The Financial Crisis – What Happened?

I’m assuming that most the readers of this blog are not (like me) reading virtually every opinion and analysis of what happened in financial markets over the past few years. So, I’m going to try to give a somewhat brief version of what I think happened, pulling together what I’ve read so far. I’m not going to list a lot of references – if you’re interested in some, ask me.

I. Long Term Trends

1. The Unequivocal Goodness of Housing in the United States. The “American Dream” since the Depression (and the formation of Fannie Mae and Freddie Mac) has been to own a house, and home ownership has steadily risen until it is now about 65% of the population. I’m not going to debate the merits of this cultural phenomenon, just stating it. The population and politicians alike think that the more people own houses, the better. So there are many, many programs to help those with marginal credit get homes (as most of those with good credit already own or live in NYC). Even now, it continues.

2. The demand for riskless assets. Let me explain this one, because it is important. Governments want a bank account just like you and I. When you get your paycheck, you want to put it somewhere safe until you need the money, so you get an FDIC insured checking account. These don’t exist for governments. Remember, currency now is basically backed by “the full faith and credit of the XXX Government” which is to day, when you give someone $1, you are basically giving them a check that says the US government backs the value of this note. So what does the government do?

Well, the US government is unique, we won’t get into that. Everyone else wants dollars. Or rather, Treasury Bills, which are basically IOUs written by the government — but this isn’t all that different from a dollar bill, right? They are written in dollars and repaid in dollars. A typical Treasury Bill will pay $100 in some set amount of time (3, 6, 9 months, 1, 5, 10 30 yrs) at some interest rate (3% or something). Foreign governments see these as their checking account. When they have some extra cash or want a “savings” account, they buy treasury bills.

Note for later: US Treasuries are AAA rated assets.

II. Medium Term Trends

3. The Asian Crisis in 1997. In 1997, most of the southeast Asian economies (Malaysia, Thailand, Phillipines, etc.) had currency and debt crises. The IMF was called in and administered some stiff medicine: large cuts in subsides and programs, currency stabilization, etc. But mostly, what these governments learned was that they never, ever wanted this to happen again. So, when their economies picked up again after 2000, they did what anyone would do who just went through a crisis like that: they started saving a bunch of money. China, nearby, wasn’t involved in the crisis, but saw the effects. China, already saving money, saved even more.

4. The Dotcom Bust, Y2K, and September 11th. These three events seemed like they were going to topple the US Economy into a recession, so the Federal Reserve responded by keeping interest rates very low for very long. I won’t go into exactly what this means, but basically they were making it so that money could be borrowed cheaply; this is way to ‘stimulate’ the economy. When you can borrow for less, you’re more likely to spend more.

5. Government Regulations which favor AAA assets. This was known as the Basel Accords, which mandated that banks hold a certain amount of “safe” capital for every dollar (or euro) of “risky” capital, weighted by how risky it was. Makes sense. Riskier capital requires more safe assets. Safe assets were defined as AAA rated by ratings agencies.

Note, banks don’t really like AAA assets because they don’t make much money on them. Remember the “cheap credit” that the Federal Reserve enabled after 9/11? The lenders make virtually nothing on it. So what banks want is the highest interest they can possibly get on AAA rated assets if they have to hold them.

======= Now, how do these trends come together? ======

Result 1: The United States gets cheap, cheap credit. Everyone: businesses, banks, consumers. Cheap credit almost always finds its way into housing, so housing starts to become more in demand and prices rise. Housing looks like a pretty good investment.

Result 2: AAA assets get expensive, yet they pay virtually nothing. Why? All of the Asian governments want the really safe AAA assets, eventually growing economies like Brazil, India, and Eastern Europe join them. Most of these government just want a safe place for their money. But all of the major multinational banks need AAA assets also. But the US only needs to issue so much debt. Even if you can borrow for cheap, eventually you run out of things to buy, right? So these AAA assets with very low interest rates which banks don’t want to hold anyway get more and more expensive to buy. But they have to buy them because their governments require them to do so. Banks don’t like this.

III. Necessity is the Mother of Innovation.

Result 1 meets Result 2. Banks come up with a way to convert risky home mortgages (and other risky loans) into (mostly) AAA assets via all these fancy acronym-named products you’ve heard of. Here are the “good” things that happen as a result:

A. Foreign banks get their ‘savings accounts’ at a lower cost. Banks didn’t want AAA US Treasuries anyway, so they don’t buy them any more, which reduces demand for them, which reduces the cost to those who do actually want them.

B. Banks buy these securitized AAA assets which allow them to comply with their regulations, but make more money.

C. More and more “marginalized” home buyers are able to buy houses. This is great, right? I’ll post some other time on subprime loans and why nobody should ever, ever get one. If we want more people to own homes, we need to help them get better jobs and better credit, not allow them to “buy” a home with awful credit.

IV. Supply and Demand still work.

As banks securitize and buy these AAA groups of home mortgages, more and more people become “eligible” to buy houses, so housing demand rises and rises, more and more homes are built. When prices go up, everyone looks like a genius. We now know how this ends. These new AAA packages of mortgages were not so “riskless” after all. In fact, nobody ended up being able to understand exactly what they did when home prices didn’t rise all the time.

V. Some Thoughts on Other Culprits

Credit Ratings Agencies: These are the guys that decided that a bunch of mortgages put together in a pot and stirred could be AAA. Those that say “the government did it” will note that the Ratings Agencies are Outsourced Government Regulation because they decide what is AAA and what is not and most government regulation is tied to holding AAA rated securities. I don’t think you can say they caused the crisis per se, but they could have stopped it. But, as is usually true, all of the A students worked at the banks, the C students worked at the ratings agencies and really wanted to work at the banks. So they thought the bankers were really, really smart. Sure, they’re AAA. Who am I to question it?

Secondly, in the name of “transparency” the ratings agencies published their methodology of how they decide on a AAA rating. So the banks knew how to make their products as risky as possible and still get AAA.

Greed. This one I don’t buy. Greed is as old as humanity, so I’m not sure how there was some new influx of greed which caused a crisis. Yes, there was greed. But that’s like saying Ambition and Desire for Power caused WWI and WWII. Sure they did. But we need a bit more, there.

Bad Incentives for Bank Traders. Yes, this is true. These guys formed these securitized assets which had multi-year payouts and they were compensated when they sold them. So they got massive bonuses in 2002-2006 and then no penalty when it all came down in 2007-2008. But this is just a “commission” style sales model – just like cars, houses, etc.  It certainly didn’t help, but there is no real evidence that it caused the crisis. In fact, recent research has shown that the banks with the strongest incentives to be cautious – i.e. the ones whose CEOs and top executives had the most to lose if things went badly – were Lehman Brothers and Bear Sterns. The executives at JP Morgan, B of A, etc. had much less equity and would have lost a lot less, yet they were more cautious. It seems that corporate culture seems to matter a bit more than contracts. JP Morgan famously refused to securitize mortgages back in the late 90′s because they weren’t comfortable with how to price them (see Gillian Tett’s Fool’s Gold).

There may be more, but that’s all I’ve got for now. Hopefully that has helped a bit piece together what happened in 1500 words

Don’t Eat the Marshmallow!

An excellent article in the New Yorker about delayed gratification and how it correlates with future success. I had heard of this before, but this is a relatively short (6 pages) summary.

The author (and researcher) are quick to remind the reader that the human psyche is complicated and jump to too many conclusions. While there is a strong link between delayed gratification and future success, it isn’t clear whether the ability to delay gratification is innate, learned, or both (likely both).

But, all that to say, this is interesting to me both from the perspective of my own development and career as well as in my life as a new parent.

Businesses are People, too

So, I’m back. We’ll see how often I can keep this up. There may be blog posts at 3am while feeding babies. I’m just sayin’.

To the topic. This is a terrible idea. SiezeBP.org is a website which is advocating the following:

YES, I support the seizure of BP’s assets to provide comprehensive compensation and relief for all affected people and for cleaning up the environment.

Seem like a good idea? Here’s the problem: Businesses need a rule of law in which to operate just like people do. While I will never say that Obama is a socialist, I do wonder sometimes if he and others on the left miss this point. Let’s see if I can elaborate.

Most people (especially on the left) are advocates of citizens rights and the rule of law. They oppose things like the arbitrary search and seizure of personal property by the police, the breaking up of demonstrations unfavorable to powerful people, etc. At it’s core is the right of personal property and freedom of speech. There is probably more here, but those are quite important. People make choices about how to live (and where to live!) based on them. That is why many choose to immigrate to the US, because those freedoms are protected here. They may change incrementally based on court decisions, new laws, but those are usually marginal changes.

The same concept applies to businesses. They operate in a given framework of taxation, private property, contract enforcement and competition. Changing the rules ex-post has massive effects on the US economy. If the Federal Government were to unilaterally seize BP’s assets, it would be catastrophic, akin to Obama having the leader of the Republican party jailed on treason charges. I don’t think I’m overstating this.

This is an extreme example, and honestly, I’m not that worried that any politician is taking this campaign seriously. But other smaller things may be tempting – like changing penalties and then making them retroactive. Even the $20B escrow account that the government has, ahem, “encouraged” BP to create is of dubious legality and still may be struck down by the courts. The fact is, Obama is in a tough position because he can’t just “kick BP’s ass.” BP has legal rights and is subject to the law, but no more. They will pay the fines and penalties based on current law, and laws will probably be enacted which apply to future spills, but not to BP.

We can’t punish them after the fact simply because we don’t like the outcome. To do so would create massive uncertainty in the business community – if a firm can be wantonly fined and/or taken over by the administration doesn’t like what it is doing is what Putin’s Russia is all about, not the United States. This will cause businesses to slow or stop investment and/or close and move abroad to an environment which is more predictable. Job losses follow and the economy falters further. People are understandably upset at what happened, but there are limits to what we can do – and that is a good thing.

Here they are! My two kids!

Welcome Claire Abigail Blocher and William Frederick Blocher, born 6/19/2010. Claire was born 4oz 14oz and Will was 14oz 12oz.

Our Addiction To Oil

It is really quite simple. We don’t need “an ass to kick” or massive cash escrow accounts. Alex Tabarraok nails it in the NYT:

Most important, nowhere did the president mention two hard ideas that the public must accept if we are to move to a cleaner energy future: nuclear power and carbon taxes.

End of story.

Financial Reform, Bank Lobbyists, and Politicians

Original story in the Financial Times. Here is the key bit:

Economic growth in the eurozone, the US and Japan will be cut by three percentage points between now and 2015 if current proposals to force banks to hold more capital and liquid assets go forward unchanged, the world’s leading banking industry group warned on Thursday.

As a result, 9.7m fewer jobs would be created in those areas over the period, according to an impact assessment issued by the Institute of International Finance at a meeting in Vienna.

The group is pushing hard for the Basel Committee on Banking Supervision to rewrite or at least delay implementation of the proposals, known as Basel III, which are slated to be voted on later this year.

Then, Tyler Cowen has an astute observation:

You will recall that the Obama administration had been claiming that Basel III will be responsible for the single most important piece of financial reform, namely tighter general restrictions on financial institution leverage.  Might this slip away?  Do you still hear serious talk of reforming the mortgage agencies?  When the choice is “jobs and homes before the next election” vs. “limiting a small probability of extreme tail risk,” guess which one wins out?

Who will regulate the regulators?

From the Washington Post.

Rep. Jane Harman (D-Calif.), for instance, served as chairman of a subcommittee responsible for overseeing technology-oriented efforts to improve homeland security, intelligence, information sharing and risk assessment in 2008. At the time, she disclosed more than $1 million in holdings in companies involved in intelligence and homeland security contracting, including Lockheed Martin and BAE Systems.

Sen. Frank Lautenberg (D-N.J.), who chaired a subcommittee that oversees water quality, owned a stake valued at more than $1 million in Linn Energy, a company that has been cited by federal authorities for alleged water pollution. It is unclear whether specific issues concerning Linn ever came before the subcommittee.

Sen. Thomas R. Carper (D-Del.), whose subcommittee keeps watch on clean air and nuclear safety, reported up to $65,000 in holdings in Duke Energy, which uses nuclear plants to generate electricity. Duke is 46th on the list of top 100 “corporate air polluters in the United States,” according to researchers at the University of Massachusetts. Duke spokesman Tom Williams said that the company provides power for 11 million people in five states and that some air pollution “kind of goes with what we do.”

The membership of some committees had disproportionately large holdings in companies or industries they oversee, The Post analysis shows.

On the House Agriculture Committee, which holds sway over farm policies and subsidies, members had farming and agribusiness investments worth five times on average the amount held by other colleagues in the House. Many of the committee members’ holdings were in family farms. Nothing prevents those members from also receiving farm subsidies, and in the past, some have.

Likewise, House Energy and Commerce Committee members, who routinely hold hearings about telecommunications and computer issues, had heavier than average investments in companies such as Oracle, Nokia, AT&T and Verizon.

House Homeland Security Committee members also had more communications and electronics holdings as a group than the House as a whole, and House Transportation and Infrastructure Committee members as a group owned almost six times more holdings in transportation firms.

In the Senate, the Banking, Housing and Urban Affairs Committee had on average almost twice the value of holdings in finance, insurance and real estate as that chamber as a whole. The Senate Environment and Public Works Committee members had almost three times the value of agribusiness holdings as their colleagues on other committees.

The thing that is sad about this is that it isn’t shocking. We want good regulators, so they are subject to congressional oversight. But who oversees Congress? I guess the answer is “the voters” but that’s doesn’t seem to be working. Right now, conflicts of interest abound and all we get is pledges that “My investments don’t interfere with my oversight work. I am an ethical person.” Does anyone really believe that? Do you trust congressment more or less than CEOs? Because the rules for CEOs are much, much stricter. Why? Because without them, fewer investors would invest in the company – they’re not suckers.

This is why I will favor markets over government more often than not – and especially in things like Education* and Health Care. There are natural checks on abuses by CEOs: investors stop investing; consumers stop buying their products. It is virtually impossible to unseat a member of congress for questionable ethical behavior, and as long as that is true it will continue and will get worse.

*In a recent podcast with Diane Ravitch, one of the architects of No Child Left Behind, noted that once the bill passed, educational testing companies with close ties to congressmen (both D and R) somehow got massive contracts to do all of the testing. Surprised? Me neither. I’m also now less surprised that NCLB didn’t work. It sounds to me like the primary people it helped were businesses who knew the right people in Congress.

Mineral Riches in Afghanistan – Risk and Reward

From the NYT: US Discovers mineral riches in Afghanistan. For better or worse, things are going to change.

The good news:

The previously unknown deposits — including huge veins of iron, copper, cobalt, gold and critical industrial metals like lithium — are so big and include so many minerals that are essential to modern industry that Afghanistan could eventually be transformed into one of the most important mining centers in the world, the United States officials believe.

This is an amazing thing for an economy whose main export has thus far been illicit drugs. These are impossible to stop because the only alternative is subsistence farming. But, many a mineral rich country has gone bad:

Instead of bringing peace, the newfound mineral wealth could lead the Taliban to battle even more fiercely to regain control of the country.

The corruption that is already rampant in the Karzai government could also be amplified by the new wealth, particularly if a handful of well-connected oligarchs, some with personal ties to the president, gain control of the resources. Just last year, Afghanistan’s minister of mines was accused by American officials of accepting a $30 million bribe to award China the rights to develop its copper mine. The minister has since been replaced.

I have no idea how this is going to play out, but I think, on net, this is good news.

a safer financial system?

Sam Peltzman is an economist who popularized what became known as the Peltzman Effect – that safety regulations (may) induce riskier behavior. The canonical example is in cars. He showed (Journal of Political Economy, 1975, “The Effects of Automobile Safety Regulaton”) that additional safety devices (regulated or voluntary – he focused on regulation) caused drivers to engage in riskier behavior. In specific, he showed that the number of non-fatal car crashed increased as did the number of pedestrian deaths due to car crashes.

Why does this happen? As with anything, there is a cost-benefit trade-off. The benefit to riskier (read: faster, more aggressive) driving is getting to your destination faster – most people view time as a valuable resource. The costs are somewhat obvious -  higher risk of accident. Specifically, there are the costs of personal injury to you, the driver, other passengers, and the cost of replacing your car. Of those, given car insurance, I think it is safe to say that the cost of personal and passenger injury is by far the major cost. With better crumple zones, airbags, and seatbelts, we have lowered the cost of an accident given that an accident happens. The problem is that by inducing riskier behavior, we increase the probability of an accident.

Here is a little math for the geeky probablists among us. Those who are math-phobic may want to skip this – it is intended to help people understand, not confuse. Let P(Injury | Accident) be the probability of Injury given an Accident. Let P(Accident) be the unconditional probability that an accident happens. Let’s ignore the cost of fixing your car or increased insurance payments, and let’s assume that the hospital bills and other personal costs (monetary or not) are constant. The, the probability that you are injured is P(Injury | Accident)*P(Accident). So, if additional safety features reduce P(Injury | Accident) then your cost has gone down. If your Overall Benefit = Benefit of Time Saved – Cost of Accident then you are better off! The problem is, accidents are rare, but you get benefits from time saved every time your drive. A whole bunch of small benefits (2-4 minutes?) of saving time is nice. So what do you do? You drive a bit faster, Overall Benefit stays the same because while you increase Benefit of Time Saved but you simultaneously increase Cost of Accident by increasing P(Accident).

Here is a personal experiment. If you are someone who typically drives with your seatbelt on (I do, I hope you do also), then experiment with driving without it for a while. I know I’ve occasionally skipped it for a quick trip to the store – or at least I started to; after a while, I felt a bit naked without it. As soon as I put it on, I felt more secure. That – that ‘secure’ feeling – is a little glimpse of what causes this problem. You feel more secure than you should. Gordon Tullock, another economist, has tongue-in-cheek proposed an “airbag” which is a 10″ spike that comes out of your steering column in the case of an accident. While nobody is proposing that in reality, it sure would make for safer drivers! By making P(Injury | Accident) = 1 (you face certain death in case of accident) you are fully incentivized to make P(Accident) as low as possible. And everyone is safer. That is because there are Externalities here as well: the pedestrians. They gain nothing from you driving faster, they only bear the cost of more reckless driving. So, we could say that increased automotive safety has increased the risk to pedestrians due to the externality. Safer drivers also mean safer pedestrians.

OK, that was sort of long. Why did I go through all of that? Because it relates to Financial Regulation. Do we want a “safer” financial system? I’m not sure we do. One of the things we found out for sure is that Wall Street bankers took enormous risks because they had at least the perception of safety. While some certainly may have knowingly sold dodgy securities, most of the purchasers (current Justice Department investigations nonwithstanding) were themselves sophisticated investors who should have known better. Everyone felt safe – markets were rising, business was good, no need to read all that fine print – look at how great this CDO has performed over the past 6 months! Investors bought all manner of securities they didn’t really understand because it seemed fine at the time; they also made a bit more money off of a AAA CDO than they did off of a AAA Government Bond. They take the small benefit now (saving a few minutes driving) while increasing the probability that something bad would happen – housing bubble and then collapse. Imagine each Wall Street bank as a bunch of drivers on the highway who, over time, find that they can drive faster and faster and closer and closer with quicker lane changes and fewer signals. There were a few bust ups along the way – Long Term Capital Management in 1998, and then a bit closer to home Bear Sterns collapse in March 2008. But each time, the creditors lost nothing – i.e the drivers got new cars. Until we had the Big One in Sept 2008 – a massive, multi-car pileup with injuries.

Our capitalist system requires that failure is an option. If it is not, all we can do is prepare for more and more risky behavior. If failure is not so bad, then why not take bigger and bigger gambles? Why did bank profits come right back; and at record levels? They got bailed out – and with fewer competitors to split the pie than before. We need a system that allows both success and failure. Right now, once big enough, that doesn’t apply any more; and I’m not sure it is limited to big banks. Passing legislation to make our financial system “safer” to me is the wrong direction. We need a system that is riskier, but at a smaller scale. We need a system with smaller banks, any of which can fail at any time.

However, I’m skeptical that this will happen. The current financial regulation bill about to be passed does nothing really, which is chronicled well at Baseline Scenario by Simon Johnson and James Kwak. I’m a bit afraid that we’re headed toward bigger business and bigger government, which to me simply says we’ll have fewer blowups, but they will be bigger in scale each time. I’d rather have more frequent, but smaller crises.

a bad sign: states outlawing videotaping of on-duty police

In response to a flood of Facebook and YouTube videos that depict police abuse, a new trend in law enforcement is gaining popularity. In at least three states, it is now illegal to record any on-duty police officer.

The full story here. This seems like a terrible idea to me – transparency, transparency, transparency. Am I missing something?

HT: MR.