conclude that, instead of limiting credit risk by linking bank capital more tightly to the riskiness of banks’ asset holdings, model-based regulation has actually increased credit risk. At the same time, because the model-based approach is relatively costly, large banks are much more likely to resort to it then smaller ones. Consequently, those banks have been able to expand their lending–and their risky lending especially–at the expense of their smaller rivals. In short, big banks gain, small banks lose, and we all are somewhat less safe than we might be otherwise.

Here is a link to the full working paper.

[Cross-posted from]

What You Should Know about Free Banking History

This is a revised excerpt from White (2015), and the first item in our “What You Should Know” series offering essential background information on various alternative money themes.

Historical monetary systems that are properly classified as free banking systems, in Kevin Dowd’s (1992, p. 2) words, have involved “at least a certain amount of bank freedom, multiple note issuers, and the absence of any government-sponsored ‘lender of last resort.” There were 60-plus episodes around the world of plural private currency issue in the 19th century (Schuler 1992). Dowd (1992) has compiled studies of 9 of these episodes, and Ignacio Briones and Hugh Rockoff (2005) have surveyed economists’ assessments of 6 relatively well-studied episodes: Scotland, the United States, Canada, Sweden, Switzerland, and Chile. Because none of the six systems they review enjoyed complete freedom from legal restrictions, they suggest that “lightly regulated banking” is a more accurate label than “free banking.” All these nineteenth-century episodes had another feature worth mentioning: banknotes and deposits were denominated in and redeemable for silver or gold coins.

When we look into these episodes, we find a record of innovation, improvement, and success at serving money-users. As in other goods and services, competition provided the public with improved products at better prices. The least regulated systems were not only the most competitive but also by and large the least crisis-prone.

Was Monetary Policy Loose During the Housing Boom?

Did the Fed’s set its policy interest rate below the market-clearing or ‘natural’ interest rate level in the early-to-mid 2000s? Or did it simply lower its policy interest rate down to a depressed natural interest rate level during this time? The answers to these questions determine whether U.S. monetary policy was loose during the housing boom.

John Taylor believes the Fed pushed interest rates below their natural interest rate level. He views this departure from a neutral stance as a key contributor to the housing boom. Ben Bernanke and Larry Summers believe otherwise. They see the Fed simply doing its job back then by adjusting its policy rate down to a low natural interest rate level. Bernanke believes the natural interest rate level was low because of a saving glut while Summers holds that its was depressed because of secular stagnation. Either way, both individuals do not blame the Fed for any role the low interest rates played in fostering the housing boom. The Fed’s lowering of interest rates was simply an endogenous response.

George Selgin, Berrak Bahadir, and I recently published an article that lends support to John Taylor’s view of Fed policy during this time. It received some pushback from Scott Sumner who is sympathetic to both the saving glut and secular stagnation views. At the same time, Tony Yates provided a critique of John Taylor’s argument on the financial crisis that was heartily endorsed by Paul Krugman. So the debate over the Fed policy during this period continues.

What I want to do here is to step back from this debate and review what I see as the key economic developments that affected U.S. interest rates at this time. Then, given these considerations, I will jump back into the debate and ask whether Fed policy pushed interest rates in the same direction as that implied by these developments.

The key developments as I see them are threefold: a falling term premiums, a spate of large positive supply shocks, and the emergence of a monetary superpower. Let us consider each one in turn.

Should the GAO Audit the Fed? A Cato-CMFA Forum

Ever since Ron Paul first introduced it in 2009, the “Federal Reserve Transparency” Act, calling for the elimination of the Federal Reserve System’s exemption from certain kinds of GAO audits, has been the subject of vigorous debate between proponents of greater government accountability and champions of an independent Federal Reserve.

But that debate has for the most part produced more heat than light, with hyperbole on both sides obscuring rather than shedding light on the debate’s central questions—questions like, “What could the proposed Fed Audits possibly reveal that existing audits and Fed testimony do not?,” and “To what extent would such audits pose a threat to the Fed’s independence?”

To get some honest answers to these questions, the Cato Institute’s Center for Monetary and Financial Alternatives recently held a Policy Forum, “Should the GAO Audit the Fed?” The forum’s participants, representing several important perspectives, were former GAO Comptroller General David Walker, Pulitzer Prize-winning author David Wessel, who also directs Brookings’ Hutchins Center on Fiscal and Monetary Policy, and our very own Mark Calabria, Cato’s director of Financial Regulation Studies.

Thanks to our participants’ expertise and also to the seamless moderation of their remarks by Wall Street Journal reporter Josh Zumbrun, the event turned out to be the most informative discussion of the issue to date!

OK, so I’m not exactly an unbiased critic. But watch the video and see if you don’t agree!

If this sample only leaves you yearning to hear more from these experts, check out Calabria’s piece on the actual content of the bill and David Wessel’s assessment of the motives behind and risks entailed in the proposed audits. For more on the GAO’s perspective, finally, have a look at this David Walker article.

[Cross-posted from]