Short take on MuCulley at the Hyman Minsky Conference

I've been meaning to post up a cut-down version Paul McCulley's recent assessment of our current plight: "Reverse Minsky Moment" interview with Kathryn M. Welling, but haven't yet. So yesterday I was glad to see Floyd Norris do a spot on McCulley's talk at the Hyman Minsky Conference for the NY times, titled Ponzi Squared:

… Minsky argued there were three levels of investment as the cycle progresses. First comes hedging, in which investments are made to reduce risk. Then comes the speculative phase, and finally the Ponzi phase, in which the investment can be justified only by the assumption that prices will keep rising, not by the expected income.

Paul McCulley of Pimco, the big bond manager, gave an interesting speech in which he said the recent subprime mortgage fiasco proceeded to a fourth level — one that he called "Ponzi-squared" — before it collapsed.

At the end, he said, the marginal subprime loan was:

No money down
No documentation of income
Initial below-market teaser interest rate
Negative amortization

That is not a loan, he said. Instead, it amounted to giving the home buyer a call option to buy the house at the current market price, coupled with a put option to sell the house back at that price.

If house prices kept rising, the "buyer" could make the small interest payments to keep the option open, and eventually sell the house. That happened for a time, and led to the conclusion by rating agencies that such borrowers were good risks.

But when prices went down, the "buyer" would suffer no loss if he exercised the put and gave the house to the lender. That is just what happened.

As Paul Simon wrote in 1975, said Mr. McCulley, the strategy became:

Drop off the key, Lee,
And set yourself free.

Here is the written version of McCulley's April 17 talk at the Minsky Conference. Oddly, the "Drop off the Key" remarks are not included, although they are in the longer, Welling-McCulley rendition above. Some tidbits:

… [I]n what I call a "Reverse Minsky Journey" … Ponzi Units evaporate. Then many Speculative Units morph into Ponzi Units and are shot. Surviving Speculative Units are only those with explicit liquidity support from banks, who have explicit liquidity support from the Federal Reserve. Hedge Units, of course, remain standing tall, fundamentally sound, though cheaper in price, providing an excellent long-term buying opportunity.

This has been precisely the process in place since almost a year ago, and particularly since last August, when the shadow banking system — defined as any levered lender who does not have access to (1) deposit insurance and/or (2) the Fed’s discount window — experienced a modern-day run, with asset-backed commercial paper holders refusing to roll over their paper. It has not been fun. It has not been pretty. And it is not over.

Along the way, policy makers have slowly recognized the Minsky Moment followed by the unfolding Reverse Minsky Journey. But I want to emphasize "slowly," as policy makers, collectively, still suffer from more than a thermos full of denial. Part of the reason is human nature: to acknowledge a Reverse Minsky Journey, it is first necessary to acknowledge a preceding Forward Minsky Journey — a bubble in asset and debt prices — as the marginal unit of debt creation morphed from Hedge to Speculative to Ponzi.

That is difficult for policy makers to do, especially ones who claim an inability to recognize bubbles while they are forming and, therefore, don’t believe that prophylactic action against them is appropriate. Nobody likes to admit they were blind, dumb, or asleep at the switch. Or all three. …

That's not to say that Minsky had confidence that regulators could stay out in front of short-term profit-driven innovation in financial arrangements. Indeed, he believed precisely the opposite:

"In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy."

Minsky wrote those words in 1986! Twenty-two years later, we can only bemoan that his sensible counsel was ignored. …

Minsky's insight that financial capitalism is inherently and endogenously given to bubbles and busts is not just right, but spectacularly right. And when the financial regulators are not only asleep but actively cheerleading financial innovation outside their direct purview, a disaster is in the making, as the last year has taught us. We have much to learn and relearn from the great man as we collectively restore prudential common sense to bank regulation — both for conventional banks and shadow banks.