I flagged this Matt Yglesias post about post-mortem examinations of the financial crisis as something to respond to. Matt writes:
I was at an interesting discussion with an ideologically diverse group of people last night of the future of financial regulations. One thing that there was broad agreement on that hadn’t really snapped into focus for me previously is the idea that doing rigorously precise forensic work on how to understand “what went wrong” and then design the rule that would have prevented this is neither necessary nor sufficient to improving things going further.
The basic reason is that we can be pretty sure that no matter what we do, we don’t need to worry about this exact thing happening all over again. Investors will be extremely reluctant to get involved in the exact kinds of products that recently crashed, everyone will worry that the first sign of housing price increases is a bubble, and regulators will be keenly aware of everyone’s pet theory of what went wrong.
I then spent most of the day wrestling with Chapter 8, and by the time I got home, I saw that Kevin Drum had responded with important data:
I think Ezra is properly skeptical of this advice, since bankers will in fact make the exact same mistakes they made this time around if we allow them to. It’ll take 20 years, but they’ll do it. Here in Southern California, just to provide an example close to home, the fact that we had a disastrous housing bubble in the late 80s didn’t put any brakes on the housing bubble in the early 2000s. In fact, the housing bubble was worse here than just about any other place in the country. It took us a grand total of 15 years to go from the peak of one housing bubble to the next.
(Ezra is, of course, Ezra Klein.)
I think Kevin’s exactly right. This plays into a minor rant I’ve been holding back for a while, which is that I’m sick to death of hearing people refer to the current financial disaster as if it were some one-in-a-million “black swan” event. On the contrary, the only thing about this that wasn’t entirely predictable was the degree of the damage.
Fundamentally, the root cause of this is that a bunch of financial wizards managed to convince themselves that real estate prices would always and only increase. That’s the only way the idiotic practices they engaged in make any sense at all– you can get away with making incredibly stupid loans to people who can’t possibly pay them back as long as they’re going to buy houses whose value will never go down, or even remain flat.
This is, at bottom, the same rock stupid decision that has led to every financial collapse ever. I’ve got a copy of Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds here, which was published in 1841, and he would recognize the current crisis as essentially the same as the other financial disasters he chronicles in his book. The only difference between this mess and the Dutch tulip mania of the 1630’s is that the people convincing themselves that prices could only increase know calculus.
The real lesson of this crisis is that the only infinite resource in the economy is financiers’ capacity for self delusion.
So, lay off the black swans. It’s not their fault. Responsibility for this crisis begins and ends with gullible bankers. And this is why we need broader regulation of the financial system: because at the end of the day, bankers (like all other humans) are greedy and gullible idiots.
I’m honestly not sure whether the “financial wizards” in question ever really believed their own hype… The key thing is that they convinced other people “that real estate prices would always and only increase” for long enough to run off with huge sacks of cash before the whole thing collapsed. I used to play poker with a couple of finance guy who were both certain that this sort of crisis was inevitable, and said so several years ago.
Why are black swans one in a million events? I hear that in Aussieland, they are black (inverted just like everything else Oz it would seem).
I don’t remember where I saw it now, but I’ve seen it argued that there is a large group of finance types who are making their fortunes by playing up bubbles, then bailing just before the bubbles pop. Then they go on to pumping up the next bubble. They’ve done the the Tech Bubble, they’ve just finished milking the Housing Bubble, and the prediction was that they are now moving on to the Alternative Energy Bubble. If true, then these guys will never “learn their lesson”, because they have learned a different lesson, which is that they can get rich by stoking other people’s gullibility and greed. *This* is the sort of behavior that regulations and laws need to tamp down.
I think you are giving the i-bankers too much credit. The individuals get paid based on short term performance, not long term performance. Even if it is glaringly obvious that the whole thing will come crashing down, so long as they can make a profit (and more importantly get the bonus) in the short term it is in the best interest of the individual bankers (who are the ones making the decisions). Once again this comes down to improperly priced externalities to short term decisions (in this case the collapse of the economy). I would think this is very similar to the decisions that lead to things like wiping out fish populations. I think the solution is to take the i-banks back to partnerships, that way all the employees at the company have a stake in the long term health of the bank.
Some what on topic:
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom
Last week I saw an article by Michael Lewis on this topic (I didn’t save the link, but it was mentioned on several financial blogs). Much of the article was focused on three guys who figured out it was a house of cards and started betting against the sliced-and-diced mortgage CDOs, only to find that their bets against it allowed their counterparties to do more of it.
I absolutely agree that the fact of the bust, if not the timing and magnitude, was entirely predictable. Until about a year ago I wasn’t particularly plugged in to what was going on. Even so, I saw real estate offered at prices that were absurdly high for mediocre locations, and when I heard rumors of loans that allowed negative amortization, I knew trouble was coming (as it had around here in the early 1990s, when some homeowners got into trouble with such loans). We didn’t have that much of a construction bubble around here, so it wasn’t until a trip out to Utah in summer 2007 that that part of it hit me: we were in a resort town about an hour east of Salt Lake City (past Park City), with lots of new houses being built, and I asked myself, “Who would want to live in all of these houses?”
design the rule that would have prevented this
There’s the trouble, right there. There will never be any such rule. You can certainly make rules that will aim to prevent the last problem from happening in exactly the same way a second time, but as you point out, people (especially unscrupulous ones) will always find a way around the rules in the interest of making a fast buck. I gather this is why a shift to principles-based accounting standards is important, although it’ll be difficult.
Quis custodiet ipsos custodes?
It really comes down to that. As many have pointed out, lots of people, including regulators, saw the insanity spreading and rang alarms.
They were actively blocked from interfering with the train wreck.
I suggest that the only, but essential, element required for prevention of the next wreck is that people in a position intervene in a timely fashion be prepared to do so.
“This is, at bottom, the same rock stupid decision that has led to every financial collapse ever.”
As an entertaining example of this, I wrote a post a while back about Bertram Mitford’s 1896 adventure novel The Sign of the Spider. A factor driving much of the plot is a bubble on gold speculation:
And Mitford was already calling it an ‘old story’!
The irony is that we don’t really have to design a rule to prevent it, we could just reinstate the one passed in 1933. The Glass-Steagall Law (preferably without the loopholes the Fed used to gradually get around it until it was repealed in 1999) might have prevented much of what happened with the big “investment banks”.
BTW, the story in #8 was an old story. I learned it in my HS American History class. There was a succession of Depressions in the 1800s that led up to the Great one. Given how ugly it was today in the markets, who knows? I might never be able to retire.
‘black swan’ does not mean ‘one in a million’. It refers to an event whose probability cannot be usefully predicted with the information you have. The analogy goes roughly like this: For thousands of years, Europeans saw only white swans. So they believed all swans were white. But then, word came back from newly Australia, that black swans had been discovered. Nothing in their previous observations could have told them anything about whether black swans existed. Seeing white swans only confirms that white swans exist. It doesn’t disprove black swans – or say anything about the probability black swans might exist in some region observations have not yet reached.
I think the article to which Eric refers was “The End,” which I linked to a few days back.
And yes, indeed, there is a mention in there about how the models couldn’t handle a drop in prices — the possibility just wasn’t programmed in.
I talked about this with my friend who worked in finance for a few years. He said that his bank did risk assessment of mortgage-backed securities and they easily saw that the risk was huge and their AAA ratings were a joke. He told me that back then, they thought that the rating agencies will pay dearly for their joke. It turned out we all are going to…
On the other hand, today the market under-prices the same stuff. If were to follow what the market prices imply, we’d have to conclude that almost all borrowers are going to default. It just ain’t going to happen.
This paper looks at the reasons of the crisis from a more technical perspective: http://www.defaultrisk.com/pp_other171.htm (John Hull is a famous researcher and teacher in mathematical finance). From myself I might add that another reason is that the credit derivatives market was mostly over-the-counter (as opposed to the exchange market of equities and futures), which greatly reduces transparency and counterparty risk. And the big reason why the financial markets are in such a bad shape now is the counterparty risk. Nobody knows what the other parties have on their books. Nobody knew what exactly would happen if AIG were to default, because so many different parties entered into CDS contracts with it. If we had a CDS exchange created 4 years ago, we wouldn’t be in such a mess now. This exchange is going to be created soon, it’s already being trialled – but the milk has been spilt.
The difference between the Great Depression and today is that we’ve got Roosevelt’s example to follow. I think his large-scale intervention was the first in modern history. I hope we will make it.