Far Off-topic

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….

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129 Responses to Far Off-topic

  1. Chris Oakley says:

    Tom K,

    1. Derivatives profits do not appear out of “thin air”. As Gordon Gecko rightly says, it is a zero-sum game. If you make money, then your counterparty loses and vice versa.

    2. Citi and BoA both have trading desks. Successful traders here will earn multi-million bonuses. I have this on good information as I worked on the interest-rate swaps desk at Citi (for all of two weeks).

    3. Any institution that takes investor money is subject to regulation. That includes investment banks, but not necessarily private funds.


    Yes – in other words quants helped provide smoke and mirrors to conceal bad loans on banks’ books. Credit default swaps (CDSs) helped spread the misery.

  2. Cplus says:

    Chris, under existing accounting rules in US and international economies, vast sums of illiquid OTC derivatives and other transactions are marked independently and creatively by the owners without recourse to market price or review by auditors or regulators to assure that counterparties to the same transaction do indeed net to zero, even in those rare instances when the counterparties are audited by the same firm or regulator.
    In other words, on the balance sheets of many countries and corporations today, capital does indeed appear out of thin air.

  3. saiko says:

    As an ignorant physicist I understand nothing about financial instruments. However, I find even the orders of magnitude difficult to digest.

    According to newspapers, the amount of money the government is going to pour into the financial sector is of the order of $1×10^12. I guess the amount of “bad” or “toxic” debt must be larger, say $1.5×10^12 to be conservative. Now, according to the CIA factbook, the US GDP is about $15×10^12.

    How is it even conceivable that the government did not notice a long time ago that the bottom line was wrong by at least 10% of the GDP? That’s just like going into an elevator and not seeing the elephant in there. How can the Treasury and the Federal Reserve claim not to be complicit? How could the government argue that they did not see this coming long ago and didn’t do anything to stop it because they actually wanted it to happen?

  4. Eric says:


    The losses are substantial, but they are not just blowing a trillion $. It is very possible the government will make a profit on its various investments, including the various Wall Street Houses it now owns big chunks of. The RTC made a profit. There is a liquidity crisis, money is freezing up, people are being forced to dump assets, but it is far from clear what the scale of actual losses will/would be when/if all is said and done and the markets are unwound in an orderly fashion, assuming that happens.

    Soryn, according to reports there were $500 Billion in sell orders against Money Market funds prior to opening on Thursday. That constitutes a real run on the system. Action was necessary. There really wasn’t time for the President to vote “Present”, and we still haven’t heard Obama’s opinion, even on the actions from last weekend.

    However, what we can definitely not afford is, going forward, to repeat the mistakes of the Hoover/FDR admins and (a) raise taxes, especially on the rich, (b) promote protectionism, and (c) promote unionism by acts like ending right to work, card check, etc. all of which are likely under an Obama administration.

  5. saiko says:

    It is very possible the government will make a profit on its various investments,

    I hope you’re right, and for very practical reasons, not just “humanitarian” ones.

    Yet, this all looks like a huge transfer of federal money to private corporations, for free. Much like the Iraq war has been.

  6. Dave Miller says:


    I don’t think it is reasonable for you to assume that most people here place all the blame on you quants. Since Peter’s blog is largely about physics, and many of the quants came out of physics, it was reasonable for him to discuss that issue, but surely his initial post was not simply a matter of blaming the quants.

    If you read my post above, you’ll notice that I put the largest blame on the “moral hazard” created by past government policies and on the “elastic” monetary policies followed by the Fed, in accord with its original mandate.

    Of course, if all the people in the financial industry had been perfect angels – both in intelligence and in personal responsibility – all that might not have mattered. But I take it as a given that human stupidity, greed, and dishonesty will always be with us. Government policy served as an enabler and amplifier of that dishonesty, stupidity, and greed.

    You also neglect the point I made about Fischer Black: the quote I provided revealed a man whose knowledge of economics was not simply overly abstract but rather stunningly, breathtakingly wrong, rather like those who think that the secrets to physics all lie in the I Ching.

    I know that Black-Scholes is not disastrously and mind-bogglingly wrong in the sense that Black’s views on monetary policy were. However, the drastic over-simplifications and unrealities in Black-Scholes should be obvious enough to anyone who seriously studied economics Am I mistaken in thinking that Black-Scholes is held in rather high regard among quants?

    I think that a profession, such as the quants, that is willing to take such an attitude, and that is willing to honor an obvious crack-pot like Fischer Black, does indeed deserve more than a little public ridicule.

    But, yes, it is not just the fault of you quants: there is plenty of blame to go around.

    Incidentally, your implication that those of us who have not worked professionally as quants, even if we have studied a great deal of economics, are not entitled to pass judgment on you guys is eerily evocative of the superstring theorists saying that no one can criticize superstring theory unless he has made significant contributions to the theory himself. It’s a very old rhetorical trick: theologians and psychoanalysts have been employing it for a long time, and I’m sure it goes back to phrenologists, astrologers, and the first guy to declare himself the tribal shaman.

    Dave Miller in Sacramento

  7. Chris Hillman says:

    Imagine you’re in an elevator car. Suddenly the cable snaps and you experience the sensation of weightlessness. Since this sensation is exactly the same as you would experience in an exilarating roller-coaster ride, your natural reaction should be to merrily scream “whheeeee!!”

    Not very funny perhaps, but there’s a point to my sardonic jest. In recent decades— particularly the last two decades— Wall Street has managed to sell the entire world on one of the biggest lies ever told, the notion that the -appearance- of wealth is exactly the same as “genuine” wealth. Now every mathematicians loves an abstraction, but we instantly recognize— or ought to— that this is at best a local isomorphism. An elevator accident might temporarily resemble a fun-fair ride, but these two scenarios end very differently. That’s one of the perennial problems with trying to “draw lessons from history”— history is told by the lucky ones. And we here will probably all agree that the problem of predicting the future from the past— particularly the problem of coping with instances of bad luck— is ultimately what this crisis is all about.

    So— let the blaming begin! There’s plenty to go around. And you guessed it: I intend to join the ranks of those claiming to have foreseen it all along. While not, I trust, exempting myself from my share of responsibility (in my case, I think my failure has been that I haven’t been sufficiently forceful or persuasive).

    Over at the New York Times, Saul Hensell (echoing Peter Voit) asks: “So where were the quants?”


    And over at The Edge, Nassim Nicholas Taleb has a timely response:


    While I take issue with parts of his analysis, I happen to think he’s spot on when he argues that the bankers and other financial managers should never have listened to the quants in the first place, because not only was their modeling suspect, the flaws were easily apparent for decades. As Taleb puts it: “the pilot did not have the qualifications to fly the plane and was using the wrong navigation tools”. That reminds me of an anecdote.

    As it happens, some years ago a boom time in quantitative analysis happened to coincide with a bust time in mathematics, and I was approached by several recruiters. The conversations went something like this: “Don’t you want to ask what I know about finance? Because the answer is zilch.” “Doesn’t matter, you just need to understand the models, which are absurdly simple— this is much easier than proving theorems and the pay is much higher.” “Something troubles me. We’ve established that -I- don’t know the meaning of money, but tell me something: how do -you- define money? Risk? Probability?” (Long pause.) “You don’t really want to work in the financial services sector, do you?” They got that right— criminal enterprise has never held any attraction for me.

    I’ve been urging the mathematical elite for years to recognize the fact that over the past two decades the single biggest failure by the universities, with regard to teaching mathematics to the masses, has been failure to inculcate decision makers in all sectors with the danger of relying upon poor statistical reasoning and poor mathematical modeling. I’ve pointed to appalling modeling errors enshrined in federal regulation of the vast biomedical industry, warning that “faulty math/stat KILLS, and in large numbers”. I’ve pointed to fabulous misapplications of the fearful securitization functor, and I’ve cried that “this will destroy the world as we know it, in your lifetime”. I’ve asked why the Millenium Problems fail to include Kolmogorov’s Last Problem: “what is probability, that we are mindful of it?” (Most of you know that as a young man, he offered an answer involving measure theory. But he wasn’t satisfied with that answer and the rise of information theory apparently convinced him it was wrong; unfortunately he died before he could formulate a better answer.)

    Some of you may remember that I have long urged that professional societies such as the AMS should organize a massive emergency effort to raise public awareness of the dangers of making decisions and predicting the future using bad statistics and bad mathematical models. I have suggested that our math/stat departments should require graduate students to spend at least one day per week in seminars with biomedical students, law students, and journalism students. That faculty and students should spent 20% of their time engaging in expository writing, fielding questions from reporters and advising government officials at all levels. And they should d all this gratis, as a generally recognized professional service obligation. I have argued that our scientific societies should make a much greater and much better organized effort to track and debunk junk mathematics, junk sci/stat, junk sci/math journalism, and junk sci/math testimony in the courts. Because only a genuine expert can efficiently spot and discredit potentially dangerous distortions dressed in mathematical garb. (Taleb speaks of the “snake-oil facade of knowledge— even more dangerous because of the mathematics”.) For example, graduate students could begin their service not simply by running a recitation section but by patrolling the Wikipedia for malicious sign errors— yes, they exist! And professors could look for deliberate distortions of the State of the Art— yes, those exist too. And for the longer term, leading experts could organize and construct a “closed edit” wikified but refereed encyclopedia addressing, above all, the intelligent citizen. (And -edited- in the strict sense, the sense in which the Brittanica is edited; my brief foray into the utterly mad world of Wikipedia, which I soon came to regret, taught me just how essential a role is played by the organizers of any encyclopedic enterprise.)

    Tim Berners Lee recently faintly echoed, I think, something else I have long been urging: debunking websites set up under the aegis of universities, which may enjoy some special if almost entirely tacit legal protections under U.S. law, and which don’t mince words regarding quacks and free energy frauds. (It’s neither fair nor wise that at present Bob Park http://bobpark.physics.umd.edu/ and a few others serve as solitary individual citizens playing this critical role, out of a compelling sense of duty.) I have also tried to argue that our academic philosophers constitute a valuable debunking resource, and we ought to ask them to turn their attention from comparatively trivial pursuits like debating the philosophy of space and time to such serious matters as founding the philosophy of probability, or poking holes in quantitative analysis and biostatistics.

    I still think these are good ideas, and they are still worth doing, but I won’t attempt to claim that they can undo the damage which has already been done. And just how bad is that damage? Right now absolutely no-one yet knows (and the reasons why no-one knows are one of the major lessons of this crisis), but last week, when allegedly stronger institutions were compelled to swallow some poison pills (failed institutions), and then gingerly began to examine what they had just acquired at the point of the federal gun, I swear I could hear the screams of incredulous dismay all the way from a small dwarf planet on the outskirts of our solar system.

    And as many commentators pointed out, there is a certain illogic in “addressing” a problem created in great part by an incomprehensible tangle of business relations by creating even -more complex- corporate entities.

    To my mind, one of the scariest aspects of the current financial crisis is that with news of the huge bailout, Wall Street actually -rallied-. That’s scary because it proves that the majority of investors remain utterly unable to grasp the awful truth. I suspect that when the dust settles, when regulators have had a chance to examine the books and follow all the ant trails (and this discovery process will probably take two years or more), it will turn out that up to last week the world thought it was half again as wealthy as it really was— perhaps more. Prominent financial commentators mentioned successive figures of 5%, 10%, then 30% of global net wealth as having vanished last week. But of course, it was only virtual wealth. If there were any justice, disclosing that embarassing fact would be literally valuable to more than a handful of disgraced executives who are running away with a few billions in severance pay. (It’s telling, I think, that this is a tiny fraction of the recent estimate of the cost of the bailout, which has surely been lowballed.)

    In an interview late last week with Bill Moyers, Kevin Phillips (who predicted the recent disaster in a series of books) argued that the United States has now irretrievably squandered its -genuine- wealth (in the “real economy”) and has forever lost its empire (and the good will of the world), and he pointed to the experience of the United Kingdom in the last century as a guide to what the United States can expect in the new century. I don’t think it’s a bad thing that as the shape of the new order becomes apparent, the U.S. will prove unable to continue to bully the rest of the world, even that it will find itself decisively removed from the front rank of the wealthy nations, but as with the UK we must expect that resentments accruing from past transgressions will linger, harmfully, for another century. As Phillips put it, the next few decades will be very tough for most Americans.

    Sadly, it seems to me that it really doesn’t matter who is elected President in November, because the next president will most likely prove powerless to mitigate the damage which has already occurred. Even worse, he will be distracted from addressing other long-term problems where some preventive measures might still be accomplished. This is in part because the much touted “imperial presidency” has been merely a puppet of Wall Street for quite some time— the reason why our politicians have lied even more in recent decades than they are naturally inclined to do is that cultivating ever more sweeping and intricate deceptions is regarded as absolutely neccessary to the “well-being” of Wall Street— and in part because under our Constitution, genuine reform would depend upon an ineffective political body which has been utterly corrupted by bad money, the Congress. The best one can hope for now is that your grandchildren will live in a world in which the position of the U.S. is somewhat analogous to the current position of the Netherlands or Portugal: a fairly stable second choice vacation destination which almost everyone forgets was once the master of a huge empire.

    And let’s not let our collective shock at the events of last week obscure the regulatory mess evident in the biomedical industry. When I examine common practices in biomedical research, I can only conclude that you could not devise a system more dangerous to human health if you tried. To repeat an example described by David Salsburg in his book The Lady Tasting Tea, decades ago some tragically deluded bureaucrat decreed that the statistical analyis in any federally funded medical research must use unbiased estimators— because, you know, bias is bad. But it should be obvious that bias (in the statistical sense) can be -beneficial- when it comes to assessing the risks versus benefits of novel medical treatments in a manner consistent with the Hippocratic Oath. And as most of you probably know, the most -reliable- statistical estimators are usually -biased-. (That’s just a fact of mathematical life.) If government officals (and reporters) were better educated in statistics, I doubt that such an insane policy would have become firmly enshrined in federal regulations. And let me add that innoculating innumerate commoners against various methods for lying with statistics is not very dissimilar with teaching the warning signs of bad mathematical modeling (for example in finance). Our task is enormous, but will made easier by recognizing that as educators and expert advisors on technical matters in our fields, we really have only one problem here, not many: combating golden-tongued sellers of snake oil and exposing scientific shibboleths.

    I and a handful of others have pointed for some time at an apparently growing problem whose true magnitude has gone largely unexamined, mostly because our professional societies prefer to stick their heads in the sand. (Sound familiar?) I speak of the problem of plagiarism and other serious scientific misconduct. Writers like Tom Friedman never seem to mention this when they celebrate our newly steamrolled world, but interestingly enough, certain geographical areas (China, the Indian subcontinent, and the Middle East) seem to have a particular problem with rampant misconduct and corruption. However, Europe and America are by no means immune. And if there are any mathematicians out there who are sniffing “this could never happen in my house!”, I can point to specific counterexamples— but since the malefactors have proven a litigious lot, let me just say here that with a little effort you can easily find ample information about some of these outrageous incidents in the Google cache. Because the universities and professional societies have studiously avoided calls to start collecting statistics, it is difficult to test my hypothesis that these widely publicized incidents represent the tip of the iceberg, but that fact that everyone I ask seems to eventually admit personal acquaintance with a case of misconduct which was covered up, I feel that the situation appears to be rather serious.

    A related problem (in my view) is the exploding phenomenon of on-line degree mills. If you think this isn’t a serious problem, I suggest you (1) obtain a list of known degree mills— which already far outnumber legitimate institutions of higher education— from one of several U.S. states which offer such a list on-line and (2) search sites like LinkedIn to see who claims such degrees and where they work. Surprise! You will find acute-care nurses at “reputable” hospitals, nuclear reactor operators, miscellaneous government officials, highly placed executives in various industries, and even faculty in some “bricks and mortar” colleges (whose chairs stoutly defend their unconventional departmental hiring practices). And what position is most prominently infected with bad degrees? You guessed it— vice principal. I also noticed that ex-military are overrepresented among the ranks of those getting by on fake degrees. Could this be because they feel that our nation has taken unfair advantage of them in various ways, and they are too frustrated to be willing to contemplate taking a more traditional and honest path back into civilian life than by claiming a fake degree?

    For anyone who wants to estimate the magnitude of this problem, one pitfall to avoid is the fact that many degree mills take names very similar to legitimate institutions, or even take the former name of a legitimate institution which has changed its name. And you certainly can’t distinguish legitimate institutions from illegitimate ones just by glancing at their websites— many degree mills display pictures of buildings which exist somewhere, but which have no relationship to their “college”, whose actual physical manifestation is generally little more than a small front office in a shopping mall, or even a mailbox in the Cocos Islands. Incidently, I think I can descry connections between the operators of many degree mills and the spam kings— certainly they often seem to hire programmers using the same pseudonyms, working from the same locations in the former Soviet Union.

    These operations resemble spam in another way: it should be perfectly obvious that such deceptions harm society. These practices should not only be illegal, but should carry a heavy penalty. But in the same breath, I must confess that the degree mill phenomenon is plainly driven in part by the insane cost (to American citizens) of a college education— fixing that ought to be part and parcel of health care reform, because in today’s economy, you really haven’t got a chance if you lack -either- a college education or a clean bill of health. (Many other countries have fixed both problems quite nicely.) And the problem of plagiarism seems to be part and parcel of a culture of self-deception which is surely not unrelated to the coercion and corruption of essentially all our mainstream media and political institutions. And I have been saying for years that scientific misconduct is not trivial– it can kill. A concensus appears to already be emerging that the recent financial crisis is due in part to mathematical incompetency, so if we all now accept that bad mathematics can cripple the economies of formerly great nations, perhaps we will be willing to recognize that deception in all its forms is potentially dangerous— and as Taleb says, particularly when dressed up in mathematical garb, because only a competent mathematician can efficiently spot mathematical nudity.

    And our genuine institutions of higher education are not immune to the culture of self-deception. Can you say “grade inflation”? Professors: hand upon your hearts, when was the last time you uncovered a case of student plagiarism and -reported it-? When I look at rate-my-professor type websites, I see a goodly number of student comments saying something like “harsh but fair”. When offered the opportunity, most students seem to recognize that nothing is more unfair than to condone dishonest practices by some students. Most students, I think, wish not to cheat. So why do we place them in a situation where, many say, they feel -compelled- to cheat in order to remain competitive, because “everyone else is doing it”, and getting away with it?

    I would second something else Taleb says: in my experience, statisticians (whom I suspect many mathematicians tend to regard as intellectually impoverished cousins whom one is embarrassed to invite to dinner) tend to be more articulate and honest than most mathematicians (or economists) in expressing the limitations of their understanding. The statistical societies even make a half-hearted effort to provide statistical consulting to reporters— but in my view, such ventures have been far too disorganized and underfunded, and AFAIK little effort has been made to liase with the medical, journalism, or law schools— or with the math departments.

    And speaking of professional responsibility: I can think of more than one profession involved in our current problems which has long needed to adopt a formal code of ethics. One aspect of the current furore which I find most unpalatable took form last week in the strained voices and pinched faces of certain leading financial commentators who desperately pleaded for bailouts for this firm or that. Am I the only one who noticed that most of these arguments were unaccompanied by disclaimers of any personal stake in the topic under discussion? In truth— this “dirty little secret” is apparently in fact rather well-known— it has been true for decades that so many “talking heads” in the economics websites are themselves investors in the companies whose causes they promote that few media outlets bother to even -try- to issue disclaimers. Well, that right there is one very obvious candidate for legislative reform: media figures should not be permitted to editorialize about corporations in which they have any personal financial stake— that’s simply common sense. Since the media have devolved into mouthpieces for various megaconglomerates, it is no surprise that they have failed to regulate themselves, so government must impose and enforce regulation.

    This would also be a good time for antitrust actions severing media concerns from their corporate overlords. And a good time to sever the universities (do I hear howls of rage?) from those same overlords, by prohibiting university researchers from accepting funding from corporate sources such as biomedical companies or organs of population control such as Google. Such corrosive conflicts of interest have long been a huge problem in engineering and biomedicine, but in the past decade I believe they have become a growing problem even in “pure” mathematics. Faculty with unclean hands are in no position to complain when their students misbehave— maybe that’s why so many seem so reluctant to tackle the issue of student misconduct.

    Another point I have pressed for years, perhaps more controversial than anything I repeated above, is that humans are obviously obsolete as the smallest recognizable economic/political decision-making agents. Jean Luminet has remarked that “physics is always near the beginning of its history”, and think that’s valid for science and for Terran civilization too. But in each stage of development “near the beginning”, one must rely upon exponentially brighter bulbs to drive progress. Inflating human population in order to access greater and greater portions of the tail of a Gaussian is not a viable solution. For one, that policy inherently promotes enormous social injustice. For another, the Earth has simply run out of room and resources, and we’ll all surely starve if we inflate human biomass another decade simply in hope of finding the next generation of hominid leaders one more half deviation out on the limb of the bell curve.

    A concensus seems to have emerged in recent days that the root cause of the recent market meltdown was that no human in the world is sufficiently intelligent to understand the financial dealings that various bankers and brokers were supposedly monitoring. I think that’s also a large component of the inertia of our political institutions. Sufficiently many politicians— despite owing their living to their corporate masters— may be momentarily in a mood to contemplate turning on the puppeteer, but they are too befuddled by the complexities confronting would-be reformers to have any idea where to start. I suspect we will all have ample cause in coming years to rue the fact that in this crucial election, the closest advisors of both candidates are former lobbyists for the very failed institutions everyone currently loves to hate, instead of national resources like Terry Tao. (Is it a hopeful sign that he just announced that he will be busy for a time?)

    Because I think the only option which might prove rational in the long term is revolutionary and thorough reform of all our political, legal, educational, and economic institutions, reform founded upon the principle that we must be governed by the best mathematics, rather than— as become apparent to all in recent weeks— by the worst mathematics, the kind which promotes self-deception. If I profess any article of faith, I suppose it would be this: deception is an ever present danger, which always proves a harmful and destablizing influence, and deception can never be indefinitely self-sustaining. The day of reckoning always comes, and usually at the worst possible time.

    Here I must admit that Wall Street is ahead of the curve— all the real decisions, it seems, are taken by stock trading software. The problem is that, as many a Vista user knows, complex software often proves unstable. Perhaps we should add another to the candidates for addition to the canon of Millenium Problems: who (or what) should make decisions (political, scientific, economic, judicial) in our global society, and how?

  8. Dave Miller says:

    Chris Oakley wrote:
    >Derivatives profits do not appear out of “thin air”. As Gordon Gecko [sic] rightly says, it is a zero-sum game. If you make money, then your counterparty loses and vice versa.

    No, Chris. Gordon Gekko is not a reliable source on economics or finance any more than Dr. Who is a reliable source on spacetime physics.

    This “zero-sum” fallacy is the same mistake that people make who suppose that, since a mortgage involves a transfer of money from the mortgagor to the mortgagee, it too is a zero-sum game. In fact, both mortgagor and mortgagee gain, assuming both act intelligently: the mortgagee earns interest and the mortgagor gets to have a house he could not otherwise have acquired at that time.

    Quant can probably explain this better than I, but used intelligently and responsibly, derivatives need not be a zero-sum game. There is a whole complicated literature on this, but, essentially, everyone can get the same profits with substantially less risk via intelligent use of derivatives.

    The problem comes when people take naïve models of the derivative markets, and aggressively push those models to the limit at which they are almost certain to fail.

    Then, we have not a “zero-sum” situation but a “negative-sum” situation in which large numbers of people will pay very dearly.

    And, as I keep emphasizing in my role as almost-was/might-have-been economist, the real problem is the institutional and incentive structure that encourages and rewards those who behave irresponsibly and that enables the continuation and prolongation of bubbles.

    Incidentally, that is why I turned down the post-doc in econ. Quant may well be, as he claims, a perfectly decent and honest fellow: if so, I fully believe his claims that he has not gotten rich out of his profession. I realized that, since I am an honest person, if I had pursued a career in economics or finance, I would not have been one of the high-flying, irresponsible, and therefore wonderfully remunerated stars of the field.

    The financial and monetary system, at the root of which is the Federal Reserve, is structured so as to reward not people like Quant and me but rather the sort of people who created this mess.

    And the system will continue to function this way no matter what cosmetic changes are made by President McCain or President Obama.

    Dave Miller in Sacramento

  9. Tom K says:

    You have tried to defend the Quants, that they played only a minor role, that they are honorable people. Don’t. The Quants did play a major role, and they did take compensations far exceeding of similar professionals in academic and industrial research. They are asked principally to come up with models to analyze derivative revenue & profitability scenarios, even develop new products, and they did perform the work. Based on these executives made their business decisions. The current derivative blow up would not have reached the depth of crisis if it weren’t with the total complicity of the quants. (I was an ex-quant back in the early 90’s and know quite a few quants – so try not to say I’m a crackpot. Moved back to academia and worked on string theory. Now you may say I am a bit of a crackpot!)

    Chris Oakley:
    “Citi and BoA both have trading desks. Successful traders here will earn multi-million bonuses. I have this on good information as I worked on the interest-rate swaps desk at Citi (for all of two weeks).”

    Quite right. Citi an BoA have brokerage/trade operations, while many smaller commercial banks don’t. But these, such as futures, options, certain swaps are quite well understood and ‘benign’. They’ve been around long time and are not responsible for what blew up. Most are also regulated – lightly. But what the independent shadow banks do is the most risky and toxic kinds – credit-default swaps, auction interest rate security, and of course subprime mortgage securitization with fake credit ratings. All are highly leveraged, some even infinitely leveraged (no capital), all unregulated.

  10. Kea Says:

    “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.

    I agree & agree with Peter’s statement that a bailout of the irresponsible companies (taking on bad risk investments)

    “The best response to a Fool, is to LET THEM HAVE WHAT THEY WANT”
    — Darwin Awards, “what goes around comes around”

    Essentially, the failure of said lending institutions & buyers are a consequence of Darwinism. Let them fail, they go extinct. Lesson learned, newcomers don’t make the mistake, & prosper.

    It’s just MIND BOGGLING that the Feds come in & bail out the “deadbeats” (I know, they are just interested in a near-term “save” to prevent a collapse of an entire system). “You never give an Idiot what they want..EVER”..& the US Govt just did!! 😮

    “You can’t fix STUPID!”
    — popular colloquial phrase in USA

    US Govt is attempting just THAT. Recall the COSMOS episode, where a Landsat image of Washington DC is shown, & Carl Sagan comments “No sign of Intelligent Life”.

    “Suppose you were a Congressman, suppose you were an Idiot, but I REPEAT MYSELF”
    — Mark Twain

    I don’t see anything changing since the 1800’s (the time of the above comment).

    All that wealth Peter is talking about is called “Stupid Money”. BTW, I saw primtime evening news coverage, where they mentioned Jim Simons & how he made 2 billion off the current crisis. You can make $$ off a market downside, even! I saw a dumbed-down demo on a newscast, of “short-selling”, man did that make me sick! You borrow a million shares of a stock, pay that guy (friend) a courtesy fee, wait till the stock tanks (market downside), SELL ALL OF IT (make millions), give it back to your buddy. Whoala..you’re a multi-millionaire! All because of a loophole in the system. (someone correct the details, I think I got most of it right)

    The paradox Peter is referring to is a consequence of a FLAW in the system. Predators were feeding off it, to “make stupid money”,

    “Stupid is, as STUPID DOES”

    Well, there’s that saying “Cheaters never prosper”..sure enough, it came back at them. And, public taxpayers money is used to bail out the con-men. DOES THAT MAKE ANY SENSE??

    “Kludge [ makes-no-sense bailout ] upon Kludge [ stupid system to begin with ]”
    — software hacking

    We are witnessing a government version of “institutional hacking”. 😮

  11. milkshake says:

    Quant, Dave – what do you think of Nassim N Taleb? For some time he has been writing diatribes like this one:


    His point has always been that statistical analysis gets frequently mis-applied by quants – used on economic processes that are extremely hard to model correctly. In his view this has developed into a habit of wishful thinking and arrogance. Taleb is a disgruntled quant himself.

  12. Krugman's Right says:

    I think Dr Woit has the right idea in this case.

    I am not convinced that this will stop the inevitable downslide. The reason the models failed was a misbelief that people were rational actors. The specific flaw (not discussed below in the link) was that the models expected that people would cut other expenditures in order to keep their homes.

    Unfortunately, cutting other expenditures wouldn’t even be a “rational” answer for the individuals faced with losing their homes in this market.

    So now its being proposed that when the government comes in to rescue these companies, the companies will behave rationally.

    Are they HIGH?

    I think the additional requirement is that any company taking advantage of this deal needs to go into receivership (banks included). The company should be broken up and sold as appropriate.

    For more about the models see the below link:


  13. Quant says:

    I don’t know if I can add anything productive at this point. This topic is highly polarizing, esp. when it admits political and moral stances and, speaking as a tax payer myself, is certainly upsetting. I am not defending any aspects of anything that led to this, or trying to suggest that anyone here is not entitled to an opinion, but I will offer the following: Summing it up in quick bits, like the press tends to, is a bit like writing in the margin that one has found the answer, but the margin is to small to write it out. Also, as most everyone on this forum knows first hand, the solution always appears simple once you are told it. Additionally, saying any one member (save for executives, perhaps) are to blame is a gross generalization, akin to saying that all physicists are mass murderers because they invented the bomb. There is a quote, which I will mangle, and I can’t recall with whom to attribute it to, but it says something like absolute black-and-white stances are for children and psychopaths. So, in sum, it is very easy after the fact to take a moral high ground, generalize, and make judgement calls because it puts it in a nice conceptual framework with which to throw stones. Tens of thousands of people, that have families, are out of work. Many are quants, lawyers, economists, traders, …. The bailout is not so much meant to save the banks or the executives, but the retirements and investments of Americans.

    I am sure that everyone on this forum has above average intelligence(s) and has the ability to delve deep into this matter, should they choose, and assign blame ex post. My initial post was only meant to add some healthy and constructive balance from, what I would hope, is an informed perspective. In the end, as painful as this is going to be, it is actually progress, albeit by violent correction, not growth. Many of us for years sensed this needed to happen. But, much like a complex system, it is very hard to disentangle the individual parts from the ensemble when trying to see where the issues are and describe the system.

    Milkshake: Nassim is an interesting one. I have met him, gone to dinner with him, and read his books. I am tempted to say he has found a niche (much like, say Kaku) whereby he can publish outside the rigor of peer review. I’d call his work observations rather than developed ideas. His Empirica blew up because he ran short positions waiting for his swan but bled out before any such large payoff. He generally has issues with his peers. I’d say he is a bit like Wolfram is to science (if that makes sense?), but a bit more accusatory towards others.

    Regarding Black. I don’t know if he is a crackpot. He was clearly intelligent, albeit a flawed man (who isn’t?). I have read Mehrling’s bio (and discussed it with him and Taleb at the same table, oddly enough). He wasn’t very charismatic. Of course he has one more Nobel Memorial than I do, so I can’t really comment about his intelligence 😉 Black Scholes is a theoretical construct intended to get one the price of an option. It was actually around for 100 years before Black, but nobody had made certain assumptions that permitted its solution. Black himself, just afterwards, is quoted as asking why anyone uses the silly theory. Of course after the rate rise of the 80’s, the advent of rate options, and the emergence of quunts from physics, they loved to talk about how it is reall ythe heat equaton and how the Laplace-Beltrami operator is really the generator for Brownian motion….. my point being that physicists took to the theory because it was stimulating intellectually. Of course finance has no symmetries and conservation laws, unless you try to shoehorn the math in (which has been done). I have met Myron Scholes, and I felt he wasn’t too imposing, but I have been present when someone tried to publicly take Merton to task and Merton eviscerated them. Again, simple in retrospect, but at the time, in the details, nothing seemed to amiss.

    I am going to go back and lurk in the shadows of this blog. I don’t read many blogs, but this is one of my regular physics/math stops for information and ideas. Maybe one day I’ll return to physics and post here again!

  14. notaquant says:

    For a nice, clear explanation, see Steve Hsu’s blog:

    Notional vs net: complexity is our enemy

  15. Cplus says:

    As of tonight, the Investment Banks are no more. The Federal Reserve has just baptized them as bank holding companies, joining the company of the other saved financial institutions masquerading as banks.

  16. JC says:

    Nassim Taleb would be more readable if his writings were a lot less angry and/or less confrontational sounding. Though I can see easily as to why a lot of pessimists and curmudgeons genuinely enjoy his writings.

    Despite the negative tone of Taleb’s writings, his “war stories” on Wall St. do have some credibility. This is judging from the time I worked on Wall St. many years ago.

  17. Bee said:

    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.

    My Caltech CS prof friend phrases is as:

    “People behaving in their own self-interest”

    Acknowledge it as a necessary evil..as abhorrent as that is. Why good papers get rejected, bad papers get accepted, good people don’t get hired, bad people get hired, good money gets wasted, bad money gets used, etc.

    Here is a particle-physics related poem that seems relevant:

    Of the Nature and State of Man, With Respect to the Universe
    Alexander Pope

    Who sees with equal eye, as God of all,
    A hero perish or a sparrow fall,
    Atoms or systems into ruin hurl’d,
    And now a bubble burst, and now a world.

    I got my 1st exposure to the above in a Hawaii Five-O episode

  18. David H. Miller says:

    Quant wrote:
    > Regarding Black. I don’t know if he is a crackpot. He was clearly intelligent, albeit a flawed man (who isn’t?). I have read Mehrling’s bio (and discussed it with him and Taleb at the same table, oddly enough). He wasn’t very charismatic. Of course he has one more Nobel Memorial than I do…

    Actually, Quant, Black does not have one more Nobel than you. He did not receive the Prize. And, no, from what I have read of his stuff, I doubt that he was intelligent, and I very much doubt that you could make that judgment from a brief interaction with him.

    What does concern me is that you are a professional in the field and you cannot see how horribly wrong the quote from Black, which I previously posted, is. Anyone who has passed a first-year macro course should be able to write an essay pointing out one fallacy after another in the Black quote. His description of what happens when the Fed creates new money is simply, factually wrong.

    For example, the new money may not just go back to buying Treasury paper – the new money might, for instance, go into buying shady mortgage-backed securities, just to use an example of current high relevancy. And even if it does go to buy Treasury paper, that simply means it is displacing some other buyers that are now free to buy, say, shady mortgage-backed securities. And, the money used to buy Treasury securities does not simply disappear – the Treasury is not known for simply destroying money. Rather, the Treasury spends it, thereby spreading the new money through the economy and increasing stimulative pressures. As the new money sloshes around the economy, it is available to buy, say, shady mortgage-backed security.

    Anyone who knows basic macro could write a lengthy essay along these lines pointing out the level of economic illiteracy required to make a statement such as Black’s. Unfortunately, this is not just an isolated example: I’ve seen a great deal of nonsense from him.

    I have read enough of Black’s stuff to know that he honestly, sincerely lacked the intelligence to grasp any of this.

    The real problem is not that there is one crack-pot in your field but that this economic illiterate is so honored by your profession. That indicates a larger, profession-wide problem.

    This would be like a physicist taking seriously the claims of the various use-vacuum-energy-to-solve-the-energy-shortage scams. Any physicist who supports those scams proves that he is incompetent or dishonest.

    Fortunately, most physicists don’t support or admire those scams. I wish the same could be said for people in the finance field who are unable to see what was wrong with the views and claims of Fischer Black.

    A field which honors a crackpot like that is a field which was heading for certain disaster. Yes, as I said before, we all know that this mess is not due solely to you quants. But, yes, many of you played a role and it appears to be because of a deep and pervasive problem in your profession: to put it bluntly, you guys have been playing multi-trillion dollar games with the world economy while remaining almost entirely ignorant of elementary principles of economics.

    The results are not surprising.

    I know it is considered rude and socially inappropriate to point out that a whole profession seems to be lacking in basic competence, but considering the situation the world economy is currently in, perhaps a bit of blunt honesty is more than overdue.

    Dave Miller in Sacramento

  19. AngryPhysicist says:

    Hmm…well, there are two outcomes to this current situation we face: 1) we’re doomed, 2) we’re not. Either way, it doesn’t really matter…if we’re doomed, there’s nothing we can do! We’re doomed! On the other hand, if we’re not doomed, then it doesn’t matter! We’re not doomed!

    Interestingly, economists know only how to *break* the economy, they don’t know a single thing about how it *works*. There’s a number of serious methodological problems they have, and a number of serious (tragicomical) mathematical errors they commit…no, mathematical *sins*. (An infinitesimal isn’t zero!)

    A rather readable dissection of economics is perhaps preferred to me maundering on and on, so please be referred to Steve Keen’s “Debunking Economics”. It’s a fun read.

    Good luck surviving economic Armageddon… 😉

  20. Name not relevant says:

    An old-fashioned Indian point of view in this article in The Telegraph (Calcutta) today. More recent Indian financial policy is more in line with removing restrictions and reducing national stake in companies built with public money.

  21. Esornep says:

    I don’t get it. What makes people so sure that playing the populist card will do McC any good? Everyone with a retirement account will tell him to take his populism and stick it. And if Obama tries to follow him in such a blatantly cynical way, how many votes will that win him?

  22. Bee says:

    Tom K: I don’t see how what you explained is in disagreement with what I wrote. You might call me naive but I believe that in the long run reason would have prevailed. The dangers could have been closer investigated, regulations could have been put into place etc. In fact, what’s happening right now is that necessary learning process taking place, just that a major crisis was necessary to draw attention to the shortcomings.

    Chimpanzee: Acknowledge it as a necessary evil..as abhorrent as that is. Oh, I do. The problem is not that people behave according to their self-interests, it’s human nature. The problem is if the system is set up such that the self-interests don’t match with a desirable long-term trend, as e.g. is the case in anarchy or free capitalizm. We have means to match both – the political system is meant to do that. Just that it typically operates way too slow to keep up with much faster trends caused by a large number of actors driven by self-interest and irrationality.

  23. Krugman's Right says:

    In order to lighten things up a bit, attached is a great (and funny) economics lesson from the stand up economist


  24. Amos says:

    Respectfuly, the Quants really didn’t have much of a role in the securitization of credit derivatives, which is what the current situation is about.

    The Quants have played a large role in the construction of arbitrage strategies, some of which involved credit derivatives, but that market has been quite small for some time.

    (As an aside, the idea that repealing Glass-Steagal had anything to do with this is bizarre. The banks that have had trouble (Lehman, Morgan Stanley, etc.) are the ones that were NOT associated with depository institutions, consistent with the rule when Glass-Steagal was in effect.)

    The current plea for “regulation, regulation, regulation” is really not helpful, since no-one has a plan for _how_ to regulate this credit market, or _what_ regulations to put into place.

    In addition, the new populist push to limit bank _executive_ compensation completely misses the point. It really doesn’t matter (or make any sense) what the bank executives are making, when the people who were making the relevant decisions were 25 year old middle managers with multi-million-dollar annual bonuses.

    Peter, if you actually are interested in any of this, please feel free to e-mail me. This is what I do for a living.

  25. Michael Bacon says:

    At the risk of over-simplifying this, I think that the basic problem is leverage, and this should be the focus of further regulation. There should be a reduction in amount of leverage allowed. In order to play, there should be a requirement to have more skin in the game. This would work wonders in terms of reducing the number of bad bets. Would it decrease upside potential — yes, by definition it would. However, that’s a trade that’s worth making in order to provide more stability and certainty in the markets going forward.

  26. Arun says:

    How we got into this mess – this narrative by Devilstower on dailykos is said by kos

    “If there was a Pulitzer for blog writing, this piece by Devilstower, explaining how we got into this financial mess, would be a shoo-in winner for 2008.

    It’s likely the single best piece of writing ever to grace this site.

    Update by Susan: So good was the post that it’s been picked up by The Nation as lead story on its web site.”


    (if this is a disruptive comment, please delete it)

  27. Amos says:

    “At the risk of over-simplifying this, I think that the basic problem is leverage, . . . In order to play, there should be a requirement to have more skin in the game. This would work wonders in terms of reducing the number of bad bets. ”

    Leverage had nothing to do with this. The banks are not in trouble because they BORROWED money for bad bets. They are in trouble because they LENT money to people who aren’t paying it back.

  28. Tony Smith says:

    In a comment above, Arun posted a link to The Subprime Primer.

    In light of some things that happened since February 2008, when The Subprime Primer appeared on google,
    I added an alternate ending and put it on the web at

    The first is a 3.4 MB pdf file and the second is a 1.9 MB mov file.

    The post-February 2008 events were:

    1 – A 23 March 2008 New York Time web article by Nelson D. Schwartz and Julie Creswell said, about Credit Default Swap Derivatives:
    “… Today, the outstanding value of the swaps stands at more than $45.5 trillion,
    up from $900 billion in 2001. …”.

    2 – Joseph Coleman, in a 6 June 2008 AP news article about an International Energy Agency (IEA) report, said:
    “…The world needs to invest $45 trillion in energy
    in coming decades, build some 1,400 nuclear
    power plants … in order to halve greenhouse gas emissions by 2050 ….”.

    3 – A Reuters web article on 17 Sep 2008 said:
    “… the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said …”.

    Tony Smith

  29. EricD says:

    I am a CDO quant. I was somewhat surprised to see that Peter actually got the economic phenomenology better than a lot of others — low interest rates spurring a classical credit bubble that is now bursting.

    However, it is wrong-headed to blame quants or anyone else in the industry for building the technology (CDS, ABS, CDOs) that played a role in distributing this bubbling credit into the wider economy. One might just as well blame the internet for making it easier to shop for mortgages, or blame auto-makers for making it possible to commute to work from more distant neighborhoods. All of this is just technology created to help satisfy a demand for credit.

    Why was this demand not brought into line with the actual supply (real savings)? What normally keeps demand in line with supply? A price, set on a free market where buyers and sellers equilibrate. But the price of credit, encoded in interest rates, is not set on a free market. It is set by the arbitrary dictate of a board of bureaucrats (the Fed) with analytical pretensions. When you throw darts to set perhaps the single most important price in the entire economy — a price that should have been the result of millions of savers and borrowers coming together in the market — expect bad things to happen.

    There is an additional confusion about what credit-related models actually do. They do not generally attempt to predict the overall credit condition of the economy. All these mortgage securitizations were not based on *projections* made by fancy models. The credit macro-state of the economy is actually reflected in the market prices of various traded indices (e.g. CDX, iTraxx). These market prices are *inputs* to the models. The primary function of the models is to translate these prices into valuations for related but non-standard securities (and to determine how to hedge them with the standard ones). This is a second-order kind of effect. But the problems in the credit world were already present at first order, i.e. already reflected in prices of the traded indices.

    One caveat to this is the models used by the credit rating agencies themselves. *These* models are the kind that try to predict the global credit state from historical data. And that is why they are not used by people who actually make money, people who of necessity tend to have fewer pretensions about what they know and what they don’t know. Incidentally, the ratings agencies are creatures of government, holding what is in effect a legally enforced oligopoly in the ratings business.

  30. Michael Bacon says:

    “Leverage had nothing to do with this. The banks are not in trouble because they BORROWED money for bad bets. They are in trouble because they LENT money to people who aren’t’t paying it back.”


    I’m sorry, but they are in trouble because they “borrowed” money to “lend” to people who couldn’t pay it back. If they couldn’t have borrowed money so easily for this purpose (if they had to use more equity), they would have checked the credit worthiness of the borrower a bit better I think.

    This is similar to what happened in Japan when banks and companies could borrower money so (relatively) cheaply that they made far too many bad investments. I lived there for seven years and watched it unfold in painful slow motion.

    I recognize that there are other factors as well, but it’s very clear that this played a big role.

  31. Amos says:

    “I’m sorry, but they are in trouble because they ‘borrowed’ money to ‘lend’ to people who couldn’t pay it back. If they couldn’t have borrowed money so easily for this purpose (if they had to use more equity), they would have checked the credit worthiness of the borrower a bit better I think.”

    That’s just wrong. This market involved making loans, securitizing the obligation to repay the loan, and then selling those securities.

  32. Amos says:

    “What normally keeps demand in line with supply? A price, set on a free market where buyers and sellers equilibrate. But the price of credit, encoded in interest rates, is not set on a free market. It is set by the arbitrary dictate of a board of bureaucrats (the Fed) with analytical pretensions.”

    This is, again, wrong. The Fed sets the price of credit for certain borrowings by regulated banks. The price of credit at issue here — the interest rate charged for the mortgages that were packaged into CDOs/CMOs, etc. — was set by the markets.

  33. Michael Bacon says:

    “market involved making loans, securitizing the obligation to repay the loan, and then selling those securities.”


    I really don’t know where you think the money comes from in the first palce — I know that once loans are made they are securitized to get them off the books.

    “Consider Lehman – or, more specifically, consider its barely controlled growth of the past half decade. Its assets more than doubled in size, to $691-billion (as of the end of ’07), while revenues and profits grew even more quickly. It was a trading house and investment bank on steroids. The juice was borrowed money, most of it short term, which allowed Lehman to accumulate $31 in assets for every buck the shareholders had in the enterprise by the end of 2007, up from $23 per dollar of equity in 2003. At Merrill, the story was exactly the same – a doubling of the balance sheet in just five years, leverage piled on top of leverage, ever more assets heaped on a thin reed of equity.”


  34. Amos says:

    Michael Bacon:

    “I really don’t know where you think the money comes from in the first palce — I know that once loans are made they are securitized to get them off the books.”

    Its true that there was (occasionally) short term bridge-loan type borrowing, to cover the time between the purchase of the mortgages and the issuance of the securities. But that isn’t relevant to what’s going on.

    In fact, you’ve got the whole thing backwards. The reason there were so many CDOs and CMOs being sold (and so many mortgages issued at such low rates) was because there was demand for the securities. (Well, that was part of the reason.) Ultimately, it was the purchasers of the CDOs and CMOs whose demand for those products drove down interest rates. The securitization was THE REASON FOR THE LOANS TO BEGIN WITH–people issued mortgages so they had something to sell to the banks, which bought the mortgages so they could sell the securities–not an afterthought intended to clean up the banks’ books.

    I read the article you posted a link to, and its an editorial by someone who doesn’t know what they’re talking about.

  35. EricD says:


    How do you think Fannie, Freddie, all the off-balance-sheet SIVs, and other credit funds were financing themselves to propagate this credit bubble? They were borrowing short-term (at low Fed-dictated rates) and lending long-term. They were taking advantage of the interest rate term structure arbitrage that the Fed set in motion by, e.g., artificially depressing short-term rates to absurdly low levels in the early 2000s. These credit players are the mechanism by which Fed meddling leaks into the rest of the term structure and the broader economy.

  36. Michael Bacon says:

    Yeah, I’m sure the guy is a complete idiot who wrote that. And so are the other 50 sources I could cite with the same basic analysis and numbers. At least now you’ve switched your argument some from leverage didn’t exist to well, OK, it existed, but it wasn’t very much, and it wasn’t really a problem. 🙂

    And you’re right that the one of the reasons, apart from cheap money, that the mortgages were made is because they knew they could get them off the books quickly through securitization (although they often had to keep the “D” piece or some part of the offering).

    Listen, if what you were trying to argue is that leverage didn’t initially trigger the meltdown, then I think we might find some area of agreement. There were a number of factors that triggered the current events. However, once the markets began to lose confidence there was no one willing to provide short-term funds to keep the ball rolling.

  37. Amos says:

    EricD & Michael Bacon:

    You are correct that there was (some) short term borrowing used to purchase the loans (made by others), which were then securitized. That was SHORT TERM borrowing that was PAID OFF when the securities were issued.


    Michael, I understand there are a 100 very confused sources out there who think what’s happening here is a replay of Long Term Capital Management and some of the hedge fund collapses of the past two years.

    They’re all wrong. There was no borrowing spree by the banks. The problem is that the banks now hold on their books enormous assets that have been substantially devalued. The problem is NOT that they borrowed money they can’t repay in order to create those assets. They were the LENDERS not the BORROWERS.

    Is this really that confusing?

  38. EricD says:


    All of these credit vehicles worked by continuously selling short-term paper and using the proceeds to buy mortgages that they tranched up and sold to investors (and partially retained for themselves). Their short-term funding was not one discreet event. It was the fuel for their business, constantly replenished by new paper being sold. Without the Fed’s loose monetary policy, and the term structure arb, these vehicles would never have been profitable. Once people finally identified the bubble and short-term funding dried up, these vehicles were toast, and the banks housing them buckled.

  39. Amos says:


    “All of these credit vehicles worked by continuously selling short-term paper and using the proceeds to buy mortgages that they tranched up and sold to investors (and partially retained for themselves). Their short-term funding was not one discreet event. It was the fuel for their business, constantly replenished by new paper being sold. Without the Fed’s loose monetary policy, and the term structure arb, these vehicles would never have been profitable. Once people finally identified the bubble and short-term funding dried up, these vehicles were toast, and the banks housing them buckled.”

    Your first point is right, but you are essentially agreeing with me that this is not a leverage crisis and Michael is wrong.

    Your second point is that this was triggered when “people identified the bubble” and “short term funding dried up,” which is completely wrong. Short-term funding (which you identify as the fed, partially right) didn’t dry up, and in fact its much more available now than it was. The Fed has tried to increase the amount of short-term funding by lowering rates, in fact.

    What has dried up interbank landing was the decline in the value of the securities on the banks’ books, which decline happened because people stopped paying their mortgages.

    What caused the “buckling” of the banks was the decline in value of the securities, which was triggered by the decline in mortgage payments and increasing default rate.

    The securities are marked-to-market, and as the market for the sale of these securities dissipated they had to be marked-down. The trigger for the last few weeks was that one bank sold a lot of the securities for a very low rate. When other banks learned of the rate, they were required to mark the securities on their own books down to that rate (this is a very rough approximation of what happened, but close enough for our purposes), which meant a large loss in asset value. This, in turn, has made banks reluctant to lend to each other, because for some banks if the assets get marked down much further then the banks’ book liabilities will exceed their book assets.

    Get it?

  40. EricD says:


    I haven’t been paying attention to your discussion with Michael. As to my “second point” about short-term funding drying up, it is irrelevant whether the Fed has kept rates low (which it has). Short term funding for these vehicles no longer exists; no one wants to provide it. That is simply a fact. That this stems from increased defaults (and increased expectations of future defaults) is true. Indeed increased expectations of future defaults is what it means for people to have identified the bubble.

    I am not sure what the point of that tangent was, however. You originally seemed to deny the critical role of the Fed in causing the mortgage bubble by pushing down short term rates. I had simply wanted to correct that.

  41. Amos says:


    “I am not sure what the point of that tangent was, however. You originally seemed to deny the critical role of the Fed in causing the mortgage bubble by pushing down short term rates. I had simply wanted to correct that.”

    Your argument is that short-term lending (a) was too available because the fed set rates too low and it was the fed banks were borrowing from, (b) is no longer available because no-one is willing to provide, and (c) is important.

    The second step of you argument is contradicted by your first step. Fed lending is more available now than it was.

    Short-term lending has not dried up leading to a collapse in the securitized credit markets. Rather, the collapse in the securitized credit markets led to a GENERAL decline in the availability of credit on commercial terms.

    This has nothing to do with interbank rates being too low, or anything like that. There simply was no short-term lending collapse prior to the decline in the value of the credit assets on banks’ balance sheets.

    I’m sorry, but the short-term bridge loans that were used to create CDOs and CMOs just have nothing to do with this. What’s dried up is the market for the securities themselves.

  42. John Baez says:

    Little People wrote:

    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 the Savings & Loan crisis, the US government spent about 125 billion dollars bailing out banks between 1986 and 1996. So, unless you’re quite young or weren’t looking, you actually have lived to see this sort of thing.

    Indeed, that earlier bailout may have helped create a “moral hazard” that’s part of the cause of the present one.

  43. Amos says:

    John Baez:

    “Indeed, that earlier bailout may have helped create a ‘moral hazard’ that’s part of the cause of the present one.”

    That’s partially true, but the S&L deposits were Federally insured, so there was a justified expectation of a government bailout, which isn’t true here.

    What the two events have _most_ in common, though, is that they were both caused by collapses in the real estate market, the first one commercial (a consequence of the ’86 tax code), the second residential.

    The moral of the story is that real estate does not always go up and the real estate market is not a securities market–it is highly inefficient, illiquid, and difficult to hedge.

  44. EricD says:


    Fed lending enabled the original short-term financing of the credit vehicles. That doesn’t mean continued Fed lending is sufficient to sustain this financing once the cycle has turned. The boom is not sustainable because the lending was accomplished on the back of an inflating money supply rather than an increase in real capital. When the effects of the boom redound through the rest of the economy and capital prices are bid up, housing prices decelerate, suddenly people can’t maintain their over-leveraged mortgages because they can no longer tap appreciating home value, defaults increase, ABS spreads gap out, no one wants SIV paper irrespective what the Fed is doing, and… bust.

    That’s the dynamics. This has nothing to do with bridge loans. It has to do with the effect of a dangerously low fed funds rate dragging down the short end of the yield curve, creating a term structure arb exploited by credit vehicles, and setting in motion an unsustainable credit boom.

  45. Amos says:

    “Fed lending enabled the original short-term financing of the credit vehicles. That doesn’t mean continued Fed lending is sufficient to sustain this financing once the cycle has turned. The boom is not sustainable because the lending was accomplished on the back of an inflating money supply rather than an increase in real capital.”

    The problem with this part of your argument is that the Fed’s lending played a very small role in the creation of the instruments at issue.

    “It has to do with the effect of a dangerously low fed funds rate dragging down the short end of the yield curve, creating a term structure arb exploited by credit vehicles, and setting in motion an unsustainable credit boom.”

    I’m not sure I get your argument anymore. Are you suggesting that the driver for credit expansion was an arbitrage between short term fed rates and higher longer term rates on the commercial market? If so, I don’t get your point, since commercial rates are always higher than the short term fed rate. I don’t think that implies the existence of an arbitrage, at least not in the usual sense of the term.

    On the other hand, are you suggesting that the fed simply maintained interest rates too low for too long leading to excess expansion? Is this a Keynesian argument or a monetarist one?

    Either way its wrong, because the market should have (but did not) accurately assessed the risk of default on the mortgages themselves and on the mortgage backed securities.

    The error you’re making is that the supply of money isn’t really a function of the fed, its a function of the capital markets. The Fed’s influence, limited to M1, has never been more than marginal, and the growth of new credit instruments made the fed even less important.

    The whole point of what was happening was that banks created new sources of loanable money.

    Think about it this way:

    In the beginning, there were loans, and they came from banks who loaned depositors’ money, and they were regulated by the Fed.

    Then there were simple securitized loans, where the mortgage-lending banks sold loans to investment banks, who turned them into bonds that could be sold to qualified investors. This made the qualified investors’ capital available for lending and reduced interest rates.

    Then came credit derivatives, where the clever bankers figured out how to divvy up bundles of loans so they could get a high credit rating and a larger pool of investors could buy them. That made lots more money available for lending, and reduced interest rates further.

    The Fed played little or no role in any of this — the whole thing was about making sources of money OTHER than the Fed available.

  46. Peter Woit says:

    Amos (and others),

    Thanks for the informed comments that add a lot to my understanding of how all this came about. If I don’t contact you or ask more questions about the details, it’s because I suspect I’m already spending more time on this than I should. The question of how this happened is one that I’m sure will be debated extensively in the future.

    While I don’t understand exactly how we got here, I think I do understand where we are: a financial system full of institutions that are effectively insolvent. The Bush administration is trying to get Congress to agree to deal with this by printing $700 billion and allowing Paulson to give it to pretty much whoever he feels like.


    This is rather different than the Savings and Loan story. There, the institutions had failed, the government owned them, and had to decide what to do. The proposal here is to bailout the current owners.

  47. EricD says:


    First, the theoretical basis for my position is neither Keynesian nor Monetarist but Austrian (Mises, Hayek). You are apparently unfamiliar with the Austrian theory, so I suggest you wiki it, but briefly it focuses on the inevitable distortions brought about in capital markets (and the inter-temporal structure of production) when the government controls the price of credit instead of letting it be determined freely on the market.

    An important aspect of this is that the Fed is substantially in control of the short end of the yield curve. It is irrelevant that a given entity is not borrowing directly from the Fed. The Fed is continuously pumping new money into the economy when it buys treasuries, or soaking money out of the economy when it sells them, in the process of fixing short term rates to its arbitrarily chosen level. Short term corporate rates include a default premium above this level, but are still substantially influenced by it.

    There is no arbitrage in the strict sense between the two ends of the yield curve, but over a decade long initial phase of the credit cycle, there is a huge incentive to put on this kind of carry trade.

    The essential point of the Austrian theory is that exactly the mechanism that the market would have in correcting a faulty assessment of future defaults, namely the mechanism of market interest rates, is thrown out the window when the central bank assumes the role of credit czar. You can’t have a price system and eat it too.

    What your account is missing is the fractional reserve nature of our system. The money lent out in mortgages did not come from depositors’ funds, it was created out of thin air and transferred off the balance sheets of banks (into SIVs) so that it ultimately did not even impair their reporting situation in regard to capital requirements. The loans were ultimately not backed by real capital and were made possible by the phony price signals (low rates) manufactured by the Fed.

    One guy who called a lot of this in detail way before it came to fruition is Grant of Grant’s Interest Rate Observer. Reading back issues would be informative.

  48. Boo Radley says:

    Actually, Peter, this question is relevant and one that is worth spending time on. You should not just walk away from it. Just look at the response you have generated, even though not all of us agree with you on all counts. (String theory is boring, indefensible mumbo-jumbo, and of no relevance to the real world, and inelegant, in spite of all claims to the contrary.)

  49. Peter Woit says:


    My comment was a purely personal one about not having the time necessary to invest in learning enough about some things to have a sensible opinion about them. This doesn’t at all mean that I think they’re not worth thinking about.

  50. Chris Oakley says:

    I recommend Liar’s Poker by Michael Lewis to anyone who is interested in the issues raised here. This book will also tell you what a “Coyote Morning” is. Although now 20 years old the only things that have really changed are

    • Traders now are soft-spoken and have degrees, the traders making markets in the simpler instruments having long since been replaced by machines. The downside is that dealing floors do not have the “buzz” they had when I started in the business.

    • The credit derivatives market has exploded, a case of the tail wagging the dog as on the back of it a whole lot of poor quality debt has entered the market, leading to the current crisis.

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