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10/12/2008

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david jowett

My questions are, what were the banks investing in? What is a Structured Investmen Vehicle (SIV)?
What is a Credit Default Swap? I do know what leverage is, but I thought I had to pay 80% down. I have read my Galbraith, and I do know Hedge Funds were cheats for the rich? So, are shaky US mortgages to blame? For Northern Rock? HBOS? RBS? Why were British Banks into US mortgage securities? Irish banks? German Banks? Is it legitemate to suggest that journalists should have given up their fascination with opinion polls, say in July, and investigated what is going on? Or why subscribe to the WSJ or The Economist? Mr. Becker, help us out, if only in retrospect.
David

david jowett

My questions are, what were the banks investing in? What is a Structured Investmen Vehicle (SIV)?
What is a Credit Default Swap? I do know what leverage is, but I thought I had to pay 80% down. I have read my Galbraith, and I do know Hedge Funds were cheats for the rich? So, are shaky US mortgages to blame? For Northern Rock? HBOS? RBS? Why were British Banks into US mortgage securities? Irish banks? German Banks? Is it legitemate to suggest that journalists should have given up their fascination with opinion polls, say in July, and investigated what is going on? Or why subscribe to the WSJ or The Economist? Mr. Becker, help us out, if only in retrospect.
David

Don the libertarian Democrat

What's the false alarm? There was an implicit government guarantee to intervene if things went sour and they have.

Jack

David, Ha! You've bit of reading to do to catch up on all the fancy means of shuffling risk around the world!

You bring up a great point though as I don't recall seeing anything about financial institutions stretching out their ratios from 1:12 to 1:30 before "the crisis".

You're familiar with the 20/80 home loan that in recent years has gone to 0/100 with some of these lenders being out there with 1/30 or so and "surprise!" when a 20% drop in home prices triggers a falling house of cards.

The Bear(Today)

The reason? Greed!Greed!Greed! And blind, unregulated markets driven by neo-con, lock-step ideology. It's really that simple. And , oh yes, a dash of human nature that cycles about every 20 years or so!

The Bear(Today)

The reason? Greed!Greed!Greed! And blind, unregulated markets driven by neo-con, lock-step ideology. It's really that simple. And , oh yes, a dash of human nature that cycles about every 20 years or so!

The Bear(Today)

The reason? Greed!Greed!Greed! And blind, unregulated markets driven by neo-con, lock-step ideology. It's really that simple. And , oh yes, a dash of human nature that cycles about every 20 years or so! As in why did Nero fiddle? Because he could and he did not want to deal with reality.

Jim

Let me please try nmy hand at some simple minded explanations:

Inflation has heretofore been controlled by the purchase of all material necessities from countries in which the wages are a fraction of what they would be in the US or western Europe (food included). Inflation in the US has been limited to goods and services which do not fall into the above category such as healthcare, legal services, housing and energy. Oil is unpegged from the dollar, the Fed prints dollars backed by paper in the private economy (derivatives, etc.) and 12T of debt in public obligations. In response, the private sector leverages itself 30:1 and allows that leverage to creep into the housing market with undocumented loans to people who have no chance of repaying the loans because their real wages have diminshed significantly in response to globalization and the accumulation of wealth in a smaller and smaller percentage of the population which then takes huge financial risks. We reach the apex of some arcane econometric and KABOOM!

And no one saw it coming?

Tom Grey

Yes Gary, too many wolf warnings 'too soon'.
In Dec. 1996 the 'irrational exuberance' speech warned about the coming dot.com bubble pop -- that didn't happen till after 2000. Huge gains by those who got in, and out before the crash.

The Economist has been warning about overpriced US houses since around 2003. Roubini should be more celebrated now, for more successfully calling it correctly. But neither he nor anybody is really saying what the 'right' prices of houses should be. (I'd suggest 5-7* avg wage in the county should be avg house price in the county, for most counties in the US.)


The increase in leverage to 1:30 was NOT much talked about. The slicing of Mortgage Backed Securities into different invest tranches was NOT much talked about.

It's possible that only construction (down for a while), newspapers (ditto), and especially financial orgs are going into deeper depression, but the rest of the economy not so much.

If much of what the Big Banks have been doing the last few years is trading MBS, and hedges around it, it's likely that finance banks need to be hugely reduced in size and number.

The bailout should be letting gov't do direct to company loans, so productive non-finance companies can keep producing.

Fred

"But neither he nor anybody is really saying what the 'right' prices of houses should be. (I'd suggest 5-7* avg wage in the county should be avg house price in the county, for most counties in the US.)"

I would suggest the "right" price for houses to be less than three times the average household income of an area.

Jim

Not to mention that anyone who wants to keep it between the lines is marginalized as unimaginative and uninspired. If economists want to be more useful, perhaps they should inject a larger dose of moral philosophy into their thinking and public involvement.

Brian Davis

Maybe, but it's more likely you'll have to find religion on your own for it to stick. Frankly, I'd be delighted to see smart academic economists tear into more of the quantitative drivel that's peddled in the B-schools. If a Wall St Journal columnist (Gordon Crovitz, op-ed page 10/13/08) can deconstruct the popular "value at risk" theorem, then imagine what else that passes for sound financial principle deserves debunking.

David Heigham

Professor Becker,

For most economic agents, there is no evident advantage - most of the time - in taking notice of the warnings. Therefore, as in the run ups to most previous downturns, they took no notice. The long-sighted minority amongst the bankers were aware that ready cash is a very profitable asset when confidence falters, and stashed it away as they usually do. The hedge funds were a new type of agent geared to taking advantage of market fluctuations. I would hypothecate that their relative good health implies that they did heed the warnings. That is to say, the people in the market who would expect to gain by taking notice of the warnings probably did so.

The people who did not take notice of the warnings and whom we now dearly wish had taken notice are the regulators of the markets. I suggest that this was because the warnings were not addressed to the key issues: adequacy of finacial reserves to face possible losses; and quality of lending. In particular, it is surprising that academic accountants and economists did not get together to question just what "off-balance sheet" meant under stressed conditions; and that economists did not attempt to model the effects on credit -worthiness of the spreading of risk through complex OTC instruments. With hindsight, it is also surprising that the Fed did not attempt to monitor both the quality of mortgages as proposed by agents and the quality and implications of the rating agencies classifications of new types of complex debt instruents. On both, they seem to have had plenty of warning signs from non-academic sources.

I am afraid the question narrows down to what warnings hould we economists have generated, but didn't; and what warnings should the market regulators have heeded, but didn't?

Jeff

Professor Becker, I agree with your assessment that the Great Depression 2 is not coming-depending on federal policy to avert it.

Unfortunately, many out there are attacking the Chicago School because "capitalism failed". However, it was the government intervention into capitalism that caused it to fail. Subsidies from Fannie and Fred lead to huge distortions in the market. This combined with easy credit, and the failure of rating agencies lead to a break down in the market.

The problem was not the instruments themselves-many exist to manage risk. The problem was there was not a proper way to manage the instruments once they were written. This is not do to a lack of regulation as some have charged, but do to a lack of the correct regulation.

There needs to be a private central clearing house that keeps track of the trades in the OTC market. The clearing house will ensure that there is transparency in the market, that actual money is put up to trade, and that the correct people make money and are on the hook to lose money when that event happens.

Today, the OTC is unfettered-and little or no risk capital is put up to establish the position. The market is not transparent, and as we have found out, one cannot even ascertain a price for many if not all of the instruments.

Chicago economists know that for a market to function, you must be able to determine a price for the good. Famously, Milton Friedman has a YouTube video that talks about the information price disseminates when you go to the store and buy something as pedestrian as a pencil. There is no difference in the complex OTC derivative market. Inability to determine an accurate price leads to distortion in the market place. When the market actually has to perform, it falls down on its knees.

A clearing house would have sent warning signs that were clear and easily understood to all participants and this entire situation would have been avoided.

neilehat

How does one determine value? It was once said, that the value of something is the price it fetches at market. Todays problem is that there was so much money sloshing around in the World's Economies, that everything took on a golden hue until it was all spent on Gilded Financial Instruments. When there was no money left, those same instruments were reconized for what they were, gilded paper. Now try and resell that.

Bryan Willman

Fear and Greed.

Too much greed, not enough fear -> bubble.

Too much fear, not enough greed -> freeze up, perhaps collapse.

Mix this with "local selection functions" that may punish risk control so much as to make it pointless.

That is, if banks that are leveraged 30:1 are making so much money that banks leveraged only 10:1 are left without shareholders or depositors, it does not matter that 10:1 is the prudent number, people doing the prudent thing may be driven out of business.

(Carrying on Posner's example - if deploying the pacific fleet to find and stop a japanese attack used so much fuel and engine time that the entire fleet was forced into refurb at the time of the attack, knowlege of the attack coming wouldn't have helped.)

Jim Few

Too many are living on credit. The politicians made it easier and empowered themselves by buying votes on credit. The basic problem going from the bottom- the individual - to the top - highest level of government -- is that we have been spending more than we take in. Greed or failure of capitalism is not the problem. Political intervention in the market is.

To me it has always seemed more like common sense. "Don't spend more than is coming in! "

The American people are mostly ignorant about economics, so how does a politician get them to vote for him? By telling them what they want to hear. That's what Obama does so well. If it is up to the savvy educated voter to prevent his election they would have to out-number the ignorant. That's why the "progressives" (a euphemism for 'liberals' ) are taking over...!! The ignorant want a "savior!"

A knowledge of economics enables people see through the rhetoric, and from being duped by politicians.

Like a recent WSJ article says:
It is impossible for Obama to give a tax cut to 95% .... without changing the definition of "tax cut"... to "welfare payments", since almost half the population pay no taxes. It's reminiscent of Clinton using the euphemism "contribution" for "taxes."

jcf

anne

I just don't understand why, in all their brilliance, investment banks did not come up with a system similar to bonds and rate these various instruments (derivatives, mortgage backed securities etc). It seems illogical to me that over the span of 25 years, no one capitalized on this option.

anne

I just don't understand why, in all their brilliance, investment banks did not come up with a system similar to bonds and rate these various instruments (derivatives, mortgage backed securities etc). It seems illogical to me that over the span of 25 years, no one capitalized on this option.

Sam Vinson

Before considering why Prof. Roubini's warning signal was ignored, it seems worth examing why Milton Friedman's analysis of the Depression was ignored at a critical juncture in '07. As I understand it, his analysis of the problem in '30-'32 period is that a contracting money supply compounded by a focus on deficit reduction resulted in the dog chasing its tail backwards.

During '06 and '07 we read stories about the declining current budget deficit due to increasing tax collections which come disproportionately from taxpayers who most efficiently deploy capital. For six critical months in '08 the narrowly defined money supply has been stagnant.

That problem nust be greatly amplified by declines in commercial paper and more exotic instruments that in normal times have ready liquidity, or money supply effect.

So before I learn about Roubini, please help me understand how Friedman could be ignored.

neilehat

Sam, It's simple. Friedman who?

mike

There is a far more accurate explanation that is evident to those of us who toil in the capital markets on a daily basis. The Federal Governemnt has been subsidizing the cost of real estate ownership for at least 60 years; Fannie, Freddy, the deductibility of mortgage interest payments from Federal Taxes, the Community Reinvestment Act, the $500,000 exclusion on capital gains from the sale of a primary residence, etc., etc., etc. This interference with the operation of the market clearing process combined with the complete and total corruption of Fannie, and Freddie, in combination with inept Fed policies were all necessary pre-conditions for what has befallen the Street.

Once again we learn the lesson; TINSTAAFL.

mike

There is a far more accurate explanation that is evident to those of us who toil in the capital markets on a daily basis. The Federal Governemnt has been subsidizing the cost of real estate ownership for at least 60 years; Fannie, Freddy, the deductibility of mortgage interest payments from Federal Taxes, the Community Reinvestment Act, the $500,000 exclusion on capital gains from the sale of a primary residence, etc., etc., etc. This interference with the operation of the market clearing process combined with the complete and total corruption of Fannie, and Freddie, in combination with inept Fed policies were all necessary pre-conditions for what has befallen the Street.

Once again we learn the lesson; TINSTAAFL.

Laxmikant

In order to prevent something like this from happening in future, do you think

Un-regulated Capitalism:
------------------------
1. laissez-faire capitalism is in-adequate?

2. In pure capitalism, a small group of powerful incumbents with access to resources will get more powerful and shape the policies (golden parachutes, bailouts) to their benefit?

Shaky assumptions of rational behavior/efficient markets
----------------------------------------
3. Normal people (within 2-3 sigma distributions) who can only hold 3 things in their mind, don't learn from the past bubbles, don't know how to evaluate chances are ready to evaluate derivatives like the options, futures, swaps?

4. Normal people; who avoid reading fine prints, side effects of medicines, even paychecks; can evaluate fundamentals of stocks/funds/derivatives?

5. Market crashes when create discontinuity (equivalent of shocks in aerodynamics, singularity in maths) several models like VAR, option valuations, securitization fail to address the effect. Should such instruments be passed through a FDA equivalent regulatory body before allowed to trade on different types of markets (OTC, exchange etc.)

6. Can a small group of powerful investors (Hedge funds, PE groups, Sovereign funds) introduce a stimulus in the market or amplify existing stimulus to tip the system out of equilibrium?

Thanks

T V Selvakumaran

(Continued on Thursday, October 16, 2008)

Q13. You had mentioned in your answer to Q9 that "as far as the Federal Reserve Bank is concerned, the most important and pressing need, at present, is for its Chairman, Professor Benjamin Bernanke to give a well-thought public speech that demonstrates that he understands the problems he is encountering in the markets." The Federal Reserve Chairman has indeed been giving public speeches on the current financial crisis during the last few days. On October 7, he spoke at the conference of the National Association of Business Economists (NABE). Yesterday (October 15), Professor Bernanke spoke at the Economic Club of New York and held a Q & A session after that. Does Professor Bernanke's speeches provide some assurance about his expertise in being able to deal with this financial crisis?

A. Yes, I have transcribed Professor Bernanke's speech and his Q & A session held yesterday at the Economic Club in New York. I have carefully considered his remarks in his opening address and his answers in the Q & A session. I have to say, with great reluctance and some sadness, that Professor Bernanke does not possess sufficient understanding of the current crisis in the financial markets. This is all the more worrisome because Professor Bernanke seems to have earnestly consulted his academic colleagues throughout this crisis. One good aspect about Professor Bernanke's stewardship of the Federal Reserve is that right from the beginning of his term, he has functioned within a rational and logical policy framework which had been derived from current academic scholarship of the Great Depression. Let me explain the broad outlines of his policy framework here. For more details, the reader should refer to the transcripts of yesterday's speech given by Professor Bernanke (a copy of the transcripts is attached to this mail):

To quote Professor Bernanke (from yesterday's speech), "The crisis we face in the financial markets has many novel aspects largely arising from the complexity and sophistication of today's financial institutions and instruments, a remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light". Professor Bernanke also made some comments about the positive geo-political reality that enables the Federal Reserve to work in close coordination with the central banks of Japan, England and Europe, in contrast to the protectionist economic policies of the industrial countries during the Great Depression. But for these novel aspects, it would seem, from listening to Professor Bernanke's speech and his Q & A, that the current crisis situation can be handled with tools and techniques developed from past experiences, particularly the Great Depression. Lastly, expressing a firm "we will not stand down", as the Chairman did yesterday would, I suppose, contribute towards managing the expectations of market participants about the future.

The first lesson of the Great Depression is that the government authorities (the Federal Reserve, the Treasury, the Congress and the President) should act early and act quickly because waiting too long could mean that many financial institutions are already insolvent. The next lesson is that the central bank should provide liquidity in the financial system by keeping interest rates down and by extending large amounts of credit to the banks by way of short-term lending. Beyond this liquidity provision, the Federal Reserve, the Treasury and the FDIC should take precautions to prevent the collapse of a large number of banks through bank-runs, as happened during the Great Depression. Moreover, the systemic risk should be monitored continuously and any large financial institution whose failure is too risky for the whole financial system should be directly assisted in avoiding bankruptcy. At some point in this crisis-prevention program, the central bank would find itself out of resources, i.e., monetary policy alone would not be sufficient to prevent the escalation of the crisis. At that point or well before that, Congress and the Administration should step in with fiscal assistance. The intellectual basis for this role for government's intervention has been long established by the great British economist John Maynard Keynes during the Great Depression. Government intervention could take the form of deficit financing, higher taxation and (partial) nationalization. While all this assistance is going on, the central bank should use its mathematical models for gauging inflationary expectations to make sure that inflation does not get out of control. It may be noted in passing that this inflationary-expectations-modelling, a body of knowledge that has evolved from the collective contributions of monetary theory, behavioral psychology and econometrics, is one of the great achievements of 20th century economic theory.

This then is the broad outline of the policy framework that the Federal Reserve has been following during the tenure of Professor Bernanke as its Chairman. The practical implication of this policy framework is that the Federal Reserve provides broad intellectual support to the Treasury's actions in this crisis. In particular, the government take-over of Fannie Mae and Freddie Mac in early September and the 700 billion dollar Troubled Assets Relief Program (TARP) passed in the US Congress in early October are given theoretical justification under the Keynesian prescription for government intervention. So far, so good. Now, regarding the future, the Keynesian tradition would advocate regulating the financial markets to prevent excessive risk-taking, and injecting equity into financial firms to prevent insolvency. The moneratist tradition would insist, I suppose, on a role for the Federal Reserve in providing liquidity and the thawing of the credit freeze. The libertarian tradition would provide assurance to the finance firms that the government's involvement is only for their own benefit. Unfortunately, this policy framework does not take into account some crucial aspects of today's economic reality. Hence, I am forced to express doubts about Professor Bernanke's understanding of the current financial situation. With all due respects, I have to give Professor Bernanke a mild thumbs-down.


Q14. In what ways are the current economic situation different from the Great Depression?

A. To my knowledge, academic literature in economics does not take into account that the Great Depression fell between the two World Wars of the 20th century. As a result, the lessons of the Great Depression for today are usually specified as abstract policy prescriptions without taking into account the particular details of the political and economic reality that existed at that time. The single major difference between the American economy during the Great Depression and the contemporary one is the massive accumulation of capital, a phenomenon which I have explained in detail in my answer to Q1 above. Before World War I, the most advanced industrial nations with well-developed pension systems and universal health care were in Europe. World War I wiped out the accumulated capital of these countries. America was beginning to experience the first blushes of affluence during the Jazz age of the 20s, just before the onset of the Great Depression. Thus there were no sizable accumulations of capital anywhere in the world. In contrast, the pension funds and mutual funds that hold the lifetime savings of today's workers all over the world amount to anywhere between 20 trillion to 50 trillion dollars. One should compare this figure with the fact that the annual GDP of the United States is of the order of 14 trillion dollars.

The second major difference is geo-political reality, which Professor Bernanke alluded to in his speech. During the Great Depression, countries were pursuing protectionist economic policies and severe restrictions on the flow of capital across the world. In contrast, global flow of capital, goods, labour are growing rapidly today. Moreover, nations are increasingly adopting democracy as the form of government. This has resulted in a much friendlier, co-operative geo-political environment at the global level. The third major difference is the advent of technology. The use of computers has ensured that communication is more quantitative, reliable and accurate. In this way, the flow of information which is crucial for economic decision making has vastly improved.


Q15. Why are the lessons drawn from the Great Depression inadequate for dealing with the current financial crisis?

A. One can easily see that when one takes the massive accumulations of capital today into account, then the most helpful policy prescriptions for dealing with the current crisis would try mostly to enable the private sector, which holds these vast quantities of capital, to function freely. The possibility that capital does not flow freely but is clogged up temporarily calls for an active policy of providing liquidity. But other than that direct government intervention to adjust the capital structure of the finance firms is evidently quite destructive. In short, the cures that Milton Freedman prescribed for avoiding the Great Depression, namely, ample liquidity and minimal government, seem to make the best policy for the current financial crisis. Keynesian policy recommendations might come useful, if and when the economy actually experiences a contraction in output. Moreover, it appears that the credit freeze that has come under intense focus among the economists of late was, in fact, caused by the loss of confidence in the credit markets due to the government's arbitrary intervention in the functioning of the markets, going back at least to the take-over of Fannie Mae and Freddie Mac in early September. One should also note that the term 'credit freeze' is quite misleading. There does not appear to be an actual unavailability of credit on Main Street. Credit freeze seems to refer to the high rates of interest that banks charge for lending to themselves, far in excess of the yield in the Treasury securities, and the high rates of mortgage loans. But, again, the reason for this could be that government is the 800-pound gorilla that is causing a lot of uncertainty in the credit markets by its arbitrary meddling in the functioning of the private sector. Also, inflation could be creeping up, and banks may be unwilling to lend at real interest rates that are negative, unlike the willingness of the Federal Reserve to keep cutting its interest rates. Lastly, the fact that private banks could be charging interest rates much higher than the Fed might help to attract money from the hedge funds and mutual funds which are looking for safer investments than stocks and mortgage securities. Thus it is not entirely a bad thing since it enables the free flow of credit.

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