Note to Self: Don't Play with Ligers

So this guy decides to violate zoo policy and feed the liger face-to-face. Even when danger is this obvious, someone will always push the boundaries.

Bad Data, Bad Theory, No Surprise

So I'm reading a paper (Economic Catastrophe Bonds by Coval, Jurek and Staffard) on how CDOs tranches are mispriced. Big publication in the American Economic Review. One of their key assumptions is that empirically the yield spread over the expected loss increases over a default rate, that is, the total return is higher for junk bonds than for investment grade bonds; risk begets return and all that. But consider that the Merrill Lynch High Yield Index had a 6.75% return from 1987 through Sep 2008, whereas the Merrill Lynch Investment Grade Index had a 6.49% annualized return. That's 26 basis points difference in return, unadjusted for risk, in an index. Add the transaction costs, and the returns to the junk bond index are lower than for investment grade, yet academics seem unaware of this.

The authors cite two papers that note the difference between the AAA and BBB rate, and just assume that it extrapolates to junk bonds (err, no). They also cite a piece by Hull, Predescu and White (2005), who assert the B spread to Treasuries to be an average of 585 basis points. Bloomberg benchmark curves, and data I had at Moody's, would estimate a 405 basis points spread from 1991 to 2005, so I have no idea where they are getting their data. Hull et al mention Merrill, but I'm not sure which index. It's wrong.

Anyway, they have this wonderful model built on bad data, and a theory (the CAPM) that hasn't worked anywhere else, and shocker, it also does not match the data:

We show that losses on the most senior tranches referencing an index of investment grade credit default swaps are largely connected to the worst economic states, suggesting that they should trade at significantly higher yield spreads than single-name bonds with identical credit ratings. Surprisingly, this implication turns out not to be supported by the data.

Surprise? In the context of all that data supporting the Sharpe-Lintner CAPM (snark)?

But still, on an important point--what is the essence of a CDO?--their whirlwind tour of finance seminars never seemed to flag the absence of a risk premium in junk bonds, which makes their paper's premise moot. What are its potentially perverse incentives? They point out that AAA CDOs have more cyclicality than AAA for regular bonds, but the correlation of the AAA security is hardly as important or interesting as its default rate point estimate. They get an irrelevant answer, that people are arbitraging a risk-premium that doesn't exist. It's just wrong on so many levels: the risk premium does not exist in the collateral where it really matters in CDOs (junk), or the tranches; the marginal players in these deals are the equity owners of the deals, not the AAA investors; AAA ABS has higher returns than straight corporate AAA rated debt so the arb there is absent (especially as AAA ABS will take a generation to gain credibility as truly AAA again).

I don't mean to be so critical--it's a clear approach, plausible (though extrapolating 0.7 moneyness is not). Just wrong.

Well, They'll Get It

Slate published the list of their major contributors, and who they are voting for. It's 55-1 for Obama. Sort of like the New York Times poll that found Obama favored among blacks, 89-2.

Private vs. Public Complexity

Much has been made about the complexity of derivatives, especially asset backed securities, as accelerators in this financial crisis. I agree these are complex, as the derivatives involve a sequences of rules, creating a waterfall of cashflows during the life of the securities, and a sequence priority in the case of default. It is difficult to get data on the key variables needed to compute their value, which combined with the standard reporting of financial statements by banks, makes it anyone's guess whether the run on Bear was a mere liquidity event, or they were truly insolvent. In the average prospectus for a mortgage backed securities you have to carefully wade through legalese to the substantive language about how the security will evolve through time.

But as with anything, you have ask, complex compared to what? Consider the complexity of ethanol production in the US. What is the true economic viability of this approach to our energy concern? To do that, you need to know the costs of the inputs and compare them to the costs of the outputs, including the fixed costs involved in creating the capital necessary to produce and use this fuel source. There are a variety of governmental subsidies that make this exercise basically impossible. You have subsidies on corn via farm programs. You have tax breaks for ethanol producers, and those using machines that can use ethanol. You have mandates that impart an implicit subsidies, and an ethanol import tariffs that are an implicit subsidy. And you have tax breaks both for the R&D, and the capital investment into ethanol refineries. These occur at the Federal Government level via corporate tax breaks, breaks on investment in various facilities, Department of Energy and Agriculture grants, and their counterparts at the state level. How much does it cost to create a gallon of ethanol? Some even claim the increased price of corn from ethanol incentives saves money that would be spent via a competing government program, as one source says the government actually saved $3.45 billion on what are called loan deficiency payments as a direct result of these ethanol subsidies. With all the subsidies, tarifs, and tax credits along the chain from farmland and inputs to the final sale at the pump, who knows?


In the private market, eventually the profitability, the market's comparison of costs to benefits, either encourage activity or squelches it. In government complexity prevents any such comparison, so that so many government programs persist indefinitely because such a day of reckoning never comes. The occasional financial crises of capitalism are not a bug, but a feature, because government programs never have crises, just continued missallocation of resources for generations. Be glad the stupid 'home ownership' policy has been stopped by this crisis, because that means it had a finite life. Public school education, Amtrak, all the meddling by our various government agencies just continues, without a crisis, and simply create more bloat and waste.

So to all those bemoaning the fact that we can't value complex derivatives, I would ask: what is the cost--without government--of generating the same amount of energy via nuclear, solar, wind, gas, and ethanol? I keep hearing about how these alternatives to coal and gas are the future, but what is there current viability? Invariably, the proponents ignore the government's action at some point in the process, but it is both ubiquitous and subtle, especially to the capital investment which for wind and solar is most of the cost and most of the pollution created in these alternatives.

New Book on Obama

First among journalists, Steve Sailer has highlighted the important way the push for increasing minority home ownership, strangely, had a major part in the this current financial crisis. He looks at things like IQ, and so is the source for the observation that George Bush is, gasp, probably a higher IQ than Gore and Kerry. Basically, he has accepted his pariah status, and so says things that are true and interesting, things that Jonah Goldberg or Peter Beinart might be thinking, but are too mainstream to be able to even mention in private company, let alone in print. He actually read both of Obama's books in detail, and they reveal a very interesting man. It's free too, here.

The Law of Unintended Consequences

Option model creator Robert Merton's dad was a sociologist of some renown, and articulated the Law of Unintended Consequences, which is a warning against the hubristic belief that humans can fully control the world around them. In light of the current push to create sweeping new financial legislation, they should keep this in mind. For example

Solar Panels: Just yesterday I read about a finding that nitrogen trifluoride one of several gases used during the manufacture thin-film photovoltaic cells and flat screen TVs. Many industries have used the gas in recent years as an alternative to fluorocarbons, and of course building photovoltaic cells is part of solar energy. Unfortunately, the gas is 17,000 times more potent as a global warming agent than a similar mass of carbon dioxide. It survives in the atmosphere about five times longer than carbon dioxide. The net result, in other words, is more greenhouse gas than using standard fluorocarbons.

Pesticides: plants have many natural toxins designed to protect themselves against herbivores. Celery defends itself by producing psoralen, a toxin that can damage DNA and tissue and also causes extreme sensitivity to sunlight in humans. People who handle celery professionally often develop skin issues: if it were man-made, it would be banned. Celery psoralen production is highest when it feels under attack, as bruised stalks of celery can have 100 times the amount of psoralen of untouched stocks. Farmers who use synthetic pesticides, while creating other problems, are protecting plants from attack. Organic farmers don't use pesticides, but this leads to stalks becoming vulnerable to attack by insect and fungi, and when those stalk are munched on by the little critters they respond by producing massive amounts of psoralen. Pick your poison.

Saving the S&Ls in 1982: When interest rates were 18% in the early 1980's, most S&L's were insolvent, so a simple off balance sheet solution was to give these highly regulated institutions more powers (Garn-St.Germain), and increase the amount of deposit insurance from the Federal Government. only 6 years later, there was a Savings and Loan crisis, the failure of 2412 S&Ls in the United States. The ultimate cost of the crisis is estimated to have totaled around $560 billion, about $320 billion of which was directly paid for by the U.S. government. This is the archetype of 'moral hazard', because those depositors who might have monitored these risky actions had no incentive, and the managers basically had a free option to swing for the fences, which they did.

I fully expect the latest legislation to create a disaster in 5-10 years.

Greenspan's Other Admission

Every 10 years or so, there is a financial crisis somewhere in the global system, and this is always galvanizes critics of capitalism. For A.J.P. Taylor notes that in the aftermath of the now-forgotten financial crisis of 1873: “The German political leaders, capitalists or the associates of capitalists, were discredited by the financial scandals, which, as always, accompanied the collapse of economic optimism” (p. 151, The Habsburg Monarchy, 1809-1918).

Thus, our current crisis is bringing forth a bunch of partisan arguments, suggesting a lack of regulation, or too much government meddling, was the essence of the problem. As we clearly had a lack of regulation on the key risk contributors, one could plausibly argue either, as ‘more’ regulation may have mitigated the problem, but it may also have encouraged greater misplaced lending under the goal of increasing home ownership. I imagine that debate will not be definitively answered, just as the causes of the financial crises of 1893, 1907, 1929-33, 1974, 1998 are hardly settled matters among economic historians.

In Greenspan’s testimony in front of congress last week, he noted:

And we have this extraordinarily complex globa1 economy which, as everybody now realizes, is very difficult to forecast in any considerable detail. Mr. Chairman, I know I agree with you in the fact that there are a lot of people who raised issues about problems emerging. But there are always a lot of people raising issues, and half the time they are wrong. And the question is, what do you do?

Indeed. The problem we have is that in a complex system there are several potential causes, so reversing their ‘true’ value given the failure of the system is a problem with more variables than observations. A 'successful' warning of a failure might be unhelpful in constructing a solution for two very different reasons:

1) The failure forecast was part of a general, unspecified prection. To that ‘something financial will crash’ covers banks, bonds, currencies, oil, a group so diverse, it suggests a meta-problem in asset markets. If you have been predicting a general crisis for, well, ever, you can hardly be called prescient. To the extent there is a breakdown in the general milieu such as too much greed, or not enough regulation, seems sufficiently unfocused to be of little help.

2) The failure was correct on the area that failed (eg, banks, mortgages), but had a wrong cause. Of those who warned about he problems with Fannie and Freddie, most focused on the interest rate risk, not credit risk.

Stan Liebowitz, who had targeted the lowering of underwriting standards in the amid 1990’s, was validated a decade later, but his focus was not the center of, say, the Republican criticisms of Fannie an Freddie in the 2005 proposal for more regulation of those institutions. He notes that “prior to 2006 What you will not find, if you read the housing literature from 1990 until 2006, is any fear that perhaps these weaker lender standards that every government agency involved with housing tried to advance… might lead to high defaults, particularly if housing prices should stop rising”. In other words, the key to this problem, the essence of what caused mortgages to crash, was crazy lending standards, but no prominent people were highlighting these risk before the fact. But what is most insidious is that this error was made by everyone: originators, rating agencies and investment banks, investors. All along the chain, people with very different incentives and objectives ignored this risk. It is easy to see how Moody's dropped the ball, but if the issuers wanted AAA ratings, and the investors wanted both AAA ratings, and stable ratings, Moody's just gave them what they wanted. How could they all have been so blind to the problem suggested by the data below (from Dr. HousingBubble)? I don't think it's so easy as saying they were greedy, or overconfident.



Just as no rational terrorist would today try to take down a plane with box-cutters—because passengers would see the end game and thus be highly motivated to overtake them at very quickly, unlike prior to 9/11/01—the problem created by high risk mortgages is not something that needs Washington’s help at this moment. The market for these securities no longer exists. Indeed, the solution to create a new Department of Homeland Security Department, with its Transportation Safety Administration, may be just wasteful bureaucratic bloat, less able to respond to new risks.

As Greenspan noted:

And the reason essentially is that a financial crisis must of necessity be unanticipated, because if it is anticipated, it will be arbitraged away, and if a financial crisis by definition is a discontinuity in asset prices, then it means from one day to the next people were surprised. Something fundamentally different happened. I think that, and I have argued this, and I am not saying whether the government resources are relevant to this, I think the academic community could do it surely as well. And what we do have to understand is that our view of the way an economy functions is not properly modeled by what we now have.

This highlights that we should be very cautious in fixing this problem, because the new laws and government agencies, once created, are usually there for a generation at least.

Why Intellectuals Like Obama

Intellectuals think they are experts, and politicians should defer to them as senior advisers (listen to New Republic writer Noam Scheiber gush about Obama's trust in experts below). Thus, to the extent a politician looks like someone who appreciates policy wonks, they will get better press. A good strategy for any politician above the city level is to make the intellectuals you speak with feel like they are the smartest guy in the whole wide world, because that is the expert's ultimate fantasy.

It's a naive fantasy, that politicians are 'technocrats' who take the best ideas from objective, leading experts in formulating policy (to think these people usually condescend to those who believe in organized religion). Experts have diametrically opposed views in terms of policy implications all the time, so it is a trivial exercise to 'listen' to them--you choose the right ones. Further, a politician's inability to implement a plan just like a certain intellectual would have wanted, merely says that this particular intellectual was not as persuasive and correct as I am, think most intellectuals, so inconsistency is brushed off w/o much concern.

Stigum's Money Market

Tyler Cowen notes Marcia Stigum's authoritative (aka 1000 pages) Money Market as a great source for understanding this crisis. I agree. It highlights that no one prior to this crisis, especially academics, had any clue it was coming, no theory that would have alerted them to coming problems.

In my 1983 edition of Money Markets there is nothing in the index under 'risk', let alone 'credit risk'. Updated versions have perfunctory mention, hardly enough to give one a clue about underwriting critera, loss curves, default rate transitions, recovery rates, the key criteria for consumer vs. commercial loans. Not relevant. Mainly a litany of definitions of various instruments, data on amounts outstanding, the minutia of daycount methodology for various securities. Its collection of facts is no more an insight into finance than a pile of bricks is a house.

My old KeyCorp boss, Kevin Blakely, told me a funny story about how he was asked, as a 45-year old banking executive with a history of risk management, to guest lecture in a Money & Banking class. He read up on the guy's notes, trying to see how he could work his insights into the class. It was all on fractional reserve banking and the money multiplier, the structure of the Federal Reserve, the Great Depression, inflation, etc., etc. In his words, nothing on actual banking, such as the many practicalities of credit risk.

Maybe soon.

Oil could go up, or down, a lot

When an analyst mentions that a crash, or boom, 'may' or 'could' occur, you can be sure this is someone who is pretty worthless in giving information, however popular. Thus, in Time magazine:

Several oil analysts — who predicted earlier this year that oil would reach $200 by year's end — have recently said that oil could drop to $50 a barrel.

Agreed. Prices can do a lot things, especially in the future.

Chris Cox Hopes to Fail Upward

If you are a loser, sometimes your best strategy is to do something insanely stupid, so off-the chart stupid, that it mandates new charts of stupidity must be made. Thus, otherwise forgettable figures like David Chapman or traders like Nick Leeson have Wikipedia entries, while their betters are assigned to ignominy; they win! Perhaps that was Chris Cox's savvy strategy all along. He screwed up in various ways (short sale prohibitions), plus missing out on making good changes that seem, with hindsight to be sure, should have been made.

Thus, it is fun to see Chris Cox, head of the SEC, whose job it is require what kind of information public companies to disclose got to say his piece in front of the current Congressional hearings. After allowing complex financial companies to basically put up opaque financial statements, and by their accomodation give the impression everything is fine, Cox notes in this insightful (though horribly depressing to any rationalist) Congressional hearing:

what happened in the mortgage meltdown and the ensuing credit crisis demonstrates that where SEC regulation is strong and backed by statute, it is effective

Just like the DC school, I'm sure more money, as opposed to different priorities or management, would help ;).

challenge its reliance on the Basel standards and the Federal Reserve's 10% well-capitalized test

OK, if the capitalization standards were much higher, say 15%, what would have been different?

credit default swaps ensured that when the housing market collapsed the effects would be felt throughout the financial system.

So, blame the messenger, not the message. Cox harps on this a lot, as if the 'unregulated' credit default swaps, which are derivatives, are the basis for the fact that mortgages issued in 2006 had twice the loss rates as previous mortgages. If mortgages weren't worth 10 cents on the dollar, there would be no problem. The ABX.HE (subprime CDS) market highlighted that prior to any other indicator--way before the rating agencies. If anything, this diversified the risk, as opposed to aggrevated it.
So, bottom line for Cox, head of the SEC,

Today’s balkanized regulatory system undermines the objectives of getting results and ensuring accountability.

In other words, double his budget, increase his power, and all will be well.

Then, when asked if the best they can do, is be, like Greenspan says, be right 60% of the time. Is the best we can expect, a regulation that has a 40% chance of being wrong? Cox replies:

That's a bit more quantitative than I have an ability to evaluate but...it is time to have a process that gets rid of regulatory gaps.

So, in other words, I don't know about 'numbers' or 'estimates', even as vague as what Greenspan mentions, but more power for the SEC is still an obvious solution.

Comically, Waxman laments that the current regulatory agencies all missed the boat, implying giving them more authority would be rather pointless (Waxman is a typical Democrat, so that's funny). What to do? Ack!

Regulations are necessary. That they be wise is very important, so the focus should not be the 'more' or 'less' debate, rather than the what (because the general debate is not soluble in finite time). Let's focus on what those might be, rather than giving blanket powers, especially to agencies that have demonstrated a lack of any efficacy in the past (SEC, OFHEO).

The crisis reveals that the stupidity that creates crisis is far deficient to the stupidity of those who rush in to assign blame and design cures. President Obama's first task should be to fire all the senior people (eg, Cox) at all the regulatory agencies, to set the tone that it will not be tolerated that regulators fail: failure has consequences. They should know that if their companies screw up, they screw up. They can not blame the companies they regulate, they are responsible for the companies they regulate. That is, the first new regulator power, should be to highlight to these bureaucrates

To do nothing is sometimes a good remedy

In a crisis, leaders 'do something'. Thus, in the Great Depression, we passed laws making it hard to lower wages, which when aggregate prices were falling about 33%, meant wages had to rise in real terms. It helps current union members, but hurts everyone else. The only people favoring these laws are those too ignorant to grasp the inconsistency, those who are merely rationalizing (if subconsciously) their deeper desire for egalitarian redistribution (though this usually helps insiders), or if one of the Officially Designated Victim Groups, self-interest.

In today's WSJ, they note that Federal Deposit Insurance Corp. Chairman Sheila Bair suggested the government give banks a financial incentive to turn troubled loans into more-affordable mortgages. Under the proposal, the government would share in any future losses on the new loans with lenders. If there is anyone who does not have a claim of victimhood, it is someone who got a mortgage they could not pay, with little money down, who now wants to be subsidized so that they have no loss (with a loss, they walk away as US banking laws mean you can default on your mortgage and not worry about the bank coming after your other wealth such as savings; ie these are non-recourse loans). The effect is then to subsidize those who behaved most recklessly, who have the least skin in the game, and increases the number of zombie properties that are not maintained because the 'owner' has abandoned the property, and the lenders are forced to go threw a costly and lengthy process before they take hold of the property, fix it up and sell it at a market-clearing price.

Trying to subsidize X means, necessarily, you tax ~X. Further, it then creates incentives for people to game these new incentives. The key is to have many small groups, so you can parade various people from these groups so every week you can bring out the most sympathetic individual within the group who mentions how legislation allowed them to avoid the poorhouse or achieve their dreams. The net effects are complex, subtle, and spread around enough that it is usually impossible to statistically prove they caused any effect, like legislating that the government given me one million dollars: to prove that it makes others worse off looking at aggregate data is empirically impossible. My personal characteristics are such that my victimhood status is pretty much near the bottom of the vanguard's list of politically attractive groups to subsidize, so I see these actions as basically more things they have magnanimously decided I should pay for--though not directly. I can see why intellectual mandarins, the super rich, the super poor, and muck-raking community activists find these actions good, because it increases their power and status.

Note that in climate discussions, the presumption on the Left is that increasing man's footprint is bad, and while certain areas may benefit, the net effect is bad because our meddling are unnatural. Thus, even though my state (Minnesota) may benefit some from Global Warming, the cost to other areas is a bad trade. No one would suggest adding chemicals to wetlands to 'improve' their pH, or introduce new flora to improve the diodiversity, is a great way to save the environment, rather the objective is highly conservative: conserve energy, growth, and stop development. In the economy, however, Washington's footprint is considered an obvious corrective to an anarchic suboptimality, because we know legislation has the public welfare at heart, in contrast to the individuals making decisions on their own, who are driven by self-interest. Every problem invites a new top down solution, as if top-down meddling in the form of encouraging home ownership was not a large, if not the singular prime mover, of the crisis we are in. The economy is very complex system, just like the climate or the environment. The biosystems and the environment, are too complex for top down intervention; the economy, however, needs top down solutions NOW.

So we have screaming that we need to help homeowners to keep them in their housing; we also need to make housing more affordable. We address the high rates of medical spending by giving more state-insurance and tax subsidization of medical expenditures. We address the high costs of college by giving more subsidies and tax breaks on education spending. Did it ever occur to these geniuses that less intervention might be a solution, as opposed to more? Lowering the subsidies, eliminating tax breaks on targeted spending?

A neighbor down the street abandoned his house in my nice neighborhood, and its landscape was not maintained for months, creating an eyesore. The 'owner' also removed many of the nicer fixtures: marble counters, everything valuable you could take out. This tactic is only encouraged by giving defaulters more power, and this is a deadweight loss for society.

Rating Agencies Grilled by Congress

The rating agencies got a good grilling today by the Congress, and it was on CSPAN (video online here). My friend and colleague Jerry Fons testified, and his theme is that there is a conflict of interest inherent in rating agencies is a big problem that underlies the lack of due diligence by rating agencies. Indeed, it is a tough problem. An important point was a quote from the Moody's CEO, who noted in an internal discussion (leaked somehow) that issuers want 'high' ratings, and investors also want 'high and stable ratings'. Now, that suggests everyone got exactly what they wanted. Of course, the rating agencies then just played along, but if the sellers and buyers want AAA ratings, it seems inevitable that AAA ratings would be justified. How do you regulate out something where the seller and buyer are willing participants?

One congressman noted that while Baa rated corporate securities had a 2% default rate over 5 years, Baa-rated CDO securities had a 24% default rate over 5 years. What's up with that? The Moody's CEO mumbled something incoherent about being different in different time periods, though he didn't specify which ones. I worked on CDOs at Moody's, on the inputs for default rates of unrated securities (RiskCalc(TM)), and think the problem was primarily that they underestimated the correlation of defaults in bad times. The problem is still there, to my knowledge. But CDO defaults are not a big part of this current crisis.

Another congressman asked why the ratings for the mortgages started to fall? Why should I believe them today, given they missed this huge trend? No good answers from the CEOs of the Big Three (Fitch, Moody's, and S&P). The S&P CEO mentioned they did incorporate house price declines of 15% when they underwrote the structures, but I think that's total BS. That is, you can always say 'that assumption is in there', and with a complicated enough process, it is difficult to prove them wrong, but I would have followed up with: 'well, what were the loss assumptions for subprime versus prime mortgages? How would these have been altered with a 30% housing price decline? How did these assumptions change over the past 10 years as underwriting criteria changed? Where in your 'transparent methodologies' is there any record that gives an expected loss estimate for collateral on mortgage pools?'

A philosophical question from Eleanor Holmes Norton: if you rate a company AAA, and it defaulted, was it accurate or inaccurate? The Fitch CEO said, inaccurate. I think the question is incomplete. You are generating a rating that refers to a frequency times an expected loss estimate, and an observation contributes to that frequency estimate, but no single observation is determinative. However, given the AAA estimated default rate of around 1 in 10,000, a single default probably doubles the sample default rate, and so gives one great pause.

But, while everyone was frustrated, no one seemed to be converging on anything to fix the problem. I bet they'll put together some new structure to monitor the agencies, that will just be a waste of time, but also get rid of the Nationally Recognized Statistical Rating Agency, a designation that gave the Big Three more credibility than they deserve.

Rise of the Regulators

Currently, congress is considering all sorts of new regulations of the financial sector. It's a good time to be a regulator. As all the major financial institutions put ex-regulators in prominent posts in their company, the current regulators anticipate this. A financial regulator who plays his cards right should be very valuable after working for a couple of years in this new regime. If I were a lawyer, I'd get into securities law, because every financial firm will need senior people with legal backgrounds, who will be able to negotiate all the fruitless, but complicated, rules that are coming down the pike.

The net result are rules and enforcement that, like most regulation, merely raises the barriers of entry. This makes it hard to enter the business, and should set the stage for nice monopoly profits for current players, all under the pretext of helping main street and the soundness of our financial system.

Once you pay the fixed cost for dealing with regulators, in terms of having protocols for filling out the right forms in place, the effects of regulation are pretty small. That is, in finance, regulation is invariably a fixed cost, plus prohibitions on the ability to do more than one thing at a time. These are really the only regulations that are put in place (think about Glass-Steagall, interstate banking restrictions, Securities Exchange Act of 1934). Have you ever filled out an ADV? Signed the recent rules from Sarbanes-Oxley? Just a bunch of fluff, saying, in effect, you wont break the law. I guess this makes it easier to find and prosecute you if you break old laws, but does it promote more honesty? I doubt it.

If I were securities czar, I would take a deep look at off-balance sheet liabilities, perhaps mandating they mark them to market in a footnote in their quarterly financial statements. Further, I would mandate greater disclosure on what securities are being held, on or off balance sheet. I'm still shocked by those tens of billions of AAA rated ABS on all those I-bank balance sheets. It made no sense, and suggested something really wrong was going on. But they never had to report that modest amount of information.

Increasing disclosure is a great new regulation, because it does not invite gaming, it discourages it.

Nobelists Generally Quite Clear

A Nobel prize winning mind should at least have a good command of language, of seeing the major point, and making a clear argument. Thus, I appreciated this little tiff in the University of Chicago paper between James Heckman, who won a Nobel for his econometric work, and John Cochrane, who is probably one of the 10 best (ie, most actively cited) finance professors alive. Heckman noted he was agreeable to suggestions they rename the proposed 'Milton Friedman Institute', which, if I were giving money, would be a deal breaker, because if you are that ashamed of the name 'Milton Friedman', then it is clear the funding will devolve into the standard littany of trendy academic pursuits, unrelated to Friedman. Secondly, Heckman suggested that the University President was moving the Friedman institute too quickly, presumably, dismissing all the leftists in the Chicago Academy who see 'free minds and free markets' as a codeword for fascism and repression.

Cochrane noted

My strong, personal suggestion is that you are digging yourself deeper and deeper into public statements that you will regret. Now, not only is Friedman’s name expendable, the GSB political, but President Zimmer ’rushed this through.’ He’ll be delighted to see that in print. You may have long, convoluted explanations, but that won’t do much good when this sort of thing gets out.

Heckman responded (via email)

Screw off, John

Why 'Leaders' Aren't Smart

Tina Fey was on Letterman, and when asked about Sarah Palin, said:

I see her and think she's as smart as I am. I want someone smarter than that in the White House

I think it is very naive to see leaders as needing to be very smart: they need to be slightly above average, no more. They are good at what they do, but that necessarily does not involve smarts. How you can read Hillary Clinton's book, It Takes a Village, and think this woman is smart? A smart person couldn't have faked such patronizing banalities no matter how hard they tried.

I bet a leader's optimal IQ is about 125, dropping off at both ends rather quickly. I find it funny when all these hyper intelligent wonks who write for political punditry magazines try to delve into politician's psyche as if they are trying to decipher Fermat's margin notes. They usually paint their guy as a genius, meaning, he articulates policies they support in a way that does not generate ridicule or indifference, as when they argue them in their general columns. Morons, meanwhile, believe in policies they don't like.

Remember, Bush is widely lambasted as an idiot, but his grades were better than both Kerry and Gore's. Based on his SATs his IQ was estimated around 124, and I bet most politicians, even successful ones, are around there. Reading about George Washington or Calvin Coolidge (my political heroes), I'm not so much struck by their brilliance, but their discipline, integrity, and good judgment on important matters.

As Arnold Kling, and Jonathan Haidt have noted, smart people are merely better at rationalizing their prejudices than the average person. Whether they start with good prejudices, seems pretty much orthogonal to their education and IQ once it reaches a minimum level (I think there are big returns to education and intelligence, but just up to, say, the 60th percentile). If you have an IQ above, say, 130, you can't mouth the inconsistent platitudes with sufficient sincerity to be elected leader. That is, a really smart person can't in good conscience say that 'giving to the United Way is the most important thing we do here at Amalgamated Financial', or that you listen to each customer suggestion on various product releases. It's BS, but the troops need to hear it, so they get the only people who actually can champion such inconsistent policies. Both Obama and McCain are overselling a load of policies that won't change much, except for the new government bureacrats in charge (as opposed to the people they are supposed to help), but that 'not-so-bright' mindset was necessary to win their party's nomination. Someone with a painful sense of the obvious and inconsistent, would be seen as not sufficiently inspiring to the masses, as I'm sure he would not be. So we give the people what they want, good and hard.

Humans live in a 'reverse dominance hierarchy', so that a leader too dominant, not sufficiently deferential, will not be chosen to lead. Humans hate hubris in their leaders more than anything else, and so a smart guy, who can't fake appreciating the vastly more numerous pedestrian managers out there, will not get enough support. Anyone with a sufficiently high IQ, to be consciously faking there enthusiasm for the pap they are pushing, is so evil they are much worse. Thus, be happy with the stupid 125 IQ guys, it's as good as it's gonna get. The exceptions you see, mainly, are really smart founders who often created their product.

When you see the candidates talk as if electing them will make a huge improvement in the average person's life, you have to think, sure, give me an example? How likely is it that Obama is, as Oprah says, 'The One'? As Robert Samuelson noted, the following would be a sure ticket to a 1.3% share of the electorate:

I know you worry about the economy. So do I. But, frankly, if you elect me, I won't do much about it... 'Energy independence' is a fraud. ... Without major technological breakthroughs, making big cuts in greenhouse gases will be impossible. ... Unless we stop poor people from coming across our Southern border ... we won't reduce [American] poverty."

The Pervasive Problem with Housing Advocates

A local politician, Mike Hatch, filed a complaint against Capital One on a deceptive-advertising charge. part of its settlement with Capital One on a deceptive-advertising complaint. Hatch’s office agreed to drop its deceptive-advertising case against Capital One Bank that February in exchange for $749,999 — a dollar short of a statutory threshold for automatic deposit of settlement funds into state coffers. Hatch’s office and the defendant were able to pick other recipients for two-thirds of the proceeds: the Minnesota chapters of the Legal Aid Society and the Association of Community Organizations for Reform Now, ACORN. The state got $250,000 to cover its investigative costs. Two weeks later, ACORN endorsed Mike Hatch in his bid for the Minnesota governorship (he lost, this was in 2006).

In a completely different venue, the New York Times outlines how Henry Cisneros, the Clinton administration’s top housing official in the mid-1990s, loosened mortgage restrictions so first-time buyers could qualify for loans they could never get before. Then, capitalizing on a housing expansion he helped unleash, he joined the boards of a major builder, KB Home, and Countrywide Financial, joining Fannie Mae chairman James Johnson. Cisneros became a developer after the Clinton administration, and joining with KB (American CityVista), he built 428 homes for low-income buyers in what was a neglected, industrial neighborhood. He has financed the construction of more than 7,000 houses.

ACORN, and I'm sure many groups like them representing other special interests, are able to game the system from the top-down using their pretext of helping the little guy. But it's a blatant shake-down of corporations. The politicians they support then perpetuate the system. All that money was not just going to Wall Street. A lot was siphoned off by corporate cronies with ties to government at all levels. It is a good thing this game is over, because the policies they are supporting just do not make any sense.

Minnesota Governor Pawlenty recently vetoed an ACORN-sponsored bill that would have imposed a two-year moratorium on foreclosures in Minnesota, and pretty much guaranteed that no mortgage lenders would do any more business in the state. A foreclosure moratorium would mean that lenders holding mortgages in default would be forced to negotiate with borrowers to modify the loans, and ACORN “counselors” would have been right in the middle of these negotiations. No doubt they would have shaken down every mortgage lender in the country for even more money in return for their cooperation. This raises costs of lending, but that cost is spread around, unseen, while ACORN then builds its patronage system, perpetuating itself.

Knocking Down Straw Men

So, in Us vs. Them, and the diavlog here, I see the author make a big deal out of his insight that instead of thinking that things are either 100% genes, or 100% environment, it is more complicated than that. This is a really silly argument, because no one arguing in favor of sociobiology thinks genes are 100% or deterministic, rather, they think it's like arguing it is better to be tall to play basketball, a multivariate explation with standard errors and several factors.

But anyway, this is David Berreby's big insight, and fellow science writer John Horgan nods approvingly in the discussion. Berreby is a best seller, so obviously this kind of thing sells, but I think it is pretty pathetic that popular authors so often set up straw men, that is, arguments that are extreme that no one holds, and then knock them down as if this takes intellectual courage. I find it kind of bizarre, like someone saying that 'not all women are shorter than all men!', therefore, men and women are generally the same because to assert otherwise is to apply a discrete stereotype to them. Or that 'free markets don't work' because markets sometimes deliver suboptimal outcomes. Uh huh.

Liberals Tired of Being Nice

In this this week's science discussion, science writer John Horgan is speaking with a science writer who has a book about the nature of tribalism in modern society, US and Them. Horgan earlier noted hat one should make an exception for Sarah Palin, because she is an idiot! Horgan notes he's tired of being part of a liberal team that is always nice (they never say anything really mean about Republicans), and a guy who wrote a book about getting along notes that when he sees McCain/Palin supporters he looks at them and thinks 'it's not your country, it's mine'.



I think all progress in talking stops when one side assumes the other side to be either stupid or dishonest, as if their opponent's view is so patently untenable that this can be the only explanation. But the evidence and arguments for and against capital punishment, late term abortions, high taxes, tort reform, is hardly like observing that 2 is greater than zero. Anyone who thinks their opponents are all lying morons, does not understand their argument, because any popular argument has something to it, some shred of plausibility. That dispassionate men like these think conservatives are lying morons, highlights that there are lots of people who are tired of thinking about issues, and just want to retreat to their echo-chambers, where they don't have to persuade anyone.

Property Right Intuition

My 17 month old daughter is very cute, of course (is it possible for a parent to think otherwise?), but as she is becoming more intelligent it is fun to see her inchoate intuitions. I go to pick her up from the child center, and she's in tears because a much older 2 year old took her diaper bag and is throwing it around. The women there can't understand why she's crying, but I know that it's because she always gets her diaper bag out of her cubby when I pick her up, and she sees that when others take her diaper bag it is 'not right'. The ladies think that kids are basically like caricatures of savages, people who don't care about who owns what. Thus, those in charge completely misdiagnosed the situation because they did not appreciate my baby's intuition for property rights, making my baby very unhappy, adults clueless.

I get the sense that lowering taxes on the bottom 95%, raising it on the top 5%, also does not appreciates peoples' intuition for property rights. Currently the top 5% of earners make over about $150k, and they pay about 60% of the income taxes. I think they will respond by gaming the system, and their will be a huge elasticity in reported income.

Complexity a Common Culprit

From the Wall Street Journal:

Borders' Mr. D'Agostini said there are five titles that appear to most interest consumers. These include: Charles Morris's "The Trillion Dollar Meltdown," which Mr. D'Agostini says predicted market turmoil caused by subprime mortgages and Wall Street greed; David Smick's "The World is Curved," which cited the mortgage crisis as a early indicator of further problems ahead; George Soros's "The New Paradigm for Financial Markets," which looks at past crises and their significance for future events; Kevin Phillips's "Bad Money," which examines the state of the dollar, credit issues, and the world market, and Peter Schiff's "Crash Proof," which warned of a coming crisis and suggested how consumers could protect themselves.

In a crisis, everyone wants answers, now. So we have the following books and their explanation of America's ills:

Trillion Dollar Meltdown: Greenspan, deregulation, greed, over-the-counter derivatives, securitization, lack of public healthcare
World is Curved: globalization, financial complexity, reckless volatility
New Paradigm for Financial Markets: globalization, credit expansion, market fundamentalist beliefs, and deregulation
Bad Money: financial complexity, power in finance, market triumphalism, weak dollar, hubris
Crash Proof: weak dollar, inflation, US trade deficit

They all contain an obligatory mention of greed/hubris by those who got rich (funny from Soros), but also the focus on finance, as opposed to real causes (eg, productivity growth). There is a great distrust in the complexity in finance, in that the connection of a mortgage, to a derivative, is often not very transparent. But is anything these days? Computers, cars, my thermostat, all have evolved greater and greater complexity, so that 'fixing them' is now beyond the average user's ability. In the 'good old days', things were simpler, perforce, because they were just starting. Complexity happens to all fields, and it would be nice if everyone could fix their cars like the old '57 Chevy, or fix their computer by going in and adjusting the autoexec.bat file, but the greater functionality of these products requires greater complexity to their parts, and so only full-time professionals can fix things that your average proficient user could fix decades ago.

It is common to long for the old times when fields were completely understood, but forcing a field back to be transparent to the masses is not a solution, it is a stifling of productivity. Wouldn't it be great if we went back to a mathematics prior to non-Euclidean geometry, and calculus? Well, if your objective is to restrain all fields so that they be understood by your average man, I guess that would work. But when any field, industry, or product evolves it generally adds functionality, adding layers, and layers add complexity.

The problem in mortgages was not derivatives, or complexity. Lowering underwriting standards (no downpayment, lower credit score) is pretty straightforward, and affected bank-owned mortgages just as much as credit default swaps. That academics, community activists, Clinton, Bush, Congress, regulators, Wall Street, and investors, did not foresee the problems in lowering credit standards for new home buyers, was hardly caused by derivatives up the food chain. These mortgages were going to blow up eventually because a vast array of special interests under the banner of 'increasing home ownership' was going to put more and more people into houses until they proved they could not afford it, by which time the seeds were sown. Complexity of the derivatives that referred to these instruments were second order in this story.

Hedge Funds and Portfolio Insurance

In the 1987 crash, there was an accelerator mechanism via portfolio insurance. Basically, Rubinstein, Leland and O'Brien got a bunch of investors to buy into portfolio insurance, which would sell securities as prices fell, emulating a put option position. In the crash, this just made things drastically worse.

But it seems hedge funds adopt this sort of strategy. Several prominent hedge funds moved to cash recently: Steven Cohen, Israel Englander, John Paulson. That's a lot of money selling equities, buying yen, etc. No wonder such disparate popular hedge fund trades: long oil, the carry trade (long Aussie dollar, short yen), equities. They were all being unwound.

Krugman's Work

Paul Krugman won the Nobel, and I remember his work was essential reading for those in the Industrial Organization series. But I never encountered it classes I took in macro, finance or information theory. So, I don't have a sense to which they are clever or useful, by actually working them through and comparing them to a literature.

My Bet

A quantitative macro-fest: Sims, Sargent and Hansen.

It would be nice if they gave it to people prior to being almost dead. Poor Leo Hurwicz won last year. He was 90, and died within the year. It's almost a kick in the teeth at that point: all your contemporaries are dead, so the pleasure of saying 'ha-ha!' to your rivals is gone. You can't really spend it on women, fast cars, or even fancy vacations. Your family will be pretty unimpressed, because you always have to ask your grandkids for help with the internet, and so they think you are just a pronounced example of the Flynn effect. As Ronald Coase said when he received the Nobel: 'it's kind of strange getting an award in your eighties for work you did in your twenties'.

When Experts are 180 Degrees Wrong

Elizabeth Thomas's Harmless People (1959) argued that hunter-gatherers were, well, harmless. Rouseau's dovelike natives, living in social harmony, individual freedom, cooperation, and absence of warfare. But, of course it was a crock. In Irenaus Eibl-Eibesfeldt's Myth of Aggression-Free Hunter-Gatherer Society (1974) started the re-write, and now, with Heeley's War Before Civilization, we know that per capita homicide rates for natives is much higher than for civilizations. Oh well.

It's funny that for decades, the experts can get it 180 degrees wrong on their field of expertise. I remember a sexuality professor arguing that all people are inherently bi-sexual to a significant degree. I thought, this may be her preference, but most of us are pretty hard wired towards a particular gender, and if she was a sex expert, she should know that. Obviously, she was projecting her vision of a societal nirvana, guilt-free sex with everyone. The list of such inanities is really quite long. Most nutritionists believed that a diet rich in fat is a major contributor to obesity, a finding now trumped by the initially derided Atkin’s claim that carbohydrates are more fat inducing; the American Medical Association declared that steroids had no affect on athletic performance; or finally that in the 1970s psychologists thought young delinquents had too little self-esteem, and now they think they have too much.

The sad fact is that experts are often more wrong on facts in their field than the average person. They are able to create a highly scientific rationale for their belief, and deflect criticism from 'conventional wisdom' because most people with mere common sense do not follow the academic protocol of the field that sets the standard for accepted expert opinion.

False facts are highly injurious to the progress of science, for they often long endure; but false views, if supported by some evidence, do little harm, as every one takes a salutary pleasure in proving their falseness.

Charles Darwin

See Shrill Nobelist Know-it-all

Everyone has had a teacher in high school or college who was sure to solve poverty if the government would only implement his plan. For example, if the poverty line is $20,000 per year, and there are 30 million Americans below the poverty line, all we have to do is take the $600B we spend on the Defense budget, and give that to the poor! Solves poverty, and lowers violence, and it's a mathematical proof--certain to be true. Why doesn’t everyone listen to me!

Stiglitz is pathetic in this little tirade, how he caricatures those who disagree with him, his inconsistencies, his assumption that bad things only happen because of insufficient government involvement (though, he hates the Iraq war, which in his mind has nothing to do with true government). He blasts the immorality of conservatives, for example, noting that his friend told him that when former Federal Reserve Chief Paul Volker was informed his tight monetary policy would ‘kill’ Latin America in 1980, he said ‘that’s not my problem’! Monetarism, of course, was based on a religion (in spite of Friedman and Schwartz’s A Monetary History of the United States). Easy credit in the 2000’s created this crisis, foolishly giving homes to too many, but then he also notes the current crisis is tragically causing millions to lose their homes, and ignores the intellectual and political genesis of easy credit.

He argues firms are ‘stupid’, as evidenced by the fact of paying dividends, which is tax inefficient, even though there are many issues in signaling and asymmetric information that explain why the debt and equity choice is not degenerate at 100% debt (and further, that a 100% debt-financed company is, in effect, equity). As one who then complains of The Economic Establishment ignoring asymmetric information, this ‘proof’ of stupidity contains a massive amount of cognitive dissonance (you have to love Nobelists, at top universities, who have had top jobs in government, railing against The Establishment).

‘Anybody looking at the behavior of financial markets, would have predicted what happened’, he says, ‘This is not 20-20 hindsight’. Sure, who didn’t call this credit crisis? His own work goes a long way of explaining the situation we are in, in his opinion, though Stiglitz and Weiss (about markets breaking down with asymmetric information), or Grossman and Stiglitz (about the impossibility of efficient markets), actually gave support to the kind of meddling by the government that was a major impetus to the relaxation of traditional underwriting standards. The disease is now the cure.

He argues that Long Term Capital Management blew up because they based their models on the work of Scholes and Merton, though these guys were mere merely marketing figureheads, and the actual investment strategies of LTCM were made without input or oversight of Scholes and Merton, and were hardly derived from a canonical option pricing formula.

Businessmen are stupid, but even stupider are the Corporate boards, and finally investors. Everyone is an idiot, so giving the government more power is clearly a good idea (as everyone knows, only really smart people get into government (except when Republicans are charge)).


He thinks his models of asymmetric information explain the problem we are in. Well, in a very, very vague way, but one could also say the roots of the crisis were mentioned in Adam Smith ('people are self interested') or the Bible ('money is the root of all evil'). His models show how certain assumptions cause markets to break down, but these are models, and his assumptions are just as 'unrealistic' as any other, because they assume a very specific information sets for all the actors, surely highly idealized . The implications of his models are ambiguous, because depending on how you modify the information of various parties, you can get opposite results, thus in practice, the efficacy of regulation is both an empirical matter, and needs a lot of common sense, two areas where Stiglitz is at a comparative disadvantage.

Markets with imperfect information are not necessarily Pareto optimal--therefore this crisis would have been avoided if we had more regulation? As if the financial markets were not already a highly regulated sector, and the body whose full-time job of monitoring Fannie had absolutely nothing to say about he relaxation of credit standards, instead focusing on interest rate risk, or games executives played to get their big bonuses (important, to be sure, but still). When the regulators were doing it wrong, 10x more does not help. His model basically is like the cartoon below: I have highlighted issues in abstract models of perfect markets (under certain assumptions, equilibrium breaks down), therefore, it explains the current crisis in our highly regulated markets.

Joe Stiglitz has done some great work. But if you consider his balance sheet, the absolute amount of his good ideas versus his bad ideas, he is insolvent. Reading the wacko letters to the editor in the local Arts Weekly gives a more balanced, and accurate view of how we got here.

Liberal Assumptions

The difference between liberals, and conservatives, is highlighted in the preface of Chris Boehm's Hierarchy in the Forest. In a book I truly love, he notes on the first page of the preface: 'We participate in this type of political leverage because we want to keep a say in our own governance, but, more basically, we exert it because we are suspicious of all governance and wish to limit the powers of those who lead and may try therefore to rule.'

He then highlights how this obviously leads to Democratic liberalism. For some reason, he thinks giving more power to the government to regulate diffuses power. But the power of Halliburton, Exxon, or Microsoft, is insignificant relative to the power of the state via its departments, laws, and regulations. I have alternatives for companies. The government, in various guises, is a monopoly.

Liberals think diffusing state power comes from regulation. Conservatives think diffusing power comes from taking authority away from the state. Same goal, different paths, based on assumptions about the facts.

US Relatively Richer, YTD

The US stock market is down about 32% year to date, but most other developed countries are down around 40%. The emerging market stock markets are generally down 40 to 60% year to date. Yields on US government bonds are down about 50 basis points on the long end, about about 3% (to near zero) on the short end. The trade-weighted dollar is up about 6% year to date, which increases the relative value of US equities even more.

The genesis of this crisis is the fall in US housing prices, which caused a lot of mortgages, and their various securities, to fall in price. I would think, therefore, the US would be the worst off, because no matter how much China and UBS bought, most of those mortgages are owned by the US. The fact that relatively, the US has become richer, in this mess, is therefore rather puzzling.

Deep Thoughts by Kevin Kelly

Over at TED, which has a lot of neat videos of talks on all sorts of subjects, Kevin Kelly made this observation:

Finite games are played to win; infinite games are played to keep playing

I find that profound on many levels: the inherent meaningless of life ('just keep playing the game'), the prisoner's dilemma (screw the other guy in single-period interactions), why being nice to friends and colleagues is a good idea (you want to 'keep playing').

Best Subprime Piece I've Read

This piece by Gary Gorton, published around August 2008, is great. Interestingly, he argues that the creation of the ABX.HE index (subprime credit default swap index) helped burst the bubble quicker. Others (Ingo Fender and Peter Hördahl at the BIS) have argued it has exagerated the credit decline in that sector.

Also interesting, Gorton advised AIG for the past 10 years, I hear.

Giving Back

Herbert and Marion Sandler, in a great moment of market timing, sold Golden West, a subprime mortgage company to Wachovia for $24.2 billion in 2006, pocketing $4.6 billion for themselves. This was in April, when there were few indications of the current problem.

They are now philanthropists, targeting such groups as ACORN, the group that encourages banks to lower underwriting standards to help poor communities.

As Stanley Kurtz notes, ACORN's is not a bit player, but a primary mover in this problem:

While the 1977 Community Reinvestment Act did call on banks to increase lending in poor and minority neighborhoods, its exact requirements were vague, and therefore open to a good deal of regulatory interpretation.
...
At the same time, a wave of banking mergers in the early 1990's provided an opening for ACORN to use CRA to force lending changes. Any merger could be blocked under CRA, and once ACORN began systematically filing protests over minority lending, a formerly toothless set of regulations began to bite.
...

As early as 1987, ACORN began pressuring Fannie and Freddie to review their standards, with modest results. By 1989, ACORN had lured Fannie Mae into the first of many “pilot projects” designed to help local banks lower credit standards. But it was all small potatoes until the serious pressure began in early 1991. At that point, Democratic Senator Allan Dixon convened a Senate subcommittee hearing at which an ACORN representative gave key testimony. It’s probably not a coincidence that Dixon, like Obama, was an Illinois Democrat, since Chicago has long been a stronghold of ACORN influence.

Dixon gave credibility to ACORN’s accusations of loan bias, although these claims of racism were disputed by Missouri Republican, Christopher Bond. ACORN’s spokesman strenuously complained that his organization’s efforts to relax local credit standards were being blocked by requirements set by the secondary market. Dixon responded by pressing Fannie and Freddie to do more to relax those standards — and by promising to introduce legislation that would ensure it. At this early stage, Fannie and Freddie walked a fine line between promising to do more, while protesting any wholesale reduction of credit requirements.

By July of 1991, ACORN’s legislative campaign began to bear fruit. As the Chicago Tribune put it, “Housing activists have been pushing hard to improve housing for the poor by extracting greater financial support from the country’s two highly profitable secondary mortgage-market companies. Thanks to the help of sympathetic lawmakers, it appeared...that they may succeed.” The Tribune went on to explain that House Democrat Henry Gonzales had announced that Fannie and Freddie had agreed to commit $3.5 billion to low-income housing in 1992 and 1993, in addition to a just-announced $10 billion “affordable housing loan program” by Fannie Mae. The article emphasizes ACORN pressure and notes that Fannie and Freddie had been fighting against the plan as recently as a week before agreement was reached. Fannie and Freddie gave in only to stave off even more restrictive legislation floated by congressional Democrats.

Finally, in June of 1995, President Clinton, Vice President Gore, and Secretary Cisneros announced the administration’s comprehensive new strategy for raising home-ownership in America to an all-time high. Representatives from ACORN were guests of honor at the ceremony. In his remarks, Clinton emphasized that: “Out homeownership strategy will not cost the taxpayers one extra cent. It will not require legislation.” Clinton meant that informal partnerships between Fannie and Freddie and groups like ACORN would make mortgages available to customers “who have historically been excluded from homeownership.”

At least the Sanders remember who buttered their bread.

Endogenous Failure in Complex Systems

It is difficult to go back, and understand how foolish we were in the past on various fads. To take an obvious example, why someone would give a $300k loan to someone with no money down, no verified income, on an 800 square foot house in a very bad neighborhood in Los Angeles. What were they thinking? A similar thought happens when one looks at the business model of internet companies in 1999. Whence the madness?

First, in spite of the slew of people who suggest they saw this all coming, we should admit it was generally unanticipated. To state that housing prices can’t rise at their current rate forever, or even of the risk from Fannie Mae without focusing on credit, implies they missed this crisis because without specifics warning cries are not actionable (eg, Richard Clarke’s vague warnings about Al-Qaeda prior to 9/11 were ignored). Robert Shiller's concern for housing in his 2005 revision of Irrational Exuberance amounted to a vague forecast that one could apply to anything: it's recent rapid increase was unsustainable. Greg Mankiw's concern downplayed the credit risk, emphasizing the interest rate risk, and the problem in incentives. The general view from academics was that these mortgage innovations (smaller down payment, lower credit scores) were not increasing risk, and those who said otherwise were in highly neglected minority.

Thus, the specific focus on Fannie and Freddie missed the real risks, which were in credit. The risk from moral hazard, emphasized by Mankiw, were then thrown in a general debate over regulation and government meddling. I don't see how if this debate had 10 times the resources applied to it, it would have changed what has happened. As Warren Buffet noted, the OFHEO, staffed with over 200 earnest workers, was basicall directed at regulating Fannie and Freddie, and they missed both the accounting fraud in the 2002 period, and this latest disaster.

To think this was obvious back in 2005 without hindsight, leads to a misdiagnosis. I'm not saying nobody saw this coming, only that those who correctly foresaw the crisis and its origins were heard, but dismissed by those should have been interested, and includes no one very famous (eg, Stan Liebowitz, David Andrukonis). I never even heard about these trends, but as I was not an investor in anything related, it wasn't something I cared about.

A useful analog was the Challenger space shuttle disaster, which blew up in 1986 because the O-rings were frozen at liftoff, and did not seal properly. With hindsight, this error was obvious, theoretically and empirically this problem had been identified by many in the large organization responsible for Shuttle launches. While this risk was designated a ‘launch constraint”, meaning its failure would kill the shuttle and must be addressed, in the context of the many launch constraints being overridden it did not seem so critical. The Shuttle ‘worked’ in the first flight even with 131 launch constraints violated, and after several flights many of these risks were deemed under control. They did not eliminate the risks, they just kept reclassifying their materiality over time, because you can’t argue with success.

In any complex system, its mere presence suggests it is somewhat battle tested. Often a risk limit can be violated yet the system works, because of offsets elsewhere in the system, or the fact that a risk is a function of time such that bad things happen once a generation. If the system is successful, in terms of shuttle flights or mortgage default rates, it doesn’t matter what your ‘theory’ is as to why certain risks are too great—-these risks will be explained away because in any complex system, the theory as to how one thing affects the entire system is tenuous. There are too many interest groups benefiting from the systems current state, and they will find good reason to dismiss concerns as evidence of envy, selfish interest, ideology or muck-raking sensationalism. The larger the system, the more resilient it is to criticism of any sort.

A good current example of a trend that cannot continue, yet there is no data against it, is government debt. While the official debt-to-GDP ratio is manageable, about 26th or so worldwide. But the off-balance sheet liabilities, thing like Medicaid, Social Security, increase our debt 5 fold (to around $60 trillion, compared to on-balance sheet debt of 10 trillion.). Ever since the passage of the unified budget act during the Nixon administration, the government has had the privilege of spending the Social Security funds by transferring the money into the general fund, from which Congress can spend on whatever pork projects they wish. Many government entities, city and state, keep increasing their off-balance sheet liabilities at a rate that implies preposterous tax rates or reneging on promises, but no one worries because this has been going on for a while. You would go to jail if you did this in the private sector, yet it is OK because it seems to work. Stein's law states that trends that can not continue, won’t, which implies the government will either have to default, reneg on benefits, or pressure the Fed to inflate. Those noting this risk of this strategy have been proven wrong by absence of any failure in this area . When the future budget crisis hits in this area, it will dwarf our current crisis by a factor of 10.

I don’t see how the risk of a complex system can be correctly calibrated without massive failure, because there are just too many incentives to rationalize risks as being under control as long as the system is working, and so it just continues until failure. They are an endogenous risks to our system, so the economy will never achieve a steady state, which given over a hundred years of business cycles, is a pretty safe forecast. The bigger question is, in my mind, is why don't large systems fail more often. That is, the average annual corporate default rate in the US is around 1.4%, over good and bad times, which is pretty low.

Executive Comp

There's a lot of talk about limiting executive pay. One compensation consultant noted:

Alan Johnson, managing director of pay consultancy Johnson Associates Inc., blames unrealistic performance targets for much of the risky behavior. He says executives of some financial firms he advised had to produce a return on equity of 20% to earn their full annual bonuses. A more realistic goal might have been around 15%, he says.

Clearly, that's a recipe for disaster, because banking is about putting on assets that are often front loaded in fees, and often have average lives of 7 years. I would think a better compensation would be to give these guys options that mature in 5 to 10 years, or some function of net income, including extraordinary items, over such a period.

Giving a financial executive a bonus based on this year's ROE, seems like an incredibly dumb incentive, moral hazard of the first order. They did mention they are trying to make executives hold stock for 2 years after leaving the firm. A good first step.

Ford and GM Screwed

Both Ford and GM haven't made an operating profit for the past 3 years. Now word that auto sales are plummeting, as financing for such loans is way down, especially for the US auto-makers.

This is the worst point we have seen in 15 years,” said Jesse Toprak, head of industry analysis for the automotive Web site Edmunds.com. “And it is likely to be even worse in the month of October."
...
“During the last 10 days of the month it was extremely weak,” said George Pipas, a market analyst at Ford. “It was tantamount, really, to a natural disaster.”

Given all the money being thrown around, going bankrupt now would be strategically advantageous.

Wilmott Called The Subrime Crisis

Wilmott Magazine sent me some spam, and had this little self-promotional blurb:

Condé Nast's Portfolio magazine had this to say recently about Wilmott: “Paul Wilmott, publisher and editor in chief of Wilmott, is looking pretty smart these days. Wilmott and his magazine, which is aimed at the quantitative-finance community - the math geeks at banks and hedge funds - foresaw many of the problems that dominate the headlines today. He and the contributors to the magazine, whose influence far outstrips its small circulation, were railing about the limits of math and financial models far in advance of the meltdown."

I was pretty indifferent and ignorant of the mortgage-backed securities market in 2006, totally unaware it was a large part of investment bank portfolios, or what was going on in the new underwriting standards. It seems I was always out of earshot when the conversation turned to the seemingly obvious idea that mortgage portfolios were going to plummet. Add Wilmott and his multitude of prolific anonymous commenters to the list of those who saw this coming.

What I love is that Wilmott and his commenters love math and quantitative formulas, but also love Taleb, who blasts the application of these tools (or as they say in England, love maths). Talk about hedging your bets.

Obama called Subprime Crisis

Senator Biden didn't give references, but in the TV debate said Obama warned about the subprime crisis two years ago.

Who didn't see this coming?

Bad Diagnosis, Bad Cure

President Franklin Delano Roosevelt diagnosed the problems of 1929-32 in his first fireside chat, a week after taking office, as follows:

We had a bad banking situation. Some of our bankers had shown themselves either incompetent or dishonest in the handling of people's funds. They had used the money entrusted to them in speculations and unwise loans . . . It was the government's job to straighten out this situation and do it as quickly as possible.

Many years later, this is still the narrative on the far-Left for what caused the Great Depression. This is just wrong. It's just extremely naive to think bad things are caused primarily by bad intentions, because invariably bad ideas, to the extent they are popular, are based on widespread incorrect assumptions that have nothing to do with malice (eg, the malleability of human nature, the Blank Slate, the size of the government multiplier, the irrelevance of down payments on mortgages).

Sure there was incompetence and dishonesty, there has been and will always be, but that was not the distinguishing characteristic of that large decline in the economy, and I know of no reputable economist who considers the Great Depression as primarily an anomaly in 'greed and incompetence'. A solution predicated on such an incorrect diagnosis, leads to the disasters outlined in Amity Shlaes' The Forgotten Man, which turned the 1930's into a prolonged recession, as opposed to the recoveries that occurred after large declines in 1920 or 1838. I have a feeling that most of the policies enacted in response to this crisis will make things worse.

'To do nothing is sometimes a good remedy' said Hippocrates. Especially given the practicalities of politics (the bailout bill sent by Paulson was 3 pages. It's already 450 pages long).

Surprises are Over Anticipated

Now, as almost everyone seems to have called the housing crisis in advance, but totally caught Wall Street flatfooted, there's a lot of tut-tut-ing about how they should have known that unexpected things can happen. In the latest, Yves Smith notes that Benoit Mandelbrot noted that securities have fat tails, and 'should have known' better that these things happen.

Well, I agree that Wall Street made a mistake. But the fact that all the big Wall Street firms made the same mistake suggests that it was not obvious--these people may be rich and morally inferior to pundits, but that does not make them stupid. On the outside, I'm not sure how anyone was to know these firms all were making this trade, and I hope transparency aimed at that end is part of any new regulation. But "not expecting the unexpected", if not a tautology, means in practice we under appreciate tail events.
Looking at implied options for KeyCorp, we see implieds going up from around 200 at the money, to 350 for out-of-the-money puts, which indicates a massive amount of market expectations of a large jump to zero. Methinks that the market if anything is too enamored with tail events.

The problem is not that people don't understand the concept of fat tails or asymmetric distributions, in general. The essence of systematic risks is more nuanced than that.

A Sign You Take Yourself Too Seriously

You publicly post your opinion on myriad grave matters without any supporting arguments, such as 'My Views on the Crisis'.

Interest Group Inertia

I asked my local city councilman, why we don't get rid of laws that do not allow private companies to sell alcohol? He noted that our city owned liquor stores generate almost $1MM in revenue, and it would be impossible to replace that revenue, or cut that expenditure (total city budget around $30MM). So, my crappy city-owned liquor stores are here to stay.

Every theoretically possible connection to the current crisis is being offered as a 'root cause', so naturally arguing against the size of banks: if we had a bunch of little banks it would be much better (eg, former Mike Huckabee adviser Jim Pinkerton). I would say this is the stupidest diagnosis, but the field is pretty thick at the stupid end, so I'll just say, 'among the stupidest' diagnoses. For the longest time we had laws against have more than one branch ('unit banking'), or having branches across state lines. This prohibited banks from benefiting from the free lunch of diversification. For example, in the 1930's, there were about 9000 bank failures in the US out of 30,000 banks; in Canada, they had 10 banks, 0 failures. As technology made this more useless all the time (because you could in, effect, own assets in other states via securities markets), in the 1990's these interstate banking laws were repealed. But did you know, that the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which was signed into law by President Clinton on September 29, 1994 only became fully operative on June 1, 1997. This lag between passage and enforcement was intended to provide states with sufficient time to rewrite their tax laws in order to avoid losing substantial corporate tax revenues to the home states of out-of-state banks. That is, they rewrote their state laws, to make sure that no state lost tax revenue from this change.

Thus, a big practical hurdle in implementing new policies, is that they must be neutral to existing interest groups. Every new law should not make any single group with a veto, worse off. So in other words, I'm going to die with mainly the same set of stupid, antiquated laws we have today, and more importantly, can only buy Hoegaarden if I'm out-of-town in own of those fancy, newfangled 'private' liquor stores. Yippee!