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