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November/December 1992
Volume 77, Number 6
Federal Reserve
Bank of Atlanta
In This Issue:
More Unsettling Evidence o n the
Perfect Markets Hypothesis
21ie Convexity Trap: Pitfalls in Financing
Mortgage Portfolios and Related Securities
.Banking in Georgia,
1865-1929
/Review Essay
•.
-
V ïy ;
•
;
"M i
'•- •
bonomie
R e v i e w
November/December 1992, Volume 77, Number 6
Federal Reserve
Bank of Atlanta
President
Robert P. Forrestal
Senior Vice President and
Director of Research
Sheila L. Tschinkel
Vice President and
Associate Director of Research
B. Frank King
Research Department
William Curt Hunter. Vice President, Basic Research
Mary Susan Rosenbaum, Vice President, Macropolicy
Thomas J. Cunningham, Research Officer, Regional
William Roberds, Research Officer, Macropolicy
Larry D. Wall, Research Officer, Financial
Public Affairs
Bobbie H. McCrackin, Vice President
Joycelyn T. Woolfolk, Editor
Lynn H. Foley, Managing Editor
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Ellen Arth, Circulation
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(Contents
November/December 1992, Volume 77, Number 6
More Unsettling Evidence
On the Perfect Markets
Hypothesis
David N. D e j o n g a n d
Charles H. W h i t e m a n
14
r h e Convexity Trap:
Pitfalls in Financing
Mortgage Portfolios and
Related Securities
J a m e s H. Gilkeson a n d
S t e p h e n D. Smith
^O
FYI—Banking in Georgia,
1865-1929
, . „ ,
Leonard A. Carlson
^o
^ ^
47
Review Essay
Jerry J. D o n o v a n
Jndex for 1992
Debate about the perfect markets hypothesis—which, put simply,
states that asset returns on stocks, bonds, and the like are not forecastable—has alternately swirled and subsided since the 1960s.
Studies challenging the validity of the hypothesis have generally
been based on one of two different assumptions—that dividends
fluctuate around a smooth trend or that variability is built into the
level of dividends. The authors' own empirical work adopting a
procedure different from the usual statistical practice eliminates the
need to decide beforehand how to account for dividend growth.
Their results indicate that the perfect markets hypothesis appears
relatively less plausible than a model designed specifically to exploit statistical regularities in forecasting prices and dividends.
Mortgage-backed securities, which have become increasingly
popular during the past decade, have unconventional cash flows
that call for hedging techniques different from those used for fixedincome securities. This article examines the potential gains and losses from issuing long-term liabilities to finance mortgage-backed
securities. After reviewing the concepts of duration and convexity
and the ways these measures are influenced by varying prepayments,
the authors analyze how equity values change with interest rates for
alternative financing arrangements. They focus particularly on the
"convexity trap"—equity losses in both low- and high-rate environments—when mortgage-backed securities are financed by fixed-rate
liabilities. Finally, the authors discuss some methods for hedging
conventional convexity risks, including higher initial equity investments and various off-balance-sheet instruments.
This history of Georgia's banking industry from 1865 to 1929
highlights the effects of the period's extreme economic shocks and
regulatory changes on Georgia's banks. As an example of how
,
.
, ,
,
,, . „ . .
...
'
banking evolved under such historical conditions, the discussion
may provide useful contemporary lessons for banking reform.
Doing Business in Eastern Europe and the Newly Independent
States: Information Sources to Get Started
JJSore Unsettling
Evidence on the
Perfect Markets
Hypothesis
David N. Dejong and Charles H. Whiteman
f y o u ' r e so smart, why aren't you rich? While most people have no
answer for this question, economists have a ready-made response—
the p e r f e c t (or e f f i c i e n t , or rational) m a r k e t s hypothesis. Loosely
speaking, the hypothesis states that asset returns (on stocks, bonds,
real estate, and the like) are not forecastable: The market aggregates
information efficiently, or market participants use that information rationally, or the market is perfectly void of unexploited profit opportunities. If the
hypothesis holds, trying to get rich in the stock market amounts to what
Burton G. Malkiel, in the title of his famous book, called A Random Walk
Down Wall Street (1973),
David N. DeJong is an associate professor of economics at
the University of Pittsburgh.
Charles H. Whiteman is a professor of economics at the
University of Iowa and a visiting scholar in the Atlanta
Fed's research department.
Federal Reserve Bank of Atlanta
If the perfect markets hypothesis is not valid, the only defensible answer
to the question posed above is " I ' m not that smart." E g o preservation might
be reason enough, but economists cling to the hypothesis for other reasons,
primarily because the alternatives are unpalatable. For one thing, it is difficult to f a t h o m the nature of the imagined e c o n o m i c profit opportunities.
These would involve something other than the usual rewards to productive
activity. Instead, they would b e easily identifiable, costless, and riskless
ways to get rich. Furthermore, even if these opportunities were to exist, h o w
could they persist? In such a scenario there would, in effect, be dollar bills
lying all over the main street and no one stooping to pick them up.
T h e possibility of persistent unexploited profit opportunities in any market poses a theoretical p r o b l e m for all of e c o n o m i c s . If e c o n o m i s t s are
wrong about such a simple premise, w h y should more subtle predictions
(for example, that a tax cut will spur economic activity) be trusted?
Economic Review
1
An Introduction to the
Perfect Markets Controversy
The crack in the foundation of economics may already h a v e a p p e a r e d . T h e empirical validity of the
perfect markets hypothesis, once thought to be settled
in the 1960s and 1970s by regression tests of one of its
implications, has recently been challenged in several
studies. Robert J. Shiller (1981b) and Stephen F. LeRoy
and Richard D. Porter (1981), for example, purport to
s h o w t h a t a g g r e g a t e a n n u a l s t o c k p r i c e s are t o o
volatile to reflect the underlying, fundamental values
predicted by the hypothesis.
However, economists have been quick to point out
that Shiller's evidence of "excess volatility" is not truly evidence or is not evidence of imperfection in the
financial markets. Indeed, one counterattack, mounted
by Marjorie A. Flavin (1983), LeRoy and C.J. LaCivita (1981), and Ronald W. Michener (1982), argues that
the volatility tests of Shiller and others suffer f r o m
sampling and specification error and that the properties of the data highlighted in the studies are in fact
consistent with the hypothesis. The work of Terry A.
Marsh and Robert C. Merton (1986, 1987) and Allan
W. Kleidon (1986a, 1986b) yielded a second counterattack, arguing that the perfect markets hypothesis can
be resurrected by simply m o d i f y i n g an a s s u m p t i o n
Shiller made regarding the temporal stability of aggregate dividends.
T h e t e m p o r a l stability issue arises in the perfect
m a r k e t s context because dividends grow over time.
Chart 1 illustrates this fact for real (corrected for inflation) a g g r e g a t e d i v i d e n d s a s s o c i a t e d with the D o w
Jones Industrials, the N e w York Stock Exchange, and
the Standard and Poor's 500 for the years f r o m 1928
to 1978.' The question for the analyst concerns what
manner of growth this is and h o w it influences share
prices. A r e dividends well described by fluctuations
around a smooth trend? (Are they "trend-stationary"?)
O r are d i v i d e n d s c h a r a c t e r i z e d by n o i s y " r a t c h e t "
growth—that is, does a random additional payout each
year add to ("integrate with") what was paid out the
previous year? (Are they "integrated"?)
The distinction between the two dividend assumptions involves how one revises one's forecasts of future
dividends in light of surprisingly high or low current
dividends. If dividends are trend-stationary, one would
expect that today's dividend surprise will not persist but
that, at some point in the not-too-distant future, dividends will revert to values predicted by the historical
trend; a trend-stationary process never strays very far
2
Economic Review
from its normal course of growth. On the other hand, an
integrated process behaves like a drunken sailor on a
random walk: regardless of the intended path, at any
given point it is a coin toss as to whether the sailor will
step right or left. If dividends are integrated, each new
surprise is built into the level of dividends so that they
may tend to grow, but they do not trend.
For interpreting the evidence on the perfect markets
h y p o t h e s i s the distinction m a t t e r s b e c a u s e the t w o
types of processes carry different implications for the
variability of dividends. If dividends are integrated,
actual dividend variability might b e much less than
what could have occurred but did not (to continue the
m e t a p h o r — b y sheer luck the d r u n k e n sailor m i g h t
have stayed on the sidewalk), whereas under trendstationarity, observed dividend variability is a good indicator of potential variability.
S h i l l e r f o l l o w e d c o m m o n p r a c t i c e in a s s u m i n g
trend-stationarity and found evidence against the perfect markets hypothesis. Marsh-Merton and Kleidon
s h o w e d that u n d e r the i n t e g r a t i o n a s s u m p t i o n , investors might have been w a r y of potential dividend
fluctuations that did not come to p a s s — f o r example,
they m i g h t h a v e held f e a r s of a Soviet invasion of
Poland in the 1980s, which of course were never realized. In this case, the interpretation of Shiller's evidence is exactly reversed, and the data thus appear to
support the perfect markets hypothesis.
To this twofold counterattack has come a fourfold response. First, the sampling and specification considerations raised by Flavin, Michener, and LeRoy-LaCivita
could account for some excess volatility but not for
the a m o u n t Shiller had f o u n d . S e c o n d , N . G r e g o r y
M a n k i w , D a v i d R o m e r , and M a t t h e w D. S h a p i r o
(1985) and Kenneth D. West (1988) developed excess
volatility-type tests that are valid under the integration
assumption about dividends; these studies found evidence against the perfect markets hypothesis, though it
was much less dramatic than the results of Shiller and
LeRoy-Porter. Third, John Y. C a m p b e l l and Shiller
(1987) explicitly adopted the integration assumption
about dividends and showed that restrictions implied
by the perfect markets hypothesis were still generally
rejected by the data. Finally, a new attack on the perfect markets hypothesis, one that does not hinge on the
temporal stability issue, has been provided by the meanreversion studies of L a w r e n c e H. S u m m e r s (1986),
J a m e s M. P o t e r b a and S u m m e r s (1988), E u g e n e F.
Fama and Kenneth R. French (1988), and Andrew W.
L o and A.C. MacKinlay (1988). These studies search
for evidence that low returns are likely to be followed
by higher ones—returns "revert" to their mean. If returns
November/December 1992
Chart 1
Real Aggregate Dividends on Stocks Traded, 1 9 2 8 - 7 8
D o w Jones Industrials
Millions of
Dollars
20
1928
1938
,
Millions of
Dollars
3.0
1928
Federal
Digitized
for Reserve
FRASERBank of Atlanta
1958
1968
1978
N e w York Stock Exchange
Millions of
Dollars
0
1948
Standard and Poor's 500
1938
1948
1958
1968
1978
Economic Review 9
are mean-reverting, they are forecastable, and the perfect markets hypothesis is violated. Using aggregate
monthly data, several of the studies did in fact find
mean reversion and thus provided seemingly robust
evidence against the perfect markets hypothesis.
S t i l l , the p e r f e c t m a r k e t s i s s u e r e m a i n s u n r e solved. Taking the most recent apparently d a m a g i n g
evidence first, the analysis below reveals no evidence
of m e a n reversion in the annual data typically e x a m ined in the excess-volatility literature. Second, while
the validity of the M a n k i w - R o m e r - S h a p i r o , West,
and Campbell-Shiller studies hinges on the plausibility of the integration representation for the stock price
and dividend data they examine, this specification is
at m i n i m u m suspect (according to e v i d e n c e obtained
by David N. DeJong, John C. Nankervis, N.E. Savin,
a n d C h a r l e s H . W h i t e m a n 1 9 9 2 a , 1 9 9 2 b ) , or by
s o m e m e a s u r e s highly unlikely ( f o r e x a m p l e , b y the
B a y e s i a n m e a s u r e s used by D e J o n g and W h i t e m a n
1991). M o r e o v e r , the e v i d e n c e against the p e r f e c t
markets hypothesis under the integration assumption
is not very dramatic and, as will be shown presently,
is in fact practically nonexistent for the annual D o w
Jones, N e w York Stock Exchange, and Standard and
P o o r ' s data.
As Herbert Hoover might have put it, what the perfect m a r k e t s hypothesis n e e d s is a good o n e - a r m e d
economist. While on the one hand (trend-stationary
dividends) the perfect markets hypothesis looks implausible, on the other hand (integrated dividends), it
is not very implausible. Yet there is a way to let the
data decide which arm is the right o n e — b y adopting
an alternative to the usual statistical practice. Upon
d o i n g so, D e J o n g a n d W h i t e m a n ( 1 9 9 2 ) r e c e n t l y
found more unsettling evidence on the perfect markets
hypothesis.
Tests of the Perfect Markets Hypothesis
Numerous studies in the 1960s (many of which are
summarized in Fama 1970) and 1970s had tested the
" w e a k " version of the p e r f e c t m a r k e t s h y p o t h e s i s ,
which posits that returns cannot be predicted f r o m
their o w n past, and the "semistrong" version of the hypothesis, which holds that returns cannot be predicted
using other economic time series. One way to think of
these tests is as follows. Let Pt denote the ex-dividend
price of a stock at time t (that is, the price of the stock
just after the most recent dividend has been paid), and
let the (end of) time t dividend be Z); assume that Pt is
4
Economic Review
known at time /, but that Dt is unknown. Then the expected one-period return to buying the stock (for price
P), holding it long enough to receive the dividend payment £>, and selling it (one period later for price P + [ )
is E t (P t+i +DrPt)/Pr where Et denotes the expectation conditioned on information publicly available at
time t. If returns are not forecastable,
E
,(pt+i + D
t
~ P M
= rt
(1)
where r is the mean real return, assumed to be constant. A rearrangement of equation (1) indicates that
the current worth of the stock ought to equal the discounted value of its worth next period:
P ^ P E ^ + D ) ,
(2)
where ¡3 = (1 + r ) H . Another implication of equation
(1) is that the only difference between the realized discounted value of the stock and its current price results
from expectation error:
=
(3)
where e = (3(P/+i - EJPl+l) is the expectation error.
The weak implication of the perfect markets hypothesis is that the expectation error in equation (3) should
not be forecastable using its own past values (that is, it
should be serially u n c o r r e c t e d ) ; the s e m i s t r o n g implication is that it should not be possible to forecast
the return residuals using any publicly available data.
M a n y tests of this sort h a v e been a p p l i e d to ( a n d
passed by) stock price and dividend data; the authors'
versions of these tests are reported in Table 1. The first
section reports statistics that result f r o m testing the hypothesis that the return residuals are not serially correlated. 2 F o r e a c h of the three annual d a t a s e t s — t h e
Dow Jones Industrials, the N e w York Stock Exchange,
and Standard and Poor's 500 (see the appendix)—the
residuals in equation (3) were computed, and the serial correlation statistic calculated. In no case is there
reason to suspect that the residuals are serially correlated; weakly, the perfect markets hypothesis is not
rejected.
Regression tests of the semistrong version of the
hypothesis are also reported in Table 1. In each of the
data sets the return residuals are forecastable by prices
or the dividend-price ratio or both. Semistrongly, then,
the perfect markets hypothesis is rejected, but the return residuals are not very forecastable—in each case
the R 2 is very small. Moreover, as Shiller notes, "Such
small correlations detected in long historical data are
Novem ber/Decem ber 1992
Table 1
Tests of the Perfect Markets Hypothesis
N e w York
D o w Jones
Industrials
Stock Exchange
1928-78
1926-81
Standard and Poor's
1871-1985
Are Return Residuals Serially Correlated? (Weak Test)
Q-statistic
Significance Level
Q(21) = 11.10
Q(30) = 25.27
0.71
0.96
Q(21) = 12.29
0.93
Are Return Residuals Forecastable? (Semistrong Test)
Regression on Lagged Price
Coefficient
¿-statistic
R Squared
-0.174
-0.241
-2.70
0.13
-2.36
0.10
-0.141
-3.27
0.09
Regression on Lagged Dividend-Price Ratio
Coefficient
f-statistic
R Squared
0.148E+11
4252.568
1.55
0.05
1.82
0.06
333.027
2.35
0.05
Volatility Tests
oip)
crip)
352.18
116.81
0.21 £+08
52.37
0.55E+07
13.40
Variance Ratio Tests-'
pVR(k)
k
Q
P-va lue
10.03
5
10.30
13
12
0.59
6
0.69
•Under the null hypothesis of no m e a n reversion, pVR(k)
is distributed as ^{q);
of questionable relevance to modern conditions and of
minor interest given possible errors in data f r o m remote times in history" (1981a, 294).
Weak though it may be, the forecastability evidence
is e v i d e n c e against the perfect m a r k e t s hypothesis.
Shiller (1981a, 1981b) argues that while this evidence
might not convince anyone of anything, his volatility
tests ought to. These tests, he suggests, h a v e advantages over regression tests of "greater power in certain
circumstances of robustness to data errors such as misa l i g n m e n t and of simplicity and u n d e r s t a n d a b i l i t y "
(1981a, 292).
Federal
Reserve Bank of Atlanta
14.40
11
14
0.42
k denotes the horizon over w h i c h returns are analyzed.
Shiller's tests are based on three assumptions:
• Stock prices reflect investor beliefs that are rational expectations of future dividends.
• The real expected rate of return on the stock market, r, is constant.
• A g g r e g a t e real dividends can be described by a
trend-stationary process.
To derive the relationship on which the test is based, it
is useful to begin by defining the ex post rational (or
perfect markets) price per share, P. It is obtained by
noting that equation (2) describes Pt in terms of D( and
P/+], which in turn must be describable by D /+1 and P/+2,
Economic Review
5
which must then be describable by Dt+2 and P
and so
o n , a n d c a r r y i n g out t h e " f o r w a r d " s u b s t i t u t i o n , "
whereupon the current price can be expressed in terms
of the entire future course of dividends:
+ P3D,,2 + . . • ^ I j s . r
P.- = pD, +
1
(4)
In words, P is the present value of actual subsequent
d i v i d e n d s . F r o m the f i r s t a s s u m p t i o n a c t u a l stock
prices are ex ante rational—that is, they equal the current expectation of P,
=
(5)
so that actual prices represent the e x p e c t e d present
value of subsequent dividends. Equation (5) indicates
that Pt is the optimal forecast of P*; hence the forecast
error ut (= P* - P) cannot be predicted using the actual price Pr By implication, P* must vary m o r e than P:
varianceiP*)
=
variance{P)
+variance(u) > variance(P).
(6)
Chart 2 shows estimates of P and P* for the three
data sets, and sample estimates of varianceiP*)
and
varianceiP) are reported in Table 1,3 The calculations
replicate Shiller's results for the D o w Jones Industrials
and the Standard and Poor's and produce similar results in the N e w York Stock Exchange figures. Note
that contrary to the prediction of the perfect markets
hypothesis, the ex post rational stock price P* is much
less volatile than the price P itself: stock prices appear
too variable to be accounted for by subsequent changes
in dividends.
There are a n u m b e r of reasons to view these calculations with some suspicion. First, the assumptions
are questionable. On the constancy of the real rate,
Michener (1982) and LeRoy and LaCivita (1981) have
s h o w n that in a t h e o r e t i c a l m o d e l e c o n o m y , r i s k averse investors may behave in such a way that the
real rate of return on the stock market fluctuates over
time. This means that the r in equation (1) would not
be the constant Shiller assumed. Further, if the return
varies, the v a r i a n c e of P need not be less than the
v a r i a n c e of P\ B u t the a m o u n t by w h i c h the P*
bound could be e x c e e d e d was not as large as what
Shiller had f o u n d . Indeed, Shiller (1981a) argued that
f o r r e a l r a t e v a r i a b i l i t y to i n d u c e e n o u g h e x c e s s
volatility to account for the P' variance bound violations he found, the real rate would have had to vary
f r o m - 8 . 1 6 to 17.27 percent, a range too large to be
believable.
6
Economic Review
A second problem, discussed by Flavin (1983) and
Kleidon (1986a), is that tests based on equation (6) are
biased in favor of the inference of excess volatility.
Their argument involves noting that the sample variances of Pt and P'* are biased estimates of the actual
variances (because they are computed using deviations
f r o m estimated means rather than the true underlying
means). Further, the greater the temporal dependence
of a series, the greater the downward bias in its sample
variance. Because P is a highly persistent series, its
sample variance exhibits greater downward bias than
that of P . However, Kleidon conceded that this bias
does not seem to explain the dramatic violations Shiller
reports.
Finally, a number of authors have attacked Shiller's
third assumption. For example, Marsh and Merton arg u e d that "his variance bound test results might be
better interpreted as an i m p r e s s i v e rejection of his
model of the dividend process than as a rejection of
stock market rationality" (1986, 485). To establish this
point, Marsh and Merton maintained the first and second assumptions but used a different model to characterize h o w dividends, and hence rational prices, are
determined. In so doing, they managed to reverse the
inequality in e q u a t i o n (6) and establish a v a r i a n c e
bound test that directly contradicts Shiller's.
Marsh and Merton began by assuming that m a n agers w h o set dividend policies for business f i r m s dislike frequent dividend changes, yet they try to achieve
a constant d i v i d e n d - p r i c e ratio. 4 T h e implication is
that the managers would m a k e the current dividend a
weighted average of historical stock prices. But P* is
itself a w e i g h t e d a v e r a g e of actual d i v i d e n d s , and
these t w o facts together imply that P* is a weighted
average of actual prices. In fact, this simultaneity (dividends are set on the basis of past prices, and prices
are the expected discounted value of future dividends)
causes both prices and dividends to be integrated. As
a result, Shiller's variance inequality should be reversed;
intuitively, b e c a u s e an average is less volatile than
the series f r o m which it is c o m p u t e d , P* should b e
"smoother" than P.5
Marsh and Merton (1987) provided empirical support for the d i v i d e n d - s m o o t h i n g idea by estimating
what can be interpreted as the managerial equation for
setting a g g r e g a t e d i v i d e n d s as a f u n c t i o n of stock
prices. This equation, it turns out, explains much more
of the variability of aggregate dividends than does the
trend-stationary model attributed to Shiller.
Kleidon (1986b) has also argued that the apparent
integration of stock prices may account for Shiller's
f i n d i n g s . H e failed to r e j e c t the null h y p o t h e s i s of
Novem ber/Decem ber 1992
Chart 2
Actual and Perfect Markets Prices for Portfolios of Stocks, 1 9 2 8 - 7 8
Millions of
Millions of
Dollars
Millions of
Federal
Reserve Bank of Atlanta
D o w Jones Industrials
N e w York Stock Exchange
Standard and Poor's 500
Economic Review 13
integration for the Standard and Poor's price and dividend series and used simulations to show that rationally determined prices can appear "excessively" volatile
if dividends are integrated. However, West (1987) and
Pierre Perron (1988) noted that the integration test
employed by Kleidon has no ability to detect trendstationary dividend processes. Thus, even if dividends
are trend-stationary and S h i l l e r ' s i n d i c t m e n t of the
perfect markets hypothesis is correct, the test conducted by Kleidon would erroneously suggest that dividends are integrated and thus mislead a researcher to
c o n c l u d e that Shiller w a s w r o n g a b o u t the p e r f e c t
markets hypothesis.
ing evidence against the integration hypothesis does
not provide convincing evidence in its favor. Moreover, DeJong and others (1992a) developed a test of a
trend-stationary representation that has approximately
60 percent power against plausible integrated alternatives and found that using this test the trend-stationarity
representation is not rejected for the stock market series. Still further, DeJong and W h i t e m a n (1991) developed a Bayesian p r o c e d u r e designed to evaluate
the relative plausibility of the integration and trendstationarity representations; this p r o c e d u r e strongly
supports trend-stationarity over integration for the data
considered here.
P e r h a p s in r e s p o n s e to these c r i t i c i s m s , several
r e s e a r c h e r s , n o t a b l y M a n k i w , R o m e r , and S h a p i r o
(1985), Campbell and Shiller (1987), and West (1988),
developed volatility tests that do not s u b s u m e trendstationarity. A s in S h i l l e r ' s ( 1 9 8 1 b ) analysis, these
studies provide s o m e e v i d e n c e of e x c e s s volatility.
However, the validity of these studies hinges upon the
validity of the integration representation.
Finally, tests i m p l e m e n t e d by S u m m e r s ( 1 9 8 6 ) ,
Poterba and Summers (1988), Fama and French (1988),
and L o and MacKinlay (1988) have also been used to
assess the empirical validity of the perfect markets hypothesis. An attractive feature of these tests is that they
do not hinge on the integration versus trend-stationarity
issue. The tests are designed to detect mean reversion
in asset returns and often indicate that monthly returns
exhibit predictable, mean-reverting behavior. However,
the results in Table 1 indicate no evidence of mean reversion in the annual stock market data.
While trend-stationarity seems to have been abandoned in favor of integration in the excess-volatility
literature, several recent studies have suggested that
this a b a n d o n m e n t has been premature. Chart 3 provides some insight about the intuition behind this statement. The chart s h o w s what remains of D o w Jones
d i v i d e n d s w h e n the t r e n d - s t a t i o n a r y a s s u m p t i o n is
a d o p t e d and the t r e n d is r e m o v e d and what is l e f t
when the integration assumption is adopted and the integration is undone by "first-differencing." The t w o
m e t h o d s for r e m o v i n g the g r o w t h c o m p o n e n t yield
r e m a r k a b l y similar time series, and casual m e t h o d s
would be hard-pressed to determine which procedure
is the correct one.
Trend-stationarity's stature seems to have been diminished by the fact that the integration representation
is not often rejected using statistical tests developed by
Wayne A. Fuller (1976) and David A. Dickey and Fuller
(1981). While Shiller (1981a) used these tests and rejected the integration representation for the Standard
and Poor's dividend series, such results are by far the
exception rather than the rule. However, the results of
D e J o n g and others (1992a, 1992b) suggest that this
dearth of rejections is not surprising because the DickeyFuller type statistical tests are ill suited to detect trends t a t i o n a r y a l t e r n a t i v e s . In the b e s t c a s e , e v e n in
experimental trend-stationary data, DeJong and others
found that the tests correctly rejected integration less
than 50 percent of the time. In more realistic cases designed to correspond to practical use, the rate fell to
less than 20 percent. Hence, a failure to find convinc-
8
Economic
Review
To s u m m a r i z e , recent e v i d e n c e suggests that the
a n n u a l s t o c k p r i c e and d i v i d e n d s e r i e s c o m m o n l y
analyzed in the excess-volatility literature are well described as trend-stationary p r o c e s s e s ( t h e r e f o r e the
findings of Mankiw, Romer, and Shapiro, West 1988,
and Campbell and Shiller appear suspect). Further, because of the bias and interpretation issues raised by
Flavin and Kleidon, the validity of Shiller's excessvolatility evidence remains in doubt. Finally, there is
no evidence of mean reversion in the annual data originally examined by Shiller and Marsh-Merton. Thus,
the unsolved question: is the perfect markets hypothesis sound empirically? Finding out requires a new perspective.
An Alternative Assessment of the
Perfect Markets Hypothesis
Tests f o r volatility and m e a n r e v e r s i o n i n v o l v e
checking whether some, but not all, of the implications of the perfect markets hypothesis are violated
by actual data. T h e regression tests for predictability of returns necessarily must rest on e c o n o m i c a l l y
u n i n t e r e s t i n g a s s u m p t i o n s r e g a r d i n g t e m p o r a l stability. By building on work by C a m p b e l l and Shiller
(1987) and DeJong and Whiteman (1991), DeJong and
Novem ber/Decem ber 1992
Chart 3
Deviations of Real D o w Jones Dividends from Trend, 1 9 2 8 - 7 8
Trend Removed by Extracting Smooth Exponential G r o w t h
Trend Removed b y First Differencing
Whiteman (1992) have developed a procedure for
testing all implications of the theory without needing
to d e c i d e b e f o r e h a n d h o w to a c c o u n t f o r d i v i d e n d
growth.
T h e Campbell-Shiller procedure involves starting
with an assumption about dividend growth and with
a general, unrestricted statistical r e p r e s e n t a t i o n for
Federal
Digitized
for Reserve
FRASERBank of Atlanta
the stock price and dividend data. 6 This representation s u m m a r i z e s the i n f o r m a t i o n in the data. In the
context of the representation the connection between
stock p r i c e s and d i v i d e n d s i m p l i e d by the p e r f e c t
markets hypothesis in equation (2) can b e tested.
Adoption of this procedure highlights the sensitivity of inferences regarding the hypothesis to the dividend
Economic Review
9
g r o w t h a s s u m p t i o n . D e J o n g and W h i t e m a n ( 1 9 9 2 ,
Table 1) report that the perfect markets hypothesis is
resoundingly rejected under the trend-stationarity ass u m p t i o n and not rejected under the integration assumption.
That this sort of situation can arise is a consequence
of h o w classical statistical analysis is done. T h e general approach is easiest to understand in the context of
a simple e x a m p l e of dice-tossing. S u p p o s e one had
observed several hundred rolls of a pair of dice (the
"sample") and wished to determine whether the dice
were fair or loaded. The classical approach would be
to locate a pair of dice k n o w n to be fair, roll them a
large n u m b e r of times, and record the results. (In actual practice, this sort of experiment is often not necessary because the properties of experiments like the
rolling of fair dice are given in probability textbooks.)
The results describe what is likely to happen on dice
rolls (the distribution of possible outcomes) given the
"fair-dice" model. The final step is to compare the actual data (the sample) to the model distribution. If the
actual data distribution looks much different f r o m the
model distribution, the data are said to reject the m o d el and would indicate that the original dice were not
fair. It is significant that the approach requires data
sufficient to sway a skeptic away f r o m a belief in a
particular model. Put another way, it involves asking
whether the data look unusual or atypical f r o m the
point of view of the hypothesized model.
An alternative approach, which developed from the
w o r k of e i g h t e e n t h - c e n t u r y statistician Sir T h o m a s
Bayes, is to take the data rather than the hypothesis as
given and ask what model is most likely to have generated those data. In the dice-tossing example, the data
would be used to d e t e r m i n e what sort of dice were
most likely used in the actual tosses.
T h e contrast b e t w e e n the p r o c e d u r e s is in w h a t
each views as k n o w n and u n k n o w n . In the classical
procedure, one behaves as if the model is known and
the data are unknown and random; in the alternative
procedure, one takes the data as known (they have already been generated) and the model as unknown (because it is the object of study.)
Both approaches have strong foundations in probability theory, but they stem f r o m different perspectives
on the meaning of probability. The classical view associates probability with relative f r e q u e n c y : if, in a
large n u m b e r of identical e x p e r i m e n t s , a particular
outcome (for example, the effectiveness of a drug) appears 75 percent of the time, the probability of that
outcome is said to be 75 percent. The Bayesian view
associates probability with the analyst's "degree of be-
10
Economic Review
lief": the analyst would say that he or she was 75 percent certain that the drug works.
For many empirical questions, the two approaches
yield identical answers, and no arcane issues involving
the fundamental m e a n i n g of probability need be addressed. But for questions like those associated with
dividend growth and the perfect markets hypothesis,
the approaches do differ. Using the classical approach
m e a n s d e c i d i n g b e f o r e h a n d w h e t h e r d i v i d e n d s are
trend-stationary or integrated. With the Bayesian approach, one begins with prior views (for instance, the
agnostic view that trend-stationarity and integration
are equally likely) that permit uncertainty regarding
the correct specification. Then the data are used to
m o d i f y these beliefs, and the resulting combination of
prior belief and data information can be used to address issues such as the validity of the perfect markets
hypothesis. The advantage of this approach is that the
uncertainty regarding the ancillary hypothesis (divid e n d g r o w t h ) can be a c c o m m o d a t e d w h i l e the researcher addresses the hypothesis of chief interest (the
perfect markets hypothesis).
A feature of the Bayesian procedure is that while
it facilitates measurement of the relative plausibility
of one model over another, there is no easily-defined
notion of absolute plausibility. Classical and Bayesian
statisticians argue constantly about these issues, with
classical statisticians often claiming that they can assess a b s o l u t e plausibility b e c a u s e their p r o c e d u r e s
take one hypothesis as given and ask whether actual
data look unusual f r o m that point of view. They claim
that their tests can pit a given hypothesis against all
c o m e r s . B a y e s i a n s argue that d o i n g so a l w a y s inv o l v e s a d o p t i n g q u e s t i o n a b l e ancillary h y p o t h e s e s
(like the dividend growth assumption in testing the
perfect markets hypothesis), that in practice the data
record could be spotty enough that it would fail to reject each of several mutually exclusive hypotheses,
and that science advances by finding new hypotheses
that are relatively m o r e plausible than the old ones.
T h e consequence of this feature of Bayesian reasoning is that, in testing a hypothesis like the perfect
markets hypothesis, one must be willing to specify an
explicit alternative—one must specify how stock
prices would evolve if the perfect markets hypothesis
were violated. There is freedom to try each of several
alternatives, but each c o m p a r i s o n m u s t i n v o l v e the
perfect markets hypothesis and a specific alternative.
For this reason, DeJong and Whiteman report tests of
the perfect markets hypothesis against a variety of alternatives. Each of these tests a c c o m m o d a t e s uncertainty regarding dividend growth.
November/Decem ber 1992
The DeJong-Whiteman results indicate that the perfect markets hypothesis appears relatively less plausible than a m o d e l d e s i g n e d s p e c i f i c a l l y to e x p l o i t
statistical regularities in forecasting prices and dividends. H o w e v e r , such a model has little theoretical
f o u n d a t i o n . D e J o n g and W h i t e m a n s h o w that researchers less certain of the nature of price-dividend
interaction would find some, but not too much, reason
to look beyond the perfect markets hypothesis.
Conclusion
Regression tests opened the controversy about the
validity of the perfect markets hypothesis. Did the hypothesis pass? Were the tests p o w e r f u l enough? W h e n
study after study either found no evidence against the
perfect markets hypothesis or explained away any evidence found, the debate subsided. The controversy was
reopened by applying volatility tests, which spurred
an additional debate concerning the temporal stability of prices and dividends. W h i l e the stability issue
seems to b e settling in f a v o r of trend-stationarity, the
volatility tests suffer from bias, misspecification, and
i n t e r p r e t a t i o n a l d i f f i c u l t i e s and h a v e d o n e little to
settle the controversy o v e r the p e r f e c t m a r k e t s hypothesis.
Work that permits analysis of the perfect markets
hypothesis without conditioning on the nature of dividend growth suggests that from at least one viewpoint
something seems to be amiss. The problem with the
perfect markets hypothesis may very well be the constancy of the real rate of return. Whatever the explanation, something other than the simplest version of the
perfect markets hypothesis is needed to explain the aggregate dividend-price data. Indeed, e c o n o m i s t s are
actively seeking better explanations (than the simple
version of the perfect m a r k e t s h y p o t h e s i s ) for w h y
they are not rich.
Appendix
Data Set 1: Modified Dow Jones
Industrial Average
Annual, 1928-78. Here, P{ and Dt refer to the real
price and dividends of the portfolio of thirty stocks that
made up the sample for the Dow Jones Industrial Average when it was created in 1928. However, because the
stocks used to calculate this average are continually adjusted, Shiller has extensively modified it to control for
these adjustments. These modifications are described in
the appendix of Shiller (1981b).
Data Set 2: Value-Weighted New York
Stock Exchange Index
Annual, 1926-81. Pt represents the January valueweighted New York Stock Exchange stock price divided
by the January producer price index (PPI). D t represents
total dividends for the year accruing to the portfolio represented by the stocks in the index, divided by the annu-
Federal Reserve Bank of Atlanta
al average PPI. These data are contained in the Center
for Research in Security Prices data set. In the Marsh
and Merton (1987) analysis, Pt represents December
rather than January prices, but January prices are considered here to remain consistent with the Shiller dating
scheme.
Data Set 3: Modified Standard and Poor's 500 Series
Annual, 1871-1985. The price series is Standard and
Poor's monthly composite stock price index for January,
divided by the producer price index (January PPI starting
in 1900, annual average PPI before 1900 scaled to 1.00
in the base year, 1979). The dividend series represents
the total calendar year's dividends accruing to the portfolio, represented by the stocks in the index, divided by the
average PPI for the year. These data differ slightly from
Shiller's (1981b) numbers; some adjustments have been
made to correct minor errors in the original data, and the
series have been updated to 1985.
Economic Review
11
Notes
1. The Dow Jones Industrials and Standard and Poor's data
were originally investigated by Shiller (1981a, 1981b), and
the New York Stock Exchange data correspond to the series
examined by Marsh and Merton (1987). The data are described in the appendix.
2. The statistic used was the Box-Pierce Q statistic. Further, the
calculations in the table are carried out on data from which
an exponential trend has been removed. Exponential defending does not materially affect the implications of the perfect
markets hypothesis: if Pt and D, possess deterministic exponential trends, then equations like (1), (2), and (3) characterize the relationships between exponentially detrended prices
and dividends but (3 is replaced by 77 = (1 + g)/(l + r), where
g is the exponential growth rate.
3. The P series was calculated by backward iteration on equation (3) beginning with a terminal price P = Pr. Shiller used
the average price over the sample for this terminal value;
Flavin (1983), Mankiw, Romer, and Shapiro (1985), and
Kleidon (1986a, 1986b) emphasize that this choice introduces biases into the calculations. Using the actual terminal
price avoids (some of) this problem.
4. Lintner's (1956) interviews suggested that managers try to
achieve a constant dividend-price ratio. Why they do it is another unsettled question.
5. Actually, the simultaneity complicates matters. It turns out
that both P* and P will have infinite variance under the dividendsmoothing assumption; sample estimates of variability will
of necessity be badly biased downward, and P" may appear
to fluctuate less than P.
6. The representation is known in the econometrics literature as
the vector autoregression.
References
Campbell, John Y., and Robert J. Shiller. "Cointegration and
Tests of Present Value Models." Journal of Political Economy 95 (October 1987): 1062-88.
DeJong, David N., John C. Nankervis, N.E. Savin, and Charles
H. Whiteman. "Integration versus Trend Stationarity in
Time Series." Econometrica 60 (March 1992a): 422-33.
. "The Power Problems of Unit Root Tests in Time Series
with Autoregressive Errors." Journal of Econometrics 53
(July-September 1992b).
DeJong, David N., and Charles H. Whiteman. "The Temporal
Stability of Dividends and Stock Prices: Evidence from the
Likelihood Function." American Economic Review 81 (June
1991): 600-617.
. "Modelling Stock Prices without Pretending to Know
How to Induce Stationarity." University of Iowa manuscript,
1992.
Dickey, David A., and Wayne A. Fuller. "Likelihood Ratio
Statistics for Autoregressive Time Series with a Unit Root."
Econometrica 49 (July 1981): 1057-72.
Fama, Eugene F. "Efficient Capital Markets: A Review of Theory and Empirical Work." Journal of Finance 25 (May
1970): 383-417.
, and Kenneth R. French. "Permanent and Temporary
Components of Stock Prices," Journal of Political Economy
96 (April 1988): 246-73.
Flavin, Marjorie A. "Excess Volatility in the Financial Markets." Journal of Political Economy 91 (December 1983):
929-56.
Fuller, Wayne A. Introduction to Statistical Time Series. New
York: John Wiley and Sons, 1976.
Kleidon, Allan W. "Bias in Small Sample Tests of Stock Price
Rationality." Journal of Business 59 (April 1986a): 237-61.
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. "Variance Bounds Tests and Stock Price Valuation
Methods." Journal of Political Economy 94 (October
1986b): 953-1001.
LeRoy, Stephen F., and C.J. LaCivita. "Risk Aversion and the
Dispersion of Asset Prices." Journal of Business 54 (October 1981): 535-47.
LeRoy, Stephen F., and Richard D. Porter. "The Present Value
Relation: Tests Based on Implied Variance Bounds." Econometrica 49 (May 1981): 555-74.
Lintner, John V., Jr. "Distribution of Incomes of Corporations
among Dividends, Retained Earnings, and Taxes." American Economic Review 66 (May 1956): 97-113.
Lo, Andrew W„ and A.C. MacKinlay. "Stock Market Prices
Do Not Follow Random Walks: Evidence from a Simple
Specification Test." Review of Financial Studies 1 (1988):
41-66.
Malkiel, Burton G. -4 Random Walk Down Wall Street. New
York: Norton, 1973.
Mankiw, N. Gregory, David Romer, and Matthew D. Shapiro.
"An Unbiased Reexamination of Stock Market Volatility."
Journal of Finance 40 (July 1985): 677-87.
Marsh, Terry A., and Robert C. Merton. "Dividend Variability
and Variance Bounds Tests for the Rationality of Stock
Market Prices." American Economic Review 76 (June
1986): 483-98.
. "Dividend Behavior for the Aggregate Stock Market."
Journal of Business 60 (January 1987): 1 -40.
Michener, Ronald W. "Variance Bounds in a Simple Model of
Asset Pricing." Journal of Political Economy 90 (February
1982): 166-75.
Perron, Pierre. "Trends and Random Walks in Macroeconomic
Time Series: Further Evidence from a New Approach."
November/December 1992
Journal
of Economic
Dynamics
and Control
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(June/September 1988): 297-332.
Poterba. James M., and Lawrence H. Summers. "Mean Reversion in Stock Returns: Evidence and Implications." Journal
of Financial Economics 1 (October 1988): 27-60.
Shiller, Robert J. "The Use of Volatility Measures in Assessing
Market Efficiency." Journal of Finance 36 (May 1981a):
291-304.
. "Do Stock Prices Move Too Much to Be Justified by
Subsequent Changes in Dividends?" American Economic
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Federal Reserve Bank of Atlanta
Summers, Lawrence H. "Does the Stock Market Rationally Reflect Fundamental Values?" Journal of Finance 41 (July
1986): 591-601.
West, Kenneth D. "A Note on the Power of Least Squares Tests
for a Unit Root." Economics Letters 24 (1987): 249-52.
. "Dividend Innovations and Stock Price Volatility."
Econometrica 56 (January 1988): 37-61.
Economic
Review
13
F i l e Convexity Trap:
Pitfalls in Financing
Mortgage Portfolios and
Related Securities
r
James H. Gilkeson and Stephen D. Smith
he securitization of residential m o r t g a g e s has been o n e of the
biggest growth areas in credit markets during the last decade. In
recent years the supply of new mortgage securities has f a r exc e e d e d the supply of n e w corporate bonds (see, for e x a m p l e ,
Douglas T. Breeden 1991), and these instruments are being purchased in large part by financial institutions. Indeed, the relatively high returns and absence of default risk has m a d e Government National Mortgage
Association ( G N M A ) passthroughs, and their corresponding derivative securities, very attractive investment vehicles for banks in all size categories.
Holdings of certificates of participation in residential mortgage pools and
collateralized mortgage obligations by U.S. banks increased tenfold between
1985 and 1991 (from around $12 billion to $120 billion). 1 Moreover, these
mortgage-related securities n o w m a k e up about 8 percent of commercial
bank assets.
Gilkeson is a Ph.D. candidate
at Duke University; Smith
holds the H. Talmage Dobbs,
Jr., Chair of Finance at Georgia State University and is a
visiting scholar in the Atlanta
Fed's research department.
The authors gratefully
acknowledge the comments of
Peter Abken, Frank King,
Bobbie McCrackin, Sheila
Tschinkel, and Larry Wall.
14
Economic
Review
T h e g r o w i n g popularity of m o r t g a g e credit instruments has caused a
t r e m e n d o u s increase in studies a n a l y z i n g the u n c o n v e n t i o n a l cash f l o w
characteristics of mortgage-backed securities. Unlike those of a true fixedincome security (such as a Treasury note or bond), the cash flows to mortg a g e s , and t h e r e f o r e m o r t g a g e - b a c k e d securities, are i n f l u e n c e d by the
h o m e o w n e r ' s option to prepay the mortgage without penalty. This clause
makes traditional yield-to-maturity measures unreliable indicators of return
because homeowners are more likely to prepay after rates have fallen. Myriad approaches have been developed to deal with this problem, including the
option-adjusted spread and arbitrage-free spread measures of return (see, for
example, John D. Finnerty and Michael Rose 1991, Lakhbir S. Hayre 1990,
and Stephen D. Smith 1991).
Novem ber/Decem ber 1992
While much work has been devoted to examining
the relationship between the value of mortgage-backed
securities and interest rates, there has been much less
discussion of the interaction between mortgage values
and the funding techniques traditionally used by banks.
Regulators concerned about bank and thrift solvency
should be a w a r e that certain m e t h o d s of f i n a n c i n g
mortgage portfolios or securitized mortgage-backed securities may expose institutions to capital losses in both
high and low interest rate environments. 2
In addition, portfolio m a n a g e r s should recognize
that traditional methods used to hedge the interest rate
risk of fixed-income securities may be counterproductive when applied to mortgage-related products. More
generally, managers of financial institutions may lack
adequate knowledge of the price/yield relationship associated with mortgage portfolios. It is important to
understand that changes in the market values of mortgagerelated assets and the liabilities used to f u n d them can
interact in ways that cause unusual swings in the market value of equity positions. M a n a g e r s need to be
aware that the value of such equity (or capital) investments in mortgage portfolios, even those f u n d e d by
(duration) " m a t c h e d " liabilities, behaves very differently from the residual ownership claim in more traditional asset/liability c o m b i n a t i o n s . S t a n d a r d return
measures, even those that are "adjusted" for risk, may
fail to capture institutions' full exposure to interest
rate fluctuations.
Practitioners are well aware that funding long-term
assets with variable-rate liabilities produces exposure
losses in high-rate environments. This article concerns
itself with the potential gains and losses f r o m issuing
long-term liabilities to f i n a n c e a portfolio of m o r t gages or a mortgage-backed security. It is not simply
that prepayments alone cause interest rate risk. Rather,
it is the asymmetric response of prepayments to rate
changes that exposes the manager to risk in both highland low-rate environments.
This article reviews the concepts of duration and
convexity and ways these measures are influenced by
prepayments. 3 T h e discussion then analyzes h o w equity values change with rates for alternative financing
arrangements. Special attention is paid to a so-called
"convexity trap" (equity losses in both low- and highrate environments) w h e n mortgage-backed securities
are financed by fixed-rate liabilities. Finally, some solutions to the risk problem are presented. These inc l u d e h i g h e r initial equity i n v e s t m e n t s and various
hedging instruments such as interest rate options, interest rate caps and floors, interest-only and principalonly strip securities, and traded futures contracts.
Federal
Reserve Bank of Atlanta
Prepayments, Mortgage Values,
And Negative Convexity
An investment in a fixed-rate mortgage-backed security p r o m i s e s a uniform stream of p a y m e n t s o v e r
the life of the contract. For the moment, suppose that
the m o r t g a g e either d i s a l l o w s p r e p a y m e n t s or that
prepayments are a fixed proportion of the mortgage
pool balance. Chart 1 shows the relationship between
the m a r k e t v a l u e of this m o r t g a g e - b a c k e d security
and interest rates. (The box on page 23 provides the
example used to construct Charts 1-6 and Tables 1-2.)
The absolute value of the slope of this function is often referred to as the security's duration. 4 T h e duration m e a s u r e can b e viewed as the weighted average
maturity of the security, with the weights being the
present value of each cash flow divided by the present
value of all the cash flows (the price). Unlike maturity, which represents only the timing of the last cash
flow, duration recognizes that some cash flows will
be received before maturity and that these timing differences influence the security's interest rate sensitivity. Indeed, as noted earlier, the (percentage) change in
price as rates c h a n g e is the duration. Therefore, the
slope of the line relating price to interest rates (approximately) equals the security's duration.
Notice, however, that in the case of the fixed prepayment portrayed in Chart 1, the slope (or duration)
gets smaller as rates increase. This shape implies that
the security's value is decreasing more slowly as market interest rates increase. The change in the duration
(or rate of change in the price) is referred to as the
convexity of the security, and in this case the convexity is positive. Positive convexity implies that the duration of the security is inversely related to the level of
interest rates: when rates are high, later payments get
less weight (in a present-value sense) than when rates
are low (earlier cash flows are relatively m o r e valuable in high-rate environments).
By way of contrast, Chart 2 shows the market value of a mortgage-backed security whose prepayment
rate (realistically) increases as interest rates decline.
Notice that the value is still decreasing as rates increase and increasing as rates decline. However, over
most of this range of rates, the duration of the mortgage is increasing as rates increase. Similarly, the duration is decreasing as rates decline. This characteristic,
called negative convexity, requires that cash flows not
only increase as rates decline but that, at least f o r
s o m e t i m e p e r i o d s , they i n c r e a s e at an i n c r e a s i n g
rate. (The appendix contains a more mathematically
Economic Review
15
Chart 1
Constant-Prepayment Mortgage
(Market
Value)
Value as a Percent of Par
140
120
100
80
60
-4%
-3%
-2%
-1%
FACE
+1%
+2%
+3%
+4%
+5%
Interest Rate Change
Chart 2
Variable-Prepayment Mortgage
(Market
Value)
Value as a Percent of Par
Economic Review
16
Interest Rate Change
November/December 1992
rigorous discussion of this issue.) The intuitive explanation for this unusual value/rate relationship as rates
decline is that prepayments are speeding up at exactly
the time that these f u n d s must be reinvested at low interest rates. On the other hand, there are f e w early cash
flows in high-rate environments as prepayment rates
decline or cease altogether. T h e r e f o r e , the weighted
maturity measure (duration) is increasing as rates rise
because less weight is being placed on early cash flows
when rates are high. Notice, however, that at a certain
low-rate level prepayments (which cannot exceed 100
percent) begin to flatten out, and the value/rate relationship m a y return to one of positive convexity. In other
words, at some (low enough) interest rate, an increase
in prepayments is unlikely, and the mortgage portfolio
behaves like a fixed-income security.
T h e f o l l o w i n g discussion analyzes the w a y s that
three different financing arrangements might influence
equity v a l u e s , d e p e n d i n g on w h e t h e r the f u n d s are
placed in a true fixed-income security or a mortgage
with varying prepayment rates. The first financing instrument considered is a fixed-term, fixed-rate certificate of deposit (CD). T h e duration of this instrument
is chosen so that liability is initially duration-matched
with both assets. 5 Chart 3A shows both the value of a
constant p r e p a y m e n t mortgage and the value of the
C D as a function of interest rates. T h e distance between the two curves is the market value of capital.
Notice that in this case the value of equity is relatively
constant, regardless of the level of rates, because the
percentage change in price is the same for both the asset and the liability. The duration is also a measure of
the percentage change in price for a 1 percent change
in rates, and this d e p i c t i o n is j u s t a n o t h e r w a y of
showing that the durations of the two securities go up
and down together as rates change.
Another deposit source c o m m o n l y used by banks is
the f i x e d - t e r m , f i x e d - r a t e d e p o s i t that a l l o w s t h e
d e p o s i t o r to w i t h d r a w f u n d s a f t e r p a y i n g an e a r l y w i t h d r a w a l penalty. T h e s e deposits typically pay a
lower rate than n o - w i t h d r a w a l deposits, a l l o w i n g a
bigger spread (higher equity value) at par. If rates decline, consumers have no incentive to withdraw and, if
the liability's initial maturity is c h o s e n to durationmatch the asset, the market value of equity remains
relatively constant. However, if rates rise significantly,
consumers m a y rationally elect to pay the withdrawal
penalty in order to reinvest their f u n d s at the new,
higher rates (see, for example, James H. Gilkeson and
Craig K. Ruff 1992). At high rates, the market value
of the bank's equity position may decline or even become negative unless some hedging activity is under-
Federal Reserve Bank of Atlanta
taken. Chart 3B s h o w s an e x a m p l e of this f u n d i n g
strategy.
Finally, Chart 3C shows how the bank may elect to
f u n d a constant prepayment mortgage security using
short-term, floating-rate deposits, such as m o n e y market deposit accounts ( M M D A s ) . These accounts typically pay the lowest rates, offering the highest equity
value at par. 6 If interest rates fall, the rates on these deposits fall as well and the market value of the bank's
equity increases. However, if interest rates rise, the deposit rates will also rise (leaving the market-value line
for deposits flat) and the market value of equity will
decrease quickly. Under this funding strategy, the bank
will have to hedge against rising rates. While the market value changes shown in Chart 3 (and throughout
the other graphs) will not immediately show up on an
i n s t i t u t i o n ' s b a l a n c e sheet ( w h i c h is in b o o k - v a l u e
terms), the lower net cash flows will eventually dilute
earnings and, therefore, capital.
Charts 4A-C consider the same three financing alternatives for variable-prepayment mortgages that Charts
3A-C considered for fixed-prepayment mortgages. In
Chart 3A, a f i x e d - t e r m , n o - w i t h d r a w a l deposit was
shown to "lock in" a positive equity value through duration matching. Chart 4A shows that, for a mortgage that
exhibits negative convexity (as discussed previously),
this kind of asset-liability management is not, by itself,
feasible. If rates rise, the market value of the mortgage
security falls more quickly than the cost of the deposits,
implying a decrease in equity value. As rates decline,
the market value of the mortgage security increases
more slowly than the cost of deposits, again implying a
decrease in equity value.
For f i x e d - r a t e , f i x e d - t e r m d e p o s i t s with a withdrawal option, the upside-rate risk is similar to that associated with fixed-prepayment mortgages. However,
there is also the risk that, if rates fall far enough, the
slower increase in mortgage value will be overwhelmed
by the faster increase in the cost of the deposit, entailing a loss of equity value. Chart 4 B represents this
risk. 7
If mortgages are financed by short-term, floating-rate
deposits, as shown in Chart 4C, the interest rate risks
are much the same as for financing fixed-prepayment
instruments. Equity value grows as interest rates decrease and falls as they rise. However, a close comparison of Charts 3C and 4 C will show that, in this case,
the increase in equity value is smaller and the decrease
in equity value is larger for mortgages with variable
prepayments. However, Chart 4 C shows that the instit u t i o n still h a s only a o n e - s i d e d h e d g i n g p r o b l e m
when using the floating-rate funding strategy.
Economic Review
17
Chart 3
Mortgage with Constant Prepayments
Fixed-Rate Funds
(no withdrawal
option)
Fixed-Rate Funds
(withdrawal
option)
Floating-Rate Funds
N o t e : S h a d e d areas represent negative equity.
Economic
18
Review
Novem ber/Decem ber 1992
Chart 4
Mortgage with Varying Prepayments
Fixed-Rate Funds
(no withdrawal
option)
Value as a Percent of Par
Fixed-Rate Funds
(withdrawal
option)
Interest Rate Change
Floating-Rate Funds
Value as a Percent of Par
Interest Rate Change
N o t e : S h a d e d areas represent negative equity.
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
Economic Review
19
/ l i e Convexity Trap
It is worthwhile to take a closer look at the implications of Chart 4A, which demonstrates financing variableprepayment mortgages with fixed-term deposits. By
traditional asset-liability techniques, the asset and liability pictured are duration-matched. The market value
of equity should not change as interest rates rise or
fall, yet the figure clearly shows that equity decreases
under any sizable interest rate movement, up or down.
This seeming paradox can be called a "convexity
trap," to coin a phrase. 8 The duration-matching strategy i g n o r e s the e f f e c t s of v a r y i n g p r e p a y m e n t s or,
equivalently, of negative convexity. Although the duration of the m o r t g a g e and the deposit are initially
matched (at the face interest rate), the convexities are
of opposite signs (the mortgage is negatively convex,
and the deposit is positively convex). As rates fall, the
deposit curve becomes steeper as the mortgage curve
gets flatter. Similarly, when rates rise, the mortgage
curve gets steeper and the deposit curve flattens. The
durations are no longer matched at rates other than
par, implying that equity cannot be held constant except by using hedging instruments, which protect equity f r o m large swings in interest rates, either up or
down. Of course, the magnitude of potential losses in
low-rate environments is limited (because nominal interest rates generally do not fall below zero). (See the
box on page 23.)
.Equity Cushions and Off-BalanceSheet Hedging Instruments
Purchasers of mortgage-backed securities can try to
protect themselves from losses associated with large
interest rate s w i n g s in a variety of ways. The m o s t
straightforward involves reducing the leverage ratio
used to fund the security. In this case, the initial equity
cushion is a higher percentage of par value. Charts
5 A - C compare three initial equity positions: 10 percent, 5 percent, and 3 percent of the purchase price, respectively. The liability used is the fixed-rate deposit
with a no-withdrawal clause, but the same idea would
apply with early withdrawal as well. The extreme cases can be seen by comparing Chart 5 A with Chart 5C.
With a 10 p e r c e n t initial i n v e s t m e n t , the b a n k can
withstand rate movements over a 9 percent range and
still retain a positive market value of equity. Alternatively, Chart 5C shows that with a 3 percent initial in-
20
Economic Review
vestment the equity value of the position will turn negative if rates either decline by roughly 1.5 percent or
increase by 3 percent. Moreover, as noted earlier, this
relatively small rate window would persist even if the
original par interest rate were 9 percent or 10 percent.
F o r e x a m p l e , p u r c h a s e r s of 9 p e r c e n t m o r t g a g e backed securities who fund with 3 percent equity capital, with the r e m a i n d e r b e i n g f u n d e d by 7 percent
fixed-rate liabilities, could encounter a negative equity
position (in market-value terms) if rates should fall to
around 7.5 percent. Keep in mind that the prepayment
assumptions used here are relatively conservative, so
the potential problem could be more severe than that
shown in Chart 5C.
Other alternatives for hedging the convexity trap involve the use of off-balance-sheet instruments. For example, the portfolio manager could purchase interest
rate caps and floors. An interest rate cap is an agreement whereby one party agrees, for an up-front fee, to
pay a counterparty the difference between market interest rates and some base rate, in the event that future
market rates should rise above the cap rate. Conversely,
an interest rate floor can be purchased that pays off the
difference between a base rate and market rates should
future interest rates fall below the floor. Such instruments are not costless. However, the simultaneous purchase of an interest rate cap and floor at the ends of the
interest rate range would provide some insurance against
large rate swings and, therefore, the negative convexity
of the mortgage. In this case, the net hedged position
(the market value of the mortgage plus the caps and
floors minus the cost of the deposit) would remain positive. Peter A. Abken (1989) and Keith C. Brown and
Donald J. Smith (1988) provide good introductions to
the mechanics of interest rate caps and floors.
A less esoteric, but potentially useful, approach to
hedging these convexity-induced swings in value involves the purchase of put and call options on Treasury bonds. Chart 6 s h o w s the hedged and u n h e d g e d
value of equity as a function of interest rates f o r the
d u r a t i o n - m a t c h e d f u n d i n g strategy. T h e u n h e d g e d
curve is simply the d i f f e r e n c e between the asset and
liability value curves in Chart 5B. T h e initial equity
position is 5 percent of assets. The options are puts
a n d c a l l s on a t h i r t y - y e a r , 8 p e r c e n t c o u p o n - r a t e
Treasury bond. The strike prices are 90 (for the put)
and 110 (for the call). The hedged market value of
equity function s h o w s that purchasing such puts and
calls can be used to lock in the market value of equity. The a s s u m p t i o n used in Chart 6 is that the upfront cost of purchasing the options is 1 percent of
the m o r t g a g e ' s par value. Therefore, the net market
Novem ber/Decem ber 1992
Chart 5
The Convexity Trap under Varying Initial Equity Positions
1 0 % Initial Equity
Value as a Percent of Par
Interest Rate Change
5 % Initial Equity
Interest Rate Change
3 % Initial Equity
Interest Rate Change
N o t e : S h a d e d areas represent negative equity.
Federal Reserve Bank of Atlanta
Economic Review
21
Chart 6
Market Value of Equity
(Hedged
versus
Unhedged)
Interest Rate Change
N o t e : S h a d e d areas represent negative equity.
value of equity is lower than 5 percent (5% - 1% = 4%)
but still roughly constant.
A third off-balance-sheet hedge involves principalonly and interest-only securities. A s their names imply, t h e s e c o n t r a c t s pay off o n l y as a f u n c t i o n of
principal and interest payments on the mortgage pool,
respectively. W h e n properly priced, the market value
of an interest-only security plus that of a principalonly security must equal the value of the mortgagebacked security w h e n purchased alone. Not surprisingly, the v a l u e of i n t e r e s t - o n l y s e c u r i t i e s tend t o
m o v e directly with interest rates because in high-rate
e n v i r o n m e n t s p r e p a y m e n t s tend to slow d o w n and
more interest income is received during the life of the
contract. On the other hand, the value of principal-only
securities tends to m o v e inversely with rates. W h e n
rates fall, the values tend to rise as principal repaym e n t s s p e e d up and the d i s c o u n t rate f a c t o r f a l l s .
T h o m a s J. O'Brien (1992) provides a discussion of the
valuation of interest-only securities, principal-only securities, and whole mortgages.
A final off-balance-sheet hedging alternative would
be to create a short position in the Treasury bond futures market. For small interest rate changes it is possible to estimate the change in the mortgage portfolio
22
Economic
Review
value (including the e f f e c t of c h a n g i n g p r e p a y m e n t
rates) with some precision. A s stated earlier, the value
of the mortgage portfolio will increase as rates fall and
decrease as rates increase. Conversely, the short f u tures position will increase in value as rates rise and
decrease as rates fall. Because futures are not subject
to prepayment risks, the change in value given a particular rate movement is known. The proper strategy is
to short (sell) a specific number of contracts so that, if
rates rise, the loss in value to the mortgage portfolio is
approximately offset by the gain in value to the futures
contracts and vice versa if rates fall.
Each of these strategies has some advantages and
disadvantages. The use of higher capital ratios is the
most straightforward, but it involves the opportunity
cost of allocating capital for this purpose. Purchasing
interest rate caps and floors or T-bond puts and calls
is m u c h like purchasing an insurance policy. 9 For a
fixed fee, paid up-front, the risks f r o m both upward
and downward rate m o v e m e n t s are covered. However, these insurance-type contracts present three potential
problems. First, because options tend to be short-term (at
most nine months), the "insurance contract" must be
rewritten in no more than nine months at an unknown
future " p r e m i u m . " Second, options can often be the
Novem ber/Decem ber 1992
AnE
The graphs presented in this article are constructed
using representative mortgage asset and deposit liability
pools and a set of conservative mortgage prepayment
and deposit withdrawal assumptions. On the asset side,
it is a s s u m e d that the bank holds a $1 million pool
of 8 percent mortgages, all currently at par. For Charts 1
and 3A-C, a constant annual prepayment rate of 6 percent is used. This rate is equivalent to 100 percent of the
Public Securities Association rate, a prepayment rate
standard developed in the 1970s. Although a constant
level of prepayments will cause the mortgage pool to
mature faster, the convexity characteristics, as shown in
these four graphs, are similar to those of a coupon-paying
annuity (that is, they exhibit positive convexity).
Charts 2 and 4A-C incorporate a prepayment schedule in which prepayment rates rise as mortgage rates fall
(see, for example, Smith 1991) and vice versa. Table 1
shows mortgage values, as a percentage of par, for various market rate changes. The first column shows the alternative market rates for mortgage-backed securities.
Prepayments are assumed to be 6 percent at par. The second and third columns provide the constant prepayment
rate and the corresponding market value of the mortgagebacked security (shown in Chart 1). The fourth column
shows moderate changes in prepayment rales as interest
rates change, and the fifth column provides the corresponding market value. The fifth column is represented
in Chart 2. Finally, the sixth and seventh columns show
"fast" prepayments and corresponding market values, respectively. If charted, the last column would look similar
to Chart 2, differing in that would display more negative
convexity.
The convexity trap displayed here is not dependent on
mortgage rates falling to 4 percent. Table 1 could be reconstructed using a 10 percent coupon rate and the risk of negative equity would still exist for rate declines of 2 percent
m o s t e x p e n s i v e m e t h o d of h e d g i n g interest rate risk. A n
o p t i o n , by n a t u r e , can n e v e r be w o r t h less than z e r o .
T h e price of the option reflects this limited liability. Finally, as these instruments are based on Treasury rates,
their values reflect positive convexity while, as stated
earlier, m o r t g a g e portfolios often exhibit negative c o n vexity. A s can be seen in Chart 6, o p t i o n - h e d g e d equity
values continue to s h o w s o m e volatility. T h e r e m a i n i n g
convexity m i s m a t c h can, h o w e v e r , b e corrected by purchasing a series of options at different strike prices.
Tt is o f t e n a r g u e d that i n t e r e s t - o n l y s e c u r i t i e s a n d
principal-only securities provide the best protection
for prepayment risks because these instruments are
s u b j e c t to the s a m e p r e p a y m e n t e f f e c t s a s m o r t g a g e
Federal
Reserve Bank of Atlanta
to 3 percent (that is, market rates of 7 percent to 8 percent). It is the market rate relative to the coupon rate,
rather than the absolute level of rates, that causes the relationship between prices and rates to be negatively convex.
On the liability side. Charts 3A-C and 4A-C compare
the effect on equity of three funding alternatives. In each
of the three cases, the market value of the cash flows is
calculated using a discount rate equal to the current
mortgage rate minus 2 percent (200 basis points). In
Charts 3A and 4A, a pool of eight-and-a-half-year, 6
percent interest bank notes, making monthly coupon
payments, is considered. These deposits may not be withdrawn under any circumstances. This maturity was chosen b e c a u s e it is d u r a t i o n - m a t c h e d ( w h e n v a r i a b l e
prepayment effects are ignored) with the thirty-year, 8
percent mortgage. In Charts 3B and 4B, another pool of
eight-and-a-half-year, 5 percent interest bank notes making monthly coupon payments is utilized for funding
purposes. These deposits may be withdrawn upon payment of a penalty equal to two years' interest (or 10 percent). Note that the market value of the deposit flattens
out at 90 percent of par (which is 100 percent minus the
10 percent penalty for early withdrawal).
Finally, in Charts 3C and 4C, a pool of floating-rate
deposits is used. The deposit rate is equal to the fixedterm deposit rate minus 3 percent. Note that the market
values of these floating-rate deposits remain constant, at
less than par, over all interest rates. These are a cheap
source of funds, but they always cost the same relative to
the current mortgage rate. In summary, Charts 1, 2, 3A-C,
and 4A-C were not constructed using extreme data assumptions. The convexity effects of actual mortgage and
deposit prices should be the same or greater than those
seen here. For completeness, Table 2 shows the market
value of the alternative funding sources as a function of
market rates.
p o r t f o l i o s . Further, as the i n t e r e s t - o n l y securities a n d
principal-only securities are based on thirty-year
m o r t g a g e p o o l s , the h e d g e p o s i t i o n s d o not h a v e t o be
f r e q u e n t l y rewritten (in contrast to o p t i o n - b a s e d strateg i e s ) . H o w e v e r , this a p p r o a c h is s u b j e c t t o a s o m e what subtle, though quite important, risk. W h e n
hedging with options or futures contracts, the only
p r e p a y m e n t risk c o m e s f r o m the m o r t g a g e p o r t f o l i o
b e i n g h e d g e d . W h i l e p r e p a y m e n t rates c a n b e e s t i m a t ed f o r a l t e r n a t i v e f u t u r e i n t e r e s t r a t e s , t h e y c a n n o t
be e x a c t l y p r e d i c t e d . If h e d g i n g is u n d e r t a k e n u s i n g
interest-only securities and principal-only securities,
three prepayment rate schedules must be estimated,
one each for the mortgage portfolio, the mortgage
Economic
Review
23
Table 1
Discounted Present Value of Thirty-Year Mortgage-Backed Security (MBS)
Cash Flows for Alternative Prepayment Rates
(8 percent coupon
rate)
Current
Mortgage
Constant Prepayment
Moderate Prepayment
Rate
Rate
M B S Value
Rate
M B S Value
Rate
M B S Value
4%
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
0.06
132.82
127.74
122.98
118.53
114.35
110.43
106.74
103.27
100.00
96.91
94.00
91.24
88.63
86.18
83.81
81.58
79.46
77.44
75.52
0.18
0.18
0.18
0.16
0.14
0.12
0.10
0.08
0.06
0.054
0.048
0.042
0.036
0.030
0.024
0.018
0.012
0.006
0.000
117.18
114.72
112.37
110.96
109.36
107.52
105.40
102.92
100.00
96.81
93.58
90.31
87.00
83.66
80.27
76.85
73.38
69.88
66.33
0.42
0.42
0.42
0.36
0.30
0.24
0.18
0.12
0.06
0.054
0.048
0.042
0.036
0.030
0.024
0.018
0.012
0.006
0.000
108.52
107.38
106.26
105.88
105.40
104.75
103.82
102.39
100.00
96.81
93.58
90.31
87.00
83.66
80.27
76.85
73.38
69.88
66.33
5%
6%
7%
8%
9%
10%
11%
12%
13%
pool on which the interest-only security is based, and
the mortgage pool on which the principal-only security is based. If actual prepayments vary widely across
groups of mortgages the hedge may, on net, be much
less effective in practice than alternative strategies.
T h e principal a d v a n t a g e of h e d g i n g with f u t u r e s
contracts is the low up-front cost. Futures positions are
always entered into at the current market price so that
the only initial cost is the exchange transaction fee.
F u r t h e r , as the risk of u p w a r d and d o w n w a r d rate
m o v e m e n t s is retained, no " i n s u r a n c e " f e e is paid.
However, futures contracts are marked to market, with
the gains or losses paid each day. With options, daily
gains and losses are experienced only on paper until
the instrument is exercised or sold. A further problem
with f u t u r e s - b a s e d h e d g i n g , as with o p t i o n s - b a s e d
hedging, is that the underlying instrument is a Treasury bond, which exhibits positive convexity. As rates
change, it is necessary to adjust the hedge ratio (change
the number of futures contracts held). Specifically, as
rates rise (and T-bond prices fall) it is necessary to
Economic
24
Review
Fast Prepayment
short (sell) additional contracts. Conversely, as rates
fall (and T-bond prices rise) the short hedge position
must be decreased, requiring that some contracts be
bought. Futures-based hedging is often referred to as a
dynamic hedging strategy because of the need for continual a d j u s t m e n t of the h e d g e position. T h i s point
brings out a final concern with futures-based or dynamic hedging. What if rates move up and then m o v e
b a c k d o w n ? A c c o r d i n g t o the strategy, a m a n a g e r
would first short additional contracts (at the low price)
and then buy back those contracts (at the high price).
Buy high and sell low is not generally a p r o f i t a b l e
business strategy. A m a n a g e r must, however, weigh
these potential losses against the higher up-front cost
of purchasing options.
In summary, there is no clear-cut best hedging strategy. Users must weigh the fixed costs of each choice
against the risks of differing prepayments or high interest
rate volatility. Finally, transactions and monitoring costs
of frequent adjustments to the hedge ratio must be considered.
Novem ber/December 1992
Table 2
Discounted Present Value of Potential Funding Sources
Eight-and-a-Half
M o n e y Market
Deposit
Eight-and-a-Halt"
Mortgage
Discount
Year
Year Banknote with
Rate
Rate 3
Banknote 1 '
W i t h d r a w a l Provision 0
4%
0.020
131.24
123.42
96.20
0.025
126.78
119.13
96.20
5%
0.030
122.48
Current
0.035
7%
0.050
106.91
0.055
103.39
8%
0.060
100.00
0.065
93.61
0.075
90.59
10%
0.080
87.69
11%
0.090
12%
0.100
13%
0.110
It is assumed
h
This is a fixed-term (eight-and-a-half
that the proper discount
This is a fixed-term
years'
(eight-and-a-half
interest (2 • 5%
sent value falls below
This is a demand
= 10%).
90 percent
deposit paying
years),
96.20
96.20
90.00
96.20
90.00
96.20
90.00
96.20
90.00
96.20
90.00
96.20
90.00
96.20
90.00
72.47
is the eight-and-a-half-year
certificate
fixed rate (5.0 percent)
The assumption
96.20
90.00
90.00
74.77
rate for all liabilities
96.20
96.20
90.22
79.64
years), fixed-rate (6.0 percent)
96.20
93.35
77.16
0.105
96.20
96.61
82.22
0.095
96.20
96.20
100.00
84.91
0.085
96.20
103.53
96.74
0.070
a
d
107.20
114.39
110.58
9%
c
111.01
0.040
96.20
114.99
118.36
0.045
6%
Deposit
Account 0
certificate
used is that the balance
optionless
that cannot
be
certificate-of-deposit
that can be withdrawn.
will be withdrawn
rate.
withdrawn.
The withdrawal
and reinvested
whenever
penalty
the discounted
is two
pre-
of par.
the current eight-and-a-half-year
Conclusion
Mortgage-backed securities have become popular
investment vehicles for managers of financial institutions. M u c h has been written about prepayment options and how to adjust return measures to reflect this
variable. This article has provided an introduction to
the interactions between variable prepayments and the
choice of liabilities used to f u n d investments in mortgage securities. The discussion highlights the fact that
variable prepayments often cause mortgage durations
to react to interest rate changes in a fashion opposite
that of a true fixed-income asset. The negative convexity of the m o r t g a g e creates a situation in which
an institution that f u n d s m o r t g a g e p u r c h a s e s with
duration-matched liabilities may expose itself to capital losses should rates either increase or decrease dramatically. This convexity trap is contrasted with the
Federal
Reserve Bank of Atlanta
rate minus 3 percent
(300 basis
points).
alternative strategy, which uses floating-rate securities
to f u n d the purchase of the mortgage-backed security.
In the latter case the institution faces losses only if interest rates should increase. T h e examples presented
show the possibility of negative equity values for rate
decreases as small as 150 basis points below the face,
or par, interest rate. M e t h o d s for hedging convexity
risks are discussed, and it is shown that increasing
capital ratios or off-balance-sheet instruments can offset m u c h of the risk of negative net worth positions in
mortgage-related investments.
Managers should be aware that the interest rate risk
of funding mortgage-backed securities with fixed-rate
liabilities is more, rather than less, complex than using
floating-rate securities to fund the same mortgage purchase. This fact does not mean that mortgage-backed
securities should be f u n d e d short-term and the net position left unhedged, however. Rather, m a n a g e r s
should realize that they are carrying up- and downside
Economic Review
25
risk s h o u l d they f u n d the s a m e m o r t g a g e - b a c k e d s e c u rity w i t h d u r a t i o n - m a t c h e d liabilities.
In c o n c l u s i o n , a s s e t / l i a b i l i t y d e c i s i o n s s h o u l d b e
m a d e j o i n t l y . R e l a t i v e v a l u e m e a s u r e s of m o r t g a g e b a c k e d securities (such a s the o p t i o n - a d j u s t e d - s p r e a d
m e a s u r e ) a s s u m e that the m o r t g a g e is d u r a t i o n - m a t c h e d
w i t h s o m e base security. T h i s article s h o w s that, u n fortunately, for anything m o r e than very small rate
c h a n g e s , s u c h m a t c h i n g d o e s n o t l o c k in the m a r k e t
v a l u e of capital for p u r c h a s e r s of variable p r e p a y m e n t
m o r t g a g e p o r t f o l i o s or m o r t g a g e - b a c k e d securities. In-
d e e d , in this c a s e t h e actual return on i n v e s t e d capital
in t h e m o r t g a g e - b a c k e d s e c u r i t y m a y fall b e l o w the
e x p e c t e d r e t u r n in b o t h h i g h - a n d l o w - r a t e e n v i r o n m e n t s . M a n a g e r s s h o u l d b e s e n s i t i v e to the c o n v e x i ties o f alternative m o r t g a g e - b a c k e d security pools a n d
h o w m u c h of the reported e x c e s s return is c o m p e n s a tion f o r this risk. L i k e w i s e , r e g u l a t o r s s h o u l d b e a w a r e
t h a t a d u r a t i o n - m a t c h e d i n v e s t m e n t in m o r t g a g e b a c k e d securities d o e s not n e c e s s a r i l y reflect the s a m e
interest rate risk as, say, a m a t c h e d p o s i t i o n in T r e a sury b o n d s .
Appendix
This appendix contains a simple presentation of the
condition necessary for variable-prepayment mortgages
to have the negative convexity property discussed in the
text. For simplicity, let the term structure be flat and let
the expected cash flow per period from the mortgage portfolio be C{. O'Brien (1992), for example, shows what Ct
would be in terms of a constant-prepayment rate and a
fixed-coupon rate on the mortgage pool. Notice that if the
prepayment rate is a function of market interest rates (not
a constant), then C ; will vary as market rates change. If
the term structure is flat, the mortgage price is just
,=N f
p = y - ^ - 7 ,
¿fa+ry
(o
where r is the market yield to maturity, X is the sum operator, N is the maturity, and P is the price.
Because the analysis of duration and convexity are in
percentage terms, it is convenient to use the continuously
compounded rate i, i = ln( 1 +r), where ln(») is the natural
log function. Taking the derivative of ln(P) with respect
to / yields a measure of duration,
(d\nCt
d\nP
I
di
di
-t\w
(2)
where D is the duration and wf is the present value of period t's cash flow divided by the sum of the present value
of the cash flows (the price). If (d\nC)/(di) = 0 for all periods t, as would be the case with either no prepayments
(Cl = C) or a constant prepayment rate, equation (2) is just
the standard measure of duration,
D=
t=N
I(m-).
In any case, it is the change in duration with respect to interest rates that is of interest here. 1
Taking the derivative of equation (2) with respect to i
and doing some algebra results in
26
Economic
Review
d2 I n f
di2
I —v/ f dlnC,
= 2
di
l=N d2\nC
di'
w.
(3)
Notice that the first term on the right-hand side is the
sum of squared terms multiplied by positive numbers
(the w ( 's). Therefore, it is always positive. So, unless
t=N
| {[(d2lnCt)/(di2)]wt}
<0,
the mortgage will display positive convexity (similar to a
fixed-income security). In order to get negative convexity,
the percentage change in the cash flows must, on average
(with weights w) decrease at an increasing rate as interest
rates rise. Put another way, the variable-prepayment function must be such that on average the cash flows are increasing at an increasing rate as interest rates fall. This
property alone is not enough, of course, because the first
term is always positive.
Finally, the fact that the price, P, is a monotone increasing function of InP and r is monotone increasing in
i establishes that the price itself will have the same qualitative properties with respect to i that In/ 5 does. These
facts establish the link between the pictures in the text
(relating P and r) and equation (3) in this appendix.
Note
l.Note that the standard duration measure will, however, differ
for the zero-prepayment and constant-prepayment rate scenarios because for C( = C (a constant),
l=N
w, = [ 1/(1 + r)']/{ g [1/(1 +/•)']},
while for C, * C,
i=N
w, = [C,/(l+r)']/{I [C,/(l +/")'])•
Novem ber/Decem ber 1992
Notes
1. Because of their tax advantages (as qualifying real estate assets for thrifts) and flexibility, one of the largest growth rates
in holdings has come from a particular type of collateralized
mortgage obligation—namely, real estate mortgage investment conduits, or REMICS.
2. The terms mortgage portfolio and mortgage-backed security
will be used interchangeably when there is no ambiguity.
3. Bartlett (1991, chap. 7), provides an alternative introduction to
these concepts in the context of mortgage-related securities.
4. Technically, the slope of the function displayed in the figures is minus the duration multiplied by the price. Duration
measures percentage changes.
5. More specifically, a deposit is chosen such that the resulting
duration of equity is zero. It can be shown that DE = DA~
(L/A)Dl, where LI A is the liability (L) to asset (A) ratio in
market value terms, DE, DA, and DL are the duration of equity, assets, and liabilities, respectively. Choosing DE = 0 is
consistent with the idea that investors have a very short-term
horizon. See, for example, Smith and Spudeck (1993, chap.
8) for a discussion of this point. As an example, consider a
fifteen-year, 8 percent coupon mortgage. If prepayments are
fixed at 6 percent annually, this asset has a duration of four
and three-fourths years, or fifty-seven months. If the initial
equity investment is 5 percent, then L/A equals .95. Setting
Dh = 0 implies that Dt is equal to sixty months or five years.
Therefore, a five-year, pure-discount CD will roughly "durationmatch" a fifteen-year mortgage. The result should be a steady
equity value, assuming these fixed prepayments of 6 percent
annually (similar to that portrayed in Chart 3A). Keep in
mind, however, that the durations of amortizing instruments
(like mortgages) and nonamortizing instruments (like CDs)
change at different rates through time. Therefore, hedges
must be periodically adjusted. This scenario is discussed in
more detail in a later section.
6. The implicit assumption is that the liquidity preference theory of the term structure is true (see, for example, Abken
1990), indicating that, on average, funding short-term is
cheaper than funding long-term.
7. The withdrawal option given to depositors in this case allows
the bank to offer a lower rate when compared with the case
portrayed in Chart 4A. This provision allows an equity cushion vis-à-vis the no-withdrawal case.
8. The term is used because it seems representative of the price
behavior associated with large changes in interest rates.
9. These strategies are almost identical, though the instruments
trade on different exchanges.
References
Abken, Peter A. "Interest-Rate Caps, Collars, and Floors." Federal Reserve Bank of Atlanta Economic Review 14 (November/December 1989): 2-24.
. "Innovations in Modeling the Term Structure of Interest
Rates." Federal Reserve Bank of Atlanta Economic Review
75 (July/August 1990): 2-27.
Bartlett, William W. Mortgage-Backed Securities: Products,
Analysis, Trading. New York: New York Institute of Finance, 1991.
Breeden, Douglas T. "Risk, Return, and Hedging of Fixed Rate
Mortgages." Journal of Fixed Income 1 (September 1991):
85-107.
Brown, Keith C., and Donald J. Smith. "Recent Innovations in
Interest Rate Risk Management and the Reintermediation of
Commercial Banking." Financial Management 17 (Winter
1988): 45-58.
Finnerty, John D., and Michael Rose. "Arbitrage-Free Spread:
A Consistent Measure of Relative Value." Journal of Portfolio Management 17 (Spring 1991): 65-77.
Federal Reserve Bank of Atlanta
Gilkeson, James H„ and Craig K. Ruff. "The Valuation of Retail CD Portfolios." Paper presented at the Financial Management Association Meetings, San Francisco, California,
1992.
Hayre, Lakhbir S. "Understanding Option-Adjusted Spreads
and Their Use." Journal of Portfolio Management 16 (Summer 1990): 68-69.
O'Brien, Thomas J. "Elementary Growth Model Valuation Expressions for Fixed-Rate Mortgage Pools and Derivatives."
Journal of Fixed Income 2 (June 1992): 68-79.
Smith, Stephen D. "Analyzing Risk and Return for MortgageBacked Securities." Federal Reserve Bank of Atlanta Economic Review (January/February 1991): 2-11.
, and Raymond E. Spudeck. Interest Rates: Principles
and Applications. Fort Worth, Tex.: Dryden Press, forthcoming, 1993.
Economic
Review
27
FYI
Banking in Georgia,
1865-1929
Leonard A. Carlson
/
The author is an associate professor in the Department of Economics at Emory University and
formerly a visiting scholar at
the Tederai Reserve Bank
of Atlanta. He thanks Jack
Blicksilver for sharing research
materials and commenting on
the article and Haiwei Chen for
research assistance. He also
thanks Claude Chauvigne and
David We iman; Curt Hunter,
Frank King, and Bobbie
McCrackin of the Atlanta
Federal Reserve Bank; and,
especially, George Benston
for helpful comments.
28
Economic
Review
t hardly needs saying that the United States, indeed the world, is
currently going through a period of rapid change in laws governing
banking and other financial institutions. Many of these changes reflect technological advances and the globalization of financial markets, interacting with age-old public-policy concerns for financial
systems' safety and soundness. The question of what constitutes an optimal
set of regulations—that is, those that ensure an efficient, profitable, and safe
banking industry—has confronted policymakers throughout the history of
U.S. banking. The issue remains unsettled in part because it is extremely difficult to distinguish the effects of the banking system on the overall economy
from those of the economy on the banking system.
In the South, banking regulation historically has been criticized for being
either too stringent, thereby denying financial services to the economy and
slowing growth, or too lax, encouraging too much risky investment, which
eventually led to instability and slower growth. For the years from 1865 to
1890, for example, many have concluded that banking laws were too restrictive and that these restrictions placed a particular burden on Georgia and the
South. The years f r o m 1890 to 1929, however, yielded the opposite argument: that banking had been allowed to grow too rapidly during the prosperous 1890-1920 period, and the opening of too many small banks made the
South vulnerable to the fall in agricultural prices during the 1920s. 1
The story of Georgia's banking industry from 1865 to 1929, presented in
this article, recounts an era noted for the severity and magnitude of its economic shocks and regulatory changes. As such, it provides an opportunity to
consider the issues concerning proper regulation of banks. The discussion
highlights the effects of interaction between regulation and the economy on
Novem ber/Decem ber 1992
banking in Georgia during this period. Georgia's exper i e n c e a l s o p r o v i d e s an e x a m p l e of h o w b a n k i n g
evolved in a poor state in the late nineteenth and early
twentieth centuries.
the act, the g r o w t h of u n i n c o r p o r a t e d b a n k s — a l s o
called private banks—presented competition for financial services. In Georgia these banks operated largely
in small towns to provide credit and other financial
services to merchants and large local planters (Ransom and Sutch 1977, 110-16).
background
Before the Civil War. A few, relatively large banks
served the needs of the S o u t h ' s plantation e c o n o m y
prior to 1860. It is generally thought that these banks,
which were engaged primarily in financing the marketing of the cotton crop, were well equipped to offer adeq u a t e f i n a n c i a l services d u r i n g the late a n t e b e l l u m
period (Roger L. Ransom and Richard Sutch 1972, 643).
However suited to its time, this system was virtually wiped out by the end of the war. The war cost southern
banks all assets they had invested in the Confederate
currency. F u r t h e r m o r e , under the National B a n k i n g
Act s o u t h e r n b a n k s had to r e o r g a n i z e with federal
charters, a requirement that proved especially burdensome.
The National B a n k i n g Act. Congress passed the
National Banking Act in 1863 both to finance the war
and to reform banking and monetary practices. Banks
chartered under this a c t — n a t i o n a l b a n k s — w e r e req u i r e d to d e p o s i t U.S. g o v e r n m e n t b o n d s with the
Treasury and in return received bank notes for issue to
the public in amounts equal to 90 percent of bonds deposited. 2
As an incentive for state banks to become part of
the national system, notes issued by state banks were
subjected to a 10 percent tax, effectively taxing such
notes out of e x i s t e n c e . B e c a u s e bank c u s t o m e r s in
Georgia—and other southern states—used bank notes
m o r e w i d e l y than d e m a n d d e p o s i t s ( c h e c k i n g a c counts), the tax made it especially difficult to operate
or open a state-chartered bank in Georgia. By 1864,
most U.S. banks had joined the national banking system (Gary M. Walton and Hugh Rockoff 1990, 408-9).
The requirements of the National Banking Act limited southern banks in other ways. Banks newly chartered u n d e r the act w e r e subject to high m i n i m u m
capital requirements—ranging from $50,000 for banks
in towns with f e w e r than 6,000 people to $200,000 for
those serving populations larger than 50,000 people.
These were substantial sums in an era when the average manufacturing wage was between $1.00 and $1.50
per day (Walton and Rockoff 1990, 388). In addition,
the act's prohibition on real estate loans severely restricted rural banks in the South. An indirect effect of
Federal
Reserve Bank of Atlanta
Georgia Banking, 1865-1890
In 1865 Georgia was a poor state, and along with
other states in the D e e p South it remained poor relative to the rest of the country for decades. A s shown in
Chart 1, per capita incomes in Georgia in 1880 were
less than half the national average, and even less in
1900. Recent research has focused on three structural
e x p l a n a t i o n s — n o n e of them related to the banking
s y s t e m — f o r the slow r e c o v e r y of the South in the
years from 1865 to the turn of the century: the destruction wrought by the Civil War, the disruption in production that followed the end of slavery, and the slow
growth of world demand for cotton. Other researchers
hypothesize that institutional factors also retarded development in the South. One institutional hypothesis,
discussed in what follows, suggests that the high minim u m capital r e q u i r e m e n t s of the National B a n k i n g
Act hindered economic growth in southern states by
limiting the entry of new banks in the South.
A l t h o u g h the physical destruction caused by the
war was devastating, it was perhaps the easiest of the
disasters f r o m w h i c h to recover. By 1870 southern
cities, rail lines, and factories had been repaired. On
the other hand, emancipation meant that black women
and children no longer worked in the fields, and the
s a m e f r e e d o m that i m p r o v e d their lives meant that
there was a fall in labor supply and output (Ransom
and Sutch 1972).
A third factor contributing to the South's sluggish
recovery on which recent research has focused was the
diminished growth in world demand for cotton. T h e
S o u t h was the m a j o r w o r l d supplier of cotton, and
f r o m 1820 to 1860 world demand had grown at roughly 5 percent per year (Gavin Wright 1978, 92). After
the war, however, growth in demand for cotton slowed
to 2.7 percent per year, a rate that barely kept pace
with the 2 percent annual growth in population in the
South (Wright 1986, 56).
Despite this sluggish growth in cotton prices, Georgia f a r m e r s in the late nineteenth century increased
their production of cotton and grew relatively less of
other crops. They did so because cotton was the only
Economic Review
29
Chart 1
Per Capita Income in Georgia, 1 8 8 0 - 1 9 3 0
(Percentage
of U.S.
Average)
Percent
100
80
6 0
- -
40 --
2 0
--
0 -I
1880
!
1
1890
1900
1
1910
t
1920
1930
S o u r c e : Easterlin (1957, 753) a n d U . S . Department of C o m m e r c e (1975, 243).
reliable cash crop, and a secure income was necessary
as they faced considerable debt (Wright 1978, chap.
6). M o r e importantly, the e x p a n s i o n of the railroad
system m a d e it possible to ship cotton f r o m North
Georgia directly to northern markets. This development made it profitable to grow cotton in that region,
and much of the increase in cotton production in the
s e c o n d half of the n i n e t e e n t h c e n t u r y o c c u r r e d in
North Georgia (see David F. Weiman 1985).
Georgia showed some signs of progress outside of
agriculture, however. Manufacturing, especially of cotton textiles, grew rapidly, as did the number of cities
and the urban population (see Wright 1986, chap. 2).
Agriculture's slow recovery in the South seems to
have made the first years after the war difficult ones
for bankers. A f e w banks opened immediately after
the war, and some even honored prewar debts, but by
1876 only t w e l v e national banks were operating in
G e o r g i a (see Jack Blicksilver 1987, 49; R o b e r t M .
Young 1961, l l ) . 3
Growth in demand for banking services picked up
along with growth in Georgia's e c o n o m y and m a j o r
changes in cotton marketing in the 1880s. 4 An issue
subject to ongoing debate in southern economic history is whether different (less restrictive) federal or state
banking laws would have allowed greater response to
growing d e m a n d for financial services and hastened
30
Economic Review
the recovery of the banking system and economic stability in the quarter-century after the Civil War.
Several studies have centered on the role of high
capital requirements imposed by the National Banking
Act as a barrier to entry for new banks in the South
during the e c o n o m y ' s slow recovery between the Civil
War and the 1890s. For example, Richard Sylla (1969)
concluded that the high capital requirements for national banks discouraged the opening of new banks,
limiting competition between banks in the rural South.
In Sylla's view it was not until the passage of the Bank
Act of 1900, lowering capital requirements for national banks, that banking expansion began in rural areas
and eliminated local bank monopolies. John A. James
(1976, 1981) also found that bank monopolies existed,
but in his opinion the monopolies were weakened by
the passage of state general incorporation laws in the
1890s, especially in the South, that led to the entry of
new state banks into rural areas. 5 Contradicting Sylla
and James, however, John J. Binder and David T. Brown
(1991), using new econometric evidence, rejected the
hypothesis that m i n i m u m capital requirements were a
significant barrier to entry in the years f r o m 1869 to
1914. 6
State-Chartered Banks. Although national banks
were the p r e d o m i n a n t f o r m of bank in 1865, statechartered b a n k s slowly r e g a i n e d i m p o r t a n c e . O v e r
Novem ber/Decem ber 1992
time, demand deposits replaced bank notes as the usual means of payment. (Nationally, by 1900 the value
of demand deposits exceeded the value of bank notes
four to one.) The wider acceptance of demand deposits
made it possible for state-chartered banks to avoid the
10 percent tax imposed by the National Banking Act
on n o t e s and to c o m p e t e with national b a n k s . T h e
number of state banks grew steadily after 1890 (Walton and Rockoff 1990, 408-9).
In Georgia the number of state-chartered banks in
operation increased from 26 to 102 during the period
from 1880 to 1892. In 1892 state banks had assets totaling more than $33 million, more than twice those of
the sixteen national banks' $15 million in assets (Young
1961, 11; Robert T. Van Orden 1985, 61-62). However, despite this growth in the number of banks in Georgia, as late as 1892 eighty-three counties in Georgia
did not have a bank (see Van Orden 1985, 58). There
was one incorporated bank for every 19,135 people
in Georgia in 1890 versus one for every 10,983 nationally. 7
1890-1914
In the late nineteenth and early twentieth centuries
commercial banking in the South increased in sophistication through a widespread system of correspondent
banks. T h e antebellum practice of holding deposits
with large banks in regional financial centers had been
f o r m a l i z e d by the National B a n k i n g A c t , and rural
banks in Georgia, like those in other parts of the nation, increasingly held deposits with c o r r e s p o n d e n t
banks in both regional and national financial centers
specified as reserve cities.
This arrangement meant that rural banks were able
to offer more highly developed financial services. For
example, through their separate credit departments established in the late nineteenth century, banks in reserve cities could check the general creditworthiness
of b o r r o w e r s f o r respondent banks. N e w York City
banks also acted as agents for rural respondent banks
u s i n g the N e w York m o n e y m a r k e t s . R e s e r v e - c i t y
banks benefited f r o m the correspondent bank relationship by having the rural banks as a source of deposits.
As James (1977, 123) has pointed out, the system also
provided a way for city banks to reach customers in
every part of the United States.
T h e period f r o m the late 1880s through the First
World War saw both increasing e c o n o m i c r e c o v e r y
and the founding of a n u m b e r of the most important
Federal
Reserve Bank of Atlanta
modern banks in Georgia. Citizens and Southern Bank
(C&S), for example, (recently merged with N C N B to
form NationsBank) was founded in Savannah in 1888
as Citizens Bank. Trust Company Bank, now operating as a subsidiary of SunTrust Banks, was founded in
Atlanta in 1891 as the Commercial Travelers Savings
Bank. The modern Bank South began as Fulton National Bank of Atlanta in 1909 (Blicksilver 1987, 50).
Economic recovery was not the only change affecting Georgia banking, however. The Bank Act of 1891,
the state's first general banking law, also changed the
environment. Along with amendments in 1893, the law
made it possible to establish a bank without a special
act of the legislature. Beginning with Mississippi in
1890 and ending with Alabama in 1901 and Virginia in
1902, all states in the South a d o p t e d such g e n e r a l
banking acts.
The expansion in Georgia that followed passage of
the Bank Act of 1891 lends support to James's argument
about the importance of general incorporation laws, permitting lower capital requirements and thereby making it
easier to charter state banks. In Georgia the minimum
capital required to open a state bank was $25,000, although a bank could open its doors with only $15,000
paid in (Young 1961, 14). By 1896 the number of banks
in the state had increased to 186 with a total of $52 million in assets (Board of Governors 1959,274-85).
T h e next two decades or so were prosperous ones
for agriculture in Georgia. According to Wright, " A f ter 1900, cotton d e m a n d accelerated to 3.5 percent
(per year) as textiles led the expansion of world trade
and the Southern economy picked up its pace" (1986,
56). Charts 2 and 3 show that the number of banks and
the value of bank assets began to grow greatly about
this time, apparently driven by increased demand for
bank services. By 1914, 801 incorporated banks with
assets of more than $252 million operated in Georgia,
and only one county in the state was without a statechartered bank (Van Orden 1985, 58).
/ 914-1920
As is well known, the creation of a central bank for
the United States in 1913, with passage of the Federal
Reserve Act, generally changed the shape of banking
and finance in America. The Federal Reserve System
was tailored by Congress to correct the perceived ills of
the national banking system. Reflecting in part Atlanta's
increasingly important role as a key financial center for
the Southeast, Atlanta was chosen as the site of the
Economic Review
31
Chart 2
Incorporated Banks in Georgia, 1 8 9 6 - 1 9 3 0
N u m b e r of B a n k s
1896
1900
1905
1910
1915
1920
1925
1930
S o u r c e : Board of G o v e r n o r s (1959, 274-85).
Chart 3
Total Bank Assets in Georgia, 1 8 9 6 - 1 9 3 0
(Assets
in Constant
Dollars,
1900=1)
M i l l i o n s of D o l l a r s
S o u r c e : Board of G o v e r n o r s (1959, 274-85); deflated using consumer price index from U . S . Department of C o m m e r c e (1975, 211).
32
Economic Review
Novem ber/December 1992
Sixth District Federal Reserve Bank (see Kerry Odell
and Weiman 1992). By this time, the banking system in
the S o u t h h a d b e c o m e m o r e d e v e l o p e d and w a s a
greater aid to the growth of business in the South. 8
A m o n g other provisions, the Federal Reserve Act
removed the restrictions that had prevented national
banks from making real estate loans. The act also established facilities to clear checks without fee to either
the writer or the receiver. National b a n k s were required to join the Federal Reserve System, but statec h a r t e r e d b a n k s had the option to j o i n or not. T h e
f r a m e r s of the Federal Reserve System hoped to induce state-chartered banks to join the Federal Reserve
and thus end the dual banking system with some banks
subject to federal regulation and others subject to state
regulation. It was also hoped that when state-chartered
banks joined the system the Federal Reserve would
take o v e r the c h e c k clearing and other services for
banks (see Eugene Nelson White 1983, 108-15).
Despite pressure, most state-chartered banks in the
Sixth District, including those in Georgia, refused to
join the Federal Reserve System, and the check clearing services of the Atlanta Federal Reserve Bank were
little used (Richard H. G a m b l e 1989, 21, 48). Two important sources of banks' revenues stood in the way.
S t a t e - r e g u l a t e d b a n k s c o u l d h o l d m o r e of their reserves in interest-earning accounts at their correspondent b a n k s , f o r o n e thing. M o r e significantly, they
c o u l d p r a c t i c e n o n p a r c h e c k c l e a r i n g — t h a t is, the
practice of clearing checks at less than their face value. The Federal Reserve System required that m e m b e r
banks clear checks at par. M a n y state banks in Georgia
(and elsewhere in the South and West) commonly remitted slightly less than the face value of checks written by their depositors (usually one-eighth of a percent
of the checks' value) as an exchange fee for the transaction (White 1983, chap. 3).
The refusal of a number of smaller banks to join the
system meant that the dual banking system continued
and that regulation of banks remained spotty and uncoordinated. Many have concluded that the mix of federal
and state regulation that existed after 1900 led to too
many small banks, endangering the safety of the system.
For example, Herman E. Kross and Martin R. Blyn conclude that "the formation of new banks, especially in the
South and West, in the first decade of the century had
been excessive by nearly all standards" (1971, 158).
Another, related controversy in these years, and later, concerned restrictions on branch banking. Many rural bankers feared competition from larger city banks.
T h e s e b a n k e r s , a l o n g w i t h o r g a n i z a t i o n s like the
A m e r i c a n Bankers Association that were dominated
Federal Reserve Bank of Atlanta
by banks in states that did not allow branches, actively
lobbied Congress and many state legislatures to outlaw branch banking. They succeeded on the national
level and in many states (White 1983, 156-65). T h e
National Banking Act of 1864 was interpreted by the
Comptroller of the Currency in 1865-68 as forbidding
branches, and the American Bankers Association successfully resisted a proposal by the Federal Reserve
Board to allow branching by national banks in 1915.
In 1918 national banks were given limited rights to
have b r a n c h e s — f o r example, w h e n a national bank
consolidated with a state bank (White 1983, 161). The
M c F a d d e n Act of 1927 permitted limited branching
by national banks, subject to state laws.
One consequence of unit banking was that banks in
small towns, where their primary business was located
in the immediate area, were typically small and had undiversified portfolios. Georgia, however, had historically been relatively liberal with respect to branching by
state-chartered banks. The state's Bank Acts of 1891
and 1893 had not explicitly forbidden the opening of
branches, and the laws were interpreted to allow branch
banking. For example, C & S Bank purchased the National Bank of Augusta in 1912, thereby establishing its
first branch outside Savannah, and later opened offices
in Macon (1917) and Atlanta (1919). The Bank Act of
1917 in Georgia had specifically allowed branching as a
way of increasing the number of banks serving rural areas. By 1926 a number of the larger city banks in Georgia had branches (Young 1961, 27).
A n o t h e r important f e a t u r e of the period was the
growth of bank chains and groups. Bank chains were
groups of nominally independent banks owned by one
or more individuals (Kross and Blyn 1971, 160). In
some areas chains were an alternative to branch banking. Although most chains were typically small, there
were exceptions. O n e of the largest was the Witham
chain, which at its peak in 1922 controlled 175 banks
in Georgia and Florida (Kross and Blyn 1971, 160).
Because banks that were members of Georgia chains
remained small, local, and separate, each bank had its
own portfolio, and, hence, chain banking did not allow
for the diversification that true branch banking might
have allowed.
Despite relatively liberal branching and the existence of chains, most state-chartered banks in Georgia
were small, with the average assets of all state banks
being less than $500,000 in 1919. 9 The system seemed
to be stable as long as agriculture was prosperous, as
it continued to be in the years f r o m 1910 to 1919,
when the average yearly price of cotton rose from 13.9
cents to 35.34 cents per pound (U.S. Department of
Economic Review
33
C o m m e r c e 1975, 517). The expectation of continued
prosperity was capitalized into the price of farm land,
which rose in value by 152 percent from 1910 to 1920.
Farmers in Georgia, faced with rising land prices, took
on mortgage debt to buy m o r e land and equipment,
and f a r m debt in G e o r g i a increased by 4 7 4 percent
f r o m 1910 to 1923 (Lawrence A. Jones and David Durand 1954,98).
2920-1929
T h e period of prosperity and rising prices c a m e
to an abrupt halt in 1921 w h e n Georgia f a r m e r s exp e r i e n c e d a d o u b l e c a l a m i t y : rapidly falling prices
and the spread of the boll weevil in Georgia. Cotton
prices declined in the recession of 1920-21 from 38.5
cents per pound in April 1920 to 9.5 cents a year later
(Jones and Durand 1954, 95). Cotton prices recovered
s o m e w h a t after 1921 but never reached their wartime
levels in either real or nominal terms during the 1920s.
World demand for cotton actually declined about onehalf of 1 percent per year from 1920 to 1930 (Wright
1986, 5 6 - 5 7 ) . M e a n w h i l e , the boll weevil, which had
been spreading north f r o m Mexico since the 1890s,
reached Georgia almost simultaneously with the fall
in prices.
The arrival of the boll weevil may have been predicted, but apparently the severity of the pest's impact
in Georgia was not foreseen. The boll weevil proved
to be especially hard to eradicate in the h u m i d climates of Georgia and South Carolina. One study estimated that the reduction in Georgia's cotton yield in
1921 that was attributable to weevil d a m a g e was 45
percent (while overall cotton production in the United
States r e m a i n e d high as p r o d u c t i o n shifted to drier
states farther west) (Jones and D u r a n d 1954, 100).
S o m e areas of the state were very hard hit, and many
f a r m e r s defaulted on their m o r t g a g e s . F u r t h e r m o r e ,
farmers in some of the hardest-hit sections of Georgia
found it difficult to shift to other crops, such as peanuts
and tobacco, because of unfavorable soil and climate
(Jones and Durand 1954, 101). Textile manufacturing
also entered a period of slower growth in the 1920s, so the
two major pillars of Georgia's economy were in distress.
The state's economic distress is reflected in the experience of Georgia banks. As shown in Charts 2 and
3, the n u m b e r of b a n k s and their assets fell in the
1920s, and, as shown in Chart 4, there were a large
number of bank suspensions. In all, about 45 percent
of banks in Georgia failed from 1921 to 1929, although
Chart 4
Bank Suspensions ¡n Georgia, 1 9 2 1 - 1 9 3 0
Number of Banks
120
100
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
Source: Board of Governors (1943, 283-90).
34
Economic
Review
November/Decem ber 1992
most of these were small state-chartered banks. The
unresolved issue is whether a set of regulations allowing banks m o r e opportunities to diversify their asset
portfolios might have produced a banking system better able to function under this stress.
The worst year for banking in Georgia was 1926.
Triggered by especially low cotton prices, the Witham
chain of b a n k s failed along with the B a n k e r s Trust
C o m p a n y , which p r o v i d e d services to b a n k s in the
chain. While each of the banks in the chain was supposedly independently operated, each was also subject
to overall corporate direction, and the chain's failure
was accompanied by findings of financial irregularities. T h e Witham c h a i n ' s failure led to calls for reform, and the state legislature responded by passing
the Bank Act of 1927.
O n e notable feature of the act was that it prohibited
opening new branches. Although the failures of the
Witham chain and the Bankers Trust C o m p a n y were
seemingly unrelated to branch banking, the small rural
banks in Georgia, fearing competition from larger urban banks, used the opportunity to obtain restrictions
on branch banking (see Young 1961, 26). It is interesting to note that 1927 was the first year since the early
1880s that the total assets of national banks in Georgia
exceeded the assets of state-chartered banks (see Chart 3).
Thus, at a time when the rest of the country was moving toward f e w e r restrictions on branching, Georgia
added restrictions. ( S o m e exceptions to the new law
allowed banks in Atlanta and Columbus to establish
branches in those cities.)
Economic shocks to the state's agriculture interacted with regulation to increase Georgia's banking troubles. Although the difficulties in the 1920s were more
severe than in most states, other predominantly agricultural states, most with small rural banks, also experienced hard times. Nationally, the number of commercial
b a n k s d e c l i n e d f r o m 3 0 , 0 0 0 in 1921 to 2 5 , 0 0 0 in
1929, with approximately 20 percent of all banks failing in those years (Kross and Blyn 1971, 158). Most
bank failures occurred in the agricultural areas of the
Midwest and South. As in Georgia, most of the failed
banks were small, rural, state-chartered banks.
As is well known, the Great Depression, which began with a downturn in industrial production in A u -
Federal
Reserve Bank of Atlanta
gust 1929 and the stock market crash of October 1929,
marked a fundamental watershed in American banking. Georgia in the 1930s, unlike some other southern
and midwestem states, was spared m a j o r bank crises,
but banks in Georgia faced runs and experienced hard
times as did banks in other parts of the country. 1 0 After
1933 banks in the United States operated under new
federal regulation that significantly changed the rules
of the game. The changes set in motion by the Great
Depression and the New Deal set the tone for banking
for the next four decades at least and deserve a separate treatment that looks at the performance of Georgia
banks and banking.
Conclusion
The history of banking in Georgia shows the close
link between the state's banks and the state's economy.
In the late nineteenth century, banks in Georgia were
part of a slowly recovering agricultural region, and some
researchers have concluded that restrictions on the formation of banks may have hindered the economic recovery of Georgia and other southern states.
In the first t w o decades of the twentieth century
G e o r g i a ' s banking system expanded along with the
rest of the state's economy as agriculture and industry
prospered, but the development was subject to laws
that fostered many small, local banks. This expansion
was followed by two decades of economic hardship, in
which many banks failed. Although the decline was
clearly caused in part by a decline in agricultural prices
and the arrival of the boll weevil in Georgia, the structure of banking, which promoted small local banks,
may have contributed to the instability of the banking
system and possibly reinforced economic hardships.
These episodes have not been completely researched,
and they deserve more attention. In an era in which
C o n g r e s s is forced to consider banking r e f o r m and
countries in Eastern E u r o p e are trying to erect new
banking institutions, there may be useful lessons to be
d r a w n f r o m the history of f i n a n c i a l institutions in
Georgia and the South.
Economic Review
35
Notes
1. See, for example, Davis (1965), Sylla (1969), and James
(1976, 1977, 1981) for the view that restrictive banking
laws hindered the South. See Kross and Blyn (1971, 158)
for the view that growth in banking was too rapid after
1900.
2. In addition, the value of notes outstanding could not exceed
the value of the banks' capital (Walton and Rockoff 1990,
408).
3. One early bank was the Atlanta National Bank (predecessor
of the First National Bank of Atlanta, now part of Wachovia), which was formed in 1865 (Blicksilver 1987, 49).
4. Before the Civil War, cotton factors had handled most cotton sales through port towns, and they had largely resumed
that role after the war (Woodman 1990, chap. 2; Ransom
and Sutch 1977, chap. 6). But the spread of cotton production to northern Georgia shifted cotton marketing to inland
merchants, who in turn needed commercial credit (Woodman 1990, chap. 23; Weiman 1985).
5. In contrast, the findings of Campen and Mayhew's (1988)
analysis of banking in Knoxville, Tennessee, indicate that
entry was relatively easy and a number of new banks were
established in the 1880s, before any changes in banking
laws. They conclude that this increased competition led to low-
er interest rates. However, the evidence from Knoxville's
experience as an urban area does not directly refute James's
results, which refer primarily to rural areas.
6. Additional issues concerning interest rates are not considered here. The view that interest rates in the South and West
were higher than justified by costs or risks associated with
high minimum capital requirements can be found in Sylla
(1969) and James (1976, 1977, 1981). See Campen and
Mayhew (1988) and Binder and Brown (1991) for a dissenting view. Davis (1965) was one of the first to consider regional interest rate differentials.
7. Calculated from data in Van Orden (1985, 50, 52), Walton
and Rockoff (1990, 409), and U.S. Department of Commerce (1975, 14, 26).
8. Odell and Weiman (1992) conclude that development in the
South in the late nineteenth century was inhibited by its undeveloped banking sector. The growth and increasing sophistication in the banking system in Georgia in the first
two decades of the twentieth century were key to the subsequent development of the South.
9. Calculated from Board of Governors (1959, 274-85).
10. Sec Roberds (1990) for an interesting discussion of one response to crisis: the creation of private money.
References
Binder, John J., and David T. Brown. "Bank Rates of Return
and Entry Restrictions, 1869-1914." Journal of Economic
History 51 (March 1991): 47-66.
Blicksilver, Jack. "Atlanta's Power: Finance." In "Celebrating
One Hundred and Fifty Years of Atlanta Business." Atlanta
Business Chronicle, 1987,49-56.
Board of Governors of the Federal Reserve System. Banking
and Monetary Statistics. Washington, D.C.: Board of Governors of the Federal Reserve System, 1943.
- All-Bank Statistics: United States ¡896-1955. Washington, D.C.: Board of Governors of the Federal Reserve System, 1959.
Campen, James T„ and Anne Mayhew. "The National Banking
System and Southern Economic Growth: Evidence from
One Southern City, 1870-1900." Journal of Economic History 48 (March 1988): 127-37.
Davis, Lance E. "The Investment Market, 1870-1914: The Evolution of a National Market." Journal of Economic History
25 (September 1965): 355-95.
Easterlin, Richard A. "State Income Estimates." In Population
Redistribution and Economic Growth, the United States
1870-1950, edited by Everett Lee et al. Philadelphia: The
American Philosophical Society, 1957.
Gamble, Richard H. A History of the Federal Reserve Bank of
Atlanta: 1914-1989. Atlanta, Ga.: Federal Reserve Bank of
Atlanta, 1989.
36
Economic
Review
James, John A. "Development of the National Money Market."
Journal of Economic History 36 (December 1976): 878-97.
• Money and Capital Markets in Postbellum
America.
Princeton, N.J.: Princeton University Press, 1977.
• "Financial Underdevelopment in the Postbellum South."
Journal of Interdisciplinary History 11 (Winter 1981): 443-54.
Jones, Lawrence A., and David Durand. Mortgage Lending Experience in Agriculture. Princeton, N.J.: Princeton University Press for the National Bureau of Economic Research,
1954.
Kross, Herman E„ and Martin R. Blyn. A History of Financial
Intermediaries. New York: Random House, 1971.
Odell, Kerry, and David J. Weiman. "Regional Metropolitan
Development and Financial Market Integration in the New
South." Paper presented at a Federal Reserve Bank of Atlanta/Emory University workshop, March 1992.
Ransom, Roger L., and Richard Sutch. "Debt Peonage in the
Cotton South after the Civil War." Journal of Economic
History 32 (March 1972): 641-69.
• One Kind of Freedom: The Economic Consequences of
Emancipation. Cambridge: Cambridge University Press,
1977.
Roberds, William. "Lenders of the Ncxt-to-Last Resort: Scrip
Issue in Georgia during the Great Depression." Federal Reserve
Bank of Atlanta Economic Review 75 (September/ October
1990): 16-30.
Novem ber/Decem ber 1992
Sylla, Richard. "Federal Policy, Banking Market Structure, and
Capital Mobilization in the United States, 1863-1913."
Journal of Economic History 24 (December 1969): 657-86.
U.S. Department of Commerce. Bureau of the Census. Historical Statistics of the United States, Colonial Times to 1970.
Washington, D.C.: U.S. Government Printing Office, 1975.
Van Orden, Robert T. "State Banks in Postbellum Georgia: An
Examination of Cost, Competition, and Risk in a Financially
Underdeveloped State." Honors thesis, Emory University,
1985.
Walton, Gary M., and Hugh Rockoff. History of the American
Economy. 6th ed. San Diego: Harcourt Brace Jovanovich,
1990.
Weiman, David F. "The Economic Emancipation of the NonSlaveholding Class: Upcountry Farmers in the Georgia Cot-
Federal Reserve Bank of Atlanta
ton Economy." Journal of Economic History 45 (March
1985): 71-93.
White, Eugene Nelson. The Regulation and Reform of the
American Banking System, 1900-1929. Princeton, N.J.:
Princeton University Press, 1983.
W o o d m a n , Harold D. King Cotton and His
Retainers.
Columbia, S.C.: University of South Carolina Press, 1990.
Wright, Gavin. Political Economy of the Cotton South: Households, Markets, and Wealth in the Nineteenth Century. New
York: W.W. Norton, 1978.
. Old South, New South: Revolutions in the Southern
Economy since the Civil War. New York: Basic Books,
1986.
Young, Robert M. "Branch Banking in Georgia." Masters thesis, Emory University, 1961.
Economic
Review
37
eview Essay
Doing Business in Eastern Europe
And the Newly Independent States:
Information Sources to Get Started
r
Jerry J. Donovan
he countries formerly called the Eastern Bloc, with 400 million or
m o r e inhabitants, now constitute enticing marketing and investment opportunities for industrial nations. 1 However, there is much
to learn about transacting business and making a profit in Eastern
Europe and the newly independent states, especially in the face of
the rapid change resulting from democratization and privatization since late
1989.
The reviewer is the research
librarian in the Atlanta Fed's
research library. He is grateful to a number of people who
assisted in evaluating the publications reviewed, especially
Bobbie McCrackin, vice president and public affairs officer
at the Atlanta Fed; Molly Molloy, Slavic reference librarian
at the Hoover Institution Library at Stanford University;
and William Curt Hunter,
vice president and senior
economist in charge of basic
research in the Atlanta Fed's
research department.
38
Economic
Review
A body of literature is emerging that is designed to meet the needs of investors, b u s i n e s s p e o p l e , and p o l i c y m a k e r s w h o wish to understand the
economies of the former Eastern Bloc in order to provide goods and services
and make profitable investments in these new and expanding economies. Academics, analysts, and librarians will find the increasingly available statistical
data and commentary useful both in their o w n right and as pointers to further information.
Domestic investors or businesspersons who decide to undertake a foreign
investment or engage in foreign trade (import or export) must carefully analyze and evaluate "country risk." This risk, sometimes called sovereign risk,
is closely tied to political developments that affect a country's stability. Assessing the g o v e r n m e n t ' s attitude toward foreign loans or investments is
particularly important. While many foreign governments encourage the inflow of foreign funds, others make it difficult, setting up obstacles such as
wage-price controls, profit controls, additional taxation, and other legal restrictions. In addition, other factors—the expropriation of foreigners' assets,
prohibition of foreign loan repayments, rebellions, civil disturbances, wars,
and unexpected changes in government or its policies—present hazards in
international trade and investment.
Novem ber/December 1992
Uncertainty about these risks is especially pronounced
for investment and business activity in the former Eastern Bloc countries. A general dearth of information
hampers informed investment and business decisions.
For m a n y years these centrally p l a n n e d e c o n o m i e s
controlled—in fact, manipulated—information for their
own purposes, sometimes releasing several versions
of the s a m e data to meet d i f f e r e n t a i m s for diverse
audiences. 2 Although current agencies and governments
of the former Eastern Bloc countries seem disposed to
distribute accurate data freely, users should be mindful
that these data still m a y not be as complete and accurate as those traditionally collected and reported in
Western countries. For business-related information,
there is considerable evidence of an aggressive aboutface in former Iron Curtain countries' attitudes toward
releasing data. For example, the flier for the Russian
Business Monitor, a new Russian newsletter (reviewed
below), uses marketing facts to attract business. T h e
flier spells out how the " n e w " Russians perceive marketing information needs and pledges to provide such
i n f o r m a t i o n . Still, i n v e s t o r s and b u s i n e s s e s should
continue to evaluate material carefully.
To assist the reader in addressing finance and trade
issues for Eastern Europe and the newly independent
states, this essay reviews a selection of publications
intended for investors, academicians, businesspeople,
and policymakers. This listing, which augments those
in two previous articles in this Economic Review surveying international finance and trade reference sources
and periodicals, focuses on government publications,
reference books, and directories that cover Eastern Eur o p e and the n e w l y i n d e p e n d e n t states. 3 ( T h e J a n uary/February 1993 Economic Review will contain a
review of periodical literature that covers the same geographic and subject areas.) Most selections are relatively new publications, published since 1990. Some
longstanding, well-known publications, such as D u n ' s
M a r k e t i n g S e r v i c e s ' Exporters'
Encyclopaedia,
are
not included because they are too broad in geographic
focus or so well known as to be self-evident choices.
U.S. Government Sources
D e p a r t m e n t of C o m m e r c e International Trade
Administration. Besides publishing Business
America: The Magazine of International
Trade and numerous other items, the International Trade Administration
of the U.S. Department of C o m m e r c e provides aggressive and comprehensive services for Americans wish-
FederalforReserve
Digitized
FRASERBank of Atlanta
ing to e s t a b l i s h b u s i n e s s and i n v e s t m e n t ties with
E a s t e r n E u r o p e and the n e w l y i n d e p e n d e n t states.
Central to these services are the Eastern E u r o p e a n
Business Information Center (EEBIC) and the Business Information Service for the Newly Independent
States ( B I S N I S ) , both of which publish b u l l e t i n s —
Eastern Europe Business Bulletin and BISNIS
Bulletin,
respectively.
Both centers serve as information clearinghouses
for small and m e d i u m - s i z e d A m e r i c a n f i r m s n e e d ing i n e x p e n s i v e access to c o m m e r c i a l and m a r k e t ing information about the former Soviet Bloc nations.
T h e two agencies, which work closely with other U.S.
agencies like the International Development Agency,
the E x p o r t - I m p o r t B a n k , and the O v e r s e a s P r i v a t e
Investment Corporation, provide information on such
items as potential customers and partners, sources of
financing, market research, advertising opportunities, upcoming trade missions, the state of trade and
investment treaties, and U.S. government programs supporting trade and investment. Both agencies' bulletins
o f f e r practical i n f o r m a t i o n about specific financial
and trade developments, including legal regulations,
crucial to international business and finance commitments. The first issue of BISNIS Bulletin, for example,
announced the authorization of the Overseas Private
Investment Corporation of April 1992 to provide loans,
loan guarantees, and investment insurance to Americ a n c o m p a n i e s t h a t i n v e s t in R u s s i a a n d o t h e r
n e w l y independent states and included a table indicating the status of a g r e e m e n t s between the United
States and the newly independent states as of June 5,
1992 (updated in the O c t o b e r / N o v e m b e r issue; see
Figure 1).
In addition to its bulletin, EEBIC offers News Sources
on Eastern Europe and the Baltics, an exhaustive list
of relevant newsletters, periodicals, and directories. Its
entries range f r o m the B u r e a u of National A f f a i r s '
BNA's Eastern Europe Report, a biweekly newsletter
covering changes in policies, laws, and regulations, as
well as market deals in Eastern Europe, to Diena, a
Western-style newspaper published five days a week
in Riga, the capital of Latvia, to the Business Foundation's General Trade Index and Business Guide (published in Warsaw), which details the intricacies of the
Polish legal and tax systems and lists potential Polish
trading partners.
Off to good beginnings, as witnessed by their bulletins, both agencies—BISNIS and EEBIC—plan to expand services. It remains to be seen, however, whether
they can adhere to their objective of providing inexpensive information access for American business and also
Economic Review
39
Figure 1
STATUS OF AGREEMENTS BETWEEN THE UNITED STATES AND THE
NEWLY INDEPENDENT STATES (AS OF NOVEMBER 4, 1992)
R E P U B L I C
T R A D E
M F N
G S P
OPIC
E X I M B A N K
YES
NO
YES
NO
A G R M T
ARMENIA
YES
AZERBAIJAN
PENDING
*
NO
NO
YES
NO
BELARUS
PENDING
*
NO
NO
YES
YES
GEORGIA
PENDING
*
NO
NO
YES
NO
KAZAKHSTAN
PENDING §
NO
NO
YES
YES
KYRGYZSTAN
YES
YES
NO
YES
NO
MOLDOVA
YES
YES
NO
PENDING #
NO
RUSSIA
YES
YES
NO
YES
YES
TAJIKISTAN
PENDING
*
N O
NO
YES
NO
TURKMENISTAN
PENDING
*
NO
NO
YES
NO
YES
NO
YES
YES
NO
NO
YES
YES
UKRAINE
UZBEKISTAN
YES
PENDING
*
* N e g o t i a t i o n s in p r o g r e s s ( f o r O P I C . s i g n i n g e x p e c t c d s h o r t l y ; c o m p a n i e s a r e c n c o u r a g c d to r e g i s t e r p r o j e c t s w i t h O P I C now).
# A w a i t i n g r a t i f i c a t i o n by c o u n t r y ' s p a r l i a m e n t .
M F N — M o s t - F a v o r e d - N a l i o n s t a t u s ; G S P — G e n e r a l i z e d S y s t e m of P r e f e r e n c e s .
O P I C — O v e r s e a s Private Investment Corporation;
S o u r e e : BISNIS
Bulletin,
October/November
E x i m b a n k — E x p o r t - I m p o r t B a n k of t h e U n i t e d S t a t e s .
1992, 3. R e p r i n t e d b y permission of t h e publisher.
extend substantive services while still operating within
shrinking government budget appropriations.
C I A Publications. The global information network
of the U.S. Central Intelligence Agency (CIA) puts it
in a uniquely advantageous position to collect, interpret, and disseminate international information. T h e
C I A p u b l i s h e s several r e f e r e n c e tools w h o s e terse
style and compact organization will be welcomed by
users in marketing m a n a g e m e n t , public policy planning, and consulting who need overviews of consistent international data. Users should also value the
"research completion dates" found on the title pages
of many C I A publications, permitting assessment of
the research's timeliness.
The World Factbook (reviewed in an earlier Economic Review [ M a y / J u n e 1991, 31]), is the centerpiece of the C I A r e f e r e n c e collection. T h i s annual
40
Economic Review
presents comprehensive information on 247 countries
in an easy-to-use "executive s u m m a r y " format. Three
c o m p l e m e n t a r y titles round out the CIA's reference
list: The Handbook of Economic Statistics,
Economic
and Energy Indicators, and International Energy Statistical Review, all p u b l i s h e d b y t h e G o v e r n m e n t
Printing O f f i c e . T h e latter two publications provide
monthly updates for the annual Handbook of Economic Statistics.
T h e Handbook
of Economic
Statistics
provides
economic indicator series of the type needed to make
worldwide comparisons. The CIA uses three country
data sources: official data f r o m the countries cited,
CIA estimates, and estimates m a d e by other organizations, such as the Organisation for Economic Cooperation and D e v e l o p m e n t ( O E C D ) . Data f o r the m o s t
recent years are frequently preliminary and subject to
November/Decem ber 1992
revision. Country data have been adjusted by the CIA
for comparability (and thus may differ from data given
in original sources). The methodology used to adjust
the data is explained in the preface. Data tables (except for distribution of economic aid) in the 1991 edition of the Handbook
cover three m a j o r groupings:
O E C D n a t i o n s ( i n c l u d i n g r e u n i f i e d G e r m a n y ) , the
USSR and Eastern Europe (USSR/EE), and other nations (China and India). All references to Communist
countries, d e v e l o p e d countries, and l e s s - d e v e l o p e d
c o u n t r i e s (except f o r e c o n o m i c aid) h a v e been removed, and new data on high-technology topics and
environmental issues have been added. 4
The Handbook
is convenient for pulling together
worldwide e c o n o m i c data grouped by O E C D , European Community, O P E C , G-Six, G-Seven, USSR and
Eastern Europe, and Newly Industrializing Economies."'
The Handbook can be of great value—to planners or
speech writers, for instance—in m a k i n g broad c o m parisons and spotting credible trends. O n the other
h a n d , e c o n o m i s t s a n d a c a d e m i c i a n s e n g a g e d in
empirical studies will find the tables lacking; the tables typically present only nine annual observations,
precluding detailed statistical analysis, and footnotes
(for e x a m p l e , " b a s e d on the routine a p p l i c a t i o n of
standard CIA estimating methods") are sometimes too
sketchy to permit serious data analysis.
T w o C I A r e s e a r c h m o n o g r a p h s — B e y o n d Perestroyka: The Soviet Economy in Crisis (Washington:
U S G P O , J u n e 1991) and Eastern Europe:
Coming
Around the First Turn (Washington: U S G P O , September 1991)—provide thoroughly informed backdrops to
the economic and political turmoil of their respective
areas during the 1989-90 period. Both titles address
three f u n d a m e n t a l concerns: e c o n o m i c r e f o r m s , advances and halts in the reform process, and possible
guidelines for restructuring in the new democracies.
Two CIA atlases provide geographical and cultural
insight into the new Eastern Europe and the former Soviet Union. The Atlas of Eastern Europe (Washington:
U S G P O , August 1990) profiles that region and its national states with retrospective and current maps, charts,,
and time lines depicting geographic, socioeconomic,
and historical factors. Put in press as German reunification was under way, this atlas helps the reader understand the p r o b l e m s and prospects besetting Eastern
Europe in the post-Cold War era. The Republics of the
Former
Soviet Union and the Baltic States:
An
Overview (Washington: U S G P O , January 1992) illustrates key demographic, ethnic and economic aspects
of each Baltic state and republic of the former Soviet
Union. For each state a pie chart depicts ethnic compo-
Federal
Digitized
forReserve
FRASERBank of Atlanta
sition, a paragraph discusses ethnic trends, and a final
paragraph explains the state's economic significance.
General Reference Works
One Nation Becomes Many: The Access Guide to
the Former Soviet Union, b y S t e p h e n W. Y o u n g ,
Ronald J. Bee, and Bruce S e y m o u r II (Washington:
Access: A Security Information Service, 1991), provides the names and addresses of resources to help the
reader understand the e n o r m o u s public policy complexities facing the former Soviet Union. The book begins with a chronology of historical events in European
Russia dating from the seventh century through April
1992. Factual sketches of all the newly independent
states follow, giving location, land area, population,
politics, economics, and current issues under consideration. Brief biographical notes on key historic individuals, including Communist luminaries since Lenin, and
current leaders of the individual republics form an upto-date "who's w h o " for the newly independent states.
A section called "Issues for Discussion" elaborates on
economic and military change, ethnic unrest, and U.S.
policy options for leadership in assisting the newly independent states at the present time. An extensive list
of suggested readings arranged by subject shores up
this discussion. One Nation Becomes Many concludes
with a formidable resources section: an annotated bibliography, guides to organizations, texts of key docum e n t s and s p e e c h e s , and a list of g o v e r n m e n t and
business assistance contacts for both the United States
and the newly independent states.
Resources cited in One Nation Becomes Many range
f r o m the easily available Washington Post newspaper
to publications from think tanks like the Brookings Institution and the R a n d C o r p o r a t i o n , s o m e of which
may prove difficult to obtain for readers without easy
access to large metropolitan or research libraries.
The Soviet Economy 1970-1990, by Dmitri Steinberg
(San Mateo, Calif.: International Trade Press, 1990),
packs into one volume a plethora of national income
and product account data necessary to understanding
Soviet e c o n o m i c growth during the 1970-90 period.
Steinberg demonstrates that the CIA significantly overestimated this growth and systematically explains the
methodology that supports his conclusions.
He discusses Cold War concerns about the real size
and structure of the U S S R e c o n o m y and the extent
to which the country was militarized. Most informed
Economic Review
41
study during the 1970s and 1980s relied on CIA reports to the U.S. Congress, reports supposedly based
on tested methods and periodically updated by CIA
analysts and prominent academic economists. However, confidence in the reports began to erode when "impressionistic accounts" showed the USSR economy to be
much smaller and more burdened with military costs
t h a n had been s u p p o s e d . In 1990 G o s k o m s t a t , the
main Soviet statistical agency, released previously unpublished data, unprecedented in scope and coverage,
giving new insights into the size, structure, and growth
of the Soviet economy. Steinberg analyzes the new data and attempts to substantiate a n u m b e r of revisions
in the CIA methodology and estimates. He integrates
all the available data on production, input-output, national income and financial flows, and capital and labor
resources and converts the integrated Soviet national
accounts into a G N P format. To assist readers in better
understanding the Soviet economic sectors, the study
contains a short description of Soviet sectoral activity
prepared by U.N. experts. T h e book also has a scholarly bibliography.
Soviet Statistics since 1950, by B.P. Pockney (New
York: St. M a r t i n ' s Press, 1991), is a scholarly c o m pendium that provides selected statistical data through
1988 for five m a j o r fields: population and labor, industry, energy, agriculture, and foreign trade, including e x p o r t s and i m p o r t s b e t w e e n p r i n c i p a l trading
partners. The data, derived mostly from Soviet sources,
include some Western statistics, all scrupulously referenced. Footnotes a c c o m p a n y i n g the tables interpret
the figures, o f f e r information about background factors not apparent in the tables themselves, and posit
reasons for statistical trends.
In the book's introduction Pockney, a professor of
Russian Studies at the University of Surrey, England,
presents his view of the nature and collection of Soviet
data, often withheld or blatantly manipulated to "cover
failures and present lackluster performances in a glowing light." Although the questions he raises about the
reliability of Soviet data are certainly not new, readers
will appreciate the informative overview presented in
P o c k n e y ' s broad outline of data d e v e l o p m e n t s f r o m
1950, with particular e m p h a s i s on the period since
1987, as glasnost progressed.
In addition, Pockney has added to the value of his
book by including data resulting from reforms in data
collection and dissemination. These kinds of data have
been included in either the main tables or accompanying notes. Pockney's historical grasp of statistical developments in Soviet data collection and promulgation,
42
Economic Review
combined with his elaborate data display, makes Soviet Statistics since 1950 an imposing statistical work
adequate for use as a lone reference for the period it
covers.
Karen Anderson and Jonathan J. Halperin, the authors of Through a Glass Clearly: Finding,
Evaluating, and Using Business Information from the Soviet
Region (Special Libraries Association Occasional Papers Series, no. 3, Washington: Special Libraries Association, 1992), point out that Eastern Europe and the
newly independent states are now awash in information vendors offering a profusion of publications and
services. The purpose of Through a Glass Clearly is to
help information-seekers ferret out from the horde of
offerings the best sources for statistical data, reliable
facts, and credible editorial opinion.
To give readers the background upon which they
can base judgments, Through a Glass Clearly examines the history and development of the information industry in Eastern Europe and newly independent states,
paying particular attention to political factors like control in a managed economy, the limited availability of
information to people beyond g o v e r n m e n t planners,
and harassment of the media (like Gorbachev's attempt
in October 1989 to force the resignation of the editorin-chief of Arguments and Facts, which had published
the results of a popularity poll omitting Gorbachev).
The book provides guidance on the hazards of dealing
with both old and new styles of information in the newly independent states: where to find information, how
to evaluate it, and how to use it. Detailed sections address each of these considerations, as well as others,
such as coping with the language barrier.
E l e v e n a p p e n d i x e s c o m p r i s e e x t e n s i v e lists of
books and periodicals broken down by genre, such as
directories (of products and services, including comm e r c i a l b a n k s ) , m a j o r n e w s p a p e r s and m a g a z i n e s ,
g o v e r n m e n t periodicals, and newsletters. Bibliographers and other collection-builders in libraries should
find these lists useful.
Through a Glass Clearly for the most part achieves
its stated goal of helping i n f o r m a t i o n p r o f e s s i o n a l s
identify quality business sources. Occasionally, however, the authors will lapse into observations that are
m o r e c o l o r f u l than practical, such as, " C o n t r a r y to
Western expectations, things like lists of textile factories handwritten on a cocktail napkin may well be far
m o r e useful than government-produced d o c u m e n t s . "
Although the length of the bibliographical appendixes
precludes extensive notation, it would have been helpful
if brief commentaries had been included along with
Novem ber/December 1992
the bibliographical information to help readers discern
differences (for instance, editorial emphasis or level of
readership addressed) among publications grouped together.
USSR Facts and Figures Annual (Gulf Breeze, Fla.:
A c a d e m i c International Press; began 1977) already
stands in U.S. research libraries' reference collections
as a principal source for news about noteworthy Soviet developments. The publication has always recorded
the full range of Soviet life in statistical data, discursive factual presentation, and editorial interpretation.
The annual derives its contents from an impressive array of sources listed in "Abbreviations of Sources" in
Volume 15 (1991) (see Figure 2).
The USSR Facts and Figures Annual is in the midst
of important changes: a new editor beginning with Volume 17 (1992), a new title, and some adjustments in
format. The new title is Russia and Eurasia Facts and
Figures Annual. The new format will divide the book
into two fundamental sections: (1) the Commonwealth
of Independent States (CIS) and Georgia and (2) the individual former republics treated separately. To preserve
continuity, both sections of the new format will provide
much the same information available in Volumes 1-17:
facts and statistical data on government, population
health and welfare, the economy, and industry.
The book is probably most useful as a reference for
current information about the former Soviet Union and
its successor entities. Annual volumes may be used to
Figure 2
Abbreviations of Sources
CDSP—Current
Digest of the S o v i e t
Press
CIA/DIA-- " T h e S o v i e t E c o n o m y S t u m b l e s
B a d l y in 1989," paper presented by Central Intelligence A g e n c y a n d D e f e n s e Intelligence A g e n c y to Technology
and
N a t i o n a l S e c u r i t y S u b c o m m i t t e e of J o i n t
E c o n o m i c Committee of U S C o n g r e s s (20
Apr 90).
CIR/54—W
W a r d Kingkade, Estimates
a n d Projections of Educational Attainment
in the U S S R to the Y e a r 2000 ( C e n t e r for
International R e s e a r c h Staff P a p e r No.
54, Mar 1990)
D O D — U S Department of D e f e n s e , Critical Technologies P l a n for the Committees
on A r m e d S e r v i c e s United S t a t e s Cong r e s s (15 Mar 90)
ECONUSSR—The
Economy
of
the
U S S R : A Study Undertaken in R e s p o n s e
to a R e q u e s t by the Houston S u m m i t :
Summary and Recommendations (Washington, D C . , 1990)
F B I S — D a i l y Report, S o v i e t Union/Foreign
B r o a d c a s t Information S e r v i c e
I E O — U S Department of E n e r g y , E n e r g y
Information Administration, International
E n e r g y Outlook 1990.
N Y T — N e w York T i m e s
R F E / R L — D a i l y Report/Radio F r e e Europe-Radio Liberty
SEER—Soviet
E a s t E u r o p e a n Report/
R a d i o F r e e Europe-Radio Liberty
S E R S — Sotsialno-ekonomicheskoe
razvitie strany v . goda: ekonomicheskii
obzor, No. 6 (1990)
S M P — U S Dept. of D e f e n s e , S o v i e t Military P o w e r , 9th ed. ( S e p 1990)
S O V M I N — S o v e t ministrov S S S R : Spravochnik serii "Kto est kto". Moscow, 1990-.
Source: USSR
Facts and Figures Annual,
Federal Reserve Bank of Atlanta
STNS—Eastern
Europe:
Long
Road
A h e a d to E c o n o m i c Well-Being", paper
presented by C I A to S u b c o m m i t t e e on
Technology a n d National Security, J o i n t
E c o n o m i c Committee (16 May 90)
U I F — T h e U S S R in Figures for 1988
( M o s c o w , 1989)
U S C I A D O I — U n i t e d S t a t e s , Central Intelligence Agency, Directorate of Information
D O S O : N O — D i r e c t o r y of S o v i e t Officials National Organizations ( F e b 1989)
D O S O . R O — D i r e c t o r y of S o v i e t Officials: Republic Organizations (Nov 1988)
D O S O : S E — D i r e c t o r y of S o v i e t Officials: S c i e n c e and Education ( M a y 1989)
DEMOGREPS—USSR:
Demographic
T r e n d s a n d Ethnic B a l a n c e in the Non
R u s s i a n Republics (April 1990)
E E I — E c o n o m i c a n d Energy Indicators
(16 Nov 90)
G O V T S — C h i e f s of S t a t e a n d Cabinet
M e m b e r s of Foreign G o v e r n m e n t s ( S e p /
Oct 1990)
H O E S — H a n d b o o k of E c o n o m i c Statistics, 1990
I E S R — I n t e r n a t i o n a l E n e r g y Statistical
R e v i e w (30 Oct 90)
S O V E N E R D A T A — S o v i e t Energy Data
R e s o u r c e Handbook ( M a y 1990)
SOVGNP—Measuring
Soviet
GNP:
P r o b l e m s a n d Solutions ( S e p 1990)
World F a c t b o o k — T h e W o r l d Factbook
1990
U S Department of S t a t e
Volkov—Demograficheskie
protsessy v
S S S R : sbornik n a u c h n y k h trudov, e d
A G. Volkov ( M o s c o w , 1990)
vol.15 (1991), xviii. Reprinted by permission of the publisher.
Economic Review
43
great advantage to compare or expand upon statistical data
or other information found in alternative sources. However, it is inconvenient to have to refer to more than one
volume to track a substantive issue (there are no cumulative volumes from 1977 forward). 6 Further, if several
volumes are consulted for data, the researcher must be
on guard against the inconsistencies of data that m a y
not be u n i f o r m l y r e b e n c h m a r k e d . T h e s e d r a w b a c k s
make the USSR Facts and Figures Annual unwieldy for
collecting information spanning several years.
the United Nations' Standard International Trade Classification ( S I T C ) and a s u p p l e m e n t to the S I T C to
cover services and activities not classified in SITC;
(2) a chapter for e a c h country broken out by broad
sectors for manufactures, services, and other activities;
and (3) a list of International Chamber of C o m m e r c e
Publications, which includes Incoterms (ICC terminology), Uniform Customs and Practice for
Documentary
Credit, and Uniform Rules for Collections:; an index to
the directory; and lists of weights and measures and
abbreviations used.
The East European Market: Sources of Information ,
by Tania Konn (Glasgow: University of Glasgow Library, 1991), is an exhaustive, scholarly bibliography
of market information sources for Eastern Europe. It is
divided into sections covering general background information; macroeconomic conditions; handbooks, directories, and reports; industry sectors; statistical data;
and on-line data base services, each section subdivided by national entity. Despite the many changes in the
Eastern European information universe since the bibliography was p u b l i s h e d in 1991, this work should
prove fundamentally useful to libraries and businesses
that wish to build a collection of books and periodicals
c o v e r i n g this area. (Librarians and other collection
builders, however, will regret the omission of place of
publication in citations for the far-flung titles, which
necessitates extra bibliographic spadework before
placing an order.)
Political and economic upheaval in the former Soviet Union have rendered some parts of the chapter on
that area virtually useless because it reflects information no longer accurate. For instance, the publication
provides one central M o s c o w address for foreign trade
organizations covering the entire Soviet Union although
each independent state currently has its own office for
trade relations. Nevertheless, other sections may still
be valid, like the one for production enterprises, associations, and scientific production complexes, which
includes local addresses throughout the newly independent states. For the most part, the Directory of Foreign Trade Organizations
in Eastern Europe remains
an attractive reference tool for comprehensive, wellorganized, and easy access to manufacturers and service organizations.
Directories
T h e Directory of Foreign Trade Organizations
in
Eastern Europe: Bulgaria, Czechoslovakia,
East Germany, Hungary, Poland, Romania, and the
U.S.S.R.
(San Mateo, Calif.: International Trade Press, 1990) is
an extensive listing of export/import companies in Eastern Europe (including what was then the U S S R ) , as
well as g o v e r n m e n t m i n i s t r i e s , c h a m b e r s of c o m merce, state committees, banks, and other supporting
organizations engaged in foreign trade. O n e section
p r o v i d e s u s e f u l i n f o r m a t i o n f r o m the I n t e r n a t i o n a l
C h a m b e r of C o m m e r c e . 7 T h e volume is intended to
help m a n u f a c t u r e r s and international traders in the
United States and abroad research local markets, locate clients, and establish direct contacts in Eastern
Europe.
The directory's contents fall into three fundamental
divisions: (1) an index to manufactures, services, and
other activities throughout Eastern E u r o p e based on
44
Economic Review
SIBD 92-93: The Business Directory for the Soviet
Region (Dnepropetrovsk, Ukraine: HA Sistema-Reserve,
and Washington, D.C.: FYI Information Resources for
a Changing World; began 1991) is a two-volume business directory, p u b l i s h e d annually, with m o r e than
6,500 detailed listings focusing on private businesses
across the former Soviet Union. The directory is generated from the IIA Sistema-Reserve data base, which
incorporates i n f o r m a t i o n f r o m a c o m p u t e r n e t w o r k
covering the Ukraine and the other newly independent
states. The format of the detailed company listings is
reminiscent of Standard and Poor's Register of Corporations in the United States (see Figure 3). Alphabetically arranged, the detailed listings for companies compose
Volume 1. Volume 2 contains four alternative indexes:
business activity (economic sectors), geographic, leaders (decision-makers), and the 500 largest enterprises.
Experienced users of business directories will appreciate the directory's useful identification of companies' "primary business activities," "main products,"
and "main services." However, some users, accustomed
to the ease of the strictly numerical codes of the standard industrial classification s y s t e m s of the U n i t e d
States and the United Nations, may find the SIBD's
Novem ber/December 1992
Figure 3
Database ID #
Country
Ownership Code
Top-500 Symbol
No. of Employees
-S-R-N-S 1172
Phone, Telex,
Teletype, and Fax
(as available)
Key Individuals,
Titles, Phone Nos.
Hard Currency
Account
Importer and/or
Exporter Status
IMI'
•
-A^*
B I O T E K S * Scientific-Research^
Center
D a t e F'stablished:
, N o . of E m p l o y e e s : 20
, Bank Acci:
Bank Account
F.XP
•
Moldova
3/12/1990
T u r n o v e r : 1.600.000
~
r/s 6 0 8 Í I 0 , l . e n i n s k B r a n c h of Z h S l i .
K i s h i n e v . V1FO 771629
A d d r e s s : 277043. Kishinev
III. Z h u k o v skogo. 3 p/ya 3168
i T e l e p h o n e : (0422) 57-29-36
Telex:
163118 O M E G A SII
Fax:
(0422)56-95-42
57-29-36
(iinorai Director
OleS Vladimirovich Voronin
Deputy Director
Yuriv Antonovich Vloro/enko
Date Founded
Turnover
Street Address
(mailing address
is also listed,
when different)
26-52-80
M V K S r e g i s t r a t i o n : P R - 2 8 0 1 / 1 9 3 , 09/06/1990
Hard Currency A i d :
67080382 in Kishinev
B r a n c h of V n e s h e k o n o m h a n k
Branches/Subsidiaries: B I O P R O T K X (Kishinev), i
U
B I O T E X - M O I . D O V A (Kishinev). B I O T E X N & D F . P ( O r g e y e v l . K O N K O R D 1 A ( Tiraspol )
I
Primary
Business Activities
Company Name
Foreign Trade
Registration
Branches and
Subsidiaries,
with Locations
Business Activities: Biotechnology, v i r u s - f r e e p l a n t
growing, c r o p protection * Radioelectronics *
l iquid c h r o m a t o g r a p h y
Main Products
Main Goods: Virus-tree planting medium for fruit,
b e r r y , and flower growing * Mobile phases f o r
high-sensitivity liquid c h r o m a t o g r a p h s * I n j e c t o r s
for gas chromatographs
Main Services
M a i n Services: Scientific c o n s u l t i n g on c h r o m a t o graphy * Virus-free plant growing * P r o g r a m m i n g
* Mathematical modeling * Export and import
operations
Actual listing (shown reduced)
Source: From an advertising brochure for SIBD
92-93: The Business Directory
alphanumeric codes somewhat awkward. On the other
hand, this alphanumeric arrangement reflects an attempt
to make the business activity index a better match to the
actual economic structure of the former Soviet Union.
The U.S.-East European Trade Directory and the
U.S.-Soviet Trade Directory, both by William S. Loiry
( C h i c a g o : P r o b u s P u b l i s h i n g C o m p a n y , 1991), are
comprehensive, handy guides to resources about the
m a r k e t s of East E u r o p e and the newly i n d e p e n d e n t
states, written f r o m an A m e r i c a n p e r s p e c t i v e . T h e
contents of the two directories roughly parallel each
other, with s o m e variation a p p r o p r i a t e to the g e o graphic and political realities of each area.
B o t h d i r e c t o r i e s h a v e c h a p t e r s on i n f o r m a t i o n
sources, w h o s e strong points are e x t e n s i v e listings
of hard-copy publications—books and periodicals—
Federal Reserve Bank of Atlanta
for the Soviet Region. Reprinted by permission of the publisher.
some of which are highly specialized for international
trade with the respective areas. The U.S.-Soviet
Trade
Directory's
" I n f o r m a t i o n S o u r c e s " chapter includes
several "Electronic Information Services" (computer
data base services) covering the former Soviet Union
( f o r e x a m p l e , M o s c o w International Business N e t work, Boston). Although this data base services feature is not included in the US-East
European
Trade
Directory, the Soviet directory list includes Reuters
I n f o r m a t i o n Services and the World Trade C e n t e r ' s
Washington, D.C., data base ( W T C W ) , both of which
offer worldwide coverage.
Of particular interest in each directory are the chapters titled " C o n s u l t a n t s and T r a d i n g C o m p a n i e s , "
" U . S . L a w F i r m s , A t t o r n e y s , and L e g a l O r g a n i z a tions," "Finance, Accounting and Auditing," and "Insurance Agencies." They offer specific contacts (primarily
Economic Review
45
in t h e U n i t e d S t a t e s but a l s o in B r u s s e l s , L o n d o n ,
M o s c o w , P r a g u e , Toronto, a n d W a r s a w ) f o r structuring
joint ventures, f o r legal expertise, f o r loan g u a r a n t e e s
( f o r e x a m p l e , the U . S . O v e r s e a s P r i v a t e I n v e s t m e n t
C o r p o r a t i o n ) , a n d f o r political risk i n s u r a n c e , r e s p e c tively. O t h e r c h a p t e r s list the n a m e s of r e s e a r c h c e n t e r s , c i t i n g t h e i r s p e c i a l p r o g r a m s ( f o r i n s t a n c e , the
H a r v a r d U n i v e r s i t y R u s s i a n R e s e a r c h C e n t e r a n d its
j o i n t v e n t u r e s a n d o t h e r b u s i n e s s t o p i c s ) ; the n a m e s
a n d a d d r e s s e s of individual translators a n d translating
agencies; a n d c o n f e r e n c e s , e x h i b i t i o n s , and s e m i n a r s .
B o t h directories o f f e r " Y e l l o w P a g e s " sections that alp h a b e t i c a l l y list e v e r y entry in e a c h directory, c u t t i n g
a c r o s s g r o u p i n g s b y s u b j e c t h e a d i n g . B o t h directories
are c o m p a c t , c o m p r e h e n s i v e , a n d a f f o r d a b l e .
1. The Eastern Bloc comprised East Germany and the other
countries of Eastern Europe—Albania, Bulgaria, Czechoslovakia, Hungary, Poland, Romania, and Yugoslavia—and the
Soviet Union (Armenia, Azerbaijan, Byelarus, Estonia,
Georgia. Kazakhstan. Kyrgyzstan, Latvia, Lithuania, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan, sometimes referred to as the newly independent
stales). There is at present no broadly accepted alternative
name for the states of the former Soviet Union. Commonwealth of Independent States encompasses only some of
these nations. The people of the area object to the term
States of the Former Soviet Union. Hence, following the lead
of the U.S. Department of Commerce International Trade
Administration, this paper will use the term newly independent states, where appropriate, throughout this article to designate the former Soviet Union.
2. Christine N. Donohue, "Eastern European Libraries: Links to
Information," in Information in Eastern and Central Europe:
Coming in from the Cold (papers presented at the Special Libraries Association State-of-the-Arl Institute, November 1213, 1991, Washington, D.C.), 79-88, (Washington, D.C.,
Special Libraries Association, 1992.)
3. The earlier Economic Review articles—"International Trade
and Finance Reference Sources" (May/June 1991, 30-37)
Economic
4 6
Review
Conclusion
T h e s e p u b l i c a t i o n s m a k e u p o n e a r m of the b o d y of
e c o n o m i c and business information available for the
f o r m e r E a s t e r n B l o c c o u n t r i e s . C o n s u l t e d a l o n g with
the p e r i o d i c a l l i t e r a t u r e that will b e r e v i e w e d in the
n e x t i s s u e of this Economic
Review, they p r o v i d e inv e s t o r s , p o l i c y m a k e r s , and o t h e r users w i t h u n p r e c e d e n t e d a c c e s s to i n f o r m a t i o n a b o u t this d r a m a t i c a l l y
c h a n g i n g part of the w o r l d .
and "International Trade and Finance Information Sources:
A Guide to Periodical Literature" (July/August 1991, 5564)—emphasized publications with either multicountry
(global) or world area (for example, Latin America or Pacific Rim) geographical coverage. Some of the publications
with multicountry focus also explore worthwhile topics concerning Eastern European and newly independent states, and
readers may wish to consult them for potentially useful references.
4. The format of the 1991 Handbook of Economic Statistics reflects the impact of changes in Eastern Europe and Russia.
Future changes will be made as regional economic groupings
realign themselves.
5. The G-Six countries are Canada, France, Germany, Italy,
Japan, and the United Kingdom. The G-Seven consists of the
United Slates and the G-Six.
6. Volume 16 (also published in 1991) is an index to the first
ten volumes (1977-86), which are not indexed individually.
7. The International Chamber of Commerce is located in Paris.
Its publishing representative in the United States is ICC Publishing Corporation, 156 Fifth Avenue, Suite 820, New
York, New York 10010.
Novemb e r / D e c e mber 1992
J n d e x for 1992
Financial Institutions
Abken, Peter A., "Corporate Pensions
and Government Insurance: Déjà Vu
All Over Again?" March/April, 1
Carlson, Leonard A., "Banking in
Georgia, 1865-1929,"
November/December, 28
Goudreau, Robert E., "Commercial
Bank Profitability Rises as Interest
Margins and Securities Sales
Increase," May/June, 33
Smith, Stephen D., and Larry D. Wall,
"Financial Panics, Bank Failures,
and the Role of Regulatory
Policy," January/February, 1
Srinivasan, Aruna, "Are There Cost
Savings from Bank Mergers?"
March/April, 17
Srinivasan, Aruna, "Review Essay:
The Future of Banking, by James L.
Pierce," September/October, 34
Financial Markets
DeJong, David N., and Charles H.
Whiteman, "More Unsettling Evidence on the Perfect Markets Hypothesis," November/December, 1
Gilkeson, James H., and Stephen D.
Smith, "The Convexity Trap:
Pitfalls in Financing Mortgage
Portfolios and Related Securities,"
November/December, 14
Hunter, William C., and David W.
Stowe, "Path-Dependent Options,"
March/April, 29
Hunter, William C., and David W.
Stowe, "Path-Dependent Options:
Valuation and Applications,"
July/August, 30
Federal Reserve Bank of Atlanta
/nternational Trade
and Finance
Donovan, Jerry J., "Review Essay:
Doing Business in Eastern Europe
and the Newly Independent States:
Information Sources to Get Started," November/December, 47
King, B. Frank, "Review Essay: Breaking Financial Boundaries: Global
Capital, National
Deregulation,
and Financial Services Firms, by
David M. Meerschwam,"
January/February, 37
Kumar, Vikram, and Joseph A. Whitt,
Jr., "Exchange Rate Variability and
International Trade," May/June, 17
Macroeconomic Policy
Leeper, Eric M., "Consumer Attitudes:
King for a Day," July/August, 1
Leeper, Eric M., "Facing Up to Our
Ignorance about Measuring Monetary Policy Effects," May/June, 1
Roberds, William, "What Hath the Fed
Wrought? Interest Rate Smoothing
in Theory and Practice," January/
February, 12
Rosenbaum, Mary S., "Review Essay:
The State of Macroeconom ics,
edited by Seppo Honkapohja,"
July/August, 44
Tallman, Ellis W „ and Ping Wang,
"Human Capital Investment and
Economic Growth: New Routes in
Theory Address Old Questions,"
September/October, 1
Manufacturing
Rogers, R. Mark, "Forecasting Industrial Production: Purchasing Managers' versus Production-Worker
Hours Data," January/February, 25
Rogers, R. Mark, "Tracking Manufacturing: The Survey of Southeastern
Manufacturing
Conditions,''
September/October, 26
Regional Economics
Kottman, Stacy E., "Regional Employment by Industry: Do Returns to
Capital Matter?" September/
October, 13
Krikelas, Andrew C., "Why Regions
Grow: A Review of Research on
the Economic Base Model,"
July/August, 16
Roberds, William, "Review Essay:
Edge City: Life on the New Frontier, by Joel Garreau," May/June, 53
Taxation
Hunter, William C., "Review Essay:
Cheating the Government: The
Economics of Evasion, by Frank A.
Cowell," March/April, 35
Economic
Review
47
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92-1
Risk Neutral Valuation, Asymmetric
Information,
the Efficient Markets
Hypothesis
V i c e n t e M a d r i g a l and Stephen D. Smith
92-2
Cost Savings Associated
with Bank
Mergers
A r u n a Srinivasan and Larry D. Wall
92-3
The Choice of Capital Instruments
by Banking
Organizations
Larry D. W a l l a n d P a m e l a P. P e t e r s o n
92-4
Motivations
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and
and
A Note on Forward Biases and Equilibrium
Exchange Hedging in a Production
Economy
V i k r a m K u m a r a n d Stephen D. Smith
92-10
Money Demand and Relative Prices in
Evidence from Germany and China
Ellis W . T a l l m a n and P i n g W a n g
92-11 Form Invariance
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Foreign
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V i c e n t e M a d r i g a l and S t e p h e n D. Smith
Acquisitions:
Enhancing
the Deposit Insurance
Put Option
Increasing Operating Net Cash Plow
G e o r g e J. B e n s t o n , W i l l i a m C. H u n t e r , a n d
Larry D. Wall
versus
92-5
Real Effects of Exchange
Vikram Kumar
Trade
92-6
Stochastic Specification
in Random
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Models of Cost Minimizing
Firms
B r y a n W . B r o w n a n d M a r y Beth W a l k e r
92-7
Optimal Venture Capital
Horizon
Constraint
W i l l i a m C. H u n t e r
92-8
Rational Expectations
and Security
Analysts'
Earnings
Forecasts
L u c y F. A c k e r t and W i l l i a m C. H u n t e r
Risk on International
Solicitation
92-9
9 2 - 1 2 A Note on Competition,
Fixed Costs, and the
Profitability
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Iftekhar Hasan and Stephen D. S m i t h
92-13
The Dynamic Impacts of Monetary
Policy:
An Exercise in Tentative
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D a v i d B. G o r d o n and Eric M. L e e p e r
92-14
Budget Constraints
and Time-Series
Consumption:
Comment
William R o b e r d s
Evidence
9 2 - 1 5 Another Hole in the Ozone Layer: Changes in
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Structure
W i l l i a m R o b e r d s , David R u n k l e , and
C h a r l e s H. W h i t e m a n
under a
on
FOMC
9 2 - 1 6 A New Method of Testing Pricing Models as
Applied to Forward Interest Rate
Models
H u g h C o h e n and D a v i d Heath
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