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Where we are at
Here is an excellent overview from Arnold Kling, read it. Soon I will myself cover derivatives in greater detail.
Posted by Tyler Cowen on September 19, 2008 at 11:04 AM in Current Affairs | Permalink
Comments
In a very narrow way Kling is right about some of the events leading up to this bubble. However, as the Fed lowered real interest rates down to negative 2% and W, greenspan, the neo-cons, the housing industry and lots of other fed worshippers cheered on the heroic acts of monetary abusrdity taking place in the mortgage industry. Greenspan gave speaches encouraging marginal buyers to purchase homes on adjustable rate mortgages. Fed defenders pointed out how the fed helps smooth over economic cycles and g-whiz they sure had learned a lot since the Fed "accidentally caused the great depression by not lowering rates enough "....nevermind the fact that the fed was supposedly created to reduce market volatility and the low real interest rates in the 20's encouraged investment in bad plans, often under the misinformed assumption that the fed would never have to slow down monetary creation forcing cascading bankruptcies.
In essence I'm saying these arguments ignore the role of the fed in this catastrophe. Blaming it on Barney frank is about as bad when those abu grahb privates got court martialed and the administration comrades encouraging torture got promotions.
Posted by: gabe at Sep 19, 2008 11:51:10 AM
Arnold Kling's article is good, although I think the next step is to ask exactly how poorly economic growth would have done over the last 20 years without deficit financing, then the stock bubble, and after that the housing bubble to boil it up. If this is what the United States has been doing, i.e. becoming a nation of attempted 30-year old financial geniuses instead of working for a living, then we are in bigger trouble than a mere $2-3 trillion write-down.
With regard to David Brooks' column further down this page, it seems to me we are going to embark upon a long New Deal-type era containing a lot closer regulatory monitoring and more social spending, because most of the people in this country are scandalized by this bailout, or whatever you want to call it. It throws a major rhetorical monkey wrench into libertarian Reaganomics, and it is going to take a generation or two of political slogan reengineering for Wall Street to surmount it.
Indeed, check the news today: has McCain decided to run against the bailouts? This could get him populist votes in a number of states.
Posted by: Lee A. Arnold at Sep 19, 2008 12:05:44 PM
Kling makes some thought-provoking points, but there's more to the issues methinks.
As a former RTC executive, I agree that the current situation is not very much like the RTC. The financial press is, as usual, mis-characterizing what went on. What happened was the government was the conservator of the failed thrifts, like a trustee. The main purpose was to make good on the government's promise of depositor insurance. To accomplish that, RTC had to sell assets. About 90% of those assets were loans, BTW, and the rest was real estate.
The current situation is very different. The government entity is going to have to buy in the assets (at what price? what assets? how do you capitalize it? what firms play? how do you distribute profits and share risk? LOTS of questions but answerable).
On the causes for the current crisis, Kling makes some good points. I think that he is redundant in breaking out two causes related to housing - low down payment and the housing bubble are two aspects of the same thing, as he goes on to imply when discussing leverage. Obviously low (or no) down payment and low interest rates team to push prices up.
I totally agree with Kling on the compensation issue. The back story is that there has been a complete breakdown of controls in the shadow banking system. It really is out of control when naked shorts, derivatives, and exotics can be so piled on and levered up that their sheer scale obscures underlying value. I've always thought that this risk could be mitigated by implementing some kind of lockbox arrangement (apologies for sounding like Al Gore) where some portion of upfront profits is reserved for when the spread goes against you (OK, so you reduce your profit expectations but we're talking about being reasonable in a system where the pigs don't get killed). Likewise, a compensation system that has some long-term involvement or loss participation, as Kling implies, makes sense but the mass delusion of the past decades has been pretty far away from that.
Another point that Kling could have made is the sheer size of some of the firms contributed to the problems, for example AIG. When any single firm bears so much risk (transparency, anyone?) that the firm's failure can take down the whole system, there is way too much concentration. Creative destructions doesn't work very well with oligopolies or any structure where there are few large players. Markets can absorb the destruction of one firm in a group of 20 similarly sized firms, but fall apart when a big one teeters on the brink. Analogous to the early 20th century problem of interlocking directorates, the system should look at optimal sizes for these firms (weighing interconnectedness as a factor - at what point does so much spread out risk sharing create its own risk) to prevent one player's bad business decisions from taking the whole system down.
Certainly there is wisdom in crowds, but not in all circumstances. Perhaps we need Bill Maher to come up with some New Rules for these markets!
Posted by: laocoon at Sep 19, 2008 12:55:21 PM
Check out point 3. Kling links to his lucid summary of the crisis and the role of the ratings agencies. I can't believe the Times didn't print this!
Posted by: Brandon at Sep 19, 2008 2:40:24 PM
Kling's post is very interesting.
One thing that puzzles me about the whole CDS business is this:
If you are going to insure a bond holding via a CDS why not just buy a Treasury instead? If the answer is that buying a corporate provides a better yield, even after the CDS payments, then I have to ask how that happens. Isn't there some sort of arbitrage that would prevent that? (Obviously the answer is no, there isn't, but what am I missing?)
Posted by: Bernard Yomtov at Sep 19, 2008 3:24:11 PM
Regarding ratings agencies, I'm confused. Can anyone elucidate further? If investors buying mortgage backed securities didn't rely on ratings agencies, but rather on the price of default risk insurance from companies like AIG, how did AIG price the insurance? Doesn't it beg the question? The securities are a black box, and the ratings were the only external assessment, weren't they?
Posted by: Greg at Sep 19, 2008 4:01:34 PM
why oh why? why did you say where we are at (sic)?
Posted by: Steve at Sep 28, 2008 11:55:04 PM
