Monday, September 01, 2008

Nobelists on Mortgage Crisis

A Nobel prize is usually awarded for some rather impressive, very particular modeling. Though they also have lots of publications, their prizes are generally for something insanely parochial. Stiglitz, Scholes, McFadden, all made such contributions. Their knowledge of the mortgage crisis is therefore predictably unenlightening in Lindau.

Scholes doesn't really say much in specific, though he highlights that risk is primarily the extreme events, not the average variability, especially in periods where everyone is trying to get out of a trade at the same time. In other words, he still has nightmares about LTCM foundering on an extreme event, where everyone knew LTCM's huge positions, and basically would not let them out at a price they could afford. Scholes did emphasize the costs of regulation, but did not have many specifics in regard to mortgages.

Stiglitz just mentions more regulation is needed, noting that as the decline in income relative to trend, if you assume a unit root process for GDP, is about $1.5 trillion. Clearly, that implies a couple hundred billion on regulation is no big deal. But this presumes the money would be spent wisely. What were the regulators of the mortgage market focused on in 2006, prior to this crisis being created? They were not focused on underwriting standards. Indeed, the government was going out of its way to weaken underwriting standards under the objective of increasing home ownership, mainly for minorities. Only with hindsight would one think regulators would have nipped this in the bud. Otherwise, they would have been like Taleb, focusing on interest rate risk, or something else that could have gone wrong, but did not.

Stiglitz betrays his bias by making the inconsistent point that all these poor people now lost their homes. But the problem was, they could not afford these homes. These are no-recourse loans, so they walk away, and the lenders have the loss. If one thinks lending was overdone, then these borrowers lost houses they should not have had anyway, and should not keep them. But Stiglitz is an economic redistributionist, in that he has a tendency to confabulate any rationale that effectively transfers wealth directly to the poor, or away from the rich.

And then there's McFadden, who notes the precautionary principle, and asks that regulators adopt the approach of our drug regulators, to first prove an innovation does no harm. Of course, this is the regulation that would make aspirin a perscription drug if it were discovered today, and contains myriad warnings on every drug that serve only to cover their behinds, because it buries any important information in the page of 8-pt font outlining the things subjects reported (nausea, light headedness). That these guys have zero upside, and only downside, does not make for a social optimum.

The productivity trend that Stiglitz takes for granted is predicated on lots of little innovation happening all the time. Innovation would be greatly diminished if it had to pass the precautionary principle. Better to accept these risks, rather than to get rid of these risks at the cost of zero growth.

I think their were many forces underlying this crisis, but the key mistake was the change in underwriting criteria (no money down, no income verification, reverse amortization loans). The rating agencies, I think, were the weak link, because if something is rated AAA, I really can't blame risk management for not appreciating the probability this paper would, in aggregate, lose 50% of its value, because it is unprecendented. Once you start asking risk managers to apply unprecedented scenarios, then everything stops, because there are an infinite number of unprecedented adverse scenarios. The fall guy, therefore, should be agencies that did not adjust their models in light of these changes.


Anonymous said...

bullshit. millions knew this would end badly. you don't need to zero in on the 50% or so default. heck, even cioffi et al knew. maybe you can't fault risk managers b/c they are lemmings who used agencies for a little CYA to keep their cushy jobs, that's why. unfortunately the spewing of 'yeah buddy in hindsight it was clear' doesn't stop. it's not hindsight and some ppl positioned themselves to profit from this. they're the silent ones.

Unknown said...

There is no Nobel prize for economics. It is actually the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel as the Nobel family (rightly) identified that economics is not a science.

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