$1.2 trillion college loan bubble?

See also When everyone goes to college: a lesson from S. Korea. Returns to a "college education" are highly dependent on the intrinsic cognitive ability and work ethic of the individual.

WSJ: College Loan Glut Worries Policy Makers

The U.S. government over the last 15 years made a trillion-dollar investment to improve the nation’s workforce, productivity and economy. A big portion of that investment has now turned toxic, with echoes of the housing crisis.

The investment was in “human capital,” or, more specifically, higher education. The government helped finance tens of millions of tuitions as enrollment in U.S. colleges and graduate schools soared 24% from 2002 to 2012, rivaling the higher-education boom of the 1970s. Millions of others attended trade schools that award career certificates.

The government financed a large share of these educations through grants, low-interest loans and loan guarantees. Total outstanding student debt—almost all guaranteed or made directly by the federal government—has quadrupled since 2000 to $1.2 trillion today. The government also spent tens of billions of dollars in grants and tax credits for students.

New research shows a significant chunk of that investment backfired, with millions of students worse off for having gone to school. Many never learned new skills because they dropped out—and now carry debt they are unwilling or unable to repay.

... nonprofit colleges, which enroll about 2.7 million students a year. A report released in May by Third Way, a nonpartisan think tank, revealed that among students who enrolled in 2005, on average only half graduated from such institutions within six years. On average, nearly four in 10 undergraduates at those schools who took on student debt earned no more than $25,000 in 2011, the same as the typical high-school graduate. ...

Looking back at the credit crisis

I thought it worthwhile to re-post my 2008 slides on the credit crisis. I wrote these slides just as the crisis was getting started (right after the big defaults), but I still think my analysis was correct and better than post-hoc discussions that are going on to this day.

I believe I called the housing bubble back in 2004 -- see, e.g., here for a specific discussion of bubbles and timescales. The figure above also first appeared on my blog in 2004 or 2005.

(2004) ... The current housing bubble is an even more egregious example. Because real estate is not a very liquid investment - the typical family has to move and perhaps change jobs to adjust to mispricing - the timescale for popping a bubble is probably 5-10 years or more. Further, I am not aware of any instruments that let you short a real estate bubble in an efficient way.

I discussed the risks from credit derivatives as early as 2005; see also here and here.

Finally, there was a lot of post-crisis discussion on this blog and elsewhere about mark to market accounting: were CDO, CDS oversold in the wake of the crisis (see also The time to buy is when there is blood in the streets; if you want to know what "leading experts" were saying in 2008, see the Yale SOM discussion here -- oops, too embarrassing, maybe they took it down ;-), or was Mr. Market still to be trusted in the worst stages of a collapse? The answer is now clear; even Fannie and Freddie have returned $180 billion to the Feds!

Akerloff on Efficient Markets Hypothesis

I particularly like his comments (@13 min or so) on Snake Oil and financial assets. When market participants are exuberant (overly confident) it is natural for firms to create and market new assets that are overpriced relative to actual value, or have dangerous risk-return tradeoffs. For the latest example, in natural gas drilling rights during the recent boom (now a bust), see here.

See also Venn diagram for economics.

The cover illustration of Akerloff and Shiller's book. Are there any economists outside of Chicago who still don't believe in "animal spirits"?

You'd be hedging too if you were a Chinese billionaire

Ill-gotten gains + giant real estate bubble in China + limited liquid investment options = windfall for top international cities such as Manhattan, LA and London.

If the RMB were allowed to float, the short term effect could easily be a decline relative to the dollar, as Chinese investors rush to diversify their portfolios.

NYTimes: ... The explosion of wealth in China has created myriad new billionaires eager to diversify their holdings with real estate investments in the United States. Often, they are looking to give their children a plush crash pad for boarding school or college, or a place to live in when they start careers and families. Many wealthy Chinese are also looking for places to invest where they can preserve their wealth and avoid the rising inflation in major Chinese cities like Shanghai and Beijing.

... The old way of doing business is no longer enough, Ms. Field said. “We as Americans always expected anyone to adapt to our business style, and they did,” she said. “That is no longer true with the Chinese. There are too many of them, they have too much power. We truly must adapt to their style of business in order to do deals.”

... Chinese billionaires continue to buy high-end properties in buildings like the Time Warner Center, 15 Central Park West and the newest, One57. But in May and June she saw something different: an “almost overwhelming volume” of calls and sales driven largely by interest in apartments ranging from $3 million to $6 million — what Ms. Lenz calls the “middle market” in Manhattan.

Chinese buyers are also no longer paying all cash as they were a few years ago. In recent months, several Chinese buyers have financed their purchases, some with United States-based loans, Ms. Lenz said. They seem to be leveraging in New York so they can also buy properties in Los Angeles, London or other cities, she said.

On her trips to China, Ms. Field has noticed a change in the conversation among potential clients. “When I first went over there five years ago, my presentations all had to be about return,” she said.

“Everyone was looking for returns. Two years ago, return questions almost dried up. Now it is all about wealth preservation. They are anticipating a bubble” in China, she added.

China economic challenges

Highlights of a special FT debate looking at the choices that lie ahead for the world’s second largest economy: video. [Related statistic: Chinese internet users now exceed 500 million, greater than the entire population of the EU.]

Forensic Asia's Gillem Tulloch believes that the Chinese property market is a bubble on a similar magnitude to the crisis in the US as a result of the huge stimulus package after the global financial crisis. He tells the FT why he thinks China could be on the verge of a property-led slump that would have an impact far beyond its own borders: video. [The only question is when this bubble will pop and whether it will be an orderly decline.]

Ruh Roh!

The dreaded double dip!



Non-Americans see here for explanation of "Ruh Roh" :-)

Almost over? part 2

Are further price declines in the cards? If you think there's some inflation around the corner (say in the next few years), now might be a good time to lever up and buy some real estate.

Here's an interesting figure from a recent paper by Case, Quigley and Shiller. The paper is primarily about wealth effects, but it has some nice panel data. They find that the wealth effect is stronger for housing than for equity assets.



Here is a video from the Financial Times discussing the paper and recent housing data.

More discussion and figures like the one below in this earlier post.

Almost over?

What's a factor of 2 between friends? :-) Note no long term appreciation of houses relative to CPI.




Here's Japan for comparison. Our bubble has popped much more quickly.




Yes, Virginia, we knew it was a bubble back in 2005, but no one believed us. Next time, watch the price to rent ratio:




Yes, equities beat housing over the long run, and even at the peak of the biggest housing bubble of the 20th century.

The bubble algorithm for human capital allocation

According the this WSJ article, at the peak of our finance bubble about a third of MIT graduates and almost half of all Harvard grads went into finance! Not so long ago a friend of mine at a derivatives desk made offers to 2 percent of the Caltech graduating class (only 4 people, but still).

To what field should society allocate the (N+1)-th big brain to achieve the highest marginal return? For years I've been told that the answer is finance -- markets are efficient after all, and price signals must be correct! ;-)

WSJ: Like nearly 30% of Massachusetts Institute of Technology graduates in recent years, Ted Fernandez set his sights on finance. Though he majored in materials science and engineering, he was wowed by tales of excitement from friends who went to Wall Street.

But when he stopped by an investment bank's booth at a job fair a year ago, it was eerily empty. The booth belonged to Lehman Brothers Holdings Inc., and the date was Sept. 18, three days after the 158-year-old bank filed for bankruptcy. Now Mr. Fernandez, 22 years old, is getting a master's in engineering at M.I.T. and aiming for a career in solar-power technology. [Another bubble? Let's hope not!]

"Undoubtedly, I would have gone into finance if the financial meltdown hadn't occurred," he says. "Now I won't make as much money, but I can go home at night and feel good about what I do. That's worth more than any amount of money."

Over the past 20 years, finance grew faster than almost any other sector of the U.S. economy, offering rich pay and luring a growing share of bright minds to trade securities, make loans, manage portfolios, engineer mergers and turn mortgages into complex derivatives. Now the finance bubble has deflated, forcing hundreds of thousands of employees to search for other work and sending new graduates looking elsewhere for careers.

... Harvard's 2009 graduating class shows the shift in career directions. Those entering finance and consulting tumbled to 20% of graduates this year from nearly twice that in 2008 and 47% the year before, according to a survey by the university's newspaper, the Crimson. ...

Even a modest of shift of talent could have an effect on society. When smart people become entrepreneurs, "they improve technology in the line of business they pursue, and, as a result, productivity and income grow," said a study by economists Kevin M. Murphy, Robert W. Vishny and Andrei Schleifer in 1990. By contrast, they said, allocation of talent to professions such as finance and law -- where returns come from distribution of wealth from others rather than wealth creation -- leads to lower productivity growth, fewer technological opportunities and slower economic growth. [Yes, I know, this argument is far from complete... better people making capital allocation decisions probably does lead to more efficient outcomes... but at what point do we reach saturation?]

"Some professions are socially more useful than others, even if they are not as well compensated," the economists said.

The figure below is from this earlier post:

The New New Meme

The other day on Jay Leno, Obama said (video here ; @13 minutes in):

We need young people, instead of a smart kid coming out of school wanting to be an investment banker, we need them to decide they want to be an engineer, a scientist, a doctor or a teacher. If we are rewarding those kinds of things that actually contribute to making things and making peoples' lives better, that's going to put our economy on solid footing. We won't have this bubble and bust economy we've been caught up in in recent years.

I hope this meme takes off! I've made this kind of argument in the past, for example here in a 2006 post on financier pay, where I wrote

I'm anticipating reactions like "Well, of course they deserve it, their decisions have disproportionate impact on the economy, allocating massive resources. The market is efficient, after all!" All well and good if you can show that the 173,340 people (2006 BLS) working in investment banking really do produce better decisions than the people who would occupy those jobs in return for lower compensation. If not, there are some rents or inefficiencies hidden here :-)

Today in 2009 it should be abundantly clear that the market doesn't always know best :-(

Earlier related posts:

The best and brightest

Is the finance boom over?

A reallocation of human capital

A new class war



Some related comments from Brad DeLong below. I don't agree in detail with everything he writes, but you can see the same sentiment at work.

The engineers of Silicon Valley startups are significantly smarter and work a lot harder than do the traders of Wall Street. Some of the engineers of Silicon Valley make fortunes: they are compensated with relatively low salaries and large restricted equity stakes in the startup businesses they work for, and so if the businesses do well they do very well indeed--in the long run, in the five to ten years it takes to assess whether the business is in fact going to be a viable and profitable going concern. And the engineers of Silicon Valley have every incentive to use all their brains and all their hours to make their firm viable and successful: they get their cash only at the end of the process. They don't get big retention bonuses if they stick around until the end of a calendar year. They don't get big payouts if they report huge profits on a mark-to-market basis.

The traders of Wall Street, by contrast, get their money largely up front. If the mark-to-market position is good, they get paid--even though it is almost surely the case that nobody has tried to actually sell the entire position to somebody else. If the strategy produces short-run profits, they get paid--even though not nearly enough time has passed for anybody to be able to assess what the risks involved in the strategy truly are.

IBM podcast: building a smarter financial system

I'm interviewed on this podcast about the financial crisis and financial systems (click through to get to an embedded player). If you listen carefully, I say "regularization" instead of "regulation" at one point ;-)

Download the Building a Smarter Financial System Podcast (mp3)

I haven't written much on the financial crisis lately, because I don't feel I have anything particularly interesting to say about how we're going to solve the problem. It's a mess, and getting things back to normal is as much a psychological problem as anything else. We have to make projections about future psychological states of other people -- Keynes' beauty pageant problem -- which makes things particularly tricky. There are plenty of "experts" (especially from a particular profession) speaking and writing authoritatively about possible solutions, as if they knew with high confidence the consequences of a particular policy or plan. See this earlier post on intellectual honesty for what I think about them. See here for an excellent discussion by two honest economists, Russ Roberts and Robin Hanson, about the general dilemma of extracting "truth" from complex systems. (Comments there are worth reading as well.)

Building a Smarter Planet blog:

It can't be a good sign that complex financial topics have begun to dominate dinner-table conversations. But the dire situation in which we find our economies extend far beyond the inner circles of the finance elite.

In this episode of the Building a Smarter Planet podcast series, we focus on the financial services industry and interview Stephen Hsu, professor of physics at the University of Oregon, Jeanne Capachin, an analyst at Financial Insights, Carl Abrams, financial services business manager within IBM Research, and Keith Saxton, global director in IBM's financial markets industry. ...

More Soros

Soros' central observation is that markets do not necessarily function properly, even when left to themselves. He is not referring to the usual causes cited for market failure, such as imperfect competition, externalities, information asymmetry, etc. Instead, he is attacking the fundamental assumption that markets are reliable processors of information, that they can be depended on to generate price signals which indicate how resources should be allocated within society.

New York Review of Books: ...This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

More excerpts below.

...the current crisis differs from the various financial crises that preceded it. I base that assertion on the hypothesis that the explosion of the US housing bubble acted as the detonator for a much larger "super-bubble" that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit—whether extended to consumers or speculators or banks—has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom.

The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect.

Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences. Indeed, we have experienced a series of financial crises since then, but the adverse consequences were suffered principally by the countries that lie on the periphery of the global financial system, not by those at the center. The system is under the control of the developed countries, especially the United States, which enjoys veto rights in the International Monetary Fund.

Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices.

It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006. Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. ...

Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and "managing" risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion. But the increased use of financial engineering set in motion a process of boom and bust. ...

It should be emphasized that this interpretation of the current situation does not necessarily follow from my model of boom and bust. Had the financial authorities succeeded in containing the subprime crisis—as they thought at the time they would be able to do—this would have been seen as just another successful test instead of the reversal point.

...Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used. Such regulation should be a high priority of the new Obama administration. It is all the more necessary because financial engineering often aims at circumventing regulations.

Take for example credit default swaps (CDSs), instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.

Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.

In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.

Bay area housing market has cracked

To all my friends in the bay area: I told you so, I told you so, I told you so... :-/

SF Chronicle:

“Twenty percent of Bay Area homeowners owe more on their mortgages than their homes are worth, according to a study being released today. This dubious distinction has entered the American lexicon as an all-too-familiar term - being underwater.

As home values continue to plunge, the real estate valuation service Zillow.com said that 20.76 percent of all homes in the nine-county Bay Area are underwater. The rate is much higher than the national average of 1 in 7 homes, or 14.3 percent. That’s because the Bay Area - like most of California - was a classic bubble market, where buyers in recent years paid overinflated prices for homes that now are rapidly losing value in the market downturn.”

(Via Barry Ritholtz.)

Michael Lewis on the subprime bubble

Michael Lewis nails it in this long Portfolio article. It's the single best piece I've read on the subject.

...In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

...Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible—because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.

Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money. The investors who held the trusts’ BBB tranche got the last payments—and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.

But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

...But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

As an investor, Eisman was allowed on the quarterly conference calls held by Moody’s but not allowed to ask questions. The people at Moody’s were polite about their brush-off, however. The C.E.O. even invited Eisman and his team to his office for a visit in June 2007. By then, Eisman was so certain that the world had been turned upside down that he just assumed this guy must know it too. “But we’re sitting there,” Daniel recalls, “and he says to us, like he actually means it, ‘I truly believe that our rating will prove accurate.’ And Steve shoots up in his chair and asks, ‘What did you just say?’ as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him.”

“With all due respect, sir,” Daniel told the C.E.O. deferentially as they left the meeting, “you’re delusional.”
This wasn’t Fitch or even S&P. This was Moody’s, the aristocrats of the rating business, 20 percent owned by Warren Buffett. And the company’s C.E.O. was being told he was either a fool or a crook by one Vincent Daniel, from Queens.

...That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all.

Wealth effect, consumer spending and recession

How much is consumer spending likely to fall as a consequence of stock and home price declines? If we assume a $10 trillion decline in housing and equity wealth, and a wealth effect of .04, we arrive at a decline in consumer spending of $400 billion. So, roughly 2-3 percent of GDP.

Even if we get the financial crisis fixed, we can expect a serious recession.



The figure (click for larger version) is from this 2005 paper by Case, Quigley and Shiller. Their analysis suggests a (housing) wealth effect of about .04

The heterodoxy strikes back

James K. Galbraith, interviewed in the NYTimes magazine.

Do you find it odd that so few economists foresaw the current credit disaster? Some did. The person with the most serious claim for seeing it coming is Dean Baker, the Washington economist. I saw it coming in general terms.

But there are at least 15,000 professional economists in this country, and you’re saying only two or three of them foresaw the mortgage crisis? Ten or 12 would be closer than two or three.

What does that say about the field of economics, which claims to be a science? It’s an enormous blot on the reputation of the profession. There are thousands of economists. Most of them teach. And most of them teach a theoretical framework that has been shown to be fundamentally useless.

You’re referring to the Washington-based conservative philosophy that rejects government regulation in favor of free-market worship? Reagan’s economists worshiped the market, but Bush didn’t worship the market. Bush simply turned over regulatory authority to his friends. It enabled all the shady operators and card sharks in the system to come to dominate how we finance.

...

Any thoughts on Treasury Secretary Henry Paulson, who engineered the bailout? He is clearly not a superman. This is the guy who had the financial crisis on his plate for a year, and when it finally became so pervasive that he couldn’t handle it on a case-by-case basis, the best he could do was send Congress a bill that was three pages long.

What’s wrong with that? Maybe he’s pithy. It shows he wasn’t adequately prepared. The bill did not contain protections for the public that Congress had to put in.

Regulation is the new mantra, and even Alan Greenspan in his mea culpa before Congress seemed to regret he hadn’t used more of it. I would say a day late and a dollar short. Greenspan blotted his copybook disastrously with his support of deregulated finance. This is a follower of Ayn Rand, an old Objectivist. His belief was you can’t really regulate and discipline the market and you shouldn’t try. I think Greenspan bears a high, high degree of responsibility for what has happened.

More from Robert Shiller, one of the "10 or 12" that Galbraith mentioned. Shiller's wife is a psychologist.

...I clearly remember a taxi driver in Miami explaining to me years ago that the housing bubble there was getting crazy. With all the construction under way, which he pointed out as we drove along, he said that there would surely be a glut in the market and, eventually, a disaster.

But why weren’t the experts at the Fed saying such things? And why didn’t a consensus of economists at universities and other institutions warn that a crisis was on the way?

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group.

...In 2005, in the second edition of my book “Irrational Exuberance,” I stated clearly that a catastrophic collapse of the housing and stock markets could be on its way. I wrote that “significant further rises in these markets could lead, eventually, to even more significant declines,” and that this might “result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well,” and said that this could result in “another, possibly worldwide, recession.”

I distinctly remember that, while writing this, I feared criticism for gratuitous alarmism. And indeed, such criticism came.

I gave talks in 2005 at both the Office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation, in which I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

I BASED my predictions largely on the recently developed field of behavioral economics, which posits that psychology matters for economic events. Behavioral economists are still regarded as a fringe group by many mainstream economists. Support from fellow behavioral economists was important in my daring to talk about speculative bubbles.

Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.

Why do professional economists always seem to find that concerns with bubbles are overblown or unsubstantiated? I have wondered about this for years, and still do not quite have an answer. It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.

In addition, it seems that concerns about professional stature may blind us to the possibility that we are witnessing a market bubble. We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.

In short, Mr. Janis’s insights seem right on the mark. People compete for stature, and the ideas often just tag along.

Has anyone ever heard of the post-autistic economics movement? :-)

Is the finance boom over?

At least for a while. Note the dip after the great depression -- is that where we are headed?




This data comes from papers by Thomas Phillippon (MA in physics, Ecole Polytechnique, PhD in economics, MIT -- vive Les Grandes Ecoles!). See here and here; via Zubin Jelveh.

From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and its wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward [deregulation!], another shift occurred. The financial sector became a high-skill high-wage industry again.

The figure below (click for larger version) shows the relative incomes of engineers and financiers over time. The data on the right is for those with postgraduate degrees. Perhaps the collapse of the finance bubble will reallocate human capital back into more "productive" activities?

Housing bubble: one third to go

Via Calculated Risk, Case-Shiller indices (10 and 20 city composites) show that, adjusted for inflation, we have given back two thirds of the peak relative to 2000.

Here is the last 100 years:





International comparisons (not inflation adjusted):

Incentives and bubble logic

Question: Were bankers and risk managers and investors who got us into this credit crisis plain stupid? Or were they just responding to incentives up and down the line?

Answer: Both. For many people, it was rational to participate in the mortgage bubble even if they thought it might (would) end in tears. On the other hand, even smart people can be taken in by bubble logic if everyone around them is convinced. For example, here is a 2006 discussion from Brad DeLong's blog of a column by Paul Krugman, making the case that most of the country was not experiencing a bubble, and that zoning was the main culprit for coastal price increases (hence prices were sustainable). If you were a CDO modeler in 2006 and believed that argument, you might not have even considered that your model assumptions were way too optimistic -- even with people like Robert Shiller (and me) shouting that we were in the midst of a gigantic bubble.


Some of the best journalistic coverage I have found of the mortgage bubble is from Ira Glass and This American Life (audio, pdf transcript). They get the "local color" right from top to bottom: self-interested individual borrowers, local mortgage brokers rushing to assemble as many loans as possible, to be sold to Wall Street banks and repackaged as CDOs, rated by agencies like Moody's and S&P that were making record profits from fees, and sold to investors chasing yield in the midst of a liquidity glut caused by low interest rates. From their coverage you can see the incentives were messed up from top to bottom, and that many individuals anticipated trouble ahead, but couldn't put up a fight without risking their careers or bonuses. Some excerpts below.

borrower: ...I wouldn't have loaned me the money. And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn't loan me that and they break your knee-caps. I don’t know why the bank did it. ...Nobody came and told me a lie: just close your eyes and the problem will go away. That's wasn’t the situation. I needed the money. I'm not trying to absolve myself of anything. I thought I could do this and get out of it within 6 to 9 months. The 6 to 9 month plan didn’t work so I’m stuck.


mortgage broker ...it was unbelievable. We almost couldn’t produce enough to keep the appetite of the investors happy. More people wanted bonds than we could actually produce. That was our difficult task, was trying to produce enough. They would call and ask “Do you have any more fixed rate? What have you got? What’s coming?” From our standpoint it's like, there's a guy out there with a lot of money. We gotta find a way to be his sole provider of bonds to fill his appetite. And his appetite’s massive.

...my boss was in the business for 25 years. He hated those loans. He hated them and used to rant and say, “It makes me sick to my stomach the kind of loans that we do.” He fought the owners and sales force tooth and neck about these guidelines. He got same answer. Nope, other people are offering it. We're going to offer them too. We’re going to get more market share this way. House prices are booming, everything’s gonna be good. And ... the company was just rolling in the cash. The owners and the production staff were just raking it in.


Wall St. banker ...No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it.

...All the data that we had to review, to look at, on loans in production that were years old, was positive. They performed very well. All those factors, when you look at the pieces and parts. A 90% NINA loan from 3 years ago is performing amazingly well. Has a little bit of risk. Instead of defaulting 1.5% of the time it defaults at 3.5% of the time. That’s not so bad. If I’m an investor buying that, if I get a little bit of return, I’m fine.


CDO packager: ... In 2005, we had an internal debate here because there were two banks coming to us, why don’t you do a deal with us, BBB securities, you get paid a million bucks in management fees per year. Very clear, just like that, in 2005. And we declined those deals. We just don't believe those BBB RMBS assets are money-good. And we thought if we do a CDO of those, that's gonna blow up completely. We were early in '05 by not wanting to do those deals. People were laughing at us. Saying you're crazy. You’re hurting your business. Why don’t you want to make ... Per deal, you could make a million dollars a year.

Lessons from Japan

It took the Japanese two decades to recover from their 80's-90's bubble. This Times article discusses the similarities and differences between their crisis and ours. (Our current crisis is also affecting them -- the Nikkei is down 11 percent as I type this.)

I first posted the graph above in 2005.

NYTimes: ...The similarities with Japan are striking. Like the United States today, Japan in the early 1990s faced a banking and real estate crisis that undermined the entire economy and required large government intervention. Some of Japan’s most venerated financial institutions collapsed as snowballing losses from failed business and property loans plunged the nation’s financial system into paralysis.

But the differences are also pointed and revealing. The United States reacted far more quickly than Japan, committing taxpayer funds just over a year after the subprime mortgage problems surfaced in summer of 2007. Japan took nearly eight years to pass a sweeping bailout, a delay that contributed to a long economic slump that Japanese call their “lost decade.”

“Japanese government and financial institutions realized there was a problem, but they tried to cover it up,” said Junichi Ujiie, chairman of Nomura Holdings, Japan’s largest investment bank. “The United States has done in months what Japan took years to do.”

...Most of the government officials, business leaders and economists interviewed praised America’s plan to spend $700 billion buying troubled mortgage-related assets from banks. But they also said they expected that Washington would soon have to put together another huge bailout package, this time to recapitalize American banks, especially with the International Monetary Fund now estimating total bank losses from the subprime mortgage crisis to reach $1.4 trillion.

On the other hand, another lesson from Japan is that the American bailout may end up costing taxpayers far less than $700 billion or whatever the final figure may be. Japanese regulators were eventually able to recover all but $100 billion of the $450 billion spent by selling off the troubled loans and bank stocks later, after the economy had rebounded.