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March 17, 2008

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Insurers, bond raters, and large institutional investors all failed to properly assess the value and the risks of securities such as the "Bear Stearns High Grade Structured Credit Enhanced Leverage Fund". It's not as if they don't have the motivation. Perhaps improved disclosure can help them do the job we need them to do.

"Regulations like the Federal Reserve system help prevent banks from experiencing these panics, but these regulations don’t encompass the entities and transactions most responsible for the current mess. That, I think, needs to change."

I think you may be confusing different things. Do you mean federal deposit insurance?

"To back up, the million dollar question going forward is what to do to prevent this type of meltdown (with its enormous externalities) from happening again."

First of all, are you open to the idea that maybe the meltdowns can't really be prevented (especially in the never again time frame) and can only have the damage mitigated?

A lot of this is the pain of transition from an accelerating housing market to a decelerating one. That pain should be spread out over time and mitigated, but NOT stopped. I think the proper analogy is with Detroit auto jobs ‘lost’ to free trade. Like the auto jobs, they are symptomatic of a necessary change—lenders that made bad loans can’t be bailed out forever, and companies that make crappy cars can’t be protected forever. Trying to hold on in the face of reality only makes things worse. But people get hurt in the transition, and the government can take temporary action to mitigate that. In Detroit, the proper government action would have been to say that your jobs are toast, we will now work to get you retrained and if needed moved to a place with different and in many cases better jobs.
In this banking crisis the proper reaction is to say: investors, you made bad decisions therefore you are going to lose lots of money. But since selling off all of your assets right this second would depress prices and cause problems even for people who didn’t make long term bad decisions, we are going to temporarily act to make sure things happen in a more orderly fashion. That isn’t really a protection for the investors (who should get approximately zero value) but rather for the other people in the economy. And that is fine.
Anyway, I’m all for forcing disclosure agreements. In my mind, if the government wants to make really clear what you are choosing, it should let you choose. I think fraud prevention in the sense of making it very clear what you are getting yourself into is a great function of the government. But in many cases I’m not sure that would have helped. If you buy a property with the intent to flip it, you don’t care what the 4 year-in payment is. You only care about the first year’s payment. That is taking a risk, and if it fails I don’t see why you shouldn’t lose the house. (This brings me to another point. If you lost your house to the bank in the 1940s through 1990s you would be losing a major investment of your downpayment and a decade of principal payments. If you buy with no down payment, make a year’s worth of payments and then lose your house, it sucks. But it isn’t at all the same things as the more traditional forclosure situation. )

a few points.

first, i don't think the analogy to the auto trade transition works. this isn't the inevitable consequence of new technology (on that front, i am more sympathetic to you). this is was essentially fraud -- a giant scheme premised on externalities (mortgage providers didn't bear costs) and information assymmetries (slicing obscured costs/values/holdings). it's a fairly textbook example of market failure.

and so, because the failures are structural and systemic, structural and systemic remedies are necessary to prevent them. i think disclosures are a good middle ground b/c they lower information costs and are self-enforcing in that it gives market participants the tools they need to let the market work. i'm not ready to nationalize the financial sector (though that seems to be where we're heading if things keep collapsing).

also, on the whole "punish the foolish" point. i agree in principle, but again externalities trip up your argument i think. the ones who got us into this mess assume a tiny fraction of the overall societal costs. it sucks, but we have to step in to do more in that situation. there still, however, should be some punishment. i'd like to see some mortgage providers a few bear stearns exectuvies thrown in jail for starters

Sebastian:

I have no substantive quarrel with the general principles, but for this:

"... investors, (who should get approximately zero value.)"

Which investors? Which investments? Have you checked all of your money market funds, bank balance sheets, mortgage security funds, if you own any, to find out if YOU are an investor in this illiquid, non-transparent paper?

I hope not, of course. But you tell me where all of this paper is and what the price is and what connection your piece of paper has to the first piece of paper that went kaput last August.

There are so many sectors of Wall Street that failed us that I am beginning to think that the entire operation is a moral hazard.

I don't think disclosure rules of the type pubius is talking about would be very useful. The people trading in this stuff aren't babes in the woods. I'm willing to bet that Bear Stearns has employees who know more about MBS than any law could require be disclosed. And they have plenty of incentive to learn about individual securities before dealing in them.

Why didn't they? Who knows? Maybe they did, but erred in their judgment of the housing market or interest rates or some other crucial fact. No amount of disclosure can solve that. Maybe they saw a chance for quick profits and just didn't look too deeply. Disclosure doesn't help if you don't pay attention.

The problem here is not investment bankers being played for suckers. To the extent they were suckers it was their own doing. The problem is the financial externalities (and losses to the kind of investors John Thullen describes).

I don't see why we need to tiptoe around the regulation issue. Ordinary banks are heavily regulated, in part because their deposits are backed by the government. Let's face the fact that much of the short term debt issued by the investment banks are de facto backed by the government as well. Surely that justifies more than just a toe dip or two.

Just thought I'd say:

Times like these are sometimes market bottoms, if there is enough fear.

While you are plunging from the window to the street below, you might want to take your cell phone out and put a little money into the market before .... SPLAT!

Times like these are sometimes market bottoms, if there is enough fear.

Or sometimes not.

"Buy when the blood is running in the streets."

or

"Never try to catch a falling knife."

Take your pick.

Publius what is happening now is not based on fraud. It's people thinking tulips were going to continue to increase in value forever. There may have been some fraud in hiding the fact that people knew the tulips were worthless.

What is happening is inevitable in a capitalist economy. Trying to stop it form happening is like trying to stop the Mississippi from flooding. Levees might do the job for a while, but it only makes it that much worse when the flood does happen (and has other unintended consequences - e.g. tons of the best topsoil in the history of the planet getting dumped into the Gulf of Mexico).

first, i don't think the analogy to the auto trade transition works. this isn't the inevitable consequence of new technology (on that front, i am more sympathetic to you).

sorry dude. this is very misinformed. jobs being lost is not an inevitable consequence of new technology. it's an inevitable consequence of not giving a shit about (some) people's ability to make a living on this planet with dignity (or maybe caring more about making sure the obscenely wealthy can continue to acquire wealth).

What kind of disclosure did you have in mind? To the subprime borrowers who thought they could get a deal too good to be true, to investment managers who bought tranches and derivatives without enough thought, or to investors who don't understand enough to manage their own investments? It seems to me that the information was there, but nobody really wanted to pay attention. I don't think bigger warning labels are the answer.

There may have been some fraud in hiding the fact that people knew the tulips were worthless.

I mean, hiding the fact once it was discovered. I think most investors truly believed in the infinite growth model.

Problem is that this era of "growth" was highly dependent on petroleum as an input (what you refer to as "new technology"). That is where the "productivity" gains are coming from (mostly). It appears that we cannot increase the production of petroleum. Thus the current economic tremors.

"first, i don't think the analogy to the auto trade transition works. this isn't the inevitable consequence of new technology (on that front, i am more sympathetic to you)."

The analogy isn’t in the cause of the change, but in the fact of the change. Eventually American car buyers decided that it was silly to pay more and more for a car that wasn’t as good as they could get for much less money. That caused a shift that a good company should have adapted to. But because of long term government action in their favor they felt insulated and didn’t have to change. So when the hammer finally fell (or really falls) there will still be a lot of relatively innocent people hurt by the transition. I’m all for the government helping out with that. Saving the Detroit jobs, no. Helping the people get other jobs, sure.
Similarly the problem in the current credit market is a failure to negotiate the change from an expanding credit market to a narrowly contracting one. Certain firms were overleveraged and won’t be able to make it on their own. They should fail. But the liquidation of their assets all at once is likely to hurt lots of other people. That is the negative externality to be avoided. The government should avoid that with a temporary transition action (which is what it sounds like they are doing).
But my fear is that government doesn’t know how to do temporary transition actions. The government tends toward permanent actions in a crisis that end up being stupid and counterproductive in the long run (see WWII temporary rent stabilization in New York and WWII farm subsidies all across the nation.)
And calling this fraud, at least so far as I can see, is wrong. Bear Stearns wasn’t defrauding anyone nor was it being defrauded. Anti-fraud measures really don’t have much to do with this situation. They had the facts, they just chose to overdiscount the risk in their own minds. Which is why they ought to lose oodles of money.
My inclination is that government can do great with disclosure and transparency rules. If all you want to do is that, I’m all for it. You are vague about what else you mean by ‘regulation’ but I wouldn’t want to sign up for it in advance if it goes beyond that.
Should there have been rules preventing banks from loaning money this way? Maybe in a super-perfect world. But in the real world there was a bunch of commentary only 3 years ago suggesting that banks ought to be making more high risk loans for homes in minority neighborhoods, and the fact that they weren’t ought to subject them to criminal liability. So needless to say I’m skeptical about politics leading to wise intervention beyond transparency.

Eventually American car buyers decided that it was silly to pay more and more for a car that wasn’t as good as they could get for much less money.

car prices never stopped increasing. in fact, the price of car compared to average wages in the u.s. is relatively more now.

Eventually American car buyers decided that it was silly to pay more and more for a car that wasn’t as good as they could get for much less money.

actually, it's like what the music industry did with cd's. they were cheaper to make than vinyl, but they charged more for them. still, the unintended consequences of digitizing music are nailing them now.

"car prices never stopped increasing. in fact, the price of car compared to average wages in the u.s. is relatively more now."

Not for a car with similar value. You couldn't drive your average Detroit 1970s car for 150,000 miles. And the price of a low end KIA is about $11,000 ($1,980 in 1970).

You can easily get twice the driving mileage out of a modern car, which cuts the effective price in half unless you feel the need to get a new car every 2 or 3 years.

Yeah, unfortunately . . .

Americans today take nearly two years longer to pay off car loans than people did 30 years ago - a trend that has helped bury consumers in debt and automakers in deficits.
A typical car loan now lasts five years, and many stretch to seven, data from the Federal Reserve show. And the length will only go up.

Toyota in January announced it would offer seven-year terms on some loans. Analysts said eight-year offerings are rare but growing in popularity.

"Just a few years ago, some banks didn't even offer a 72-month loan," said Jesse Toprak, chief economist with automotive research firm Edmunds.com. "It seems like a problem with no solution on the horizon."

For consumers, long-term loans tie up budgets, preventing people from saving or paying off other debts.

For automakers, they can depress future auto sales because consumers are too strapped to buy new cars.

Sebastian,

As I commented on another thread, I don't think it's accurate to describe this as a problem caused by a sudden transition, which simply needs to be managed for a time. Follow publius' link and read Roubini's post. I think his description is accurate, and if it is the same problem will recur. The housing market is just the cause this time around. Next time it will be something else.

Hm. Smells like we need some industry deconsolidation.

I bet the situation wouldn't be so bad if the big banks hadn't gotten into new and risky financial businesses in the last decade or two.

Why would I give a shit about a bunch of crack heads working in a car factory? They are why the cars cost so much. I would rather buy a cheaper car. Buy american, support unions, support the way of America.......... I would rather buy foreign, better quality.

The job numbers. All that meant was the evil dems want a crash now. The mortgage crisis. The evil dems wanted a crash then too. Bear goes under, those damn foreigners should'nt have bought!!! I would rather buy foreign.

Publius what is happening now is not based on fraud. It's people thinking tulips were going to continue to increase in value forever. There may have been some fraud in hiding the fact that people knew the tulips were worthless.

What is happening is inevitable in a capitalist economy. Trying to stop it form happening is like trying to stop the Mississippi from flooding. Levees might do the job for a while, but it only makes it that much worse when the flood does happen (and has other unintended consequences - e.g. tons of the best topsoil in the history of the planet getting dumped into the Gulf of Mexico).

I agree with this view. Manias and crashes are intrinsic to human psychology and have been with us even longer the capitalism has. You can't make them go away. At best you can take steps to minimize to some small degree their speed and size, and provide relief to the innocent in their wake.

What I would like to see is regulation imposing limits on the use of leverage, which acts to accelerate both the inflation and deflation of bubbles. Excessive leverage allows irresponsible actors (in a mania what other kind are there?) to do damage which is out of proportion to their size - it is a force multiplier in the hands of children. The banks are already regulated with respect to their leverage; let the shadow banking system be put under similar restraints. If you can't color within the lines, then we need to take the crayons away from you because they can mutate into something very dangerous while nobody is looking.

The other thing which needs to be looked at is the failure of political leadership here. The Fed did not take away the punchbowl when they should have. We need a better set of institutional and cultural incentives in place at the Fed to make them more responsible for long term management of the economy, and less subject to capture by the impulses of the markets.

In retrospect the many bailouts orchestrated under Greenspan were stepping stones on the road to hell we've traveled down. For me LTCM stands out especially, as a warning sign that short term thinking was taking over at the Fed. This is important because no regulatory environment will last for very long without the political will to enforce and maintain it. The walls of an undefended castle will not stop barbarians.

Did you know that there is a profession called ‘Financial Engineering’? Or that there is an organization called the “The International Association of Financial Engineers”?

They recently held a conference at Goldman Sachs called “The Boundaries Between Credit Risk and Operational Risk: Are They Real?”. One conclusion of the conference was:

“It is important to manage risk across silos and to include operational risk in enterprisewide risk dialogs.”

I’m not sure exactly how to translate those words. But I think the intent is to make sure that if the risky financial dealing that these guys ‘engineer’ collapse, we all end up holding the bag.

Meet the IAFE:

http://www.iafe.org/

What is happening is inevitable in a capitalist economy. Trying to stop it form happening is like trying to stop the Mississippi from flooding. Levees might do the job for a while, but it only makes it that much worse when the flood does happen (and has other unintended consequences - e.g. tons of the best topsoil in the history of the planet getting dumped into the Gulf of Mexico).

Following up on my previous post, this analogy posted by a-train is very significant. A number of mathematicians have pointed out obvious parallels between the systemic behavior of markets and natural systems which have scalable power-law features.

One of the things we've learned from the latter (hydrologic systems and fire suppression in forests are examples that come to mind) is that trying too hard to prevent little disasters (which are frequent) is a good way to store up energy for making big disasters (which are less frequent but much more devastating).

One of the really bad ideas which took root under Greenspan was the idea that preventing small manageable recessions was a good idea. With the benefit of hindsight this is working out about as well as the fire suppression policy used by the US Forest Service for most of the 20th Cen. turned out - which is to say very badly indeed.

The Fed could learn a lot from modern ecology and the way that we are learning to think about the management of natural systems in a state of dynamic equilibrium. We need to learn to think of the economy as an ecosystem rather than a machine we can engineeer and control.

Did you know that there is a profession called ‘Financial Engineering’? Or that there is an organization called the “The International Association of Financial Engineers”?

Bill,

It looks like you and I are thinking along similar lines, assuming that you are being sarcastic about the pretentions on display here.

There is something almost chillingly Stalinist about the phrase "Financial Engineers", with the implication it carries that we can leap into a glorious future by quantifying the unquantifiable. Did we really fight so long and hard to rid ourselves of Marxism, only to have similar thinking take root again in different soil?

There may have been some fraud in hiding the fact that people knew the tulips were worthless.

And calling this fraud, at least so far as I can see, is wrong.

I really can't speak to the details of the situation at Bear Stearns specifically.

Regarding the current crisis more generally, I have to say, advantage a-train.

Thanks -

Headline of the Day:

"Whole Class of Debt in Canada Is Bankrupt"

Also, there's a very good play-by-play account of the Bear Stearns buyout in the WSJ.

there are actually some grumblings that there could be securities violations (read: fraud) associated with the representations involving BS solvency and made by company executives at the beginning of last week. i don't think that's the fraud that the post contemplates, but fraud is in the discussion from a different angle.

and i guess i'm not clear why disclosure is not desirable - it would have gone a long way to alleviating the credit freeze because nobody knew how much exposure the different institutions had.

Nor one gathers do they yet nor may they until the last bad deal goes down.
At least there’s no run on wheelbarrows yet, and the Sun rose this morning.
Still the loss of entire neighborhooods, as in the Atlantic piece, with African Americans taking a disproportionate hit, cries out for some visionary remediation. Maybe Habitat for Humanity taking on the role of a kind of domestic Peace Corps or something.

Interesting with the Canadian 38B bankruptcy they hope to recover 80 cents on the dollar; sounds as if the losses will be non-catastrophic. It suggests the global dominoes will survive, and points to the diminished US influence on global markets. As I gather.

and i guess i'm not clear why disclosure is not desirable - it would have gone a long way to alleviating the credit freeze because nobody knew how much exposure the different institutions had.

I don't it's undesirable. I just don't think it will accomplish much by itself. The institutions are free to disclose now if they can't get credit otherwise, and lenders are free to (and should, of course) demand disclosure of risks before lending.

A big part of the problem seems to be that many of these securities are very complex. It's one thing to describe what you own and another to make an accurate assessment of the risk and expected return.

Thanks ABQ for making my points more eloquently (and with less typos!).

Also, regarding my previous comments, I implied that technology was irrelevant. That's wrong. It does play some role in recent productivity gains, but not nearly as much as the energy input of fossil fuels. Moreover, the energy input of fossil fuels is what makes the development of technology possible.

The underlying problem here is that most economists, financiers, and financial advisors view economic history as if it began with the Industrial Revolution (or maybe 80 years ago). This really hides just what an aberration this last couple hundred years has been in human history. The single biggest difference is the discovery of fossil fuels as a source of energy (work/productivity multiplier). That is when everything took off. There had been (and does not appear there ever will be) another source of that kind of net positive energy. It took billions of years to store up that amount of energy. It has taken us a few hundred to expend (apparently) almost half of it.

Consider a gallon of gas. You can carry it around. Put it almost anywhere. And, e.g., that single gallon can move a loaded multi-ton vehicle up a mountain 20+ miles. That is just amazing when you think how much effort it took to move stuff around before. Technology has allowed us to get better using that energy efficiently, but there really has been no adequate substitute for petroleum and it is hard to imagine one. Most of what people suggest (nuclear, wind, hydro, solar, etc) requires vast amounts of petroleum to be useful.

The idea of infinite growth is (unwittingly?) based on idea of infinite petroleum (or some other similarly net positive energy input). In other words, the idea that you can continue to put more and more energy into doing work (and get more and more efficient as well). However, $100+ a barrel oil with not apparent substitute on the horizon is finally grinding against this fantasy. IMO, what is happening in the markets is a direct result of this somewhat unconscious realization.

"As I commented on another thread, I don't think it's accurate to describe this as a problem caused by a sudden transition, which simply needs to be managed for a time. Follow publius' link and read Roubini's post. I think his description is accurate, and if it is the same problem will recur. The housing market is just the cause this time around. Next time it will be something else."

I don't see how your first sentence is in contradiction to the rest. In the real world we often can't tell where the next transition will come, and sometimes if we can tell where it will come we can't tell when it will come. In this case, we all knew it had to come, but we didn't know when or how to force it to happen easily. (I also note that the problem was made much worse by zoning laws in and around the high price cities driving prices up by government regulation). But human psychology is what it is and it does a lot of good things on the way up (even if everyone who bought in the last year loses their house, which isn't even close to happening, the ownership gains in the past 10 years are worth it). That is why I think that government would be best employed in trying to manage the transition points rather than try to control the whole process.

Next time it will definitely be something else. If we discover cold fusion there will be lots of gas stations out of business. And the world will be much better. But there will be lots of gas station people who will have trouble transitioning. The next run up may be in green car companies--and it may bring lots of great technologies on the way up before bringing lots of pain on the way down. In Europe there is a serious looming pension crisis and thank God they get to deal with it first so we can learn from it.

My point is that some sort of no failure concept gets you GM. You have to allow failures in a functioning economy. The question is how to mitigate the pain to everyone else when they properly go down.

"One of the really bad ideas which took root under Greenspan was the idea that preventing small manageable recessions was a good idea."

And this is an idea that people here seem to (and maybe I'm wrong about it) share.

Felix, "Interesting with the Canadian 38B bankruptcy they hope to recover 80 cents on the dollar; sounds as if the losses will be non-catastrophic. It suggests the global dominoes will survive, and points to the diminished US influence on global markets. As I gather."

The Bear Stearns assets will likely recover everything in the long run. The problem is that they don't have a long run. That is what makes a credit crunch so interesting (in a clinical sense). The long term worth of the underlying assets haven't been destroyed (unlike say a job made worthless by technology innovation), the problem is that the structures of the deals make it difficult for certain institutions to hold on to them long enough to see that through.

My point is that some sort of no failure concept gets you GM. You have to allow failures in a functioning economy. The question is how to mitigate the pain to everyone else when they properly go down.

I agree.

If Bear's failure affected only its shareholders and executives there would be no argument for any bailout of any sort. But that's not the case here. Outsiders are affected, and will be again the next time a large financial firm fails.

And the mechanisms to mitigate pain should be in place, and not have to be invented ad hoc. This is especially true in the financial sector, where the external effects are hard to limit and can be quite damaging.

When a business fails, and workers lose their jobs, we have unemployment insurance and, in some cases, further assistance available. We don't sit around and say, "Oh dear, what now?" before rigging something up over the weekend.

Banks, for example, can fail, but we have deposit insurance in place to protect depositers, who are after all simply lenders to the bank. This in turn leads to some regulation of bank activity.

One way to look at this is as an environmental problem. Lots of companies would be more profitable if they did not have to comply with environmental rules. But they do have to comply, on the perfectly sensible grounds that those extra profits would come at the expense of third parties who would not be compensated for the costs they bear.

Can this model be applied to some of the financial whiz-bangery going on? Clearly people make money off it - lots of money. Equally clearly there is the risk of doing great damage to outsiders who derive no benefit. So what systems should be in place to protect the outsiders? And if no sensible system can be devised, maybe we could look at regulating the underlying activity, to see if its benefits are worth the risks. Private profit at public cost is not a good formula.

This has nothng to do with not allowing firms to fail. It has to do with not allowing them to succeed at others' expense.

My point is that some sort of no failure concept gets you GM. You have to allow failures in a functioning economy. The question is how to mitigate the pain to everyone else when they properly go down.

The problem here is that, IMHO, the entire financial system is broken. These guys, JPM, Citi, the hedge funds and the rest had to know that they were booking future profits that never had a rat's chance so actually materializing. They just shut their eyes, pretended it would all work out and cashed their multimillion bonuses for printing a bunch of worthless paper. Enron did the same damn think just 6 years ago - with the help of these same bastards.

If Bear cannot now follow through on it's obligations and this has negative effect on the other financial firms so be it. They knew who they were dealing with. Trading firms crash like a helicopter running out of fuel.

Did we really fight so long and hard to rid ourselves of Marxism, only to have similar thinking take root again in different soil?

It must be in the air. Quoth Digby:

We've essentially in the Bush era set up a kind of corporate Marxism, where risk is socialized, but where wealth is privatized.

You have me thinking.

Thanks -

It must be in the air. Quoth Digby:

We've essentially in the Bush era set up a kind of corporate Marxism, where risk is socialized, but where wealth is privatized.

You have me thinking.

Thanks -

russell,

The "privatize profits, socialize costs" meme has been floating around for a long time so I can't take even 3rd hand credit for it, but that wasn't really what I meant.

I was thinking of the way that Marxism tried to treat messy, unquantifiable and ultimately intractable aspects of human psychology as something that could be understood, measured, analyzed, and (with the application of sufficient force) engineered - hence Maxim Gorky's notorious phrase addressed to the 1st Congress of the Union of Soviet Writers in 1934 suggesting that they should be "engineers of the soul".

The citations Bill quoted struck me as bearing a disturbing resemblance to this way of thinking, in the sense that our brave new financial "engineers" also have deluded themselves into thinking that they can control something (the behavior of markets) which they can't even measure properly, and consequently a great many lies are being told to paper over a very basic epistemological problem with real world consequences which are not benign.

To me it seems that the same basic mindset is at work once again, which is to construct a faith-based psuedo-science (in this case quantitative economics assuming rational and efficient markets) using the trappings of engineering-like terminology to create an aura of authority which this new discipline has not earned, does not deserve, and seems unlikely ever to merit except in the minds of its acolytes (for whom it is not falsifiable).

To me it seems that the same basic mindset is at work once again, which is to construct a faith-based psuedo-science (in this case quantitative economics assuming rational and efficient markets) using the trappings of engineering-like terminology to create an aura of authority which this new discipline has not earned, does not deserve, and seems unlikely ever to merit except in the minds of its acolytes (for whom it is not falsifiable).

Well, they attempted to do this in science, with intelligent design, which your description fits to a "T". Apparently, they were more successful in economics.

Apparently, they were more successful in economics.

I would say, apparently they were not.

Thanks -

I would say, apparently they were not.

Heh.

Or they won the battle, but lost the war....

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