Chaos Theory in Financial Markets: The Fiasco of Bankruptcy Reform

Capitalism at a Crossroads

The Fiasco of Bankruptcy Reform: Finding the Butterfly

PREFACE

The Great Recession is a rolling disaster that the world economy seemingly stumbled into in the spring of 2008 and continues most colorfully today with the slow motion train wreck of monetary policy in the EU. This rolling economic Verdun was born many years before in a series of ill-conceived and poorly understood policy initiatives championed by consumer advocates and industry groups alike. These reforms – generally characterized as deregulation – were targeted at the seemingly laudable targets of risk mitigation and fairness, and categorically achieved just the opposite.

Each of these examples is a terrific case study of chaos theory at work. In chaos theory, a small action/change in a complex/dynamic system can have enormously disproportionate impact in the future. The classic example is posited by Lorenzo in his 1972 paper, Predictability: Does the Flap of a Butterfly’s Wings in Brazil set off a Tornado in Texas? What is most important to remember here is that chaos theory is very sensitive to initial conditions, and unpredictable beyond very short periods of time. For those making economic policy this requires a constant vigilance for the undesirable unintended consequences of policy changes – clearly the butterfly did not intend the tornado.

It is to the quest of finding Lorenzo’s butterfly that I dedicate this series of articles.

The first such reform considered in this series is Bankruptcy Reform – the singular achievement of financial lobbyists of the last two decades.

Bankruptcy – An American Perspective

Colonial America utilized the standard debt collection/remediation practices of Great Britain, the debtor paid or the creditor had him jailed and or enslaved through indentured servitude. Some great and notable Americans from this era spent some time in debtors prison including three signatories to the Declaration of Independence – Robert Morris, James Wilson and Henry Lee III (the father of Robert E. Lee and former Governor of Virginia). The debtors prisons in both Europe and the Americas were hotbeds of corruption by the jailers – sort of the company store on steroids. Inmates paid for their own accommodations, and bribes to the jailers were a necessary component of daily existence.

The English practice of indentured servitude was really enslavement to work off debts, and has precedents back into Roman business practice. Indentured servitude was a common practice in colonial America, and accounted for many of the English immigrants arriving on our shores – and tied to the land to work off their debt of passage.

In such a system, the niceties and exact rules of bankruptcy were largely irrelevant – either pay or 1) you go to prison, or 2) you become my slave.

The entire system stunk of privilege, and clearly went against the revolutionary concepts of liberty championed by the “populist wing” of the Founding Fathers. Andrew Jackson literally rode a horse into the White House as part of inaugural celebration, and symbolically started a second revolution – this one aimed at financial institutions. He shut down the National Bank, paid off the National Debt, and shut down all Federal Debtors prisons – permanently separating private legitimate debts from the criminal justice system. In 1833 Federal debtors prisons were outlawed and closed, as were most state’s. By the 1850’s, most states had explicitly included a prohibition on debtors prisons in their constitutions.

The message in this was clear, the lender was responsible for prudent lending practices, and could not resort to the tools of state based criminal justice for the resolution of legitimate (not fraudulently incurred) debt. Without a doubt this reduced both the propensity to lend as well as the availability of credit. As a corollary, this increased the requirement for savings and equity based financing. Within 60 years the US was the leading industrial power in the world.
Can you hear the butterfly’s wings flapping?

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

This Act, commonly referred to as The Bankruptcy Reform Act (BRA) was initially passed by both houses of Congress in 2000, but was pocket vetoed by President Clinton, and was subject to endless congressional squabbling until it was ultimately passed in 2005, in legislation sponsored by Chuck Grassley (R-IA). The thesis behind the legislation was that the unscrupulous use of the bankruptcy system by consumers was having a material and negative impact on the availability of credit, and dramatically increasing its cost.

Specifically, BRA would limit the availability of Chapter 7 filings for individuals, and dramatically expand the use of Chapter 13. In general terms Chapter 7 is available for individuals who are really broke – and it discharges their debts and starts them with a fresh slate. Chapter 13 provides for a reduction of some of an individual’s debts, but puts in place a required repayment plan by which creditors are treated fairly relative to the individual’s ability to repay. Chapter 13 is generally used by people who have means to pay some debts, but who have imprudently or through bad luck – e.g. medical bills – accumulated more debt than they can possibly service. In general, BRA was designed to prevent consumers from ducking unsecured credit through bankruptcy – it was as simple as that. As Congressman F. James Sensenbrenner Jr. (R-WI), one of the bill’s key supporters in the House, argued, “This bill will help restore responsibility and integrity to the bankruptcy system by cracking down on fraudulent, abusive, and opportunistic bankruptcy claims.”

As can be seen in the chart above, passage of the BRA did not change the trajectory of consumer loan growth, but it probably continued the growth of consumer credit well beyond what was prudent. The declining quality of consumer lending can be noted by the immediate increase in the charge-off rate of consumer credit after the passage of BRA, as shown below. Charge-offs are seen to spike at the end of 2005, just prior to the passage of the BRA, and then climb steadily through 2010. After 2010, the dramatic reduction in credit availability through the banking system in response to the Great Recession began to reduce charge-offs, as non-credit worthy borrowers were removed from the system.

Charge-Off Rates

All Banks, NSA: Consumer Credit

2011:3	3.52%	5.63%	1.26%
2011:2	3.51	5.58	1.29
2011:1	4.46	6.96	1.70
2010:4	4.90	7.70	1.93
2010:3	5.28	8.55	1.81
2010:2	6.70	10.97	2.05
2010:1	6.62	10.16	2.45
2009:4	5.73	10.11	3.03
2009:3	5.74	10.10	3.07
2009:2	5.67	9.77	3.10
2009:1	4.83	7.62	2.98
2008:4	4.30	6.30	3.03
2008:3	3.56	5.62	2.37
2008:2	3.27	5.47	2.02
2008:1	2.98	4.70	1.96
2007:4	2.85	4.18	2.03
2007:3	2.48	4.05	1.54
2007:2	2.29	3.85	1.35
2007:1	2.36	3.93	1.38
2006:4	2.41	4.03	1.39
2006:3	2.16	3.87	1.09
2006:2	3.52	0.87	0.09
2006:1	3.12	0.90	0.19
2005:4	6.05	1.35	0.77

Default rates, on the other hand, reversed their downward trend in 2005, exactly contemporaneous with the passage of the BRA and began increasing again. This increase in defaults is despite the bankruptcy proof status that these loans gained in 2005. Better yet, Federal government recently enacted a plan by which student borrowers could agree to dedicate 10-15% of their after-tax disposable income to student loan repayment – regardless of the amount earned – and be fully in compliance. After 10-20 years the debt is discharged – whether or not the principal is repaid. Such are the luxuries afforded the youth.

No one talks about the BRA when talking about the origins of the Great Recession, or how we get out of it. It is a historical butterfly, whose wing beats “sowed the wind and reaped the whirlwind”. The message here is pretty simple, by attempting to limit credit risk, lenders have sponsored legislation to limit borrowers access to bankruptcy – both individual and corporate. Feeling greatly comforted that recalcitrant borrowers would be compelled to repay, lenders threw credit standards to the wind and went on a lending spree – more loans meant more money. Credit risk had been banned by effective – if punitive – legislation. Or so they thought.

This ill-conceived legislation flew in the face of 160 years of wildly successful reform – reform sponsored by Andrew Jackson and directed at making lenders accountable for their own actions. Imagine, Jackson promulgated and passed his program before the “too big to fail doctrine” truly insulated lenders from their own folly.

In reality, this legislative attempt at credit enhancement only served to drive lenders into the arms of the least prudent and credit worthy borrowers. The amazing outcome was the universal failure of every single element of the financial system touched by this legislation. This is chaos theory at its best – an obscure piece of largely forgotten legislation wreaks havoc on the financial system, and so distant is the causal event that nobody can connect the dots.Can you hear the butterfly’s wings flapping?

Thanksgiving on Moosilauke

Perverse Incentives, Clumsy Laws, and the Value/Volume & RVU Conundrum in Medical Quality

By Wes Chapman; Charles Hutchinson, PhD; & Michael Choukas, MBA

Preface

This is the second of four articles regarding quality issues in the delivery of clinical healthcare. The first looked at the popular methods for quality improvement in healthcare, and their applications and limitations. This second article examines the alignment/quality issues and system design considerations regarding high volume procedures and high Relative Value Units. The third article will propose recommendations on system design for optimized protocol-based care in delivery systems involving small and large hospital systems. The fourth article looks at the development and utilization of process and outcome metrics, and how metrics can help in the development and continuous improvement of medical care protocols.

Summary

The largest single problem with flow-based quality concepts in medicine is that neither patients nor providers consider process quality measures to be relevant to their personal concept of quality. Instead, they focus on the practical concepts of provider skill and experience – the results of constant training and procedure volume. On the other hand, doctors and hospitals are paid according to Relative Value Units (RVUs), which have nothing to do with volume, experience, or the resulting improvements in quality. Instead, RVUs create a system where specialized procedures are paid far more highly than primary care. This lures many struggling hospitals into offering high RVU procedures, regardless of their ability to attract sufficient patient volume to develop the experience and skill required for a high quality outcome. Legal restrictions on referrals compact the problem by blocking the ability of smaller hospitals to direct patients to high-volume centers without losing all of the potential revenue. To achieve an acceptable level of quality improvement in healthcare, we must first find a solution to this value/volume conundrum.

Divergent Views on Medical Quality

There has been a tremendous amount of work in clinical and academic circles addressing medical quality as a process-related function. As we addressed in our August paper, Medical Quality Systems: the Elusive Goal of Quality in Complex Systems, there are considerable practical problems with this approach, mostly centered on the non-linear process flow in the vast majority of medical clinical systems. The largest single problem with flow-based quality concepts in medicine, however, is that neither patients nor providers really consider process quality measures to be at all relevant to their personal concept of quality.

Patients and doctors focus on the practical concepts of provider skill and experience as the key determinants of quality, and with good reason. The literature is very clear that, more than any other single factor, experience – of both the provider and the medical center – determines the success or failure of a medical procedure (Birkmeyer et al). Specifically, in their seminal paper Hospital Volume and Surgical Mortality in the United States, the authors conclude, “In the absence of other information about the quality of the surgery at the hospitals near them, Medicare patients undergoing selected cardiovascular or cancer procedures can significantly reduce their risk of operative death by selecting a high-volume hospital.” (N Engl J Med 2002;346:1128-37)

This is pretty strong stuff, and published in a top journal. Staying on the same theme, Birkmeyer et al concluded in a paper in the New England Journal of Medicine the following year, “For many procedures, the observed associations between hospital volume and operative mortality are largely mediated by surgeon volume. Patients can often improve their chances of survival substantially, even at high-volume hospitals, by selecting surgeons who perform the operations frequently.” (N Engl J Med 2003;349:2117-27)

The racetrack metaphor that pops to mind is, if the horses are all pretty much the same, bet on the jockey. Clearly patients are encouraged by the academic literature to select busy jockeys at busy tracks.

The academic literature about this subject is voluminous, straightforward, and unassailable: practice makes perfect. The Leap Frog Group is a Washington advocacy group sponsored by major corporate employers; the kind who have great (and very expensive) healthcare plans for their employees. These folks are uninhibited by the limitations of peer reviewed publication and state with no mistaken purpose:

Tens of thousands of Americans die every year undergoing elective surgery. For many high-risk procedures, surgical patients can reduce their risks considerably by having their procedures performed at hospitals with low risk-adjusted mortality rates and/or sufficient experience with those procedures.

Phelps Mt. – Prouty Mountaineeering Prep Hike #4

The 7% Solution: A Trigger for Fiscal Collapse?

A Curious Relationship between Addictions to Cocaine and Cheap Money

Sherlock Holmes Meets Silvio Berlusconi & George Papandreou

I have long likened the flood of cheap money released into the world economy over the last twenty years to drugs for an addict. Our financial system craves more and cheaper money to feed our ever growing addiction to asset inflation as a substitute for real economic growth. The collapse of the Italian government this week – putatively due to interest rates hitting 7% – brought to mind the great fictional collapse of Sherlock Holmes due to abuse of a 7% solution of cocaine. The metaphor of addiction intertwined with the mysteriously recurring 7% was simply irresistible.

Three Titans Laid Low by a 7% Solution

Sherlock Holmes

Berlusconi 

Papandreou

Listening to and reading the popular financial media over the last week, I was struck by the new standard of failure in international finance – a 7% rate on a 10 year government bonds. The financial world was bloviating endlessly about the abject failure of Italy – as evidenced by a 7% plus rate demanded for its “full faith and credit” financial instruments. For those of us who came of age in the early ‘80’s, 7% is an interest rate for Euro-wimps. We grew and flourished in short term US Government rates of over 15% – and they were difficult to sell at that price.

But the media got it right; Greece also started to fail when its interest rates hit 7%, as did Ireland and Portugal. What made all of the pundits so agitated was the fact that given the enormous levels of debt to GDP – at or near 100% in all of these countries (as well as the US) – at 7% interest rates, the cumulative interest burdens become simply unsupportable.

Consider the Durability of the Characters

Silvio Berlusconi enjoys a reputation as perhaps the most notorious national leader in the Western World. His eight years in office have been marked by unrelenting scandal and barely dodged jail sentences – this was the guy who introduced bunga-bunga parties into popular parlance.  Papandreou on the other hand is a Minnesota born Greek patriarch, the third member of his family to hold the position of Greek Prime Minister. Yet both of these characters succumbed to the fury of the Euro Bond market – the fatal potency of the 7% solution.

All of the leaders of the Euro Zone should consider the words of European Central Bank policymaker Juergen Stark who warned European governments on Wednesday against asking the ECB for support in dealing with the region’s sovereign debt crisis, saying this would put the central bank’s independence at risk. “We are not the lender of last resort (to governments) and I do not advise European governments to ask the ECB to become lender of last resort,” Stark, a member of the ECB’s executive board, said at a business conference. “This will mean that the ECB immediately will lose its independence.”

Fabulous – it sounds just like the US Fed during the Great Depression. If a central bank is not the lender of last resort, then who is? Central banks really only have one crisis oriented function – lender of last resort. Their role is not to act as deflation fighter, employment agency or investment advisor. The Central Bank is exactly the lender of last resort – lest chaos ensue. Take comfort Silvio and George, other European leaders will be joining you soon.

The rolling fiasco in Europe has raised an immediate series of questions for me regarding the US:

1. How much Federal Government debt do we currently have in the US, and where will it be in the next two years or so?
2. What part of our deficit is currently interest, and at what average interest rate?
3. What would happen to our deficit if our debt went to 7% interest rates, and what would that do to the work of the Congressional Super Committee (finding a minimum of $1.5 Trillion in expenditure reductions/tax increases over the next 10 years)?

Question 1 – How Much Debt Are we talking about?

 

Digging around it appears pretty clear that the total debt of the US Federal Government is currently around $13.5 T. The next question is this stable, or should we expect continued growth over the next 2 years – the period of our analysis.

Looking at current growth rates, tax rates, and expenditures, it seems pretty clear that we will be doing pretty well to hold US budget deficits to $1.25 T for each of the next couple of years. The government projects getting under $1.0 T, but they have missed all of their projections since the Great Recession began, and I have no reason to believe that it will get any better. For prudence, we’ll figure that total debt will be $16 T by the end of 2013, and we will base our calculations on the $16.0 T figure.

Base Case Federal Debt

$13.5+ (1.25*2) = $16.0 T by the of 2013

Question 2 – How much interest are we talking about?

First, let’s take a look at current interest rates on Federal Debt.

Average Interest Rates on US Government Debt

Clearly, the weighted average cost of US debt is 2.859%, and has been falling pretty rapidly since the beginning of the fiasco in Europe this summer. Calculating the cost of the US debt as of today:

Total Interest Expense, and as % of the deficit

1. Current:
Total interest: $13.5 T * 2.859% = $386 B
Interest as a % of Deficit = $386/$1,250 B = 30.9%
Interest as a % of total budget = $386/$3,456 B = 11.2%

2) End of 2013:
Total Interest: $16.0 T * 2.859% = $ 457B
Interest as a % of Deficit = $457/$1,250 B = 36.6 %
Interest as a % of total budget = 447/$3,336 = 13.4% (1)

(1) Assumes target budget reductions are met reducing annual budget by $120 B

It is important to note that historically there has been widespread reporting of net interest – net of the interest paid on the debt held by the Social Security Trust Fund. While historically this may have made sense – the combination of the scale of interest now paid to foreign entities (over 50%) and the huge reductions in collections by social security over the last several years due to suspension of payroll tax collection and increase in unemployment make a gross level much more relevant.

Question 3 – What happens if Interest rates rise?

First, it’s worth taking a look at historical levels of interest rates. The market seems to have chosen 7% as the level of mortal peril. Let’s take a look and see if this was simply arbitrary, or perhaps is something more tangible. We’ll take a look at both long term and short term interest rates, with a simple objective – determine if 7% is a reasonable level of interest rates for long and short term instruments.

7% interest rates may be high for short term rates

Looking at the historical interest rate levels, it seems perfectly plausible that rates could hit the magical 7% level. The real question is what would be the impact if they did?

Outcome from 7% interest rates and above

 

The key factors for future interest rates

The key factors influencing sovereign interest rates are classically given as inflation, credit quality, liquidity, and alternative investments. In the real world the factors are fear and greed. The final determinant is always more buyers than sellers. Consider the application of the real world portion of these factors to the current Euro Bond market. People are scared, the governments need huge amounts of money and there are no buyers. The ECB has stated that they are not the buyer of last resort – so there is none. The sovereign states members of the Euro have given up their ability to print money – and they are consequently in big trouble.

So what does this mean for the US – if rates were to hit 7% to 9%, our deficit would increase by 45-65%. This is about 4.5-7.0X the total amount of “doomsday” deficit reduction targeted by the so-called Super Committee.

A 7% Solution for the US ?

It is a perverse feature of highly indebted borrowers – raising interest rates to adequately compensate for credit risk results increases the risk of default. Sovereign borrowers frequently (and unfortunately) adjust to higher rates by increasing the monetary base and inflation, resulting in the demand for higher rates – entering into a death spiral leading to currency recalibration – typically through the practical expedient of dropping three to six zeros. What could be easier?

The US has enormous borrowing needs over the next three years – at least $2.5 T in deficit funding, and 2.5 T in refinancing – for a total of $5.0 T. This compares to around $14 T in total value for all US stocks – while the comparison is imperfect, it does give a good idea as to how much of our financial resources will be needed for funding the federal debt. In short, the federal government will need to borrow an amount equal to 36% of total US stocks – and that is just to keep going with no increase in interest rates. Increasing interest rates to 7% would increase the total amount needed to around $6.1 T, or around 43% of total equities. Another way to put the enormous growth in demand for government debt, is that in the first 200 years of the republic we accumulated $1 T in debt. We will need to borrow 5-6 X that in the next two years just to stay even.

In order to sell this much debt there will have to be buyers, and the buyers will want to be compensated for risk. The easy solution has been to stuff money into the Fed’s balance sheet and pawn it off on the Chinese, but after a while even these sources will dry up – we are talking about $5-6 T. We may well see the day in the next year or two when the US will need to sell its obligations to real buyers, and even 7% may look too cheap.

In summary, there is no magic number at which sovereign credits become unsustainable. Too much is dependent on exogenous factors – the principle factor being the willingness of people to keep on lending. One thing is certain, however, the US needs to borrow a tremendous amount of money over the next three years, and will consume enormous amounts of liquidity doing so. There are a lot of things that will need to go right to pull this off, and interest rate increases are only one of many factors that can cause a fiscal train-wreck.

Mt. Cube – Prouty Mountaineering Prep Hike # 2

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