Monday, June 15, 2009

QOTD

On the Library of Economics and Liberty site, economist Anthony de Jasay cautions against over-simplifying the explanation for the credit-crisis:
The technocratic view is that the dysfunction that was set off in August 2007 and has since grown to alarming proportions, was due to reckless deregulation of the financial system and more generally to the withdrawal of governments from their controlling and safeguarding role. Since the invisible hand has proved to be unsafe, let us once again put our trust in the strong hands of the state and let us, without procrastination and horse-trading, build a new regulatory framework that will preserve the strengths of free markets while ensuring their smooth working and protecting them from wild stress and strain.

It should not surprise us if future historians were to conclude that this reasoning was a typical case of post hoc, ergo propter hoc--the troubles came after deregulation, therefore they were caused by deregulation. In fact, the chain of causation was probably less pat and simple. An exceptionally low real interest rate spectrum due primarily to the gigantic East Asian excess saving has generated a housing price bubble in the United States, Britain, Spain and Ireland. It is very doubtful whether the Federal Reserve could have resisted this even if it had wanted to. At least partly if not wholly as a result of stimulation by public policies favouring home ownership by very low income groups, there was much overlending on mortgages, risky even if house prices had remained at their inflated level and loss-making if they turned down--as they duly did. Fannie May and Freddie Mac could not hold off the degradation of mortgage portfolios. The physical capital represented by the mortgaged housing stock was not damaged, but the securities that had big batches of both prime and subprime mortgages as their collateral (and that bankers allegedly did not even understand) were damaged by a loss of confidence that temporarily froze them into illiquidity. There were many would-be sellers but only a few "vultures" would buy, and they only at near-absurd prices. Securities whose mortgage collateral may have become 30 per cent non-performing and that percentage, in turn, would all end in foreclosure and permit, within a year or so, no more than 50 per cent of the mortgage debt to be recovered, would under these conditions have an intrinsic worth of roughly 85 per cent of their par value (a loss of 50 per cent on the 30 per cent of defaulting mortgages, i.e. a 15 per cent on all the mortgages). The "vultures" might buy some at 20 per cent of the nominal value which very few banks would willingly accept. However, in that case under the "mark to market" rule, they had no choice but to devalue their mortgage-backed securities to 20 per cent of the par value, declaring a truly frightening loss of 80 per cent. This was the trigger of the panic.

From then on, the rest follows fairly easily. Credit default insurance losses are a multiple of the mortgage-based losses, although they are matched by the gains of counterparties. In fact, all purely financial losses are matched by gains or avoided losses, the whole being a zero-sum game that impacts the distribution of wealth, but not its total, amount. However, at this point the effects on confidence enters the game. In particular the influence of modern, aggressive media on partly-informed opinion becomes decisive. "Things are really not too bad" is not a good headline but "things are catastrophic" is. August authorities, including the head of the IMF, get into the headlines and the evening news by announcing that much, much worse is to come. Such prophecies are self-fulfilling. Even the prudent customers who have no credit card debt will stop buying durable goods, and the financial mayhem infects the "real" economy. It is a perfectly open question whether more regulation could have prevented such an outcome. Quite possibly it might have aggravated it, and may yet make any recovery slow and awkward.

Be that as it may, the politicians and the technocrats will now pile regulation on regulation, making the economy more rigid and sluggish, because the groundswell of popular sentiment imperatively demands it.
Agreed.

13 comments:

bobn said...

Pure garbage.

The technocratic view is that the dysfunction that was set off in August 2007

No, all the blogs I was reading knew the banks and housing markets were dead meat 1-2 years before.

post hoc, ergo propter hoc - invoking this mantra proves nothing other than that the invoker has just been presented with a lot of evidence for which he has no answer - already dealt with here.

At least partly if not wholly as a result of stimulation by public policies favouring home ownership by very low income groups, there was much overlending on mortgages, risky even if house prices had remained at their inflated level and loss-making if they turned down--as they duly did. Fannie May and Freddie Mac could not hold off the degradation of mortgage portfolios.

More trying to blame the CRA without saying so. Also neglects the fact that the mortgages made by your heroes on Wall Street were 12.7 times as likely to go bad as was a GSE mortgage, as shown by the numbers here.

Securities whose mortgage collateral may have become 30 per cent non-performing and that percentage, in turn, would all end in foreclosure and permit, within a year or so, no more than 50 per cent of the mortgage debt to be recovered, would under these conditions have an intrinsic worth of roughly 85 per cent of their par value (a loss of 50 per cent on the 30 per cent of defaulting mortgages, i.e. a 15 per cent on all the mortgages).

Sorry, doesn't cover the insanely complicated effects of tranching and other forms of deranged math. Many lower and medium ("investment grade") tranches truly did become completely worthless, and even the higher ones suffered greatly. And you're arguing that the market doesn't work when you say that securities with "intrinsic worth of roughly 85 per cent of their par value" will only draw 20%. If they could be seen to be worth 85%, they would draw bids in that neighborhood.

(You free-marketeers are such true believers until one second after the market gives you the bad news.)


The market had *no idea* what this crap was worth after the math-swindlers got done - they only had bought-and-paid-for ratings which turned out to be meaningless. Lesson to Wall Street: if you want something to be saleable, it needs to be comprehensible.

bobn said...

The market had *no idea* what this crap was worth after the math-swindlers got done - except they knew it was worth *way* less than whatever the owner or rating agencies said they were worth.

OBloodyHell said...

> If they could be seen to be worth 85%, they would draw bids in that neighborhood.

That's stupid, bob. Presumption on a massive scale. If I'm not willing to sell at a price, and I don't need to sell at that price, I generally would not sell at that price.

Confidence erodes, people tighten up their spending ("batten the hatches in case of a storm" -- whether that storm happens or not) and stop buying at a "fair market valuation" -- i.e., what any rational person would sell it for given an alternative to just sit on it.

The correct behavior in most such instances is to hold, sit pat, and wait out the storm.

Mark to market, though, is the equivalent of a fire sale, "everything must go!!" -- no matter the state of the market and whether anyone would rationally sell in such a market unless desperate for cash -- regardless of if they are desperate for cash.

Mark-to-market is valuable investment information -- "what is the company worth at this exact moment if we were going to liquidate it?". It's not the valuation of the company unless there's a valid reason TO liquidate it, however. If a company has 3 years of operating expenses as cash reserves, then its worst-case liquidation value is whatever the highest value is during that three-year period -- i.e., if it's ridiculously low due to the market equivalent of an epileptic seizure, then you would do the prudent thing and wait it out. Which makes the mark-to-market value irrelevant, unless some idiot regulation rams the sale down their throats.

> The market had *no idea* what this crap was worth after the math-swindlers got done

It's called a "bubble", bob, and it's got nothing to do with math-swindlers -- And anyone stupid enough to believe that that wasn't a bubble market deserved to get ripped off. It's "buy low, sell high", not "buy high and get screwed". When you artificially inflate demand (which is what heavily subsidizing ownership, along with interest rates well below the ROI for a product -- i.e., real estate does), gee, you get an overheated market!!! Gosh, whoodathunkit? Well, anyone who could smell the stench of cooking rotten meat, actually...

suek said...

I'm still trying to figure out what happened. I've found this blog informative - though not enough to make me feel like I know anything.

http://market-ticker.denninger.net/

I'd welcome opinions...

(also suggest using the search function with "prosecution" as a search term.)

bobn said...

OK, let me try again:

IF they could be SEEN to be worth 85%, they would draw bids in that neighborhood.


Nobody could see that with the bizarre creations of Wall Street - sometimes because of the absurd complexity, often because the stuff wasn't worth anything like what the banks thought it was.

here is an example. The geniuses owning this security price it at 97% of par. The geniuses at S&P rate it at 87%. The market gave it 38%. Keep in mind the security is composed of 2nd mortgages. Although the quoted article states "losses on defaulted mortgages are averaging 40 percent", in fact in this environment, the loss severity on 2nd mortgages is probably greater than 100%, after expences are factored in. So, is the market wrong? The only way I think it is wrong is if it paid too much.

Do not underestimate the amount of real trash that the banks are holding.

Do the stockholders of those I-Banks deserve a mark-to-market view of the "assets" held by the I-Banks? I believe so. Mark to Market was a reaction to Enron.

It may not be the best way to handle regulatory capital requirements, except what do you propose as an alternative? Mark to fantasy, as the banks are doing? That cannot be the right answer.

Also, bubble or no bubble, if the securities involved were not so compilcated, people could get some idea of what they were worth.

When you artificially inflate demand (which is what heavily subsidizing ownership,

Um. Wall Street funded loans were 12.7 times as likely to blow up as GSE loans, as shown by the numbers here. Yes, Franklin Raines was an asshole. No, the GSEs did not do this. Wall Street did.

bobn said...

Suek:

I'm not always sure what to think about Denninger, except that I agree with him that the whole bailout meme is wrong and some companies, especially I-Banks need to die.

He does get over-wrought sometimes. Also, he gets into the "technical analysis" side of market calling, which I've always considered nonsense - and I'm in stock at all these days - too much manipulation and just general wierdness going on.

bobn said...

meant to say "and I'm NOT in stock at all these days".

OBloodyHell said...

> Mark to Market was a reaction to Enron.

I have no problem with that estimation being a part of the information on a company's balance sheets. The problem is when a company can find itself in a forced fire sale when it's sufficiently liquid to wait out the market collapse. And that concern was a large part of the panic that drove things well below rational values, and more than one of the companies-that-are-no-more were driven to that condition by the notion that mark-to-market is the only evaluation that matters.

bobn said...

OBH:

I understand what you are saying. I think the FASB backed off some in April, allowing a little more leniency in the evaluating of long-term assets. I'm not clear on the details, but I know everybody on the econ blogs thought it was a return or expansion of "mark to fantasy". It may be that these changes helped the issue you raise. It may also be that it allows the banks to mark trash as not-trash. With all the recent government intervention, I'm not sure how to tell anymore.

bobn said...

Suek,

If you go to my blog, near the bottom is a list of Econ blogs I find useful.

Carl said...

suek:

I'm not positive I know what happened either. But I agree with at least one proposed remedy.

Carl said...

suek:

This Arnold Kling piece is interesting, and consistent with my views.

bobn said...

I said:

Wall Street funded loans were 12.7 times as likely to blow up as GSE loans, as shown by the numbers here.

This statement. while accurate, may not be a true representation of underwriting failure rates during the bubble, as the total number of GSE mortgages probably includes more pre-bubble mortgages than do the private label numbers.