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Roger Congleton's notes on the credit crisis
They are a good outline to many events behind the current crisis; many of you have been writing to me and asking for background reading.
Another of my colleagues, David Levy, just published this short piece (with Sandra Peart) on the ratings agencies and the idea of experts.
Posted by Tyler Cowen on October 1, 2008 at 03:30 PM in Economics | Permalink
Comments
Levy is saying that MBS caused regional housing markets to become more correlated? Is there (i) any empirical evidence for that proposition or (ii) a theoretical mechanism which predicts such a result? I am even sure that such correlation has increased, much less that MBS are the reason.
Posted by: y81 at Oct 1, 2008 4:08:44 PM
I found Congleton's notes very interesting.
Posted by: Bernard Yomtov at Oct 1, 2008 4:14:21 PM
Tyler and Roger,
Well done. One big exception, 7 (d) and (e) on page 2. Roger confused percents and percentage points. A one-percentage point decline in the risk premium, which he obviously means, is a 50% decline (50% of 2%), which is huge. By making the statement, "Suppose the bundler-insurer can lower the risk premium by just 1%," he made it sound easy. He meant one percentage point, which is hard.
Best,
David
Posted by: David R. Henderson at Oct 1, 2008 6:11:32 PM
How much should we trust an expert on mortgage lending who does not know how to spell principal?
Posted by: ogmb at Oct 1, 2008 6:24:18 PM
I loved this line from Congleton:
If a general credit crisis is coming, it will be in the future.
Yogi couldn't have said it better.
Posted by: Bill Stepp at Oct 1, 2008 7:39:42 PM
Thanks for the link. I'm worried about what housing policies Washington will concoct after (if?) the Federal Government buys 700 billion dollars of mortgage backed securities.
Posted by: Vova Shklovsky at Oct 1, 2008 8:36:14 PM
Thanks for the link. Lots of good thought here.
But he doesn't mention two aspects that my other reading suggests are critical:
+ creation of huge amounts of collateralized debt obligations from MBS, which new obligations were poorly structured and misrated by the agencies;
+ explosion of credit default swap market, largely driven by insuring these CDOs, and the facts that the market for these derivatives is private, opaque and unregulated and that capital requirements are insufficient at best.
My understanding is that Fannie and Freddie, though they created the underlying MBS, weren't responsible for the critical addition of the CDOs or the CDSs.
Have I misunderstood the situation, or are these major factors in the transformation of this mess from a large but garden variety housing crisis to a major credit crisis?
Posted by: Larry Cooper at Oct 1, 2008 8:53:44 PM
Thanks for the pointer to the Congleton comments. It seems a valuable summary as seen from the perspective of the financial markets. But Joe Sixpack would like to know more: in particular, Joe realizes that "if you want less of a behavior you punish it, you don't reward it". Take one of the "bad firms" -- Merrill Lynch (where I happen to have a large amount of money parked). What decision makers at Merrill are going to be punished? If your answer is "no one", why should the next crisis be any happier?
Posted by: Robert Ayers at Oct 1, 2008 9:01:30 PM
Robert Ayers, I don't think you are serious or even writing in good faith. If you want a list of senior Merrill executives who have lost their jobs, read the annual reports and the financial pages. If you want to know the numbers of mid-level and junior employees who have lost their jobs, that too has been reported in the financial pages rather extensively (try Google). If you are too lazy to do that work, I infer that you are not in fact interested in the question. If you want people sent to jail, you are being silly.
Posted by: y81 at Oct 1, 2008 10:00:01 PM
Loved this. He should qualify this more, though:
"(c) There have been bankruptcies of unusually large financial firms, but the firms that failed are unusually large, because of deregulation which allowed a great deal of inter and intra state mergers and consolidation to take place, and because of the internationalization of finance. (In previous times, there would have been many more bankruptcies, but of smaller firms, as in the S&L crisis.)"
And discuss the dangers (counterparty risk e.g. AIG) and the benefits (large universal banks being able to absorb losers and keep viable businesses afloat).
Also, he should touch on what a powderkeg this provision is (beyond the quotation marks):
"(b) The bill has also includes provisions for resources to be used to “keep persons in their houses” where possible."
Depending on how it's implemented.
The non-homogeneity of the assets and problems in organizing and appropriate reverse auction/purchase plan are probably too wonkish.
This should be required reading for every high school senior.
Posted by: Anthony at Oct 1, 2008 10:02:37 PM
Some thoughts -
History:
7(e) - ... (As long as one does not have to actually pay much out on the insurance provided).
Couple this with 7(f) - which compares the insured sub-prime rates to the average default rate (without actually specifying which average or whether prime default rates are included - and it seems that while the insurance can be profitable the insurers in this case seem to be betting that the lenders are mis-pricing their loans.
I would challenge that such activities can be "highly profitable" in the long-term, and basic macro-economic theory - not to mention the realities of today - seem to support that conclusion.
Meltdown:
3(a) - "...insurers of [MBS] had assumed (or hoped) that housing prices would rise forever..." - this is not necessary if those making the decisions are "greedy"; which it is ignorant to assume they are not. They take their cut while the taking is good and get out (are kicked out) when things turn south. I don't think government or even shareholders can avoid this reality no matter how much regulation is imposed. Slash-and-burn comes to mind.
How Bad?:
1(c) - The statement "failed to clear at long-run equilibrium prices" makes no sense to me? Long-Run doesn't matter, the currently equilibrium price IS one where all assets clear. If someone would rather hold an asset than sell it at a given price then it is illogical to consider that assets as "failing to have cleared".
5(c) Has there been a comparison of the total bankruptcies (liability values at declaration) between now and previous times frames (i.e., do the fewer large firms constitute more liabilities than the many small firms, with adjustments for say the average GDP at the time - or without)?
It does appear that "mark-to-market" does have a greatly negative effect that could be reduced since these assets could be held to maturity and thus an expected payout/default calculation could be done. If the maturity calculation gives a higher asset value credit ratings would stabilize and loan calls would decrease. One possibility is introduce a CD-like product that could wrap the MBS using the hold-to-maturity value with some room for slack. If the government, or banks, offered these then the market for those impaired assets goes away and effectively becomes an annuity. There would be no way for the "CD" to be sold and so while it would become a long-term asset tying up capital for the firm in question it would never change in value and could be amortized away over time as opposed to the immediate loss incurred from selling the impaired asset.
Posted by: David J at Oct 1, 2008 10:54:02 PM
"y81" suggests that many people at Merrill are out of a job. I do not doubt it. Let's look at the decision makers: the people who gambled (with other people's money) that the housing market would stay healthy forever.
The Reuters headline announcing E. Stanley O'Neal "stepping down" as CEO reads: "Merrill CEO's package may top $200 mln".
I did not suggest government retribution. What I stated was that if a behavior is rewarded rather than punished, it continues.
I don't consider retiring on $200 million as "negative feedback" that will change wall-street habits: If I was there and wondering whether I should gamble with the future of my company (and a lot of other people's money) and I thought that the bad-outcome would be that I would be given $200 million, I'd gamble too.
Posted by: Robert Ayers at Oct 1, 2008 10:59:11 PM
y81 - Those people may have lost their jobs but that doesn't mean they have been black-listed nor haven't saved their cash in safe investments and thus never need to work again anyway. I would offer that being able to pull out 10s of millions of dollars and then walk-away and never have to work again is a great career gig if you can get it.
I think jail would be good (or exile), though meeting a burden of proof would be nearly impossibly except in cases of fraud and that can already be prosecuted anyway.
Posted by: David J at Oct 1, 2008 11:00:05 PM
From the short piece
"Only once investors realized that the housing market is a national market—not a local one—did it become clear that these securities were extraordinarily risky. Hence the collapse."
Housing is local, but the credit market is (inter)national. Diversification exposes you to and doesn't protect you from market risk.
"All of this is a telling lesson about how much and when to trust the experts. This is especially so now that a new set of experts is attempting to get us all out of the mess we're in."
In other words, how likely is the same shovel that got us to the bottom of this hole to get us out?
Posted by: Andrew at Oct 2, 2008 3:59:25 AM
"The art of medicine is to entertain the patient while nature cures the disease." ~ Voltaire
From Congleton "predictions of a “great depression” to be fear mongering."
Regardless of what happens going forward, which will happen in the future, while the experts who now want to lead us out of the wilderness kept quiet, other experts were telling us our biggest problem was health insurance, or global warming, or terrorists, or oil speculators. Can we at least agree that experts are full of crap? Or, more formally, they suffer what Charlie Munger calls incentive-cause bias.
I vote we say no to them until they start giving real information. As long as they are blowing smoke, we simply don't have to do business.
Posted by: Andrew at Oct 2, 2008 5:25:53 AM
Episode 1: Pyramid Selling (with good intentions).
Episode 2: Bank Run (performed not by ordinary folks, but by those institutions).
So, I guess Milton Friedman would argue for a low- (or zero-) rate loan to the banks. That's as far as I can go leaving the Free Market standing.
Posted by: Cowcup at Oct 2, 2008 6:51:55 AM
The current bill passed by Senate is road to a new New Deal. In other words, a prolonged recession is ahead of us.
Posted by: Cowcup at Oct 2, 2008 6:55:52 AM
"This should be required reading for every high school senior."
I am going to require high school seniors to read it today! We'll see how that goes.
Posted by: josh at Oct 2, 2008 7:28:16 AM
Tyler-
Thanks for the reference. I thought the article was very clear and a terrific antidote to the unreasoning fear that's being peddled.
Posted by: Rich Berger at Oct 2, 2008 9:38:46 AM
Thanks all for the comments and suggestions. I update the notes every day or so, and will think about some of your suggestions. Some will affect the tomorrow's revisions. My apologies for the typos, although they should be gradually disappearing as I revise the notes.
Initially, I was just trying to organize my own thoughts on this "crisis," as so much of what was being reported seemed obviously false or misleading. "Fear mongering" is also a significant problem, and probably has contributed both to the decline in the stock market (which should be falling anyway as we head into a recession and to reflect weaker balance sheets ) and in credit between banks. The notes aim to plow through the main events without hysterics to see how they all fit together, which seems rare in published material, so I though it would be useful to post them.
Re profit opportunities from mortgage-insurance, obviously there were rather large profits--just as there are now large losses--or those enormous bonuses would not have been forthcoming. If everything were always perfectly priced, we would not be in the present mess.
The main problem, however, seems to be the "largely unexpected" great loss in asset value on a single class of assets on wide range of international balance sheets. The over-leveraging, wrong mortgage portfolios, and recession problems are in a sense separate problems that always emerge when a bubble bursts or an economy heads into recession, although they reinforce the main problem (and have also been reinforced by that problem).
Best regards,
Roger
Posted by: Roger Congleton at Oct 2, 2008 4:25:00 PM
I appreciate the effort Mr. (?) Congleton put into his outline of the crisis, but I am dissatisfied w/ his apparent desire to put blame squarely on Freddie and Fannie (with very little mention of the role of the entirely private players).
In 2004, Fannie and Freddie purchased 44% of all subprime MBS sold, in 2005, 35.3%; and in 2006, 25.2%. Total 2006 estimates have 15% of Fannie and Freddie’s mortgage exposure as subprime.
Now, I think it is deplorable that our politicians did nothing about this when voices from all sides warned about the impending Fannie and Freddie blowup. However, since the gov't has already stepped in and "rescued" the two GSEs (as well as stepped in as explicit guarantors), if the problem had been isolated to F/F, as suggested in the outline, we certainly wouldn't be progressing to the much more dire situation we are in today.
The outline mentions CDSs almost not at all (as another reader notes above), despite the fact that they were the sole instrument that necessitated the takeover of AIG. With somewhere between $40-$70 trillion CDSs outstanding and tottering, which completely overshadows the underlying $12 trillion in mortgages in the US, its no wonder the Paulson twins felt the need to come in with their emergency bailout.
Posted by: Kady at Oct 2, 2008 4:50:07 PM
