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Subject: Why the latest meltdown? rss

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Ken
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From another thread, Wray made this statement:

Wrayman wrote:
I can roll with that. What then caused the market meltdown? Could it be characterized, at least partly, as fiscal irresponsibility by the government? Were there not voices for years calling attention to the pending bubble burst that those in power in Congress poo-pooed?


I told him that a new thread was in order since it was a derailment of a derailment of a slight accident in that thread, then decided to open it up.

So here's my take: Yes, our government had a role, but I don't think it was fiscal policy. Fiscal policy is what's going to hurt us for decades going forward right now, but it was not a major contributor to the crisis. What was?

In my mind, horribly, horribly loose credit rules that then turned into derivatives, which basically meant we were betting on black that they'd never fail. The sub-prime mortgage market hit around $1.5 trillion (yes, you read that right) in total value at it's peak. But the use of derivatives allowed banks to issue bets that the debt wouldn't fail to the tune of 5-6x that amount (and occasionally more) because the derivative market was very, very lightly regulated. Since the purchasers of these instruments were often funds or entities that were similarly lightly regulated, the total exposure to the system was masked because it wasn't easy to see the web of swaps that had suddenly sprung into place. (By the way, the total worldwide market for derivatives of different kinds has gone back to the growth side. One recent estimate put it at $650 trillion in total exposure if they come due, which is more than the total GDP of every nation in the world.)

Yes, oversight was lax at FNMA and FDMC. Yes, their underwriting rules were lax. No, they aren't the root cause - they're simply not big enough to have that kind of impact. What happened was a combination of complex financial instruments being used and marketed in new ways, risk management practices that failed to question the fundamental assumptions of the models used to rate the derivatives, and too little regulation of a market that had the potential to bring down the world economy. Throw in credit rating agencies that don't always seem to have the interest of the borrower in mind, and it was really just a matter of time.

Then, when the doo-doo did hit the fan, the securitization of the debts made it impossible for anyone to make any actual decisions about how to handle restructuring the debt to avoid foreclosure and keep the loan from going into default. Throw the massive growth in unemployment, lost wages as the recession kicked in, and you had a system that was simply gridlocked because nobody could make any decisions to keep the debts from going bad. That strains capital reserves, calls in those derivatives, causes institutions to fail, which creates massive counter-party exposures... The dominoes nearly don't stop falling.

Too much regulation is bad - of this there is no question. I wouldn't want airlines to go back to the way they were in the '70s (though I might not mind the service you got back then coming back). But when you're dealing with a market measured in the trillions of dollars, there's got to be some oversight. That oversight also needs to be sufficiently expert to know what the hell might be going on (read - not your average congressional committee) and have sufficient know-how to keep the market functioning without letting it become too risky.

And that's where we fell down. We chased profits without considering risks (either in the real estate market or in the derivative market). We didn't ask whether an investment vehicle that took a debt and allowed exposure to that debt to multiply made sense. We didn't wonder at why banks were no longer holding on to a significant portion of the notes they wrote and what that might mean if things went south. And we paid a steep price (total investment losses over the collapse hit something like $8 trillion in stockholder value, foreclosures/deliquencies approached 15% in the nation, and the unemployment rate went through the roof).

You can't "bet on black" and assume the wheel's never gonna turn up red. And that's pretty much what happened.
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Ken -- I largely agree. However, I place the lion's share of the blame on the credit rating agency. All the derivative swaps were made to "feel safe" by the AAA credit ratings they got. The problem being that those at investment banks basically "outsmarted" those doing the ratings. The naiveness in the manner in which the ratings were made is simply dumbfounding to me.

I know that hindsight is 20/20, but the ratings models were beyond simplistic. Many have argued that the investment banks were basically able to lure the brightest people via high salaries and the ratings agencies just couldn't compete. However, some of the principles that were overlooked are literally taught to undergraduate statistics majors. Some of it could be intentional deception of borrowers -- however, many of the borrowers are at the institutoinal level -- rather I think that it was the ratings agencies were turning a tidy profit without much effort. More of a case of negligence and going with the flow, rather then purposeful malfeasance; of course, that is the optimistic side of me.
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BJ:

1. Low interest rates combined with unrealistic models for default rates.

2. Both of these were arrived at because the original mortgages were "chopped up" into bundles with mostly reliable borrowers and some unreliable ones.

3. The overall bundles were rated AAA because about 80% were highly reliable.

4. Each level of the bundle had different times of payout depending on their rating.

5. The ratings didn't take into account that about a 7-8% failure rate would cause the whole bundle to implode

So a poor ratings model by the rating agency caused it (sorry, I know I am not Ken) as the lending never would have happened if the risks were properly rated to be BBB or some such.
 
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Daniel Edwards
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Governments (mostly the US government but certainly others as well) share the blame for:

1. the almost complete lack of regulation of the derivative market which effectively allowed the private financial sector to bet the farm;

2. stupid monetary policy which artificially kept interest rates low contributing to the US housing bubble which was the catalyst for the collapse.

But saying that government caused the problem by encouraging the private sector to loan sub-prime is just silly. It was almost completely up to the private sector how much lending took place and on what terms. Government didn't mandate lending 120% of the purchase price with no external security based on valuations virtually written on the back of napkins.

Investments analysts, brokers, rating agencies, property valuers, real estate agents, buyers basically the entire market failed to accurately assess the risks. I like the roulette example although it was more like everyone bet on black without seeing the wheel which was more like 75% red.

I think the Anglo concept that every family can and should own their own home also was a major contributor. Prices rapidly increased in so many places that many thought that there chance would soon be gone for ever. So they jumped on the bandwagon forgetting that property is an invesment that can go up or down like any other.
 
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Ken
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bjlillo wrote:
Ken, in your opinion, what caused/allowed consumers to spend so much money on homes which in retrospect were significantly overpriced?


A combination of banks looking to generate origination fee income and SDO income with regulation that didn't require lenders to either hold more of their debt or ensure creditworthiness.

And the homes were only "overpriced" due to the lax credit. Keep the subprime mortgage market at a reasonable size and you take a whole lot of demand out of the picture, which reduces the growth of prices.
 
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Ken
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myopia wrote:
But saying that government caused the problem by encouraging the private sector to loan sub-prime is just silly.


I'm just confirming - are you suggesting someone has said this? Because I don't believe anyone in the thread has.
 
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SpaceGhost wrote:
So a poor ratings model by the rating agency caused it (sorry, I know I am not Ken) as the lending never would have happened if the risks were properly rated to be BBB or some such.


I don't mind that you impersonated me. And it's a good answer. I think it's a contributing factor, but really only after the banks and derivative investors figured out they could sell the SDOs and make a profit.
 
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perfalbion wrote:
myopia wrote:
But saying that government caused the problem by encouraging the private sector to loan sub-prime is just silly.


I'm just confirming - are you suggesting someone has said this? Because I don't believe anyone in the thread has.


Its been floated around the forum a few times but I agree the originating statement doesn't quite go that far so I hereby withdraw any insinuation to that effect.
 
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Ken
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It has floated around the forums, but I'm absolutely not in that camp. I think that allowing FNMA and FDMC to buy subprimes was a bad idea, myself, and in that the government made a mistake. But the accounting issues at the two were a bigger problem - their balance sheets don't appear to have accurately reflected reality.

The derivative market is what strikes me as the big factor. Effectively, we let anybody that wanted to buy insurance that you would pay your mortgage. That's not too different from allowing anybody to buy fire insurance on your house and collect the value of the home if it burns to the ground. I can see letting one company make that bet so that it's a 1:1 offset for the company that's betting you will pay your mortgage (AIG was the largest example of this). But that market grew way, way beyond 1:1 so once things started to unravel, the impact was magnified by a massive amount.

Throw in shaky risk models and that was a huge issue.
 
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CW Lumm
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Economist Russ Roberts, a Libertarian economist from George Mason, did a fascinating podcast on the crisis recently; it can be found here: http://www.econtalk.org/archives/2010/05/roberts_on_the_2.ht...

(Note that I am absolutely not a Libertarian and tend to favor government intervention in stuff like housing markets.)

He thinks that incentives were such that creditors had no reason not to lend to banks, who were in turn making ludicrously risky investments.

I'm not enough of an expert to have a firm opinion on how right Roberts is, but this particular podcast is aimed at people who, like me and others here, might blame deregulation for the financial crisis. It's really worth a listen.
 
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I'd skip the pundit and go to Congressional Research Service for something closer to a balanced presentation. It's not perfect, mind you, but it's also not pushing an agenda.
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CW Lumm
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perfalbion wrote:
I'd skip the pundit and go to Congressional Research Service for something closer to a balanced presentation. It's not perfect, mind you, but it's also not pushing an agenda.


Really?

Anyway, he's a pretty well-respected economist, not a "pundit" (or at least only a part-time one), and like I said, it's worth listening to no matter what your political stripe. But, obviously, do what you like.
 
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Wall street greed had nothing to do with it. It's the government fault EVERY time. I suprised you guys didn't know that already. I just wish the government would stop putting a gun to the private sectors head and making them act like unethical popous ass holes.
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Oh, if I get a free hour, I may give it a listen. But I have read some stuff he's written before and find he often pushes a particular agenda. Not as hard as some, and he often has good points in there. But still an agenda.

I like the CRS report because it pulls from many different sources and doesn't have lots of baggage. But then I tend to like reports like that because it mutes some of the opinion. That report has numerous citations in it for additional reading, as well.
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Jeff Brown
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SpaceGhost wrote:
Ken -- I largely agree. However, I place the lion's share of the blame on the credit rating agency. All the derivative swaps were made to "feel safe" by the AAA credit ratings they got. The problem being that those at investment banks basically "outsmarted" those doing the ratings. The naiveness in the manner in which the ratings were made is simply dumbfounding to me.

I know that hindsight is 20/20, but the ratings models were beyond simplistic. Many have argued that the investment banks were basically able to lure the brightest people via high salaries and the ratings agencies just couldn't compete. However, some of the principles that were overlooked are literally taught to undergraduate statistics majors. Some of it could be intentional deception of borrowers -- however, many of the borrowers are at the institutoinal level -- rather I think that it was the ratings agencies were turning a tidy profit without much effort. More of a case of negligence and going with the flow, rather then purposeful malfeasance; of course, that is the optimistic side of me.


It seems to me that what happened was so inevitable that I think alot of people knew what was going to happen but chose to ignore it because they were personally getting rich from what eventually became a ponzi scheme.

You're right hindsight is 20/20 but I think that the CEO's of a few investment banks would have some inkling of the problems involved in pushing the envelope as far as they did on acceptable mortgage holders. The investment companies made massive amounts of money that many of the executives still have in their bank accounts.

The ratings agencies seemed so incompetent as you mentioned that their ratings were based on crazy assumptions. I don't really know the relationship between the ratings agencies and the companies but I wonder about it.

The types of mortgages that people were pulling out were so insane that I think people were being willfully ignorant because it meant they could lie themselves into getting a larger house. It's also much easier to lie to yourself when everyone else is lying to themselves also. It's kind of a willful mass delusion that a lot of people put on themselves with incredibly stupid wishful thinking.

Just as uncontrolled lust can lead people to make really stupid decisions. Uncontrolled greed can do the same when your brain is flooded with dopamine you are much more likely to accept lies that you tell yourself even if somewhere in your head you know that its a lie. The dopamine or desire makes you not really care.
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perfalbion wrote:
Oh, if I get a free hour, I may give it a listen. But I have read some stuff he's written before and find he often pushes a particular agenda. Not as hard as some, and he often has good points in there. But still an agenda.

I like the CRS report because it pulls from many different sources and doesn't have lots of baggage. But then I tend to like reports like that because it mutes some of the opinion. That report has numerous citations in it for additional reading, as well.


I agree that Roberts can approach some issues with a lot of baggage. Occasionally he's really surprising, though, and this podcast was one of those times. He seems to have gone through a bit of a change lately; whereas in years past he was just a pretty smug free marketeer and still mostly is, he's also become very skeptical about economists' and econometricians' ability to really say much of anything with a reasonable level of confidence due to inherent epistemological problems/limitations.

It's an unusual posture for economists to take and one I like to hear him elaborate.
 
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Ken
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jeff brown wrote:
It seems to me that what happened was so inevitable that I think alot of people knew what was going to happen but chose to ignore it because they were personally getting rich from what eventually became a ponzi scheme.


It's sort of frightening, but I think you're assuming too much here. I either know a number of executives at banks directly or through family/friends. Most of the ones I know said they'd recommended not getting into the derivative/SDO/CDO/CDS markets because they couldn't accurately weigh the risks. A few approved entering the market, but relied upon sources that turned out to under-report the risk. And the huge exposure from counter-party trading caught nearly everyone by surprise (the Lehmann failure was the only thing that made this apparent to most).

The rest I don't really disagree with on the whole.
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perfalbion wrote:
jeff brown wrote:
It seems to me that what happened was so inevitable that I think alot of people knew what was going to happen but chose to ignore it because they were personally getting rich from what eventually became a ponzi scheme.


It's sort of frightening, but I think you're assuming too much here. I either know a number of executives at banks directly or through family/friends. Most of the ones I know said they'd recommended not getting into the derivative/SDO/CDO/CDS markets because they couldn't accurately weigh the risks. A few approved entering the market, but relied upon sources that turned out to under-report the risk. And the huge exposure from counter-party trading caught nearly everyone by surprise (the Lehmann failure was the only thing that made this apparent to most).

The rest I don't really disagree with on the whole.

yeah, perhaps I'm going to far to say that it was a conspiracy. I guess I would use the term willful ignorance. People told themselves things were safer than they really were and they were all to eager to believe it. I would call it hubris rather than a conspiracy.
 
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perfalbion wrote:
Too much regulation is bad - of this there is no question.


In most industries, we have no effective regulation. Call the current governmental policy 'unregulation'. You'd think that the US public would wise up but there is no indictation. The Oil Spill, multiple bank failures, Enron, etc... are all examples. Regulations won't totally stop these failures but they can mitigate the damage and reduce the number.
 
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BFoy wrote:
In most industries, we have no effective regulation. Call the current governmental policy 'unregulation'. You'd think that the US public would wise up but there is no indictation. The Oil Spill, multiple bank failures, Enron, etc... are all examples. Regulations won't totally stop these failures but they can mitigate the damage and reduce the number.


Seems to me a lot of this is a legacy of Reaganomics, and I don't mean the actual unregulation, but the way we talk about it.

Reagan and that era's conservative economists developed a rhetoric according to which FDA procedures for testing new drugs, local municipalities' inspection of deep fryer grease traps, and laws that outlined when and how you can short stocks were all facets of the same phenomenon.

They're three different sets of regulations with many different groups of stakeholders and massive differences in implementation. But the baby went out with the bathwater as soon as hitting eject on government became the raison d'etre of the conservative movement.

There's a big difference between getting heavy-handed local officials to quit telling people how they have to paint the fences around their houses and the other, more critical regulatory structures, but many politicians have become all too happy to paint them with the same brush.
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BFoy wrote:
perfalbion wrote:
Too much regulation is bad - of this there is no question.


In most industries, we have no effective regulation. Call the current governmental policy 'unregulation'. You'd think that the US public would wise up but there is no indictation. The Oil Spill, multiple bank failures, Enron, etc... are all examples. Regulations won't totally stop these failures but they can mitigate the damage and reduce the number.


I'm generally in favor of increased regulation, but it's hard to see the effects of poor regulation as distinct from too much regulation. I also don't know how we create incentives to increase the likelihood of effective regulations.

perfalbion wrote:
That's not too different from allowing anybody to buy fire insurance on your house and collect the value of the home if it burns to the ground.


Agreed, but markets should be much more sensitive to the messages sent by offers to buy such insurance. The sorts of insurance most of us are interested in aren't about making money, but about paying for stability. If you know the people buying insurance on a house don't stand to lose money if it burns and aren't idiots, that gives you a lot of information about the fire safety of the house. People could trumpet the problems with subprime mortgages all they wanted, but I wouldn't expect global finance to care until they're putting their money where their mouths are. At that point, buying such insurance ought to constitute a message of such value that I'm reluctant to ban it--one of the many reasons this crisis happened is that people had more faith in their bad models than interest in such messages.
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The problem with allowing unlimited "bets" along the lines we're discussing is that the upside (payment stream if the bad event doesn't occur) won't come close to matching the downside if the investment goes south. Don't get me wrong - there's nothing wrong with someone going out and looking to make some cash by offering a form of insurance to the market as a hedge to those exposed to the risk. I get that - it's a valid way for someone to manage risk and for those willing to accept the risk to put up the cash to do so.

The problem is when you allow this to expand such that there's no investment interest or original risk being offset. If you're allowed to bet on whether or not my house burns to the ground for 1% of it's total value annually as income to you and 5 other people are as well, then the total exposure to the market if it does is 7x (my exposure, your exposure, and the other 5 individuals with exposure) instead of the 1-2x (my exposure & my lender's exposure). That's a huge increase in the consequence of the event occurring with no offsetting decrease in the probability of the event.

Understand - I do not think derivatives are evil/bad/stupid/wrong. I think they're a valid financial tool that companies can and should leverage under the right conditions. The problem is that those conditions aren't being met, they're being turned into a "raw" investment vehicle rather than a focused financial tool.

Look at it this way - you probably wouldn't add a second mortgage on your house to be able to pick up the check at dinner tomorrow night, would you? It's the wrong financial vehicle for that type of transaction. That's where I think derivatives need to be looked at - how can they be used by those exposed to risk to reduce it rather than how can those exposed to risk turn them into massive profit-making tools on their own.
 
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perfalbion wrote:
SpaceGhost wrote:
So a poor ratings model by the rating agency caused it (sorry, I know I am not Ken) as the lending never would have happened if the risks were properly rated to be BBB or some such.


I don't mind that you impersonated me. And it's a good answer. I think it's a contributing factor, but really only after the banks and derivative investors figured out they could sell the SDOs and make a profit.


True.....but, I see the ratings agencies as the "stop gap" that gives the final approval to how worthy the SDOs are in the first place. You can sell anything, but if it is rated lowest possible then nobody is going to buy it.

I suppose another big problem is that agencies basically "bid" to be able to rate products. So if a company doesn't like the rating, they just take it somewhere else. Conflict of interest, anyone? I believe Franken is proposing regulatino in the form of randomly assigning products to agencies --- that is the best idea I've heard yet.
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rinelk wrote:
I'm generally in favor of increased regulation, but it's hard to see the effects of poor regulation as distinct from too much regulation.


We aren't taking about 'poor' regulation; we are talking about regulation that has no appreciable effect on the industries being regulated.

rinelk wrote:
I also don't know how we create incentives to increase the likelihood of effective regulations.


The first thing we have to do, is debunk the dogma. Second, I'd say we need to take a risk based look at each industry and develop regulations to reduce the risks with the greatest impacts.
 
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BFoy wrote:
The first thing we have to do, is debunk the dogma. Second, I'd say we need to take a risk based look at each industry and develop regulations to reduce the risks with the greatest impacts.


Given the complexity of regulatory standards, I wonder if dogma isn't an inevitable or even necessary way for politicians to distinguish themselves to potential constituents.

People aren't stupid. I think just it's really hard to reduce accurate market valuation, auditing and yield curves to something that the voters who indirectly hold regulators accountable will see as critical to their well-being.

I mean, I try pretty hard and still don't understand this stuff.

So more/less regulation or free-market-oriented Wall Street/venal, unconstrained Wall Street become the order of the day.

There is the possibility that without giving regulators a (dangerous) level of discretion that puts them above elected officials, the system as it stands will always be too slow to outwit people who don't have election cycles to worry about.
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