Last Wednesday (September 24, 2008), I posted a blog entry entitled “Financial market risk and the “Peltzman” effect” which showed a time series graph since 2006 for the CBOE volatility index (aka “VIX”). Today is noteworthy in financial market history not only because the Dow Jones industrial average suffered its largest one day point drop in history — 778 points — but also because the VIX registered its highest closing level since its inception (in January 1990). The VIX closed today at 46.72, which is impressive considering that the average closing price for the VIX is 19.17 (this is based upon a total of 4,723 daily closing prices dating back to January 2, 1990). Today’s VIX reading also represents the 6th largest one day change in volatility for the entire time series. This is all the more impressive since volatility has been well above average long-run levels ever since the middle of September, which is the day that Lehman Brothers filed for Chapter 11 bankruptcy reorganization.

As I noted in my 9/24/2008 blog entry, VIX measures “consensus” forecasts of future (U.S.) stock market volatility as reflected in the market prices of call and put options written on the S&P 500 index. The higher the value for VIX, the more risk averse investors are in the aggregate. The last time the VIX was this high was on October 8, 1998, in the middle of the so-called Long-Term Capital Management financial crisis.

Here’s the daily time series graph for VIX from January 2, 1990 through the close of business today; the spike at the far right of the graph is from today:

So asks Peter Bernstein, the founding editor of the Journal of Portfolio Management and author of the book Against the Gods, in a New York Times article by this same name. Here’s the abstract for the article:

“Once the federal government declares, “Thou shalt not fail,” there are no limits to how far future risk-takers will go.”

Greg Mankiw has compiled a very worthwhile list of articles that provide thoughtful analysis concerning the Financial Crisis of 2008:

1. Lucian Bebchuk
2. Steven Landsburg
3. Anne Krueger
4. Glenn Hubbard, Hal Scott, and Luigi Zingales
5. Richard Epstein
6. Sebastian Mallaby
7. Robert Samuelson
8. Nouriel Roubini
9. Bruce Bartlett

Keith Murphy writes, “Déjà vu, which is French for “already seen,” is the feeling that you have already witnessed a scene or a situation even though you are seeing it for the first time.” The Financial Crisis of 2008 is having this very effect upon me. The last time that the U.S. suffered through a financial catastrophe related to the real estate sector of the economy was during the so-called savings and loan (S&L) crisis of the 1980s. The Troubled Asset Relief Program (aka “TARP”) which has been proposed by Treasury Secretary Hank Paulson is essentially the 2008 version of the Resolution Trust Corporation (RTC), a governmental entity created by the Financial Institutions Reform Recovery and Enforcement Act (FIRREA) of 1989 for the purpose of liquidating assets of failed thrift institutions.

The S&L crisis stimulated considerable public policy and academic interest in the roles played by federal financial guarantee programs. At the time of the S&L crisis, I was an assistant professor of finance at University of Texas-Austin, and I was motivated to write an essay which explored various moral hazard and adverse selection aspects of mispriced financial guarantees. While I never published this essay before, I have used it on occasion in my teaching. Although this essay is now nearly 20 years old, I think that it nevertheless raises a number of important issues which lie at the heart of the current financial crisis.

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Besides insuring bank and thrift deposits, the federal government guarantees a number of other financial transactions, including farm credits, home mortgages, student loans, small business loans, pensions, and export credits (to name a few). Recently, the financial difficulties of the banking industry have focused considerable attention on the structure and viability of the deposit insurance system. However, the structural problems of deposit insurance are shared by many of these other programs.

In order to better understand the problems faced by federal financial guarantee programs, consider the conditions which give rise to a well functioning private insurance market. In private markets, insurers segregate policyholders with similar exposures to risk into separate risk classifications, or pools. As long as the risks of the policyholders are not significantly correlated (that is, all policyholders do not suffer a loss at the same time), pooling reduces the risk of the average loss through the operation of a statistical principle known as the “law of large numbers”. Consequently, an insurer can cover its costs by charging a premium that is roughly proportional to the average loss. Such a premium is said to be actuarially fair.

By limiting membership in a risk pool to policyholders with similar risk exposures, the tendency of higher risk individuals to seek membership in the pool (commonly referred to as adverse selection) is controlled. This makes participation in a risk pool financially attractive to its members. Although an individual with a high chance of loss must consequently pay a higher premium than someone with a low chance of loss, both will insure if they are averse to risk and premiums are actuarially fair. By charging risk-sensitive premiums and limiting coverage through policy provisions such as deductibles, the tendency of individuals to seek greater exposure to risk once they have become insured (commonly referred to as moral hazard) is also controlled.

In contrast, federal financial guarantees often exaggerate the problems of adverse selection and moral hazard. Premiums are typically based upon the average loss of a risk pool whose members’ risk exposures may vary greatly. This makes participation financially unattractive for low risk members who end up subsidizing high risk members if they remain in the pool. In order to prevent low risk members from leaving, the government’s typical response has been to make participation mandatory. However, various avenues exist by which low risk members can leave “mandatory” risk pools. For example, prior to the reorganization of the Federal Savings and Loan Insurance Corporation (FSLIC) as part of the Federal Deposit Insurance Corporation (FDIC), a number of low risk thrifts became commercial banks. This change in corporate structure enabled these firms to switch insurance coverage to the FDIC, which at the time charged substantially lower premiums than did the FSLIC. Similarly, terminations of overfunded defined benefit pension plans enable firms to redeploy excess pension assets as well as drop out of the pension insurance pool operated by the Pension Benefit Guarantee Corporation (PBGC).

Although financial restructuring makes it possible to leave mandatory insurance pools, the costs of leaving may be sufficiently high for some low risk firms that they will remain. Unfortunately, the only way risk-insensitive insurance can possibly become a “good deal” for remaining members is by increasing exposure to risk; for example, by increasing the riskiness of investments or financial leverage. Furthermore, this problem is even more severe for high risk members of the pool, especially if they are financially distressed. The owners of these firms are entitled to all of the benefits of risky activities, while the insurance mechanism (in conjunction with limited liability if the firm is incorporated) minimizes the extent to which they must bear costs. Consequently, it is tempting to “go for broke” by making very risky investments which have substantial downside risk as well as potential for upside gain. The costs of this largely insurance-induced moral hazard problem can be staggering, both for the firm and the economy as a whole.

In light of this analysis, it is interesting to consider the current policy debate over the financial difficulties of the banking industry and the FDIC. Recently, capital requirements as well as deposit insurance premiums have been raised in response to the crisis. Ironically, as Professor George Kaufman of Loyola University has noted, the banking industry is undercapitalized largely because federal deposit insurance has permitted banks to substitute government capital for private capital. Although increased capital requirements will (at least in the short run) mitigate the moral hazard of increased risk exposure, in the long run the cycle of increased risk exposure and higher premium costs is likely to continue so long as the structure of the present system is not reformed.

Ultimately, the key to restoring the financial viability of deposit insurance and other similarly troubled federal financial guarantee programs is to institute reforms which engender lower adverse selection and moral hazard costs. Policymakers would do well to consider how private insurers, who cannot rely upon taxpayer-financed bailouts, resolve these problems. The most common private market solution typically involves some combination of risk-sensitive premiums and economically meaningful limits on coverage. Federal financial guarantee programs should be similarly designed so that excessively risky behavior is penalized rather than rewarded.

PART 2: `RACE TO BOTTOM’ AT MOODY’S, S&P SECURED SUBPRIME’S BOOM, BUST

An exclusive two-part BLOOMBERG NEWS report investigates how flawed AAA ratings on mortgage-backed securities that turned to junk now lie at the root of the world financial system’s biggest crisis since the Great Depression. The BLOOMBERG NEWS report shows how — driven by competition for fees and market share — rating companies Moody’s and Standard & Poor’s issued top ratings on debt pools that included $3.2 trillion of loans to homebuyers with inferior credit between 2002 and 2007. Without those AAA ratings, the report shows, insurance companies and pension funds wouldn’t have bought the products. Bank writedowns and losses on the investments totaling $523.3 billion led to the collapse or disappearance of Bear Stearns., Lehman Brothers and Merrill Lynch, and compelled the Bush administration to propose a $700 billion Wall Street bailout.

EXCERPTS FROM PART 2 OF THE BLOOMBERG NEWS REPORT:

Former S&P Managing Director Richard Gugliada:
“I knew it was wrong at the time,” says Gugliada, 46, who retired from the McGraw-Hill Cos. subsidiary in 2006 and was interviewed in May near his home in Staten Island, New York. “It was either that or skip the business. That wasn’t my mandate. My mandate was to find a way. Find the way.”

“The rating agencies’ models were too flawed and cut too many corners, and the raters got pressured by the bankers,” says Tonko Gast, the chief investment officer of the $5.1 billion New York hedge fund Dynamic Credit Partners LLC, who reverse-engineers the raters’ models as part of his investing strategy. “That’s how the race to the bottom was kind of invisible.”

Kai Gilkes, 40, a former S&P quantitative analyst in London:
“The discussion tends to proceed in this sort of way,” he says. “`Look, I know you’re not comfortable with such and such assumption, but apparently Moody’s are even lower, and, if that’s the only thing that is standing between rating this deal and not rating this deal, are we really hung up on that assumption?’ You don’t have infinite data. Nothing is perfect. So the line in the sand shifts and shifts, and can shift quite a bit.”

Find the full story on http://www.bloomberg.com/apps/news?pid=20601109&sid=ax3vfya_Vtdo&refer=home

In a March 2007 interview, Nobel Laureate Myron Scholes presciently notes, “My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking (italics added for emphasis).” In a December 2006 WSJ article entitled “The Risk Business”, it is noted that risk premiums seemed at the time to have been “drained” out of whole classes of financial assets. The article goes on to suggest that the reason for this was because advances in financial innovation (in all its various forms, including the buying, selling, swapping, trading and securitization of risk) had actually made the financial markets safer for investors; consequently risk premiums up to that point in time had fallen substantially.

One way to measure the overall degree of “safety” in financial markets is to look at the CBOE volatility index (aka “VIX”). Here’s what the time series looks like for this index starting December 1, 2006 (around the time that the WSJ article “The Risk Business” was published) up to yesterday.  The best way to think about it is that it measures “consensus” forecasts of future (U.S.) stock market volatility as reflected in the market prices of call and put options written on the S&P 500 index. The higher the value for VIX, the more risk averse investors are in the aggregate. What’s interesting about this time series is that at the time that Scholes’ interview was published (March 2007), forecasted stock market volatility (specifically, expected annualized volatility) had rather dramatically increased nearly twofold in a matter of a few days, going from around 10% to 20% (putting this into perspective, the long run average value for VIX, going back to January 1990, has been around 19%, so this really reflects more of a mean reversion effect). However, since July 2007 (and within the last week in particular), this data series has undergone a substantial increase in terms of its level as well as the “volatility of volatility”, as you can see in the graph below:

These data provide an important context for Scholes’ quote. The “dark side” of innovations in risk management is that they often encourage offsetting risky behaviors (e.g., as in the development over time of the subprime mortgage market); as Scholes noted, these offsetting behaviors came in the forms of more leverage and more risk taking. This is an important example of “moral hazard” in the real world, and it is commonly referred to as the “Peltzman” effect (named after economics Prof. Sam Peltzman at the University of Chicago).

because the system is now more stable, we’ll make it less stable through more leverage, more risk taking (italics added for emphasis).” In a December 2006 WSJ article entitled “The Risk Business”, it is noted that risk premiums seemed at the time to have been “drained” out of whole classes of financial assets. The article goes on to suggest that the reason for this was because advances in financial innovation (in all its various forms, including the buying, selling, swapping, trading and securitization of risk) had actually made the financial markets safer for investors; consequently risk premiums up to that point in time had fallen substantially.

One way to measure the overall degree of “safety” in financial markets is to look at the CBOE volatility index (aka “VIX”). Here’s what the time series looks like for this index starting December 1, 2006 (around the time that the WSJ article “The Risk Business” was published) up to yesterday.  The best way to think about it is that it measures “consensus” forecasts of future (U.S.) stock market volatility as reflected in the market prices of call and put options written on the S&P 500 index. The higher the value for VIX, the more risk averse investors are in the aggregate. What’s interesting about this time series is that at the time that Scholes’ interview was published (March 2007), forecasted stock market volatility (specifically, expected annualized volatility) had rather dramatically increased nearly twofold in a matter of a few days, going from around 10% to 20% (putting this into perspective, the long run average value for VIX, going back to January 1990, has been around 19%, so this really reflects more of a mean reversion effect). However, since July 2007 (and within the last week in particular), this data series has undergone a substantial increase in terms of its level as well as the “volatility of volatility”, as you can see in the graph below:
These data provide an important context for Scholes’ quote. The “dark side” of innovations in risk management is that they often encourage offsetting risky behaviors (e.g., as in the development over time of the subprime mortgage market); as Scholes noted, these offsetting behaviors came in the forms of more leverage and more risk taking. This is an important example of “moral hazard” in the real world, and it is commonly referred to as the “Peltzman” effect (named after economics Prof. Sam Peltzman at the University of Chicago).

Intrade has opened a new market on whether the proposed bill (AKA “TARP”, an acronym for Troubled Asset Relief Program) to bailout financial firms will pass Congress by the end of the month. The contract trades as BAILOUT.APPROVE.SEP08. Open for less than 24 hours, the market has already gained significant trading volumes, and an early verdict: the bill is far from a sure thing.

The likelihood the bill would pass by September 30th initially traded between 55% and 65% for much of yesterday. It hit an overnight high of 95% before settling at 74.8% as of 5AM CST this morning.

Charles W. Calomiris and Peter J. Wallison do an excellent job explaining how the complicity of certain government sponspored entreprises (aka GSE’s, aka Fannie Mae and Freddie Mac) during the course of the past 5 years are largely responsible for the Financial Crisis of 2008. See today’s Wall Street Journal article entitled “Blame Fannie Mae and Congress for the Credit Mess”.