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….
First you observe, “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. ” Then you suggest to lobby and support the presidential candidate and the party that just demonstrated irresponsible leadership on what you regard as the defining issue of the coming election. Where is logic?
Nationalizing corporative debts… where have I seen that before? This kind of scam used to be orchestrated by US corporations (and, probably, governments) in foreign countries. Now they are doing the same thing to their own people. I never thought I’d live to see this.
In one of the local newspapers here in Turkey a pandit wrote that “people who claimed that the Big Bang experiment will create a black hole that would swallow the world turned out to be right. They were only wrong in the place (or space) and the responsible parties. Big Bang did not happen in European Union’s CERN but in the world’s financial center Wall Street in the United States. And the people responsible for this were not physicists but bankers and institutions that evaluate credit worthiness. But as a result black holes resulting from the Big Bang happened and they swallow everything they encounter.”
I think that if the pandit I quoted knew that the bankers were using models developed by physicists he would have seen that his analogy is even better than he thinks. And isn’t one of the reasons that string theory is so spectacularly popular in the academia even though it is a “complicated failed model” is because it allows physicists quick academic returns “in the short-term?”
The banks were bailed out so that the black hole created by the Quants (not the guys at the LHC!) doesn’t swallow the planet. I’d say this administration did the right thing – for once (although it was pretty much on gunpoint). Things will be bad, sure, but not nearly as horrible as they would have been.
It is rather unfortunate that people do not understand this.
Dear Peter
I enjoyed this last post quite a lot. I am not a financial
expert either and do think that it is “Far Off-Topic”
but I do think that it is right on topic discuss how many
theoretical physicists have gone into the financial industry
and the extent to which the complex financial instruments
they have created (through confusion) the current financial
situation. It is also should be realized that these very highly
paid positions do not create real wealth the way that experimental
physicists who invent the laser or invent the web do. I also
wonder to what extent the malaise in theoretical physics,
the general lack of funding, and lack of oppotunities in
real industries, leads these individuals to enter the financial
service sector.
these individuals
Hi Peter,
Don’t confuse the “correct policy” with the “correct politics”. They are two completely different things. It is in no way clear to me, with the media screaming “the sky is falling”, that McCain is in the better political position.
Regarding the correct policy. You seem to want to punish wall street for their recklessness by letting the global financial system freeze up. That probably isn’t a good idea.
I think this crisis was partially created by the government-both the Clinton and Bush administrations-pushing bankers to issue risky loans in order to promote the common good:
http://www.openmarket.org/2008/09/19/trillion-dollar-bailout-will-lead-to-future-bubbles/?disqus_reply=2501529#comment-2501529
It’s quite interesting how the Feds didn’t seem to have a trillion to rebuild New Orleans but now the water is rising in Wall Street the money magically appeared over a weekend.
You’re right, this is a complicated issue. But it hardly makes sense to expect effective reform from the candidate who is the #2 Congressional recipient of Fannie Mae and Freddie Mac campaign contributions over the last 10 years (Democratic Sen. Chris Dodd is #1). Senator Obama achieved this dubious distinction despite only joining the Senate in 2005, well under 4 years ago. Also note that the primarily responsibility for oversight of banking operations belongs to the Congress, not the executive branch (Barney Frank, another Democrat, chairs the House Banking Committee).
As usual, we don’t get to choose between the Good and the Bad, but between the Bad the Worse.
The Republican conservative philosophy caused this crisis. It’s that simple. They deregulated the investment banks, which then naturally took extremely large risks to maximize short term profit.
Voters may not be very bright, but there’s no way they are going to see McCain as being separate from the Republican party that is to blame. And McCain’s support of the bail out is tearing the Republican Party apart.
So far, Obama and the Dems have been quick to place blame on McCain and the Republicans, to point out the need to help the middle class, to regulate the investment banks, and to control the size of the golden parachutes going to very bad CEOs. I think this is the correct response.
I find this argument rather far fetched. I don’t know how many ex string theorists work in finance. But it’s pretty obvious that many more particle physicists (phenomenologists, latticists, etc) do. After the SSC collapse there were many more jobs in academia for string theorists than for particle physicists, so the latter flocked to computing and to finance.
Actually, I think Peter is wrong with his remark “These assumptions were chosen because they allowed a lot of money to be made in the short-term”. From what I’ve read, that’s ascribing the results to poor motives whereas I think the quants were attempting to do their best to “remove the variance” from variable financial instruments and a fair degree of both analysis and simulation goes into verifying that these aims have been acheived in the simulated case that, eg, mortgage defaults follow a specified probability distribution. From what I understand, these tests are genuinely and stringently applied until some modification of the model passes them. The difficulty is that the tests aren’t the right tests.
The problem stems from the fact that these are physicists who by the nature of the subject are very used to considering elements to be independent rather than “colluding” or “cooperating” and just didn’t consider possibilities such as that almost all loans packaged in a given financial instrument might be liar loans, that every realtor would co-operate with “house price worth” inflation, that most lenders would get “spooked” at the same time, etc, etc.
So I don’t think it was ill-intent so much as picking in researchers who in their previous careers never had any reason to get experience with an important aspect of the financial world. I’ve said in the past that I can see why finance houses would want the best people, but why it should be the best physicists rather than population biologists, epidemiologists, network researchers, etc, (who have much more experience of systems of colluding and non-independent components) never made sense to me.
Your account of the state of play, although not inaccurate, is incomplete. For a bit more than the last 20 years, unfounded debt has been created globally in most economic zones and has been hidden in opaque government and corporate balance sheets worldwide. The housing sector in the US is only one of many manifestations of this phenomenon, although it has been the first to receive public scrutiny.
The global markets have been correcting and will most likely continue to do so until all this fictitious capital has been destroyed. Since it is hidden, probably more than the worthless paper will be incinerated in the process.
Eventually when all this has taken place, transparency will be in everyone’s interest, and probably will be the way forward at that time. Until then,every effort is being made to conceal the lack of value and shift the losses to other parties. This is the function of Paulson’s piecemeal proposals.
None of this is surprising. NYU’s Noriel Roubini has analyzed in broad terms this entire unfolding process, by way of addition to the sound sources you cite.
Some ironies of the situation are striking. Eleven years ago, the Long Term Capital blow-up took place under the direction of a Nobel Prize winner in Economics, and John Meriwether, who subsequently started another fund which is reported in the Wall Street Journal today to be about to blow up for the second time.
This process will not be without consequences for some major US Universities which today receive more income from endowment ( ie Hedge ) funds than from tuition, and for public Universities as government funding and debt become more difficult to generate.
It is rather unfortunate that people do not understand this.
People understand perfectly well. The issue is how you manage the debt. Many assume that the only way to do this is throw money at the banks to buy back as much debt as possible. That’s bullshit. Every new dollar that goes into the pockets of those overpaid twads is a dollar wasted.
Peter,
I’m not sure I understood your final paragraphs. Are you advocating that Dems be persuaded to oppose the bailout or that we trust McCain to fix it?
I do think the bailout deserves tough scrutiny, and I think we need to insure that those who perpetrated this disaster get, at the least, a severe haircut, but I’m not sure that we can afford the alternative – an international financial meltdown.
It looks like quants, “financial engineering”, and the science of “risk management” could finally lose all credibility. It’s probably going to be finally seen now as modern alchemy and snake oil. But anyone really could have seen that this rediculously overblown credit and real estate bubble was going to explode. The massive bailout package has a real air of desperation about it. I’ve got a bad feeling about the whole thing but I guess there is no other choice. I’m reminded of Towering Inferno where Steve McQueen has to blow up the tanks at the top of the building in the hope that they release enough water to put out the raging fire that won’t otherwise stop. But bailouts are part of the problem.
Exactly 10 years ago hedge fund LTCM was bailed out but that then seemed to set a trend: financial institutions and hedge funds then realised that they could borrow massive and take on monster risk/leverage and the government would bail them out if it all went totally awry, in order to safeguard the global economy and the normal functioning of the markets; the principle of too big to be allowed to fail and too connected to be allowed to fail. This has proven to be case with recent events although Lehman was especially unlucky.
But how many hedge funds have imploded this week and how many will continue to implode, especially with the ban of short selling, and what effect this will have? The short selling ban could turn out to be a bad idea too. I’m especially interested to see how James Simons and Renaissance will come out of this. The consistency of their past performance suggests they are probably the only ones who have any real mathematical/statistical grasp of markets and their underlying dynamics. Will their strategies withstand everything?
Finally, it’s worrying that neither of the candidates in the election race seem to have any real clue.
‘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.’
It’s interesting that ex-string theorists are deemed expert enough in real-world social dynamics to model credit risks. In the 90s I worked for the credit control/debt collection industry, dealing with defaulting mortgages in England near the tail-end of a recession that had begun in the early 90s. As inflation drives house prices ever higher, the average cost of mortgages gets bigger, people struggle more to pay with both partners working long hours, so any problem sends them into default.
Banks can’t collect money from people who literally can’t pay (back in 1997 many banks – our clients – were happy for us to accept from debtors as little as 5-10% of a mortgage in a lump sum ‘final settlement’ – writing off the remainder – rather than wasting time and money getting fruitless court orders for token payments that were hardly worth the effort to try to enforce).
As a result, banks increase interest rates to compensate for the money they lose in writing off uncollectable debt, and this increase in interest rates means fewer property buyers can afford mortgages, so the property market slows down. Eventually, people trying to sell property have to cut prices in order to secure a sale, so there is a slump in prices, which devalues the equity people have in their owned homes. Many people who bought property at high prices end up with ‘negative equity’, a home worth less than the mortgage they have outstanding to pay back.
If a bank repossesses such property (after expensive legal costs to do so), it can’t recover most of the money because the property isn’t worth as much as was paid for it. Property is only ‘worth’ what somebody else is prepared to pay for it, which is partly a psychological consideration. If you think there is a risk that the value will drop in the future, you lose confidence in buying. So it’s a very complex risk analysis situation with a lot of interdependence between different factors once a recession kicks in. No matter how many credit rating checks a bank does before lending money, people will still default en masse if there is a major economic recession that drives prices beyond their wages or which leads to a lot of business closures and unemployment. (One suggestion I have for investors fearful of a recession is to invest in debt collection companies, which do great business and profit greatly during bad recessions. We got big bonuses in 1997!)
CIP,
I’m advocating that the Democrats oppose the bailout. I believe that McCain is fundamentally another W, an irresponsible and incompetent person, and if he gets elected we’re in big, big trouble. However, I suspect that he and his advisors are not so stupid that they won’t see the opportunity Obama and the Democrats are putting in front of them to portray McCain as the Maverick real American determined to save people from the “elite” intent on taking all their savings and giving it to the New York bankers.
As for Paulson’s claims that the financial system will melt down if Goldman Sachs, Morgan Stanley, and the banks are not bailed out, I think one should keep in mind that the guy is someone who made a better part of a billion dollars at Goldman Sachs, and so far what he has done to address the credit crisis has just continued to make things worse. A complete melt-down of some parts of the financial system such as the CDS market might actually be desirable, allowing the wreckage to be cleared and something new to be built. The plan now seems to be to keep the current dysfunctional system limping along, with new lubrication provided by the $700 billion from the taxpayers.
My understanding, far from complete, is that the so called quants saw that there were huge numbers of individuals and families who would like to own homes, but hadn’t yet been able to do so. The problem in any society is that there always seems to be a fair proportion of people that, for any number of reasons, can’t qualify to come up with the down payment or can’t qualify for the mortgage payments. But these people would love to own homes.
What the quants did was split mortages for these non-qualifying individuals into two parts. There was a “good” part that had low risk to the lender because they were first in line to get paid if the debt holder defaulted. And the poor part of the loan was sold as sub-prime loans with high risk, but also high interest.
The reasoning went like this: As long as wall street knew the risk of each half of the loan then individuals could take the proper precautions, i.e. have only small proportions of the high risk loans. But, as is usually the case, they packaged it differently and didn’t sell it has high risk. Instead they packaged the debt with less risky debt so that everyone got invested in it to pump up their interest rate and nobody realized the loans would never have been made had they not been split into a “good” half and a “bad” half.
Now the chickens have come home to roost and their is an avalanche effect that is spreading into loans that are above sub-prime as homes are put into foreclosure and prices collapse. There is a very real analogy to what has been going on in physics during this housing crisis. Though I wouldn’t it put on string theorists exactly, I would say the problems in both come from too much faith in manipulating numbers to get the results you need and too little heed to fundamental, or foundational, research.
If indeed a cascading global crisis was imminent, Obama acted responsibly by not interfering with efforts to avert it. McCain banged on the operating room door and screamed at the surgeons.
At present the election looks to be close. McCain’s demagoguery costs him support (votes, donations and/or advocacy) from economic conservatives and libertarians. It’s not clear to me that he gains more than he loses.
Senator Bernie Sanders has a proposal:
http://www.sanders.senate.gov/news/record.cfm?id=303313
In my view, we need to go forward in addressing this financial crisis by insisting on four basic principles:
(1) The people who can best afford to pay and the people who have benefited most from Bush’s economic policies are the people who should provide the funds for the bailout. It would be immoral to ask the middle class, the people whose standard of living has declined under Bush, to pay for this bailout while the rich, once again, avoid their responsibilities. Further, if the government is going to save companies from bankruptcy, the taxpayers of this country should be rewarded for assuming the risk by sharing in the gains that result from this government bailout.
Specifically, to pay for the bailout, which is estimated to cost up to $1 trillion, the government should:
a) Impose a five-year, 10 percent surtax on income over $1 million a year for couples and over $500,000 for single taxpayers. That would raise more than $300 billion in revenue;
b) Ensure that assets purchased from banks are realistically discounted so companies are not rewarded for their risky behavior and taxpayers can recover the amount they paid for them; and
c) Require that taxpayers receive equity stakes in the bailed-out companies so that the assumption of risk is rewarded when companies’ stock goes up.
(2) There must be a major economic recovery package which puts Americans to work at decent wages. Among many other areas, we can create millions of jobs rebuilding our crumbling infrastructure and moving our country from fossil fuels to energy efficiency and sustainable energy. Further, we must protect working families from the difficult times they are experiencing. We must ensure that every child has health insurance and that every American has access to quality health and dental care, that families can send their children to college, that seniors are not allowed to go without heat in the winter, and that no American goes to bed hungry.
(3) Legislation must be passed which undoes the damage caused by excessive de-regulation. That means reinstalling the regulatory firewalls that were ripped down in 1999. That means re-regulating the energy markets so that we never again see the rampant speculation in oil that helped drive up prices. That means regulating or abolishing various financial instruments that have created the enormous shadow banking system that is at the heart of the collapse of AIG and the financial services meltdown.
(4) We must end the danger posed by companies that are “too big too fail,” that is, companies whose failure would cause systemic harm to the U.S. economy. If a company is too big to fail, it is too big to exist. We need to determine which companies fall in this category and then break them up. Right now, for example, the Bank of America, the nation’s largest depository institution, has absorbed Countrywide, the nation’s largest mortgage lender, and Merrill Lynch, the nation’s largest brokerage house. We should not be trying to solve the current financial crisis by creating even larger, more powerful institutions. Their failure could cause even more harm to the entire economy.
There is an excellent presentation on how this happened here:
The Subprime Primer:
http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1
Peter and some commenters have modestly deprecated their econ credentials, but it’s not scholarship that’s required here. It’s a commonplace that when it comes to debunking spoon benders, spiritualists, and various other fraudsters of that kind, physicists perform poorly in comparison to stage magicians, who can easily spot the deception.
In this case, the ‘rescue’ itself is the crime, with the politicians stampeded by the antecedent theatrics. For example, twice last week Charlie Rose had on Hank Greenberg, who built AIG and ran it for 30 years or so. He and his people had wanted to set up a bridging loan, far short of the government’s $85 billion final solution, but they couldn’t get a seat at the table. Charlie Rose kept saying he didn’t understand why. Then Friday’s hystrionics came along and cleared-up the mystery: Paulson needed a Reichstag fire to stampede the pols into the biggest raid on the U.S. Treasury in history, and AIG was it.
I trust everyone has noticed the part of the proposed plan that makes it non-reviewable by the courts? What does that tell you? I just emailed my senator and congressman, and told them to stop it. I suggest you all do the same.
They aren’t paying $700bn for nothing; provided the price is right (pennies on the dollar) this could actually make a large profit for Uncle Sam.
However the government should ensure banks are forced to hand over well performing derivatives as well as bad ones, and then regulate to just prevent these things from being created and traded. Contrary to popular opinion, the actual structure of CDOs is very simple to state mathematically – any first year undergraduate in a numerate subject could pick it up. What is genuinely difficult isn’t the instrument itself but the risk modelling of it – which is true, though to a slightly lesser degree, even for simple shares and options. This is where the quants failed.
A slow liquidation of CDOs seems far more sensible than a fast panic driven one. Provided the plan commits to a selloff over a period of say, 10 years, I see no real problem with it.
That said, the deliberate lack of oversight being built in is extremely disturbing. This is the part people should be complaining about. It is scandalous that no elected official will be responsible for the management of this programme.
Just to inject a professional perspective here, it’s not quite right to say that “flaws coming from certain built-in assumptions” caused risk pricing error. In actual fact, total reliance upon private rating agencies, who had insufficient information to price nearly unregulated non-exchange-traded instruments, was the immediate culprit.
The underlying problem, a combination of irrational monetary policy and total lack of political will to tighten loan & credit regulation over the last 13 years, has been widely understood for a very long time, and many people are doing quite well; just look at the massive pre-collapse short interest on Lehman.
Of course, if you’re sitting on a $1m Option ARM for some pasteboard monstrosity you saw on Flip This House, better leave the keys on the table now.
While quants I’m sure deserve some of the blame, the key failure was that the ratings agencies and banks essentially colluded to get around banking regulations. Banks need to hold investment-grade debt (such as AAA rated corporate bonds) as collateral. The ratings agencies obligingly gave certain kinds of mortgage bonds AAA ratings (the quants’ inadequate risk analysis probably helped with this step). The bonds had higher returns than ordinary AAA bonds, which allowed the banks to make more money on their collateral.
Now much of the collateral isn’t worth much, so the banks all have to raise more money, and some are probably already insolvent. Nobody wants to lend to the banks because nobody knows which banks are going to go under. If the victims of the crisis were just hedge funds, it wouldn’t be nearly as big a deal.
“While quants I’m sure deserve some of the blame, the key failure was that the ratings agencies and banks essentially colluded to get around banking regulations.”
Walt, while I think there’s room for blame to go around, it was obviously the quant’s who set the thing in motion and who oversold it to their employers as the best thing since sliced bread. What you’re saying reminds of the pirate who says to his crew,
“Tie me to the mast before I do somethin ‘orid, arrrghhhhh!”
The best introduction to the credit crisis I’ve heard until now is the program called “The Great Pool Of Money” presented in the radio show “This American Life” (Chicago Public Radio). It is very clear!
It may be of help to review the state of play.
On one hand ,there is a congressional leadership of both parties which is well aware of its culpability in creating these problems over many years, and terrified of facing elections in a few weeks in the midst of crisis, and a financial leadership typified by Paulson, who helped to create the subprime debacle when CEO of Goldman, is now at risk of accountability and financial consequence, and until now has a remarkable almost 100% negative correlation with the unfolding financial realities. He appears to have contempt for the petty corruption prevalent in Washington, in comparison to the larger scale activity to which he was accustomed as an investment bank chief, and intends to bulldoze the Congress into rubberstamping another ill conceived and costly scheme. There is so much fear and weakness that his gamble may be won, but it is far from certain. If not, expect a degeneration into serious finger pointing on all sides.
On the other hand, there are the markets, which have an enormous number of degrees of freedom to come to terms with reality. There are currency markets, energy markets, grain markets, precious metal markets, short term money markets, commercial paper markets, government debt markets, corporate debt markets, municipal debt markets, interest rate swaps, mortgage debt markets, credit default swaps, and other derivatives in addition to all the markets directly related to equities. All of these have played a part in slicing through a good deal of the pretense in a little more than the past year since Paulson assured all that the problems were “ well contained “. Of course their timing does not follow anyone’s schedule. As Keynes, who made an enormous fortune for his college as its treasurer and knew a bit about it, put it, the markets can remain irrational longer than you can remain solvent. But eventually what has value will be valued, and what does not will not.
I suggest you all do the same.
But we’re not all American.
No, the basics is quite simple, while the details are quite complicated.
When the Greenspan era began, he changed how the fiat money system, which is used by just about all countries, worked. (The fiat money system is one which a sovereign state issue money ‘out of thin air’,without any material wealth backing them.) There are 3 types of money. First, the Federal government prints paper money and mint coins. Second the Federal Reserve creates money in the form of credit (i.e. debt for those who use it), which only commercial banks can use under strict regulatory control. One such key control is: a commercial bank can re-lend same amount of credit it borrowed from the Fed up to 10 times to businesses. Such 10x multiplier permits such credit to make up 95% of all money created. So far so good.
But there is a third form of money – money which the Fed does not create directly – called shadow credit. Shadow credit is created, out of thin air of course, by the shadow banking system – so-called investment banks. You know, Goldman-Sachs, Morgan Stanley, ex-Leyman Brothers, etc. They create shadow money by inventing things called derivatives and trading them. The type of derivative invented is a function of their ‘innovation’, how the trading work is unregulated, and the resulting financial credit generated is unlimited. It is in fact the ‘perfect’ money machine – private money that can be created out of thin air, outside of the government, outside of the Fed, outside of regulatory control, and which can be converted to real money (Fed credit or notes) with a click of a mouse.
When the US began to loose competitiveness around the world back 20 years ago, industries were ‘forced’ to outsource the industrial base in order to maintain a high profit return. While this takes care of the business side, the working people side will create trouble as good jobs disappear.
Greenspan needs to create a situation where the good life can be pumped into the economy without doing the real and smart hard work, with a downsized industrial base. He found the perfect ‘free lunch’ machine – unlimited money creation by the shadow banking system – to finance unlimited growth. But there is also a side beauty – details of such activities are secret, unregulated, so that very few people knows how the magic works. (Greenspan the magician knows!) So he arranged things so as to give the shadow banks a regulation-free reign – confident that the ‘smartest guys in town’ will know how to manage things.
Soon, investment banks realized they can do anything they want – invent any financial instruments, trade anything in any manner, brand their quality in any manner (since they control the rating agencies) and sell unlimited ‘securitized’ bonds to the world. The ‘perfect’ fake money machines was put into over-drive and trillions upon trillions of fake wealth thus created – to fund wars, security, and unlimited importation of goodies for the good life. The executives and traders pay themselves bonuses so great it make kings and queens blush with envy.
The fake-money machine works great for a decade – as long as the population can be convinced to keep on buying the fake credits (i.e. go into debt) without end. But when just about everybody is up to their eyeballs in debt, the executives at the Double-Word houses need to find ever more fools to keep the machine, thus their bonuses, running. Desperate, they turned to the poor class who has no wealth nor credit. Thus began the sub-prime mortgage con game. Bear Stearns was the one who invented the fake subprime mortgages to sell to fake buyers, collect them back in Wall Street and turn them into fake bonds to sell to unsuspecting pension funds and world banks. And the rest is recent history we all know.
Why did I bother to write this story in this blog. Because I want to point out one thing – Knowing about the real story of America’s shadow banking system, whose function has been to create fake money to any amount they wish without transparency and regulation, who did operate in the most reckless of ways that resulted in destroying much of the fake wealth (along with much real wealth of the innocents), do you wish to maintain this shadow bank system?
Hank Paulson, ex-CEO of Goldman-Sachs, obvious does. He is asking the Fed to create (out of thin air of course) a trillion dollar worth of real money to buy up the fake zero-worth wreckage of the investment banks so that they can continue doing what they have done. When an addition $1T is created and added to the existing USD money supply without any corresponding economic activity, every dollar is thereby depreciated. In this way the taxpayer indirectly pays for it.
Now there’s a reason why Congress might go along. See, the fake money machine also finances a great deal of politics and pork in DC.
then again
What’s the odds that the biggest insurer to fail is also the most political, foreign tied, intelligence tied, company, on the planet?
Read,
Another Greenberg Swindle Scam at CIA AIG ?
http://geo-economics.blogspot.com/2008/09/another-greenberg-swindle-scam-at-cia.html
truth is stranger than fiction
Thus, all that money to make Manhattan a shiny bauble and give many people an Ali Baba lifestyle came from the future, in the form of the current raid on the taxpayer’s pockets, augmenting the US national debt by possibly >>1 trillion or so. Nicely done.
I shudder to think what will happen to the “wonderful budget” promised for HE physics this year.
Hi Peter,
Both the strength and weakness of capitalism is that the buyer determines the value of things by what they are prepared to pay, which of course to a large degree is subjective. The problem here is when this extends to things that are necessities such as housing and food, which are not optional, things can be manipulated in this way. Perhaps it is time that in terms of economic policy there is a distinction made and that greater regulation of prices and supply in such areas should be considered to be both permanent and necessary. This of course is not true capitalism, yet when governments are forced to bail out banks and financial institutes, who are we kidding anyway.
Best,
Phil
So – we have the most right-wing government in recent US history, along with their proposed successors, advocating the biggest nationalization in history, with their left-leaning opponents, who go along with this, being chastised by a left-wing mathematics professor for not embracing the laws (and accompanying brutality) of the free market.
Or have I missed something here?
Personally, I do not see how the bail out can be avoided. The banks do not just comprise of Porsche-driving spivs earning multi-million-dollar bonuses; they also have savings of you, me and millions of others. The failure of a major bank would be a catastrophe. It may even turn out that even Lehman was too big to fail … we will see. Governments are well aware of all of this and hence the tight regulation of the financial industry. What I think recent events have demonstrated, though, is that the regulations need to be even tighter, and the “every man for himself” attitude that investment banks have needs to be replaced by something a little more responsible. We could start by looking at remuneration – if a trader is paid a percentage of gross profits as his bonus, but does not participate in losses – the usual practice – then of course his inclination will be to take on more risk. What is is the worst that can happen? He gets fired. No problem – he can get hired by a rival where he can do the same thing all over again. In technical terms, the trader owns a free call option on his own profitability. Many of my former trader colleagues, who are now setting up Hedge Funds, are now discovering just how nice it was when someone else (i.e. their employer) would pick up the bill for losses.
Hi Peter,
An interesting post – if you plan on writing more off-topical threads of that sort, go ahead. I too have a couple of friends who became ‘quants’. Given that postdoccing sucks big time I’ve thought about going that same way, but it seems to be mutually incompatible with my political orientation.
Anyway, the way I see the problem is that the system (I mean the economical combined with the political) wasn’t able to learn fast enough and to adapt in order to avoid a major crisis like this. Too many people doing their own planning to increase profit, too few people asking whether that’s a sensible behavior in the long term. It’s a classical mismatch of micro-interests with a desirable macro-behavior.
If you look at it from the system perspective, the problem is strikingly similar to those of the academic system. Too many people working for their own immediate advantage, dismissing thinking about the long-term consequences, too few people who pay attention to what science is about and under which circumstances it can flourish. It supports the formation of bubbles of nothing that eventually have to burst.
The problem in both cases is that the noticing of the mismatch between personal incentives and the desirable long-term large-scale trend does not feed back into the system – other than through a major breakdown. It’s the case in which people working in the system are aware its setup does not make sense, but are unable to change something about it (and unwilling since it won’t be of advantage for them either).
Best,
B.
Peter,
I very seriously considered majoring in economics rather than physics, and, in fact, had an offer to do a post-doc in econ after getting my physics Ph.D. Sadly, I turned it down: I could have been one of those Wall Street gangsters making millions by defrauding the public!
Seriously, since I actually did know a good deal of economics (and since I’m honest), I would have been the naysayer pointing out the lack of reality in the models: my refusal to be a “team player” would no doubt have curtailed my career rather abruptly and I would not have made those millions anyway.
I remember some decades ago reading some stuff by Fischer Black on monetary policy and realizing that, for all his fame (this is the Black of the quants’ famous Black-Scholes equation), he had almost no knowledge of real economics. That knowledge would not have endeared me to Wall Street.
Here for example is a quote from Black, courtesy of the wikipedia:
>In the U.S. economy, much of the public debt is in the form of Treasury bills. Each week, some of these bills mature, and new bills are sold. If the Federal Reserve System tries to inject money into the private sector, the private sector will simply turn around and exchange its money for Treasury bills at the next auction. If the Federal Reserve withdraws money, the private sector will allow some of its Treasury bills to mature without replacing them.
That betrays incredible, breathtaking ignorance of the monetary system, obvious to anyone who knows basic economics.
I think your own summary of the current crisis is generally accurate, but rather ignores two long-term issues.
First, there is the matter known in the literature as “moral hazard.” In simple terms, bailing out bad behavior today sets a bad example for the future, encouraging people to engage in such behavior in the future, believing that they too will be bailed out.
The bailout of the S&Ls in the eighties and the implicit and widely believed (and true, through long officially denied) government guarantee of Fannie and Freddie are two examples of moral hazard that helped produce the current crisis.
Second, there is the issue of the “flexible” monetary policy followed for nearly a century by the Fed.
The Fed was created because, back in the bad old days of the gold standard, irresponsible behavior by the banks and the investment community led to repeated, sharp monetary crises that damaged the economy in general. The gold standard is inherently inflexible and there was no “lender of last resort” to bail out irresponsible financial actors.
However, exactly because of that lack of a flexible monetary regime, unsound financial practices could not be concealed for very long: crises and the resulting correction tended to be sharp, deep, but usually of fairly brief duration.
The monetary flexibility for which the Fed was created changed all that. By inflating the monetary supply (“adding liquidity to the system”), the Fed could delay the day of reckoning for some years, allowing the bubble to grow much, much bigger. And the Fed could similarly drag out the correction period for a rather long time, leading to periods such as the “stagflation” of the 1970s (the model, I’d guess, for the next ten years).
A side effect of this flexibility has been the huge inflation of the last century: from 1914, when the Fed went into operation, until 2008, the dollar has lost more than 95 percent of its value according to the Bureau of Labor Statistics ( http://www.bls.gov/data/inflation_calculator.htm ). By contrast, between 1800 and 1900, back in the bad old days before the Fed existed, when the monetary supply was “inelastic,” the value of the dollar actually increased (see, e.g., http://www.measuringworth.org/uscpi/ ); the data for the nineteenth century are incidentally much rougher than for the twentieth.
All of this is old stuff, known since the early twentieth century: Friedrich Hayek won the Nobel Prize in Economics in 1974 for analyzing and explaining this in great detail (see, e.g., his “Prices and Production” and “Monetary Theory and the Trade Ccyle”), building on earlier work by Mises, Wicksell, etc.
Incidentally, I am not making any sort of claim that the Fed is some sort of secret conspiracy by the Illuminati, the Elders of Zion, or whatever. It’s basic purpose and function are quite clear and have been publicly announced since it was founded. Unfortunately, carrying out that function, i.e., providing an “elastic’ currency, has certain predicable results: intensifying and lengthening financial bubbles is one of those predictable results, a result that we are all observing as we write.
Despite my own lack of confidence in economic predictions, I will make one here: the monetary and financial system as we know it will not be (and for obvious political reasons cannot be) seriously reformed during the lifetime of anyone reading this. Any new regulatory agencies will simply be “captured” in a few years by the regulated industry (this too is a standard result in economics); no one who wishes to preserve his political viability will dare touch the system of “elastic” currency created early in the last century; and the bailouts, no matter how well-intentioned, will simply lay the groundwork for even greater acts of financial irresponsibility in the future.
Dave Miller in Sacramento
After the 1929 crash, we had 10 yrs of 20% unemployment because the government response was:
(1) raise taxes, particularly on the wealthy,
(2) protectionist,
(3) strong laws to favor unionism, which raised costs and according to academic research, lowered productivity, and also had the effect of preventing wages from falling to clear the labor market, and
(4) eat the rich mentality, prosecutions, etc.
Obama favors every one of those things and so do most of his backers and the interest groups pushing him.
Is it your opinion Peter, that this policy mix will work out better this time around?
Eric,
You’re trying to take a far off-topic discussion farther off-topic.
Please folks, take the standard right/left Democrat/Republican arguments elsewhere. If you have something interesting to contribute about the current financial crisis and the proposed bailout, please do so.
Chris Oakley finds the bailout to be inevitable.
Not so fast.
Sebastian Mallaby in the WaPo:
Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into a bad-loan bazaar and being ripped off by every merchant.
Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don’t do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don’t want to signal weakness and they don’t want to dilute existing shareholders. A government order could cut through these obstacles.
Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks’ bad loans but by buying equity stakes in the banks themselves. Whereas it’s horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.
Congress and the administration may not like the sound of these ideas. Taking bad loans off the shoulders of the banks seems like a merciful rescue; ordering banks to raise capital or buying equity stakes in them sounds like big-government meddling. But we are in the midst of a crisis, and it shouldn’t matter how things sound. The Treasury plan outlined on Friday involves vast risks to taxpayers, huge complexity and no guarantee of success. There are better ways forward.
http://www.washingtonpost.com/wp-dyn/content/article/2008/09/20/AR2008092001059.html?hpid=opinionsbox1
Bravo, this shows your sense extends well beyond debunking pseudo science. However, as far as your claim that you really know little about the situation, that is false modesty, I think. It is high time that the American people do a little reading about our nation’s founding principles in regard to credit, etc. I urge you to read Alexander Hamilton’s report on the Subject of Manufactures, ASAP.
Dear Peter,
As before, I will not identify myself except for the following, which might give away my identity to those who know me.
I dabbled for sometime in string theory and am seriously dissatisfied with the subject. I have found some holes in some claims by certain string theorists which I have been prevented from publishing, and I do not have a future in academia. Consequently, I support myself and my family by taking up a job in finance.
From whatever little I know of these quant models, I would say they are seriously outdated. They need improvement, and perhaps the correction requires deep study. More than this I refuse to say.
There is a redeeming feature about the world of finance though. It is always possible that some guy like Robert Merton wins the Nobel one year, and within two years his hedge fund goes bust. However smart you think you are, you just can’t beat the market.
In the world of high energy physics that does not seem to be the case. I don’t see any Nobel laureate in physics biting the dust as easily, and that creates the illusion of infallibility. And any young unknown who comes along has a hard time. But all we do in physics really is glorified curve-fitting, you know. Nothing all that great.
In economics, people know very well that the prediction itself can affect the system’s behavior. In that way, these people are more realistic than physicists.
Don’t blame it on the quant geeks. It is blind faith in any mathematical paradigm that leads people into error. In the world of finance, there are plenty of skeptics, so it will correct itself faster. There are not enough skeptics in the world of physics, but the string bubble is also going to burst pretty soon, if it already has not.
There are some simple arguments that can kill off string theory -or at least suggest modifications to its present form – but you seem to be averse to physics discussion in the comments section here (you deleted some of my posts in the last fortnight), and seem intent to criticize string theory and also opine about quantitative finance without any real understanding of either subject. Is that fair?
Anyway, to borrow a few words from Robert Frost,
“Why hurry to tell Belshazzar
What soon enough he’ll know.”
Why don’t you forget string theory and find something better to spend your time on? I would not say it is not even wrong. It is not the right model, and nothing will come of it. Trust an ex-“insider”.
Robert Jungk once compared the lot of a physicist with that of Hamlet, so perhaps rephrasing a few lines from there would help.
There are more things on heaven and earth
Than there is in Green, Schwarz and Witten,
Or Polchinski, for that matter, or even in this blog.
Boo
As one of those who did not benefit from the various bubbles, all I want to feel is schadenfreude, baby!
But the problem is that my taxes will now go to the rescue of those who did so irresponsibly benefit from them, no matter who wins the election. I rent a crappy apartment in a crappy city, yet my dollars will now help pay for the emergency penthousing of the golden people you describe filling the sidewalks of Manhattan. People like me are left behind whoever is in power. Is it any wonder then that I will not vote for either candidate?
Bee:
“Anyway, the way I see the problem is that the system (I mean the economical combined with the political) wasn’t able to learn fast enough and to adapt in order to avoid a major crisis like this.”
Incorrect. Read my post. The shadow banking system is a deliberate business creation that has operated many years. The repeal of legal constraints on their operations were deliberate moves by Congress, Fed and Treasury. They wanted to free up the investment banks to create unlimited amount of money outside of the regular commercial banking system. The investment banks are completely independent, outside of the Federal Reserve system. They don’t take deposits and have no insurance. They make their ‘wealth’ purely out of thin air, by creating financial derivatives, mostly of such complexity (thanks to the quants) that even upper execs do not fully understand the consequences. But for a decade they brought in obscene profits and that was good enough.
Chris Oakley:
“The banks do not just comprise of Porsche-driving spivs earning multi-million-dollar bonuses; they also have savings of you, me and millions of others.”
Incorrect. What’s being bailed out is not, *not* the commercial banks like Citi of BoA. These banks accept your deposits in saving and checking accounts, are under strict regulations, protected by the FDIC insurance, and are pretty safe. (But many smaller commercial banks are in trouble due to downturn of the housing market.) What’s being bailed out is the investment banks (in truth, they are not even banks, just trader/broker). The investment banks accept no deposits from consumers. They make their money by trading other people stocks, finance business takeover, sell bonds. All these are fine. But what blew up is their derivative activities. Derivative as highly complex, high risk financial bets and insurance. They have little capital behind it (frequently, $1 of capital is used to fund up to $40 of betting). The derivatives have turned the investment banks into world’s biggest gambling houses, with a total of around $100T, that’s trillions, bets have been wagered on the table, but backed up only by a few hundred billions of real capital. It is easy to see how the slightest wrong moves can destroy the house. That’s exactly what have happened.
Since this shadow banks are not insured by the FDIC, they have to be rescued by special acts of the government or go bankrupt.
I can say after reading these posts that most of you should stick to your day jobs. The discipline admits armchair quants just as easily as theoretical physics does. That is to say, it doesn’t. So, as one former physics/math type turned quant to (I’d assume) mostly physicists, I’d caution on dimensional reductions that that boil this down to one aspect. Like many areas of specialization this takes years to learn, is rife with pitfalls, conundrums, and counter-intuitive solutions. While it has been 8 years since I studied physics, I don’t pretend to be able to make sound arguments on the current state, despite the fact that I still follow it, and perhaps could still work out some problems in qft. That being said, while many can’t tell you exactly what it is, I can tell you what it is not, and that it is not just because of models and opaque mathematical finance. Certainly the fall of Glass-Steagall led to tremendous securitization which facilitated unprecedented lending for reasons that were purely economic/accounting. The lending is clearly suspect, if not outright unethical or, even, criminal. These off-balance sheet transactions were bundled up and sold as MBS or in CDO’s. Yes, this required modeling. There were no market observed prices for these CDOs and required complex modeling. Further, insurance wraps and arcane structuring did make these seem very safe. The massive amount of these “level 3” type assets, and their subsequent mark downs in illiquid environments whereby they could not be traded, did cause much of what we see. That being said, this is a very small part of the market, and a very small part of the theatre that “quants” work in. There are many people that get up and go to work each day and do it because they enjoy problem solving. They provide liquidity and risk management on a global scale with millions of transactions every day for decades without issue. They are not super wealthy. They are not usually poor, but they are not the 1:10,000 that the news likes to sensationalize. Quants are a small part of a big system, they often still have ties to academia, and many still publish (people who report to me still work in areas of mathematics and physics doing active research).
Before making broad brush-stroke generalizations, do your homework. I assure you it takes longer than a day, though, as this one former-physicist-turned-credit-turned-equity-derivatives-quant sees it.
That being said, this is a very small part of the market, and a very small part of the theatre that “quants” work in.
Then why cannot the market (say via a tax) bailout the “very small part of the market” that is in trouble? Why are taxpayers being asked to fork out?
Arun: I assume you were not being rhetorical? There was significant leverage, it was tied to the financial health of the larger institution, and you’ll hear this word “contagion” thrown around. There is a great graph that Jim Reid at Deutsche has been showing in his research. It plots GDP, profits of non-financials, and financials. The first two basically track one another. Financials deviate in about 2000-2001 and just spread away. So, either they were printing money, or they were leveraged selling financial claims. I think the leverage works out in average to be about $1 to $2.50 according to a study I recently read (UBS, George Magnus, Financial stability) as it pertained to mortgages. There was just a ton of subprime origination and too much CDS written on it to get you AAA super senior structures, which stayed on book, and was marked down as it corrected (read: delevered=no liquidity) to put it in a nutshell. Go to bis.org and look for total outstanding notional of all derivative contracts. The total notional amount of the OTC market is probably around $650tr now.
Dear Quant. I did actually work as a quant in the fixed interest market for 18 months when I was younger, and I hated every second. It was perfectly clear to me that the whole business stank. Time to change.
Quant, while you’re on – is such massive leverage necessary to the market? That is, suppose by law, the institution is limited in its leverage, say 12-1 as a strawman. Would trading in derivative securities then be viable? Attractive?
Arun, there are limits in many markets. Where things get a bit opaque are in OTC (over-the-counter) markets where there are no exchanges or clearing houses. With this would come limits, collateral, price discovery, etc. In fact, this in one of the solutions being proposed in credit derivatives (it has been for years). I should mention that, in a way, derivatives are leveraged from the perspective of having non-linear payoffs. So, not to be overly semantic, but by leverage I mean leverage of illiquid-to-liquid assets under the constraint of poor marks on the illiquid stuff leaving the firm capital starved in a correction (like we see now). Also, for instance in the case of AIG, why were they selling credit default swaps? This was indicative of people operating outside of their forte.
One odd thing that will play out this week in equity markets will be for option traders. Given that one can’t take short positions, it is therefore fuzzy in a Black-Scholes theory context in that the price of an option is contingent on continuous trading in the underlying. Many people aren’t even going to trade this week because of the dislocation that is ensuing from these bizarre trading rules. What is the price of an option? What is the risk neutral density?
There are many very smart and ethical people in this field, and nobody wanted this. Like any profession, physics included, there are pockets, and cliques and areas of research go in and out of vogue. I know people that hate their jobs getting beat on my traders to build trading models, I know people that are in energy that trade weather derivatives and model rocky mountain snow packs on super computers in lofts in Manhattan, I know people that were doing computational E&M and now doe the exact same thing (same pde’s), but just in finance. I know number theorists who went from working on L-functions at IAS to doing the exact credit structures you are reading about. Like anything, you have good eggs and bad eggs.