The Center Way

August 7, 2010

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:)

July 26, 2010

Don’t Eat the Marshmallow!

Filed under: Uncategorized — Jesse @ 11:59 pm

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.

July 22, 2010

Race Matters in NC

Filed under: Politics — Tags: , , , , — Travis @ 2:37 pm

Link: Study of Death Penalty in North Carolina Shows That ‘Race Matters’

If you are convicted of killing a white person in North Carolina, you are 3 times more likely to be sentenced to death than if you are convicted of killing a black person, according to a recent study.

The authors also looked for any additional factors — such as multiple victims or homicides accompanied by an additional felony, such as rape or robbery — that might explain the disparity in death penalty sentencing. These additional factors partially explained death penalty decisions, but even after statistically controlling for their effect, race remained an important predictor of who was sentenced to death.
An examination of these factors “show that the reason why the probability of a death sentence is higher for those who are suspected of killing whites than for those who are suspected of killing blacks is not because the former cases tend to be more aggravated,” the authors wrote. “Regardless of whether there are zero, one or two additional legally relevant factors present, cases with white victims are more likely to result in a death sentence than are cases with black victims.”
Specifically, the study found that the odds of receiving a death sentence in North Carolina “in a white victim case are on average 2.96 times higher than are the odds of a death sentence in a black victim case.” The finding is statistically significant and the probability of obtaining a similar result if racial bias were not an option is less than 5 percent, according to the authors.

July 20, 2010

Quote of the Day

Filed under: Politics — Tags: , , , , — Travis @ 11:18 am

I hate that we’re speculating about the 2012 presidential race already, but I loved this quote from Andrew Sullivan:

I think almost anyone can defeat Romney, a hologram of a politician defined only by ambition and great hair. Palin would destroy him.

That about sums up my opinion of Mitt Romney. He looks like the guy who would be playing the president in a made-for-TV movie about an asteroid strike.

July 19, 2010

The 5th Amendment

Filed under: Politics — Tags: , , , , — Travis @ 4:55 pm

A Regent law professor explains why you should never talk to the police:

July 9, 2010

Businesses are People, too

Filed under: economics, Politics — Tags: , , — Jesse @ 6:29 pm

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. 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.

July 7, 2010

Debunking immigration myths

Filed under: economics, Politics — Tags: , , , , — Travis @ 8:10 am

Jeb Bush and Robert Putnam convincingly debunk the idea that Hispanic immigrants are somehow more of a threat to American identity than previous waves of immigration. Cleverly, they quote a famous American leader on the immigration problem:

Few of their children in the country learn English. The signs in our streets have inscriptions in both languages. . . . Unless the stream of their importation could be turned . . . they will soon so outnumber us that we will not preserve our language, and even our government will become precarious.

No, that wasn’t Lou Dobbs or some Tea Partier. It was Benjamin Franklin, in 1753, talking about German immigrants.

After laying out the case that all immigrant waves follow similar patterns (isolated enclaves at first, but then bilingual 2nd generation children and then eventually intermarriage and full assimilation, while retaining important cultural heritages), Bush and Putnam make three suggestions:

  • Low-cost English classes for immigrants
  • Invest in public education, to foster a shared national identity
  • Assist communities experiencing rapid immigration, especially schools and hospitals, which bear the brunt of the costs while everyone shares in the economic benefits

The English classes, especially, seem like a no-brainer. If you are willing to hold up a sign that angrily says “Learn English!”, you should be willing to put up a sign that says “Learn English here”.

July 6, 2010

The Chamomile Tea Party

Filed under: Uncategorized — Travis @ 11:24 am

I’m enjoying these WWII propaganda-style posters from the Chamomile Tea Party.

June 25, 2010

Urban/rural political differences

Karl Smith:

Urbanites clearly see government in more favorable lights than suburban and rural dwellers for the simple reason that proximity breeds externality. Spillovers of all sorts, positive and negative are more likely in the city and demands for a government capable of handling negative spillovers will increase.

An externality, as Jesse would doubtlessly be better able to explain, is a result (cost or benefit) that happens to folks who didn’t agree to what caused the result. So, a factory next to a river dumps polluted water into the river. They benefit from this (free waste-removal!) but the people down the river who suffer the consequences (our fish are dead! we can’t go swimming!) don’t get any benefit. This is among the major reasons a free market needs some amount of government regulation to function.

This is partly the idea behind some kind of carbon tax. It’s not just “oil is bad, we need to stop it with a tax”. It’s the idea that the price of oil does not reflect its true cost in terms of environmental damage, healthcare costs, etc. Not to mention its potential for black swan events like the BP oil spill.

Anyway, it makes sense to think that more rural dwellers, who are spaced further apart and do not as frequently face the kind of situations that call for government intervention, would tend to a more libertarian economic/government perspective.

But I do think cultural values play a large role here. I recently saw this blog post with a blurb from some research which found that

the more educated on average believe themselves to be more left wing than their actual beliefs on a substantive issue might suggest.

Well, that makes sense too. If your peer group is all of one political persuasion, not only will there be subtle but intense social pressure for you to follow suit, but you may not have met enough people on the Other Side to realize they are just as kind, reasonable, and thoughtful as the people in your own tribe. And you probably won’t have noticed that your actual policy differences are not generally the unbridgeable apocalyptic divides of political rhetoric.

So which is it: Are political differences the result of differing life experiences based on location, or some lizard-brain us vs. them mechanism based on peer group echo chambers? Or neither, or both?

June 23, 2010

How divorce spreads

Filed under: Politics — Tags: , , , — Travis @ 10:48 am

Andrew Sullivan linked to this interesting study on how divorce spreads. The main point?

Overall, the results suggest that attending to the health of one’s friends’ marriages serves to support and enhance the durability of one’s own relationship, and that, from a policy perspective, divorce should be understood as a collective phenomenon that extends far beyond those directly affected.

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