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!

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. ...

Confidence matters

More on confidence via Barry Ritholtz:

Which raises the question: Why [no] runs on semis or software companies? The short answer is their business model does not depend upon a belief system — of solvency, liquidity, profitability or risk management.

It wasn’t a crisis of confidence that did the iBanks in, it was a crisis of competence.

That was the element CEOs like Dick Fuld, Hank Paulson, Stan O’Neal and Jimmy Cayne failed to consider: When you are a bank, your existence depends upon the confidence of your clients, investors and counter-parties. Anything you do that puts that at risk is extremely dangerous. If you want to run lots of leverage, push the envelope, well, then, you better hope nothing else goes wrong. At 35X, you do not leave any room for error.

It is inexcusable that the investment CEOs did not seem to realize this. It was unconsionable that the firms had been purposefully put into a risk taking position in extremis. That the CEOs blamed short sellers and rumors, but exonerated themselves, only serves to emphasize their own failures, their lack of comprehension of what they had dome to themselves. It was their own incompetent stewardship that purposefully and unknowingly placed these firms at such grave danger of destruction.

Macro modelers take note: no realistic results without accounting for ape psychology.

Here's a nice video feauring the confidence men (financial CEOs) and their recent payouts:




And this (both via Barry Ritholtz):



Related: Central limit theorem and securitization.

DeLong on the $20 trillion dollar mystery

Brad can't understand how a $2 trillion mortgage loss can destroy $20 trillion in value in the world's capital markets. He does a good job of laying out the mystery here:

[First list 5 factors that affect market value of capital stock:]

(1) Savings and Investment
(2) News
(3) Default Discount
(4) Liquidity Discount
(5) Risk Discount

...In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values.

The problem is made bigger by the fact that for (4), the Federal Reserve, the European Central Bank, and the Bank of England have flooded the market with massive amounts of high-quality liquid claims on governments’ treasuries, and so have reduced the liquidity discount — not increased it — by an amount that I estimate to be roughly $3 trillion. Thus (3) and (4) together can only account for a $3 trillion decrease in market value. The rest of that decline in the value of global capital — all $17 trillion of it — thus comes by arithmetic from (5): a rise in the risk discount. There has been a massive crash in the risk tolerance of the globe’s investors.

Thus we have an impulse — a $2 trillion increase in the default discount from the problems in the mortgage market — but the thing deserving attention is the extraordinary financial accelerator that amplified $2 trillion in actual on-the-ground losses in terms of mortgage payments that will not be made into an extra $17 trillion of lost value because global investors now want to hold less risky portfolios than they wanted two years ago.

From my standpoint, the puzzle is multiplied by the fact that we economists have what we regard as pretty good theories about (4) and (5), and yet those theories do not seem to work at all....

...Things are even worse as far as the risk discount is concerned. Our models predict that in normal times, with the ability to diversify portfolios that exists today, the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times — and more like 10% per year today. And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level but that has led to ten times the total losses in financial wealth of the impulse.

Short answer for physicists: phase transition in investor sentiment. People woke up one day and realized that the black box utility called "finance" (on which society relies so heavily) may not actually work properly. So they lost confidence, which is hard to regain. The importance of confidence is clear once we admit that most of the workings of financial markets are indeed a black box -- few people understand what is really going on. The same is true for individual companies -- we assume management knows what it is doing, until we realize otherwise. We might have a similar sudden shift in societal risk attitudes if, for instance, it were suddenly revealed (e.g., by the explosion of a submarine taking San Diego with it) that nuclear reactor and weapon designs were faulty and that random megaton explosions should be expected every decade or so.***

(Oh, and there's also the matter of CDS markets, a big amplifier of uncertainty and systemic risk which Brad doesn't mention at all.)

Some of this is explained in my talk. See also this paper for references to agent-based simulations which exhibit phase transitions in sentiment (bubbles and crashes). The intellectual toolkit of neoclassicals like Brad tends to focus on equilibrium ideas, which are unable to explain such phenomena. More discussion here on Arnold King's blog. I also recommend Bill Janeway.

Final technical point: it is very wrong to back out the implied total market capitalization from trades executed by a minority of distressed agents. A market cap extracted this way will inevitably exhibit wild fluctuations. Confidence in this quantity relies on particularly unwarranted efficient market assumptions: that markets (even in periods of dislocation) are the best forecasters of real economic value (discounted future cash flows).

*** You might try to accommodate events into a story of weakly efficient markets -- we received a shock or infusion of information (news) that caused a sudden revaluation. But the story doesn't work so when well the actual news is "financial markets are highly unreliable" or "nobody really understands this system as it is too complex" -- if that's the news, how efficient are / were markets? :-/

Be kind to your creditors

The Atlantic has a long interview with Gao Xiqing, president of the China Investment Corporation, which manages about $200 billion of the country’s foreign assets. CIC makes most of the high-visibility investments, like buying stakes in Blackstone and Morgan Stanley. Gao was a professor in China, then earned a law degree at Duke and practiced here before returning to China.

...His office, in one of the more tasteful new glass-walled high-rises in Beijing, itself seems less Chinese than internationally “fusion”-minded in its aesthetic and furnishings. Bonsai trees in large pots, elegant Japanese-looking arrangements of individual smooth stones on display shelves, Chinese and Western financial textbooks behind the desk, with a photo of Martin Luther King Jr. perched among the books. Two very large, very thin desktop monitors read out financial data from around the world. As we spoke, Western classical music played softly from a good sound system.

Gao dressed and acted like a Silicon Valley moneyman rather than one from Wall Street—open-necked tattersall shirt, muted plaid jacket, dark slacks, scuffed walking shoes. Rimless glasses. His father was a Red Army officer who was on the Long March with Mao. As a teenager during the Cultural Revolution, Gao worked on a railroad-building gang and in an ammunition factory. He is 55, fit-looking, with crew-cut hair and a jokey demeanor rather than an air of sternness. ...

About the financial crisis of 2008: We are not quite at the bottom yet. Because we don’t really know what’s going to happen next. Everyone is saying, “Oh, look, the dollar is getting stronger!” [As it was when we spoke.] I say, that’s really temporary. It’s simply because a lot of people need to cash in, they need U.S. dollars in order to pay back their creditors. But after a short while, the dollar may be going down again. I’d like to bet on that!

The overall financial situation in the U.S. is changing, and that’s what we don’t know about. It’s going to be changed fundamentally in many ways.

Think about the way we’ve been living the past 30 years. Thirty years ago, the leverage of the investment banks was like 4-to-1, 5-to-1. Today, it’s 30-to-1. This is not just a change of numbers. This is a change of fundamental thinking.

People, especially Americans, started believing that they can live on other people’s money. And more and more so. First other people’s money in your own country. And then the savings rate comes down, and you start living on other people’s money from outside. At first it was the Japanese. Now the Chinese and the Middle Easterners.

We—the Chinese, the Middle Easterners, the Japanese—we can see this too. Okay, we’d love to support you guys—if it’s sustainable. But if it’s not, why should we be doing this? After we are gone, you cannot just go to the moon to get more money. So, forget it. Let’s change the way of living. [By which he meant: less debt, lower rewards for financial wizardry, more attention to the “real economy,” etc.]

About Wall Street jobs, wealth, and the cultural distortion of America: I have to say it: you have to do something about pay in the financial system. People in this field have way too much money. And this is not right.

...Individually, everyone needs to be compensated. But collectively, this directs the resources of the country. It distorts the talents of the country. The best and brightest minds go to lawyering, go to M.B.A.s. And that affects our country, too! Many of the brightest youngsters come to me and say, “Okay, I want to go to the U.S. and get into business school, or law school.” I say, “Why? Why not science and engineering?” They say, “Look at some of my primary-school classmates. Their IQ is half of mine, but they’re in finance and now they’re making all this money.” So you have all these clever people going into financial engineering, where they come up with all these complicated products to sell to people.

About the $700 billion U.S. financial-rescue plan enacted in October: Finally, after months and months of struggling with your own ideology, with your own pride, your self-right-eousness … finally [the U.S. applied] one of the great gifts of Americans, which is that you’re pragmatic. Now our people are joking that we look at the U.S. and see “socialism with American characteristics.” [The Chinese term for its mainly capitalist market-opening of the last 30 years is “socialism with Chinese characteristics.”]


On what might make the Chinese government start taking its dollars out of America: (I began the question by saying that China would hurt itself by pulling out dollar assets—at which he interjected, “in the short term”—and then asked about the long-term view).

Today when we look at all the markets, the U.S. still is probably the most viable, the most predictable. I was trained as a lawyer, and predictability is always very important for me.

We have a PR department, which collects all the comments about us, from Chinese newspapers and the Web. Every night, I try to pick a time when I’m in a relatively good mood to read it, because most of the comments are very critical of us. Recently we increased our holdings in Blackstone a little bit. Now we’re increasing a little bit our holdings in Morgan Stanley, so as not to be diluted by the Japanese. People here hate it. They come out and say, “Why the hell are you trying to save those people? You are the representative of the poor people eating porridge, and you’re saving people eating shark fins!” It’s always that sort of thing.


...I have great admiration of American people. Creative, hard-working, trusting, and freedom-loving. But you have to have someone to tell you the truth. And then, start realizing it. And if you do it, just like what you did in the Second World War, then you’ll be great again!

If that happens, then of course—American power would still be there for at least as long as I am living. But many people are betting on the other side.

The value of trust

In no-arb efficient market fairy tale land, investors are assumed to be able to value a company by simply looking at its balance sheet, researching its market and business model and projecting into the future. Sound difficult? Why, yes, it's almost impossible to do, and even after a lengthy research project executed by a team of brilliant analysts there is a huge remaining uncertainty.

So what happens in the real world? Well, we apes with limited cognitive power and limited information rely on simple heuristics -- rules of thumb -- to guess what will happen in the future. That is, we say "Robert Rubin seems like a smart, careful guy, and top management at Citi must know what they are doing, and surely the market knows what it's doing, so, yeah, $40 a share seems ok with me..."

Of course, after a while we might notice some data suggesting that the leadership at Citi has been dishonest ("we are adequately capitalized" -- CEO Vikram Pandit) and ignorant of their own business operations ("what's a SIV?" -- Chairman Robert Rubin, November, 2007), and suddenly decide that NO, they DON'T KNOW WHAT THEY ARE DOING.

Yikes!: as reported on this blog, Rubin comments from November 2007.

[SIV = Structured Investment Vehicle = (roughly, see link) CDO]

"I think the problem with this SIV issue is that it's been substantially misunderstood in the press," said Rubin, who has a considerable personal stake in the fate of Citigroup. The banking firm paid him $17.3 million last year.

"The banks appear to be in fine shape," he said. "That's not a problem."

The SIV issue isn't critical for the economy, he insisted.

"It's massively less important that it's been presented," Rubin said. "It's been presented as a sort of centerpiece of what's going on. I just don't think that's right."

The cost of the evaporation of trust? $200 billion dollars in lost market capitalization in the last year. The real reason Citi melted down is that people no longer trust their senior management to meet future obligations. This senior management was left in place in Treasury's latest sweetheart deal.

Tell me an efficient market story that explains Citi's recent history and I'll sell you a slightly devalued "Nobel Prize" in financial economics along with the Brooklyn bridge. (Click below for larger image.)



Thanks to Mark Thoma for links to the articles quoted below.

Bronte Capital:

...due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout. It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts. I can not understand them and I am a pretty sophisticated bank analyst. I know people I think are better than me – and they can’t understand Citigroup either. So Citigroup was always a “trust us” thing and now we do not trust.

The cause of the crisis

This is a wholesale funding crisis and the cause of the crisis is plain. It is lies told by financial institutions. Financial institutions sold AAA rated paper which they almost certainly – deep in their bowels – knew was crap. They sold it to people who provide wholesale funding.

Now they need to roll their own debt. The people who would normally wholesale fund them are the same people who have had a large dose of defaulting AAAs. They no longer believe. It is “fool me once, shame on me, fool me twice, shame on you”. As I have put it the lies that destroyed Bear Stearns were not told by short sellers. They were told by Bear Stearns.

Now the problem is that no matter how many times Pandit says that Citigroup is well capitalised nobody will believe him. In answer to the Brad DeLong question – the company told lies about its mortgage book – which compounded the lies about the dodgy CDO product they sold. The lies about the mortgage book totalled $20 billion on say $43 billion of optimistically valued assets – and those lies reduced the value of Citigroup by $200 billion because they removed the trust in Citigroup.

It is one of those ironic things that when financial institutions lied in 2006 the market seemed to believe them. When they tell the truth now, nobody will listen.

Robert Rubin racks his brain about how he would have done things differently. Well one thing he would have done differently is get Citigroup to remove the culture of obfuscation – the culture that allowed it to be perceived as if it were lying even when it was telling the truth. The problem is that even Robert Rubin doesn’t have enough uncashed integrity to save Citigroup. Even Robert Rubin.

The US government is now selling systemic risk insurance.

Finally, System-Risk Insurance, by Laurence Kotlikoff and Perry Mehrling, FT

As we advocated two months back (Bagehot plus RFC: The Right Financial Fix), Uncle Sam is finally starting to sell systematic risk insurance on high-grade securities in exchange for preferred stock. This is a critical function for the U.S. government; Uncle Sam is the only player capable of hedging systemic risk because he’s the only player capable of taking actions that keep the overall economic system on the right course.

The real question now is whether the U.S. government will begin selling system-risk insurance on a routine basis and, thereby, help refloat trillions of dollars in high-grade mortgage-related securities owned by banks and other financial institutions - institutions that are in desperate need of more capital to support new lending.

Writing one-off insurance deals with a few large players, like Citigroup, is not the same as standing ready to write system-risk insurance to all players that issue conforming high-grade paper - something that’s needed to support ongoing securitization of such obligations. We stress the word “conforming,” because it’s vital for the government to begin stipulating which securities are “safe” under normal conditions and which are “toxic” and, thus, no longer to be held by financial intermediaries.

Like any insurance underwriter, Uncle Sam needs not only to know and approve what he’s insuring; he also needs to make sure there are appropriate deductibles and co-insurance provisions to limit moral hazard on the part of the insured. The moral hazard in this case is that financial institutions try to pass off low-grade loans as high-grade.

The weekend deal with Citigroup is instructive in clarifying the nature of the insurance the government should sell on an ongoing basis. The deal to support $306bn of Citigroup’s mortgage-related securities puts a floor under the value of the best such securities at about 90 cents on the dollar. This deal represents the first use of the insurance capability authorized by Section 102 of the TARP.

[90 cents on the dollar? WTF!?! Incompetent management is left in place while the taxpayer foots the bill. Why not bail out Detroit while we're at it? Note: this is clarified by a commenter -- it's 90% of current market value, not face value.]

The structure of the deal is convoluted, so it takes some probing to see precisely what insurance is being sold and for what price. We are told that Citigroup itself is on the hook for the first loss of $29bn (plus whatever loss reserves are already on its books) on the cash flows due on the $306bn in mortgages. This amounts to roughly a 10 percent deductible.

Any losses beyond $29bn will be shared by the government (90 per cent) and Citigroup (10 per cent). This is the co-insurance (co-pay) element. This insurance runs for the next 10 years, and Citigroup is paying a one-time $7bn premium for it, using preferred stock.

Deflation

Global bond markets are forecasting deflation. The spread between inflation protected and ordinary bonds is negative. (I'm not sure how the graphs below are calculated -- the negative values seem too big.)



Via Paul Kedrosky.

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.

Money men congressional testimony

Five big hedgies testified today before Congress, including Paulson, Griffin, Soros and Simons. Simons gave a very succinct and accurate summary of the causes of the current crisis.

Mr. Simons, the founder of Renaissance Technologies and a former mathematics professor who devises complex computer models to predict market moves, says there is plenty of blame to go around for the current financial crisis.

“In my view, the crisis has many causes: The regulators who took a hands-off position on investment bank leverage and credit default swaps; everyone along the mortgage-backed securities chain who should have blown a whistle rather than passing the problem on; and, in my opinion the most culpable, the rating agencies, which allowed sows’ ears to be sold as silk purses,” Mr. Simons says.

See my talk for related comments.

Before the money men testified, four finance professors had their say. From Andy Lo's (MIT Sloan School) testimony:

...[Government funding for training quants!]

6. All technology-focused industries run the risk of technological innovations temporarily exceeding our ability to use those technologies wisely. In the same way that government grants currently support the majority of Ph.D. programs in science and engineering, new funding should be allocated to major universities to greatly expand degree programs in financial technology.

...[Behavioral finance!]

Economists do not naturally gravitate toward behavioral explanations of economic phenomena, preferring, instead, the framework of rational deliberation by optimizing agents in a free-market context. And the ineluctable logic of neoclassical economics is difficult to challenge. However, recent research in the cognitive neurosciences has provided equally compelling experimental evidence that human decisionmaking consists of a complex blend of logical calculation and emotional response (see, for example, Damaso, 1994, Lo and Repin, 2002, and Lo, Repin, and Steenbarger, 2005). Under normal circumstances, that blend typically leads to decisions that work well in free markets. However, under extreme conditions, the balance between logic and emotion can shift, leading to extreme behavior such as the recent gyrations in stock markets around the world in September and October 2008.

This new perspective implies that preferences may not be stable through time or over circumstances, but are likely to be shaped by a number of factors, both internal and external to the individual, i.e., factors related to the individual's personality, and factors related to specific environmental conditions in which the individual is currently situated. When environmental conditions shift, we should expect behavior to change in response, both through learning and, over time, through changes in preferences via the forces of natural selection. These evolutionary underpinnings are more than simple speculation in the context of financial market participants. The extraordinary degree of competitiveness of global financial markets and the outsize rewards that accrue to the “fittest” traders suggest that Darwinian selection is at work in determining the typical profile of the successful investor. After all, unsuccessful market participants are eventually eliminated from the population after suffering a certain level of losses. For this reason, the hedge-fund industry is the Galapagos Islands of the financial system in that the forces of competition, innovation, natural selection are so clearly discernible in that industry.

This new perspective also yields a broader interpretation of free-market economics (see, for example, Lo, 2004, 2005), and presents a new rationale for regulatory oversight. Left to their own devices, market forces generally yield economically efficient outcomes under normal market conditions, and regulatory intervention is not only unnecessary but often counter-productive. However, under atypical market conditions—prolonged periods of prosperity, or episodes of great uncertainty—market forces cannot be trusted to yield the most desirable outcomes, which motivates the need for regulation. Of course, the traditional motivation for regulation—market failures due to externalities, natural monopolies, and public-goods characteristics—is no less compelling, and the desire to prevent sub-optimal behavior under these conditions provides yet another role for government intervention.

A simple example of this dynamic is the existence of fire codes enacted by federal, state, and local governments requiring all public buildings to have a minimum number of exits, well-lit exit signs, a maximum occupancy, and certain types of sprinklers, smoke detectors, and fire alarms. Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition— after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire.5 In fact, assuming that improbable events are impossible is a universal human trait (see, for example, Plous, 1993, and Slovic, 2000), hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.

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.

Fear and loathing of the plutocracy

Did Paulson and Treasury deliberately overpay for shares in Goldman and eight other banks? What did taxpayers get for their $125 billion, versus what Buffet got for his $5 billion Goldman investment just a few weeks earlier? See Black-Scholes analysis here.

Will banks like Citi pay out bonuses using bailout funds? Citi plans to distribute $26 billion after receiving $25 billion from you and me. Will the public let them get away with it? Given the tremendous value destruction they've caused, on Wall Street and beyond, how can top executives at these companies justify any bonus compensation for themselves?

After leaving the Clinton administration, how did Rahm Emanuel make $16 million in two years (at Wasserstein Perella) with no prior business experience? Did you really think Obama was going to be a radical left president?

Michael Lewis, Bloomberg commentary:

It may still take awhile before Wall Street finally accepts that it won't get paid.

At the moment, as their bony fingers fondle the new taxpayer loot, the firms appear to believe that they might still fool the public into thinking that bonus money isn't taxpayer money.

``We've responded appropriately to the attorney general's request for information about 2008 bonus pools,'' a Citigroup Inc. spokeswoman told Bloomberg News recently, ``and confirmed that we will not use TARP funds for compensation.'' But as the Bloomberg report noted, ``she declined to elaborate.''

As well she might! For if the Citigroup spokeswoman had elaborated she would have needed to say something like this: ``We're still trying to figure out how the $25 billion we've already taken of taxpayers' money has nothing to do with the $26 billion we're planning to hand out to our highly paid employees in 2008 (up 4 percent from 2007!). But it's a tricky problem because, when you think about it, it's all the same money.''

...If you are one of those people currently sitting inside a big Wall Street firm praying for some kind of bonus it may already have dawned on you that you need to rethink your approach. It's no longer any use to hint darkly that they had better fork over serious sticks or you'll bolt for Morgan Stanley. There's no point even in thinking up clever ways to make profits for your firm: who cares how much money you bring into Goldman Sachs if the U.S. Congress doesn't allow Goldman Sachs to pay bonuses?

The moment your firm accepted taxpayer money, you lost control of your money machine. ...

More from Michael Lewis at Portfolio Magazine (via Paul Kedrosky).


Figure from earlier post: Is the finance boom over?

AIG watch

Treasury is setting up a special vehicle to buy up (face value) $70 billion in "troubled" CDOs insured by AIG CDS. At 50 cents on the dollar they intend to spend $30 billion in taxpayer dollars and $5 billion of AIG's money. This should reduce the collateral calls on AIG, although it's not clear that all the entities holding AIG CDS actually own the referenced CDO. Who at Treasury did the calculation to confirm that the ultimate value of the CDOs in question is over 50 percent of face value? If I'm holding the CDO and corresponding CDS contract, and I'm confident that the government is behind AIG, why should I sell at a 50 percent loss?

Kashkari remarks on TARP.

WSJ: ...The government's initial intervention was driven by concern that AIG's failure to meet it obligations in the credit default swap market would create a global financial meltdown. ...

Under the revised deal, AIG is expected to transfer the troubled holdings into two separate entities.

The first such vehicle is to be capitalized with $30 billion from the government and $5 billion from AIG. That money will be used to acquire the underlying securities with a face value of $70 billion that AIG agreed to insure with the credit default swaps. These securities, known as collateralized debt obligations, are thinly traded investments that include pools of loans. The vehicle will seek to acquire the securities from their trading partners on the CDS contracts for about 50 cents on the dollar.

The securities in question don't account for all of AIG's credit default swap exposure but are connected to the most troubled assets. The government may be betting that its involvement will encourage AIG's trading partners to sell the securities tied to the CDS contracts to the new entity.

Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted to back the contracts. The total collateral at stake is about $30 billion.

It may also have some unintended consequences across the markets. For the plan to work, AIG's trading partners -- the banks and financial institutions that are on the other side of its credit-default-swap contracts -- may have to agree to any changes in the terms of their agreements with AIG.

Gary Gorton on YSM panel

Via Arnold Kling, this Yale School of Management panel (video) on the financial crisis. In the audience are YSM students and other professors.

The opening comments by Gary Gorton are good, and the last 10 minutes are excellent as well -- it ends with a debate over mark to market accounting. Note Gorton's comments at 59:55 -- 9 minutes from the end :-)

AIG killed by CDS collateral calls

As I suspected, AIG's CDS collateral obligations have eaten up the government's initial $85 billion loan commitment, which was recently boosted to $123 billion. AIG's CEO reported that they had sold over $400 billion in CDS contracts.

The WSJ piece below profiles Yale finance professor Gary Gorton, who helped Cassano's group (AIG Financial Products) build their risk models. They note that there is still a chance that the models are ok -- that in the long run losses on the securities they insured may not be large. The problem is that the CDS contracts require the insurer to post additional collateral if the market value of the security in question falls. Since all credit related products are oversold due to rampant fear, this forces collateral calls even on good securities (if there are any). I can imagine that triggers might depend on the value of various CDS indices, which have plummeted during the crisis.

If -- and it's a big if -- AIG's actual CDS payouts are limited, the government and taxpayers stand to make a lot of money over the next 3-5 years. When markets return to normal the profitable ordinary insurance parts of AIG can be liquidated to pay off the bridge loan. In that scenario the big losers are AIG shareholders -- the government, as the lender of last resort, will have bought a distressed AIG for a song. In the bad scenario we will enter a long, harsh recession and AIG will end up paying out on much of its $400 billion in obligations, perhaps exceeding even the long term liquidation value of the firm. In that case the US taxpayer will foot the bill.

WSJ: ...AIG itself has been forced to post about $50 billion in collateral to its trading partners, largely to offset sharp drops in the value of securities it insured with the credit-default swaps. These payments have continued to balloon after the bailout -- raising the specter that the government will eventually have to lend more taxpayer money to AIG.

...AIG's credit-default-swaps operation was run out of its AIG Financial Products Corp. unit, which had offices in London and Wilton, Conn. In essence, AIG sold insurance on billions of dollars of debt securities backed by everything from corporate loans to subprime mortgages to auto loans to credit-card receivables. It promised buyers of the swaps that if the debt securities defaulted, AIG would make good on them.

...The swaps expose AIG to three types of financial pain. If the debt securities default, AIG has to pay up. But there are two other financial risks as well. The buyers of the swaps -- AIG's "counterparties" or trading partners on the deals -- typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG's own corporate-debt rating is cut. In addition, AIG is obliged to account for the contracts on its own books based on their market values. If those values fall, AIG has to take write-downs.

...Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances.

The problem for AIG is that it didn't apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate. The firm left itself exposed to potentially large collateral calls because it had agreed to insure so much debt without protecting itself adequately through hedging.

...Early on, Mr. Gorton billed AIG about $250 an hour, which likely would have netted him about $200,000 a year, says a former senior executive at the unit. Eventually, his pay was far greater; another former colleague estimates it at $1 million a year.

Mr. Gorton collected vast amounts of data and built models to forecast losses on pools of assets such as home loans and corporate bonds. Speaking to investors last December, Mr. Cassano credited Mr. Gorton with "developing the intuition" that he and another top executive had "relied on in a great deal of the modeling that we've done and the business that we've created."

...As the debt securities created by Wall Street became more complicated, so did the swaps AIG offered. Around 2004, it began selling swaps designed to provide insurance on securities called collateralized-debt obligations, or CDOs, that were backed by securities such as mortgage bonds. Merrill Lynch & Co., then a major seller of the CDOs, was a big client.

So-called multisector CDOs, in particular, were exceptionally complex, involving more than 100 securities, each backed by multiple mortgages, auto loans or credit-card receivables. Their performance depended on tens of thousands of disparate loans whose value was hard to determine and performance difficult to systematically predict. In assessing their risk, Mr. Gorton constructed worst-case scenarios that factored in the probability of defaults on the underlying securities.

In late 2005, senior executives at the unit grew worried about loosening lending standards in the subprime-mortgage market. AIG decided to stop selling credit protection on multisector CDOs, partly due to "concerns that the model was not going to be able to handle declining underwriting standards," Mr. Gorton told investors last December. But by the time it stopped, in early 2006, its exposure to multisector CDOs had ballooned to $80 billion.

My talk on the financial crisis

I was asked by the graduate students in our department to give a talk on the financial crisis. The talk is oriented towards physicists and other scientists, but everyone is welcome. Slides (pdf).

Institute of Theoretical Science, 4 pm Tuesday November 4.

Speaker: Steve Hsu
Title: The Financial Crisis

Abstract: After a brief review of basic financial topics such as valuation, markets and bubbles, I discuss the origins and consequences of the current financial crisis. The discussion focuses on issues such as leverage, securitization, mortgage finance, CDO (collateralized debt obligations) and CDS (credit default swaps). The talk is aimed at non-experts.

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? :-)

Greenspan now agrees with Soros; Galbraith interview and a calculation

Bill Moyers' Journal is usually pretty boring, but of late he's been quite good. Two weeks ago he interviewed George Soros, who said the following:

GEORGE SOROS: ...this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes.

Yesterday he interviewed (thanks to Mark Thoma for the link) heterodox economist James Galbraith (UT Austin; son of John Kenneth Galbraith). Moyers led into the Galbraith interview by first quoting from Alan Greenspan's recent congressional testimony.

ALAN GREENSPAN: I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.

CHAIRMAN WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working.

ALAN GREENSPAN: Absolutely, precisely. You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.

Now on to the heterodoxy:

BILL MOYERS: With his ideological blinders stripped away by reality, Alan Greenspan might well do penance by curling up this weekend not with THE FOUNTAINHEAD and ATLAS SHRUGGED but with James K. Galbraith's new book THE PREDATOR STATE: HOW CONSERVATIVES ABANDONED THE FREE MARKET AND WHY LIBERALS SHOULD TOO. In it, the author asks: "Why not build a new economic policy based on what is really happening?" ...

BILL MOYERS: What scares you most right now?

JAMES GALBRAITH: Well, a week ago or two weeks ago I would have said the possibility that [McCain economic advisor] Phil Gramm might become Secretary of the Treasury. ...Gramm himself was the architect, a deep architect of the speculative markets that have just collapsed. ...

BILL MOYERS: You call your book THE PREDATOR STATE, what do you mean predator?

JAMES GALBRAITH: What I mean is the people who took over the government were not interested in reducing the government and having a small government, the conservative principle. They were interested in using these great institutions for private benefit, to place them in the control of their friends and to put them to the use of their clients. They wanted to privatize Social Security. They created a Medicare drug benefit in such a way as to create the maximum profit for pharmaceutical companies.

They used trade agreements to extend patent protections for various interests or to promote the expansion of the corporate agriculture's markets in the third world. A whole range of things that were basically political and clientelistic. That's the predator state.

BILL MOYERS: You call it a corporate republic.

JAMES GALBRAITH: It is a corporate republic.

BILL MOYERS: Which means that the purpose of government is to divert funds from the public sector to the private sector?

JAMES GALBRAITH: I think it's very clear. They also turned over the regulatory apparatus to the regulated industries. They turned over the henhouse to the foxes in every single case. And that is the source of the decline in, the abandonment of environmental responsibility, the source of the collapse of consumer protection, and the source of the collapse of the financial system, all trace back to a common root, which is the failure to maintain a public sector that works in the public interest, that provides discipline and standards, a framework within which the private sector can operate and compete. That's been abandoned.

BILL MOYERS: We saw what Alan Greenspan said yesterday. But did you see what the chairman of the Securities and Exchange Commission, Christopher Cox, said? I mean, it was one of the great recantings in modern American history. Quote, "The last six months have made it abundantly clear that voluntary regulation does not work."

Now to my heterodox heterodoxy: always estimate costs and benefits when making a decision. A little calculation is in order: suppose unfettered markets lead to systemic crises every 20 years that cost 15% of GDP to clean up. I think that's an upper bound: a $2 trillion (current dollars) crisis every 20 years.

Easy Question: What growth rate advantage (additional GDP growth rate per annum) would savage, unfettered markets need to generate to justify these occasional disasters?

Answer: an additional 0.1 percent annual GDP growth would be more than enough. That is, an unregulated economy whose growth rate was 0.1 percent higher would, even after paying for each 20 year crisis, be richer than the heavily regulated comparator which avoided the crises but had a lower growth rate.

Hard Question: would additional regulation decrease economic growth rates by that amount or more?

Unless you think you can evaluate the relative GDP growth effects of two different policy regimes with accuracy of better than 0.1 percent, then the intellectually honest answer to the policy question is: I don't know. No shouting, no shaking your fist, no lecturing other people, no writing op eds, just I don't know. Correct the things that are obviously stupid, but don't overstate your confidence level about additional policy changes.

(Note I'm aware that distributional issues are also important. In the most recent era gains went mostly to a small number of top earners whereas the cost of the bailout will be spread over the whole tax base.)

CDO, CDO-squared and CDS in pictures

If you already know what a CDO is, this is too elementary, but it might be helpful for explaining to your friends...


Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.


Here's one for CDS (thanks to MFA for the pointer):


Untangling credit default swaps from Marketplace on Vimeo.

Complexity in the ruins of Lehman

Lehman was too connected to be allowed to fail. Now a bankruptcy court is trying to sort through 1.5 million derivatives trades with 8000 counterparties...

WSJ: Lehman Brothers Holdings Inc.'s legal and financial advisers said Thursday they plan to hire about 200 professionals to help settle the more than 1 million derivatives trades the investment bank entered into before it collapsed last month.

Lehman attorney Harvey Miller said at a court hearing that advisers are working around the clock to understand Lehman's transactions in the wake of the "chaos" that resulted from its Sept. 15 bankruptcy filing, the largest ever in U.S. history.

Much of their work will focus on wading through about 1.5 million derivatives trades involving 8,000 counterparties. Lehman's chief restructuring officer Bryan Marsal of turnaround firm Alvarez & Marsal said about 210 financial professionals will be hired to unwind those trades.

Mr. Miller credited Mr. Marsal for his work so far, saying he has "brought order to this chaos." Alvarez & Marsal has 144 employees working on the Lehman matter along with 165 Lehman employees still working at the bank.

...Mr. Miller told Judge Peck he expects it will take 45 to 60 days before Lehman can answer numerous inquiries from creditors.

Soros speaks the truth

The bottom line from George Soros, from this interview with Bill Moyers (via Barry Ritholtz). Read the whole transcript, or watch the interview -- there's much more about the credit crisis, modern finance, etc.

GEORGE SOROS: ...this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes.

It would be much easier for Soros to wax eloquent about how greed is good, greed works, markets are efficient optimizers, etc. He is, after all, a huge winner in the capitalist system. But he's seen too much to buy everything that Ayn Rand and market fundamentalists are selling.

Longer NYBooks article on Soros by John Cassidy, who covers business and finance for the New Yorker.

In 2007, after the subprime crisis erupted, he returned, at the age of seventy-seven, to directing Quantum's investments, with results suggesting he hadn't lost his touch. Alpha magazine, a glossy publication that covers hedge funds, estimates that he made $2.9 billion in 2007, placing him second on its list of mega-speculators, behind only John Paulson, of Paulson & Co., who raked in an even more astonishing $3.7 billion.

Earlier post on investor John Paulson, who made $15B for his fund betting against the credit bubble.