Financial disasters

Within the field of geography there is an area of specialization referred to as disaster management. The basic concepts of disaster management involve: (1) prevention and mitigation, (2) preparedness and response and (3) recovery. The first involves preventing or at least minimizing the chances of a disaster, the second –recognizing that many disasters cannot be prevented- involves making sure that an area is ready with a set of plans in place to respond as effectively as possible while the third involves a careful consideration of the steps needed to help a region pick up the pieces and return to normal as quickly as possible. The current financial crisis can certainly be referred to as a disaster. In what follows I argue that what we have been doing over the last several years has been the financial equivalent of allowing and even encouraging the extensive building of huge but poorly constructed structures on a major fault, a major floodplain or a very cyclone prone area. One cannot reasonably expect experts to be able to predict with any precision just when the next major earthquake, flood or cyclone will occur in an area prone to such calamities but to actively encourage settlement in such places or to fail to have plans in place to deal with disaster when it, inevitably, occurs is extremely poor disaster management. How financiers are like poor Bangladeshi farmers: Driven by poverty and overpopulation poor Bangladeshi farmers settle in islands of rich fertile alluvial soil that form islands of farmland in the Sunderbans of Bangladesh. If they are spared from cyclones and flooding, it is possible to eke out a better living on these islands (or chars as they are called) than they could manage elsewhere. Of course, flooding and cyclones do occur but the choice made is taking one’s chances and making ends meet rather than starving . So farmers settle on chars hoping and praying that they are spared from disaster. Sometimes prayers are answered more often they are not. The Bangladeshi government can do little to control this settlement and, given its limited resources, can offer little in the way of alternatives to those who settle there. The U.S. financial sector -driven not by poverty and overpopulation but by an increasingly crowded and hence competitive environment- has settled in the financial equivalent of disaster prone areas of financial services such as the packaging and sale of mortgage backed securities and credit default swaps. In fact, through deregulation our government has encouraged settlement in these disaster zones. Disaster has struck with a clear recognition that it was simply a matter of time and we have, until this week, had no plan in place in terms of how to respond or how to recover from the inevitable. “Financial statesmanship”: On August 6th of this year an organization of major players in the financial services industry (a group called the counterparty risk management group project, CRMGP) issued their third report. This report was expressly directed to Secretary Paulson (as the report issued by the same group three years ago had been) and to Mario Daghi, governor of the Bank of Italy and chair of the Financial Stability Forum. To their credit, the CRMGP clearly has recognized that the root cause of our current difficulties is a lack of what they call “financial statesmanship”. They define financial statesmanship as requiring that management of individual firms look at the broader and longer run perspective of what ultimately would be better for the financial sector the world economy overall, and themselves rather than their own firms’ short run (real or imagined) profits and cash flow. Beyond this frank admission of short-sightedness what is amazing is that they clearly point to the dilemma that an individual firms faces if chooses to rise above the fray. As they put it “ …in a highly competitive marketplace it is very difficult for one or a few institutions to hold the line on best practices or to stand on the sidelines in the face of booming markets.” Although the CRMGP does not identify the dilemma as such, what individual financial firms face is a classic prisoners’ dilemma. Just as the guy who confesses first is potentially better off to the swift goes the race in financial markets. To move cautiously when you are not at all sure that others will be so wise means that the sort of returns earned may be far below one’s competitors’. Just as the prisoners’ dilemma provides support to the old adage that there is no honor among thieves what the CRMGP is drawing our attention to in their report is that, for good reasons, financial statesmanship is an exceedingly rare commodity. What I hasten to add is that, with the right expertise, you shuffle the deck and put most of us in the position of top management in the financial services industry and we would behave no differently. This dilemma is a problem inherent in financial markets. But what has happened here is that the ultimately self-defeating and potentially dangerous game has shifted from the risky trading of financial paper to first mergers and acquisitions and initial public offerings (which in hindsight seem tame in comparison) to the disaster prone territories of mortgage backed securities, credit default swaps, and such. It is natural enough to expect the quest for higher returns to have encouraged this movement but the level of competition and the ability to take on far greater risks have both grown largely thanks to less stringent regulation. Regulation has become far more relaxed: Among many recent changes to our regulatory environment in 2003 the current administration asserted the superior power of the federal government, through the SEC and other federal agencies, to regulate the financial sector, over the states. This is in keeping with the Bush administration’s later position that federal carbon emissions standards were binding and that states such as California could not set their own more stringent standards. With looser controls predatory lending became the order of the day as mortgage credit was given to many borrowers with little thought given to the credit history or actual earnings of the borrowers, the market value of the properties to be purchased with these mortgages or concern that the borrowers were aware of what risks were involved once the low or zero interest-principal only period of their mortgages expired, they had to “reset” and, for some reason, they could not refinance. Originators left it to the third parties buying mortgages to sort all of this out Those buying these mortgages pooled them with the hopes that the pooling would make risks of default insurable. Perhaps not coincidentally issuance of MBSs over the course of 2003 grew by some 48% over what it had been in 2002 (according to the Bond Market Association). As of 2006 the same organization estimates that the market value of MBSs outstanding stood at some $6.1 trillion (in comparison to about $8.5 trillion worth of U.S. Treasury debt held in government accounts and by the public in the same year). The magic of financial engineering: Take a MBS based on a collection of subprime mortgages. As an investment banker you buy 10 subprime mortgages to package together in a security. Because of a higher default risk, the individual subprime mortgages let's say yield 7% when prime mortgages only pay 5%. First by assuming that although the chances of default on any one subprime mortgage may be relatively high (say a one in ten chance) if the likelihood of any one borrower defaulting is independent of the others in the pool (which is an extremely naïve assumption for any one with even an elementary understanding of macroeconomics) the likelihood of default goes from a 1/10 chance if you held each mortgage individually to an infinitesimally small chance when you pool ten together. This pooling of risk is how insurance works. By pooling two such mortgages together you cut the odds of complete default not getting any of the money risked from a 10% chance to only 1 out of 100. Double the pool again to four and the odds of complete default falls to one in 10,000. The flip side of this is that the odds of at least half of the money at risk being paid back as you go from 1 subprime mortgage on its own ten mortgages collected in a pool goes from 90% to 99.98%. Of course, in an actual insurance policy the odds are capable of more or less exact estimation whereas the likelihood of default is not. Ignoring this simple fact, money is to be made by buying these mortgages up at discounted prices that reflect individual default risks and by pooling them, theoretically reducing the default risk in the way I have just described. Essentially a 2% profit in interest income on 10 mortgages is divided between the seller and the buyers of mortgage backed securities with the notion that the default risk has virtually disappeared and those involved are earning 2% more than previously the market would have paid for a “risk free” investment. Tranches, what makes MBSs toxic, credit default swaps, and counterparty risk: The idea behind tranches is that not all who might wish to invest in MBS share the same level of confidence. If more cautious one may invest in an upper tranche. If one is less cautious, in exchange for helping the issuing company shoulder part of the default risk, lower tranche investors receive a greater share of the total overall gain. The tradeoff is that in the event that a significant number of borrowers in the underlying pool of mortgages go into default those in the upper tranches have a prior claim on cash flow and are paid first. If all goes well then you get a bigger share of the total gain for simply being less risk averse. However, when there is not enough money flowing in because of higher than expected defaults those in the lower tranches lose out. When there is not enough coming in to pay those in the upper tranches out what otherwise would be paid to the lower ones, MBSs become toxic. (For a wonderful description of tranches, toxicity, and such click here, here or here) At least subconsciously, investors realized the tremendous risks inherent in all of this. To address this, credit default swaps were created. They offer to the buyer a form of insurance. However, unlike real insurance , CDSs are completely unregulated and, unlike real insurance, based on incalculable odds. You are concerned that the company issuing the MBSs you hold will not be able to pay back your initial investment. Let’s say that for 1 basis point on the $10 million of your money that is at risk in MBSs (i.e. for $100,000) I agree to cover the loss if the company issuing your MBS, based on this package of pooled subprime mortgages, goes into default. You rest easier, I have pocketed $100,000 and given GAAP (generally accepted accounting principles) having “insured” your investment you no longer have to mark to market the value of the MBSs you hold (even if they are falling in value). I may not have the $10 million to make good on my promise and so may in turn take out a credit default swap on this same MBS for ½ a basis point (i.e. $50,000) with another party. As a result, I have netted $50,000 profit but no longer have to worry about the fact that I don’t have the $10 million promised. If all goes well, all goes well. However, if defaults begin to increase or if the credit ratings of individual institutions along the chain are downgraded, clouds on the horizon gather and the chances of your losing everything grows. You begin to worry that at the same time the company issuing the MBS that you sold the CDS to me to cover the CDS you bought will not be honored because the seller of that credit default swap has gone into default as well. Driven into this fertile but dangerous area by increased competition and, at the very least, not discouraged from settling here by those in power you now realize that perhaps should have settled some place safer. There is no evacuation plan and no clear idea of how long the storms will last, if you will survive and, if you are lucky enough to pull through what the recovery effort will be. There is plenty of blame to go around. The more fundamental question is what lessons we will draw from what has just happened. Some links on the candidates' positions on the crisis: Senator Obama Senator McCain 1 Senator McCain 2 Senator McCain 3

Leadship, parenting, and differing views on economic policy

You have a friend. He is a parent. He obviously loves his kids. It is equally clear that he firmly believes his children can do no wrong. It looks to you as though serious problems are soon to arise. You say nothing because you know that your friend will not listen to anyone who might suggest that his children could have problems. Time passes and some of his kids have gotten into very serious trouble. Your friend minimizes the problems that are popping up. It is only when they have reached a crisis stage that he steps in. You must face the fact that your friend is a bad parent.

Your country has leaders who love their country. Listening to them it is clear that they firmly believe that businesses can do no wrong. It looks to you and others as though serious problems are soon to arise. You know that your leaders will not listen to anyone who might suggest that businesses (that are, after all, managed by rational intelligent people whose fortunes and reputations are at stake) could have problems. Time passes and some businesses have gotten into very serious trouble. You and others see your leaders minimizing these problems. It is only when they have reached a crisis stage that they step in. You must face the fact that your leaders are inept.

My point is that bad governance is much like bad parenting and good governance is much like good parenting. As a thoughtful parent you assume that your children will behave. At the same time you nonetheless carefully monitor their behavior and stand ready to step in sooner rather than later when difficulties arise. Business people are fond of saying that all that they want from government is to be left alone, much like many teenagers might wish their parents did not treat them like they were still children. But just like the supposedly adult teenager runs to Mom and Dad once they have run out of money or are stranded along the road because they forgot, yet again, to buy gas; businesses rush to government for help when crises emerge.

It isn't wrong that a parent helps in times of crisis. What is wrong is a parent refusing to recognize that the problems they must deal with would not be nearly as great and that both they and their kids would be happier and better off if they had simply kept a closer eye on what was going on. What is wrong is the refusal to recognize that one's children do need to be watched and do need to be disciplined. It isn't government stepping in to help in times of crisis that is the problem. It is the refusal of those in power to recognize that the problems they must deal with would not be nearly as great and that we would all be happier and better off if they had simply kept a closer eye on what was going on that is the problem. It is the refusal to recognize that business, especially financial concerns, need to be watched and need to be disciplined that it the problem. Unfortunately, the business community is populated by mature and intelligent people who collectively act like children. Bizarre and ill-conceived ideas like bond insurance (credit default swaps) or making relatively riskier investments in an increasingly competitve environment with wholely inadequate reserves have a way as sounding as sensible as tearing down the highway at 100 mph in your Mom's car or racking $200 in text messages on your cell phone does to all too many teenagers.

Following, among others, the late Arizona Senator, Barry Goldwater, conservatives are fond of saying the government that governs least is the one that governs best (although religious conservative tellingly leave out the second part of what Senator McCain's mentor quickly added to this: " and stays out of the imposible task of legislating morality")* what would you think of someone who told you that they firmly felt that the parent who parents least is the parent who parents best? The odds are quite high that the only intelligent thoughtful human being who would say such a thing would be a teenager. As an economist, I can explain in detail how, under the right circumstances, free and unfettered markets can yield better results than those produced by well meaning but inept government intervention. What is too often overlooked is just how idealized the right circumstances are. Especially relevant in the financial sphere is the need for the uncertainty we face to be only uncertain in the sense of rolling a six or getting heads. The great sin economists have committed is therefore a sin of omisson. We have failed to draw attention to that fact that in practice the uncertainty we face is of a mch more profound nature. By not emphasizing this, and the potential it creates for episodes like this past week, we become family counselors describing how children can theoretically grow and prosper without parents doing much more than paying the bills and keeping the car filled with gas. The kids (i.e. businesses) love us and everyone else, justifiably thinks we're awfully far off base.

Children need parental regulation just like markets need regulation. Government is a necessary evil but least does not mean zero. Nor does it necessarily mean, and this is a key thing to remember, that the oversight required is small. Just as in families there are parents who are too actively involved in their children's affairs, who are too ready to step in the second that problems arise or who are too domineering or just plain foolish there are examples of government intervention, regulation, and management of economic affairs that exhibit such traits too. Like good parenting, good governance is difficult. But simply because there is such a tremendous potential to fail does not in the slightest give us an excuse not to try.

When Sentor Obama this week pointed to the current crisis as providing the final verdict on the validity of the economic philosophy that has driven the economic policy (the philosophy that business can do no wrong and that the fundamentals are to be assumed sound until it is apparent to almost everyone else that they are not) of the current administration for the last eight years he was right. And when Sentor Obama says that Senator McCain is obviously not to blame in any meaningful way for the current crisis ( in humbler times, Senator McCain has freely noted that economic and financial policy is not his forte) he is of course correct. Most importantly, when Senator Obama notes that what is the root of our current difficulties is the economic philosophy that Senator McCain (at least until November 4th) claims to subscribe to, he was right as well.

On Thursday , Senator McCain has made a statement that was quite revealing. While viewing the damage left by flooding this summer in Cedar Rapids, Iowa he remarked that this is where he sees government playing a role, to step in, in the wake of disaster, to help people pick up the pieces. Viewing this as the sole role of government, to step in after disasters have occured begs the question about what government might do to minimize the likelihood of disasters in the first place. In the case of this summer's floods in Iowa, one might counter that floods are an act of God. However the significant loss of wetlands; to farming, to business development, and to new home construction over the years has led to a significant increase in the frequency and the severity of flooding in the midwest (see Postel, 2008). Just as the neglect of the more difficult to monitor and seemingly antibusiness prevention of the loss of wetlands might help control the severity and therefore the cost of floods when they do occur "needless government meddling" in financial markets (perhaps some time after Warren Buffet in 2002/2003 told us all that derivatives were financial WMDs and it was apparent that no one was really listening) might have helped control the severity and therefore the cost of this week's financial crisis.

*Government that governs least is a somewhat loose paraphrase of Thomas Paine's "Government, even in its best state, is but a necessary evil; in its worst state, an intolerable one."

Bailout of Freddie Mac and Fannie Mae

What does the move by Treasury secretary Paulson and OFHEO director Lockhart this weekend to put both Freddie Mac and Fannie Mae under conservatorship mean? What conservatorship means is that the federal government has agreed to absorb up to $100 billion in potential future losses of the two institutions. There are all sorts of ways that one could try to put this in some perspective: at one extreme you could characterize the decision as Paulson and Lockhart as tantamount to their promising that every man, woman, and child in America pay as much as $333 apiece for the excesses of Freddie and Fannie management (and that much of this could have been avoided if Congress, President Bush, officials in the Treasury, or at the FED had done something earlier to rein in these two institutions before they got to the point they are now.) At the opposite extreme you could argue that for less than what the typical American family spends in a month on cable services and cell phones we have, at the very least, bought some time for badly stressed financial markets and, at best, taken action that will help us move forward out of the liquidity crunch that world financial markets face. The fact of the matter is that we have been part of a massive run up in housing values that has been fueled by and which in turn has helped perpetuate a massive expansion in the volume of mortgage credit granted to the US population as a whole. With 20-20 hindsight it is easy to say that we should have known better. However I am not confident that we will ever learn. We should be thankful that the much ballyhooed fall in housing prices only really bites those of us unfortunate enough to have purchased homes since the end of 2005. Not to minimize in the slightest the plight of those who entered the housing market at precisely the wrong time, the decline in housing prices only began nationally in the Spring of 2007. For those of us who purchased homes at at any time prior to this the market value of our homes is still higher now than when we purchased them and for those of us who bought in the early to mid 1990s or earlier, just following national trends, the market value of our homes remain ridiculously inflated (on average over two times higher in value now than in the early to mid 1990s) SHOULD WE HAVE KNOWN BETTER? In today’s New York Times (NYT “Countdown to Inevitability”) former secretary of the Treasury under President Clinton, Lawrence Summers, is quoted as saying that he had expressed grave concerns about the explosive growth in Freddie Mac and Fannie Mae’s mortgage loan portfolio and the increased investment in subprime and other risky mortgages. The current administration is far less inclined to worry about decisions being taken when those decisions are being scrutinized by the market and so can perhaps be excused for being so slow to react. The point is that we are at present in a position where vis-à-vis the bailout there is really no other choice open to us. The more fundamental question is indeed how to avoid such crises in the future or more fundamental still, whether, we have the ability to avoid them. In form or another the principles of increasing risk first explicitly outlined in a paper published by Michal Kalecki over seventy year ago (M. Kalecki, “The Principles of Increasing Risk” Economica, November 1937), further developed by Hyman Minsky, and as of late, again the focus of our attention thanks to Nouriel Roubini suggests that part of the price we pay for a sophisticated financial system are these sorts of problems. At the same time, it would be foolhardy in the extreme to celebrate such episodes and to do nothing to prevent them from happening in the first place. At Freddie and Fannie we have seen mortgages or mortgage backed securities owned or guaranteed by the two grow by over a factor of 6 since 1990 and more than doubling since 2000 with an increasing share of these being subprime and Alt-A mortgages. The fine line between making credit as easily available as possible and being over-leveraged is what at root needs to be drawn, despite the fact that it is indeed a fine line. We should look to the specific statements made by both nominees regarding this issue of leverage and try to gauge how well either understands the inability of the market to discipline the financial sector seriously enough ex ante and gently enough ex post. For a bit more background on these two institutions click here.