This posting will quickly veer far off the usual topics of this blog into political issues that I normally avoid like the plague. For once, the issues involved seem important enough to interrupt your regularly-scheduled programming. I hope to not ever repeat this in future postings.
Over the last 20 years I’ve seen an increasingly large number of colleagues, students and friends leave academia to go to work in the financial industry. Many were hired as “quants”, working on mathematically sophisticated models for valuing various financial instruments. During the same period, I’ve watched New York City change in dramatic ways, driven by the vast wealth flowing into the financial industry here. I’ve seen recent estimates that half the personal income on the island of Manhattan has been going to the 20 percent or so of the population that work in finance-related jobs. The effects of this wealth include something like a five-fold increase in apartment prices, with a modest two-bedroom apartment now selling for a million dollars. In many neighborhoods, a majority of the people on the sidewalks have a net worth above a million, and annual incomes of many hundreds of thousands of dollars. Not surprisingly, the streets are clean, buildings shiny and beautifully renovated, restaurants excellent and street crime non-existent. Banks have opened huge branches on every street corner.
For many years I couldn’t figure out where all this money was coming from. When I’d ask people about this, I’d get a list of some of the things generating investment banking fees, but none of these seemed to add up to something that could provide the profits necessary to pay million-dollar bonuses to tens of thousands of people. Over the last year or so, the so-callled “credit crisis” has started to make clear what has been going on, and I (like many others, I suspect) have spent more time than is healthy following the story as it has unfolded.
It’s a very complicated subject, but the most important part of it is relatively easy to understand, and there’s not much disagreement about this. Starting about 10 years ago, housing prices in the United States began to increase dramatically, fed by low interest rates, and easy credit. A classic financial bubble developed as people borrowed ever-increasing amounts of money to invest in housing, sure that prices would keep going up. You can make a lot of money very fast this way. In 2006, housing prices nationwide had increased by a factor of 2.5 over the past ten years. This was the peak of the bubble and since then prices are off by 25%. They will still have to come down another 25% or so to get back to pre-bubble levels (inflation-adjusted).
The fall in prices has made a lot of housing worth less than the loans secured by it. More and more people have mortgages that cannot be refinanced and that they sometimes cannot afford, leading to foreclosure, or to a strong incentive to just leave and give the housing back to the bank. It turns out that one of the things the quants had been doing was developing pricing models for complex ways to market the risk associated with these loans. One of the sources of the huge income coming into Manhattan was the fees that this generated. The models being used turned out to be highly flawed, dramatically underestimating the fall-out from the all-too likely end to the bubble.
Since more than a couple ex-string theorists were involved in this, there’s a temptation to make an analogy with the complicated failed models that they were trained in working on during their years in academia, but that would be highly unfair. Most of the flawed models were developed by people whose training had nothing to do with string theory, with the flaws coming from certain built-in assumptions. These assumptions were chosen because they allowed a lot of money to be made in the short-term, making many Manhattanites quite wealthy.
Now that the bubble has burst and it has become clear that the financial instruments created are worth far less than anyone had expected, the fundamental problem is that, absent some optimism about a turn-around in prices, it is likely that many US financial institutions are insolvent. Their assets may be worth less than their liabilities (depending on exactly how low housing prices go). As a result, their stock prices have collapsed, and no one is much interested in investing more money in them. The situation has gotten so bad in recent weeks that the normal operation of the credit markets is in danger of coming to a halt, as institutions stop trading with others out of fear that they will soon be bankrupt.
Today the Bush administration put out draft legislation to deal with the problem (see here). The solution proposed is strikingly simple: the Secretary of the Treasury will be given $700 billion to hand over to financial institutions in return for mortgage-related financial assets, as he sees fit. On news of this possibility the stocks of these institutions rose dramatically late Thursday and yesterday. Assuming that this is enough to make most of the insolvent institutions solvent again, this will allow them to return to business as usual and get the credit markets working smoothly again. If it’s not enough, presumably Congress will just be asked to increase the amount.
Of course the devil is in the details, especially those concerning how Secretary Paulson will distribute the $700 billion. The plan seems to be to bring this legislation to a vote within days, unlinked to anything that would change the way the finance industry operates, or change the incentives that led to the current disaster.
Personally I think that, as economic policy, this is a really bad idea, for a host of reasons I won’t go on about. But I’m no expert on these issues, so that opinion isn’t worth very much and it’s besides the point of this no-business-as-usual posting, which is the following:
The response to this that I have seen from Obama and the Democrats is extremely disturbing. Obama seems to be inclined to go along with this, as long as some aid to people who can’t afford their mortgages is tacked on. This also appears to be the attitude of the Democratic congressional leadership, which includes senators Schumer and Clinton, acting in their roles as representatives of the largest industry in New York City. On the other hand, McCain appears to be choosing to take the populist position of ranting against Wall Street. It is now a few short weeks until the election, and I believe this will be the defining issue that decides it. If Obama and the Democrats support this bailout of the financial industry and McCain resists it in populist terms, I think we’re in for four more years of irresponsible leadership. McCain has already done a good job of painting his opponent as an Eastern “elitist”, and I can’t believe he’s too stupid to take advantage of the opportunity the Democrats will hand him if they vote for this legislation.
So, call and write your congressional representatives and the Obama campaign now.
For good sources to follow this story, there are some excellent blogs, including Calculated Risk and Naked Capitalism. This is also the kind of story on which some of the mainstream media shines, so read the New York Times, Wall Street Journal, and Financial Times.
Update: I hope Obama is reading not the Sunday New York Times which seems to indicate that this bailout of New York’s main industry is essential, but Krugman’s blog instead.
Update: Maybe Krugman is reading Not Even Wrong….
My reading now of what is going on is that Obama and the Democrats are starting to get a clue, based on seeing a firestorm of oppostion to the bail-out. The danger that they would go along with it seems to be receding. They can read polls too….