The global financial crisis
I asked my economist friend Penny Wise to explain just what the hell is happening out there. She writes:
I have been ordered to explain this. But why should I do all the work for nothing? Fortunately, smarter and harder working people than you or I have already done this, so I will instead point those interested to useful sources of instruction, rather like a traffic officer at an intersection, wearing the crisp white gloves of seriousness and pointing authoritatively at the links.
1. Does this crisis represent a failure of free markets, of untrammelled deregulation, and the consequence of unrelenting greed?
Oh please.
2. But surely it is greed that motivates Wall St, and is behind all these troubles?
Lest we forget, greed starts early – see these greedy little fuckers. I doubt you are much different. What do you want, that you haven’t actually earned yourself, from Helen and John this election?
3. Did nobody see this coming?
Yes, of course, even decent investigative journalists. Read the opening and closing paragraphs of this from eight years ago. At the heart of this whole sub-prime mortgage mess was Fannie Mae and Freddie Mac. The story is in hundreds of places, such as here.
This opened up a vast new business in risky loans, which greedy and opportunistic, or enterprising (take your pick), folks leapt into with enthusiasm. These bundled up mortgages became tradeable securities themselves, and holders naturally wanted to shed some of the risk of holding them. Thus insurance companies like AIG got involved and, risk being a difficult thing to assess, they clearly got that terribly wrong. So too did the credit rating agencies that assessed the risk of these financial instruments and financial institutions. Mistakes galore: some were simply mistakes, some were no doubt errors inspired by an inclination to lean in the most profitable direction.
Read on...
4. But don’t these central banking bailouts show that capitalist banking doesn’t work?
No, all financial firms are vulnerable to panics. That is what we have central banks for. Read Willem Buiter: and this earlier post of his as well.
The point about this crisis is that as problems have mounted, and inevitable mistakes have been made by all parties involved, a sense of urgency turns quickly to a sense of panic. We see the stock market on the news, but the real problems are in credit markets, which are hugely larger and more important than the stock market. When Lehman was allowed to fall into bankruptcy, a vast amount of cash got locked in. From that moment, all investment banks became suspect. Hedge funds wanted their cash out, just in case. In this environment, even a very well-run bank can fail. Thus even an investment bank like Goldman Sachs, which appeared to have avoided the sub-prime exposures, got caught and had to be recapitalised quickly to survive – enter Warren Buffett, who may well have grabbed himself another bargain.
With credit markets seizing up, intervention by central banks became essential. That is happening around the globe. But each step up in the intensity of the crisis lowers the value of the assets on financial institution balance sheets – for example, is a package of sub-prime mortgages on Bank A’s balance sheet worth 50c in the dollar, or 20c? As that estimate falls, so does the viability of that bank, and thus its need for recapitalisation. That death spiral is a contagion of panic that the Fed, and now the US government, has to stop. That is why an intervention of some sort must happen. The devil is in the details, but that needn’t concern us – it will be messy and political, and the deficiencies of whatever gets done will be debated for decades.
5. If it doesn’t get done?
It will, because the alternative is genuinely terrible. Let's visit Willem Buiter again.
6. OK, but isn’t the bailout just going to renew all the moral hazard issues associated with the so-called “Greenspan put”?
Ah yes, Greenspan. US monetary policy has been much criticised, and a summary of that argument is here. To be fair to central bankers, and Greenspan, different courses of action would all have led to different sets of problems. Their decisions are always trade-offs made under great uncertainty. There will always be something to moan about with the benefit of hindsight.
The problem with all this is moral hazard, where the message of a rescue package can be that risky activities get rewarded whatever happens. The Fed was clearly concerned about that a few months ago. At this point, however, with Wall Street utterly transformed, that is much less of a concern. Probably unwittingly, the Fed has created way more pain than intended. Shareholders in genuinely insolvent businesses need to get slaughtered, management fired and so forth, all fairly obviously.
7. So should we feel smug that the New Zealand banking system seems very safe by comparison?
Ahem – recall all those finance companies that have gone bust in the past few years, and all the savings that went with them. If the recession here continues, there will be plenty more mortgagee sales as well.
Our own recent experiment with very low interest rates, and high tax rates, helped propel all those naive folks into putting their life savings into finance company debentures to try and get a positive return (after tax and inflation), or into property as that seemed the hot asset. The arithmetic? By late 2003 you could get about 5% on term deposits at the local bank, rising to about 6% through 2004. Inflation was heading up to reach 3% into 2005. House prices were rising at annual rate of 10-20+%. So what does that financially unsophisticated person, not far off retirement, do? What they were facing was a 5% return at the bank, less tax of 33% to 39%, thus an after-tax return of 3.1 to 3.4%. But with inflation in the process of rising to 3% (and they would have felt that it was higher still given the way house prices were flying) their expected real, after-tax return (i.e. subtract 3% for inflation) would have been a mere 0.1 to 0.4%. In short, you really weren’t getting ahead at all by putting money in the bank – it seemed a dumb move. Thus starts the mad and desperate search for higher yields – go directly to the finance company and, as it turned out, without passing GO. Or, leverage up and buy some investment property. Finally we get to today in NZ, with many regular folk wiped out financially, and many who are about to be.
The NZ Reserve Bank and Dr Cullen may have to take part in the walk of shame as well.
8. This is all terribly serious, is there nothing to laugh at here?
Hell, yes. Read this risible attempt from somebody who regularly splashes around in the shallows of economics and finance, but still drowns each time. In a particularly weak attempt to use the financial crisis for shallow political point scoring, we see Finlay McDonald parroting one of the more fatuous lines we have heard from Dr Cullen, namely that John Key as an ex-Merrill Lynch manager is in some way associated with this crisis. McDonald ladles it on further by referencing the Enron scandal and the US Savings & Loan crisis. The Kiwiblog response to this childishness was best.
McDonald cannot seem to refer to something he disapproves of without tossing in a useless descriptor. We don’t have “complex financial instruments”; they must be “insanely complex financial instruments” Well, no, they are just complex – you need a bit of maths to understand them, but not much. He refers to the entertaining book Barbarians at the Gate, but has obviously not caught up with the fact that the authors managed to write the book and get the moral completely wrong – the problem with RJR Nabisco was that the real barbarians (the existing woeful management, wasting the massive cashflow of that company) were inside the gates. He refers to another colourful book, Liars Poker, but the author, Michael Lewis, was no insider, just another guy on a giant trading floor where all sorts of personality types flourish... And so on, splashing around in the shallows, the concluding paragraph being the shallowest of them all.
And we mustn’t forget the political hacks, for example Matt McCarten.
It would be wasting everybody’s time to go through and point out that virtually every sentence is plain wrong, absurdly overstated, or utterly lacking in context or exploration of alternatives. Only the brain-dead could not do this for themselves. The problem with political hacks, from the right and the left, is that they see everything in party political terms. On the right we have all manner of strident commentaries, the strangest being those from the Republican right in the US which oppose any bailout/rescue because it undermines the principle of “so-called” free markets.
9. What does this mean for investors?
If you have your financial snout still deep in the trough, are heavily borrowed and invested in real estate or shares, then life is hellish. As they say on Wall Street: bulls make money, bears make money, pigs get slaughtered.
Oh, and for god’s sake – especially all you folk about to retire – don’t put your life savings into just the one asset or institution. You know what grandma used to say about eggs and baskets.
10. In summary?
There is blame to go around for everybody. Of course we need better regulation, better monetary policy, less political meddling, better governance structures in corporate America and around the world. But just saying so does not equal a solution. These issues are difficult.
Less greedy and opportunistic people, from corporate captains down to unemployed house-buyers would help as well, but we shouldn’t base any policies on that prospect.
At the heart of this crisis is the vast stock of toxic mortgage debt that has unhinged the global financial system. The aggressive buying of sub-prime mortgages, and mortgage-backed securities, by Fannie Mae and Freddie Mac are a key part of this story. But only a part.
Now, back to work.
Penny Wise is an economist who has spent many a dark and stormy night working in Australasian financial markets.
I have been ordered to explain this. But why should I do all the work for nothing? Fortunately, smarter and harder working people than you or I have already done this, so I will instead point those interested to useful sources of instruction, rather like a traffic officer at an intersection, wearing the crisp white gloves of seriousness and pointing authoritatively at the links.
1. Does this crisis represent a failure of free markets, of untrammelled deregulation, and the consequence of unrelenting greed?
Oh please.
2. But surely it is greed that motivates Wall St, and is behind all these troubles?
Lest we forget, greed starts early – see these greedy little fuckers. I doubt you are much different. What do you want, that you haven’t actually earned yourself, from Helen and John this election?
3. Did nobody see this coming?
Yes, of course, even decent investigative journalists. Read the opening and closing paragraphs of this from eight years ago. At the heart of this whole sub-prime mortgage mess was Fannie Mae and Freddie Mac. The story is in hundreds of places, such as here.
This opened up a vast new business in risky loans, which greedy and opportunistic, or enterprising (take your pick), folks leapt into with enthusiasm. These bundled up mortgages became tradeable securities themselves, and holders naturally wanted to shed some of the risk of holding them. Thus insurance companies like AIG got involved and, risk being a difficult thing to assess, they clearly got that terribly wrong. So too did the credit rating agencies that assessed the risk of these financial instruments and financial institutions. Mistakes galore: some were simply mistakes, some were no doubt errors inspired by an inclination to lean in the most profitable direction.
Read on...
4. But don’t these central banking bailouts show that capitalist banking doesn’t work?
No, all financial firms are vulnerable to panics. That is what we have central banks for. Read Willem Buiter: and this earlier post of his as well.
The point about this crisis is that as problems have mounted, and inevitable mistakes have been made by all parties involved, a sense of urgency turns quickly to a sense of panic. We see the stock market on the news, but the real problems are in credit markets, which are hugely larger and more important than the stock market. When Lehman was allowed to fall into bankruptcy, a vast amount of cash got locked in. From that moment, all investment banks became suspect. Hedge funds wanted their cash out, just in case. In this environment, even a very well-run bank can fail. Thus even an investment bank like Goldman Sachs, which appeared to have avoided the sub-prime exposures, got caught and had to be recapitalised quickly to survive – enter Warren Buffett, who may well have grabbed himself another bargain.
With credit markets seizing up, intervention by central banks became essential. That is happening around the globe. But each step up in the intensity of the crisis lowers the value of the assets on financial institution balance sheets – for example, is a package of sub-prime mortgages on Bank A’s balance sheet worth 50c in the dollar, or 20c? As that estimate falls, so does the viability of that bank, and thus its need for recapitalisation. That death spiral is a contagion of panic that the Fed, and now the US government, has to stop. That is why an intervention of some sort must happen. The devil is in the details, but that needn’t concern us – it will be messy and political, and the deficiencies of whatever gets done will be debated for decades.
5. If it doesn’t get done?
It will, because the alternative is genuinely terrible. Let's visit Willem Buiter again.
6. OK, but isn’t the bailout just going to renew all the moral hazard issues associated with the so-called “Greenspan put”?
Ah yes, Greenspan. US monetary policy has been much criticised, and a summary of that argument is here. To be fair to central bankers, and Greenspan, different courses of action would all have led to different sets of problems. Their decisions are always trade-offs made under great uncertainty. There will always be something to moan about with the benefit of hindsight.
The problem with all this is moral hazard, where the message of a rescue package can be that risky activities get rewarded whatever happens. The Fed was clearly concerned about that a few months ago. At this point, however, with Wall Street utterly transformed, that is much less of a concern. Probably unwittingly, the Fed has created way more pain than intended. Shareholders in genuinely insolvent businesses need to get slaughtered, management fired and so forth, all fairly obviously.
7. So should we feel smug that the New Zealand banking system seems very safe by comparison?
Ahem – recall all those finance companies that have gone bust in the past few years, and all the savings that went with them. If the recession here continues, there will be plenty more mortgagee sales as well.
Our own recent experiment with very low interest rates, and high tax rates, helped propel all those naive folks into putting their life savings into finance company debentures to try and get a positive return (after tax and inflation), or into property as that seemed the hot asset. The arithmetic? By late 2003 you could get about 5% on term deposits at the local bank, rising to about 6% through 2004. Inflation was heading up to reach 3% into 2005. House prices were rising at annual rate of 10-20+%. So what does that financially unsophisticated person, not far off retirement, do? What they were facing was a 5% return at the bank, less tax of 33% to 39%, thus an after-tax return of 3.1 to 3.4%. But with inflation in the process of rising to 3% (and they would have felt that it was higher still given the way house prices were flying) their expected real, after-tax return (i.e. subtract 3% for inflation) would have been a mere 0.1 to 0.4%. In short, you really weren’t getting ahead at all by putting money in the bank – it seemed a dumb move. Thus starts the mad and desperate search for higher yields – go directly to the finance company and, as it turned out, without passing GO. Or, leverage up and buy some investment property. Finally we get to today in NZ, with many regular folk wiped out financially, and many who are about to be.
The NZ Reserve Bank and Dr Cullen may have to take part in the walk of shame as well.
8. This is all terribly serious, is there nothing to laugh at here?
Hell, yes. Read this risible attempt from somebody who regularly splashes around in the shallows of economics and finance, but still drowns each time. In a particularly weak attempt to use the financial crisis for shallow political point scoring, we see Finlay McDonald parroting one of the more fatuous lines we have heard from Dr Cullen, namely that John Key as an ex-Merrill Lynch manager is in some way associated with this crisis. McDonald ladles it on further by referencing the Enron scandal and the US Savings & Loan crisis. The Kiwiblog response to this childishness was best.
McDonald cannot seem to refer to something he disapproves of without tossing in a useless descriptor. We don’t have “complex financial instruments”; they must be “insanely complex financial instruments” Well, no, they are just complex – you need a bit of maths to understand them, but not much. He refers to the entertaining book Barbarians at the Gate, but has obviously not caught up with the fact that the authors managed to write the book and get the moral completely wrong – the problem with RJR Nabisco was that the real barbarians (the existing woeful management, wasting the massive cashflow of that company) were inside the gates. He refers to another colourful book, Liars Poker, but the author, Michael Lewis, was no insider, just another guy on a giant trading floor where all sorts of personality types flourish... And so on, splashing around in the shallows, the concluding paragraph being the shallowest of them all.
And we mustn’t forget the political hacks, for example Matt McCarten.
It would be wasting everybody’s time to go through and point out that virtually every sentence is plain wrong, absurdly overstated, or utterly lacking in context or exploration of alternatives. Only the brain-dead could not do this for themselves. The problem with political hacks, from the right and the left, is that they see everything in party political terms. On the right we have all manner of strident commentaries, the strangest being those from the Republican right in the US which oppose any bailout/rescue because it undermines the principle of “so-called” free markets.
9. What does this mean for investors?
If you have your financial snout still deep in the trough, are heavily borrowed and invested in real estate or shares, then life is hellish. As they say on Wall Street: bulls make money, bears make money, pigs get slaughtered.
Oh, and for god’s sake – especially all you folk about to retire – don’t put your life savings into just the one asset or institution. You know what grandma used to say about eggs and baskets.
10. In summary?
There is blame to go around for everybody. Of course we need better regulation, better monetary policy, less political meddling, better governance structures in corporate America and around the world. But just saying so does not equal a solution. These issues are difficult.
Less greedy and opportunistic people, from corporate captains down to unemployed house-buyers would help as well, but we shouldn’t base any policies on that prospect.
At the heart of this crisis is the vast stock of toxic mortgage debt that has unhinged the global financial system. The aggressive buying of sub-prime mortgages, and mortgage-backed securities, by Fannie Mae and Freddie Mac are a key part of this story. But only a part.
Now, back to work.
Penny Wise is an economist who has spent many a dark and stormy night working in Australasian financial markets.
posted by Stephen Stratford at 10:23 PM
2 Comments:
"The Kiwiblog response to this childishness was best."
That reminds me - about this increase in violent crime this year - do we know exactly where John Key was?
Horowitz appears persuasive at the outset but there are flaws in his analysis. His argument goes like this:
“the vast accumulation of toxic mortgage debt that poisoned the global financial system was driven by the aggressive buying of subprime and Alt-A mortgages, and mortgage-backed securities, by Fannie Mae and Freddie Mac.”
“It is important to understand that, as GSEs, Fannie and Freddie were viewed in the capital markets as government-backed buyers”
” In order to curry congressional support after their accounting scandals in 2003 and 2004, Fannie Mae and Freddie Mac committed to increased financing of “affordable housing.” They became the largest buyers of subprime and Alt-A mortgages between 2004 and 2007, with total GSE exposure eventually exceeding $1 trillion. In doing so, they stimulated the growth of the subpar mortgage market and substantially magnified the costs of its collapse.”
“By late 2004, Fannie and Freddie very much wanted subprime and Alt-A loans. Their accounting had just been revealed as fraudulent, and they were under pressure from Congress to demonstrate that they deserved their considerable privileges.”
http://www.aei.org/publications/pubID.28664,filter.all/pub_detail.asp
Here's what is wrong with it:
First the time line. The market for SIVs had been on the boil long before Fannie Mae entered it in “late 2004″. It had nearly doubled in 2003.
Second, Fannie and Freddie were not “viewed in the capital markets as government-backed buyers” as these citations from Deutsche Bank and Wikipedia attest:
"Neither the certificates nor payments of principal and interest on the certificates are guaranteed by the United States government. The certificates do not constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than Fannie Mae.”
http://en.wikipedia.org/wiki/Fannie_Mae#Guarantees_and_subsidies
“Despite the fact that Fannie Mae is not explicitly backed or funded by the US Government, nor do the securities it issues benefit from any statutory government guarantee or protection, most investors believe that, because it is a “quasi” governmental agency, it has an implicit government guarantee. But Fannie Mae receives no direct government funding or backing. And Fannie Mae securities carry no government guarantee of being repaid. ”
https://www.dws-investments.com/EN/market-insight/fannie-mae-freddie-mac-are-no-laughing-matter.jsp
Thirdly, Fannie Mae only ever absorbed 40% (if that much) of subprime at its peak in 2007 - had little when the thing took off in 2003.
Lastly, even if the above were to be the case, it would not excuse the behaviour of the Banks. Nobody forced them to ignore the creditworthiness of their customer and thereby break what few regulations were left at the time. To the contrary, all regulations and guidelines from the CRA down all emphasised safe lending practices.
Here is a link to another viewpoint:
http://www.prospect.org/cs/articles?article=did_liberals_cause_the_subprime_crisis
It is sobering to note that the crisis is so far confined to those countries that have deregulated banking. Countries that have stricter controls are experiencing only the secondary effects.
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