Arnold Kling  

Morning Commentary

We Don't Need No, Continued... Klein, Clark, and the Liberty ...

A bunch of thoughts:

1. On the new Resolution Trust Corporation, several people agree with me that it is nothing like the old RTC, echoing what I wrote ages ago Wednesday. The old RTC got handed to it the assets of defunct S&L's. The new RTC will acquire the assets of active firms. Also, amplifying on an issue that I also raised yesterday, Steve Randy Waldman writes,

As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I'd rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let's spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.

I'd like to see his views get more play. Read the whole thing.

2. No one knows what the real losses are on all this paper. Some people, like Rogoff and Setser, think that the number has 12 zeroes behind it (if I'm counting right. How many zeroes in a trillion?) William Isaac thinks it's less. He notes that there were $1.2 trillion of subprime mortgages.

The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.

He sees these losses being compounded by mark-to-market accounting, short-selling, and the Basel II capital requirements.

I understand the argument about mark-to-market accounting. When there is a severe imbalance in the market, with nobody buying, mark-to-market feeds on itself to produce lower and lower valuations of assets. I'm just not sure what alternative we have. Book value accounting would be a joke. The term "mark-to-model," where you estimate the value of a security based on a mathematical model, is an epithet. But maybe if the model has been properly audited, that's a better intermediate approach. It sounds to me as though Isaac's complaint about Basel II is that the capital requirements are sort of mark-to-model. So I don't think he would support mark-to-model accounting.

As to short selling, I am not buying. Perhaps I'm selling the argument short. Read Isaac and decide for yourself.

3. I think that the most over-rated alleged villains are short-sellers and bond rating agencies. I wrote an op-ed for the New York Times on the rating agencies just the other day. You will note, however, that the link takes you to a page on my site. A guy from the Times emailed me soliciting the op-ed. I asked him whether it would have an interesting enough punch line. He said yes. Then I wrote it and sent it to him. He then said, "you're right. The punch line is too obvious." So there you go. It's not just the Times that jerks you around. I've had an op-ed sitting at the Wall Street Journal for five months on health care vouchers that they solicited and say that they just love. Anyway, read the op-ed on my site if you want to know the rating-agency story.

4. To me, the three big factors in the crisis are (a) low-down-payment mortgages, (b) the housing bubble, and (c) systemic risk from derivatives and Wall Street compensation incentives

Update: Mark Cuban writes,

Find me the one story where the headline is “CEO has to pay the company losses back for being an idiot” or ” Risky moves cost CEO his lifetime savings” or “Hedge fund manager gives back bonuses and exits with $1500 dollars a month severance”

Rightly or wrongly, my guess is we'll be hearing a lot more of that rhetoric in the future.

a. Without low-down-payment mortgages, you don't get the housing bubble. The CEO of Freddie Mac, Richard Syron, got sacked. Good. Barney Frank, Syron's chief sponsor, kept his job, and continues to push the idea of Freddie and Fannie taking their "profits" and using them to fund low-down-payment mortgages. I'm sorry to keep harping on Congressman Frank. He didn't cause the whole crisis, or if he did he didn't mean to. It's just that markets learn from their mistakes, and he doesn't.

The guys who got it right on low-down-payment mortgage are the Freddie Mac folks that Syron ignored. (There has got to be a siren-Syron pun in their somewhere, but I'm missing it.) See my chapter or the New York Times story.

In fact, I would nominate Freddie Mac's former Chief Risk Officer, Dave Andrukonis, to head the new Resolution Trust thingy. There are a lot of outstanding Freddie Mac employees who would work for Dave in a minute, and they know mortgage credit risk inside-out.

b. The housing bubble was a bubble. I give props (what are props? I have no idea. I just know it's a cool thing to say) to Dean Baker, Paul Krugman, and Bob Shiller for calling it. I don't come off so well. In 2004, I wrote,

If you are worried about house prices being too high, and you would like to hedge or speculate against this, keep in mind that the bubble is more likely to be in interest rates than in house prices. Therefore, if you were to short Treasury bond futures, you probably will earn a profit in almost any scenario in which house prices decline, because a drop in bond prices (increase in interest rates) will almost certainly be necessary to trigger any major setback for home prices.

Now, that was June of 2004, and the last upward lurch of home prices took place afterward. But in thinking that it would take a rise in interest rates to put a damper on home prices, I was clearly wrong.

I still think we're in an interest rate bubble, by which I mean that rates on Treasuries are unsustainably low. But, based on my track record, you've got to be skeptical.

c. Systemic risk caused by derivatives and bad incentives. Derivatives are sort of like private bets that shift risk around. You buy a junk bond, but then you go to AIG and buy insurance that if the junk bond defaults, AIG will buy the bond from you at its face value. That's one example of a derivative.

For an individual firm, derivatives make a lot of sense. You get to focus on your business and unload unnecessary risk. For example, I've said a couple of times that oil companies should not forecast oil prices. Instead, they should explore for oil whenever the futures price is high enough to justify the investment, and sell futures contracts to hedge their risk.

For the market as a whole, derivatives are more problematic. The problem is that, in Talebian terms, risk is a predatory animal that seeks out the weakest victim. There's kind of a law of conservation of stupidity at work. Derivatives make the best money managers smarter and the worst money managers dumber. Taleb himself thinks that even the smart money managers fool themselves and become over-confident. In any case, this is a tough problem, and I'm not sure what to do about it.

The incentives on Wall Street were a big problem. If you made $X in profits a year for seven years and lose $10X in the eighth year, you got to keep all your compensation for the first seven years, and then maybe you lost your job. But, as Bob Samuelson put it, "Wall Street as we know it is kaput." The adverse incentive problem may re-emerge somewhere else, in some other form, but it's not a barn door we need to close now.

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The author at NEMA Currents in a related article titled Uncle Sam (and Hank) to the Rescue writes:
    After seeing numerous investment and commercial banks (even an insurance giant) come out of the woodworks [Tracked on September 19, 2008 1:03 PM]
COMMENTS (31 to date)
Chuck writes:

'props' is short for 'proper respect'.

Props to you for a good post.

Mark writes:

Arnold says:
"The incentives on Wall Street were a big problem. If you made $X in profits a year for seven years and lose $10X in the eighth year, you got to keep all your compensation for the first seven years, and then maybe you lost your job. But, as Bob Samuelson put it, "Wall Street as we know it is kaput." The adverse incentive problem may re-emerge somewhere else, in some other form, but it's not a barn door we need to close now."

Why? Are you saying that markets don't work for executive compensation? I bet there are a bunch of shareholders of companies like Merrill-Lynch, Bear Stearns, Lehman Bros., etc., (even AIG), who won't make the same mistake twice.

Dan Weber writes:

I bet there are a bunch of shareholders of companies like Merrill-Lynch, Bear Stearns, Lehman Bros., etc., (even AIG), who won't make the same mistake twice.

Shareholders are sheep. How many times in the US have shareholders rejected a board recommendation?

The one consolation is that when shareholders suck at their job, it's shareholders who lose money.

Matt C writes:

> I bet there are a bunch of shareholders ... who won't make the same mistake twice.

Maybe for a few years. The old wine will have to find a new bottle. Then they'll chase returns same as always. I don't exempt myself here.

Arnold Kling writes:

I don't think shareholders will make the same mistake twice. That's why I agree that Wall Street as we know it is kaput.

8 writes:

Most shareholders are institutions, and their money is managed by financial professionals. I don't think they are sheep so much as the management and shareholders were from the same group.

Johan Richter writes:

Aren't investors gonna figure out that the mortages suck regardless of what sort of accounting you use? And then be as likely to panic regardless?

Marcus writes:

"Now, that was June of 2004, and the last upward lurch of home prices took place afterward. But in thinking that it would take a rise in interest rates to put a damper on home prices, I was clearly wrong."

But interest rates did rise. The Fed kept raising the rates until the bubble burst. Short term rates were over 5% at the end of 2006 and early 2007.

shayne writes:

Perhaps it's just me, but the government (taxpayer) intervention being described (absent salient details) has every appearance of placing a FLOOR price - above the market equilibrium - for each of the following commodities:

1.) Financial entity stock prices (short sell suspension)
2.) Unsold Homes
3.) Toxic paper - currently held by number 1 and relating to number 2.

... with ALL of the related imbalance between suppliers and demanders, AND with ALL of the costs of that imbalance borne by the taxpayers.

I am neither impressed nor amused. I suspect that a government that plays by it's own rules and requires ALL of it's constituents to play by those rules is in order.

Ed Brenegar writes:

This is a great explanation of the financial crisis we are in. It strikes me that what we are experiencing is equivalent to a Katrina event. Well-meaning, even naive, people invest in property in a hurricane zone, never thinking that the next hurricane could wipe them out. We are an eternally optimistic people, and that when something like Katrina or FM/FM,LB,ML,or AIG happens, we are surprised and emotionally devastated. The reality is that we bring it on ourselves for being intellectually lazy and trusting of people's words instead of the range of potential consequences to their actions.
Thanks a lot. Love your blog.

kurt9 writes:

A 60 to 1 leveraging ratio at Freddie and Fannie is quite good! Rogue trader Nick Leeson made it to only an 8 to 1 ratio before crashing Barings Bank.

Isaac K. writes:

"I still think we're in an interest rate bubble, by which I mean that rates on Treasuries are unsustainably low. But, based on my track record, you've got to be skeptical."
I really admire your honesty and modesty. For someone so accomplished with such good writing, it's a breath of fresh air.

a. How about "Barney Frank keeps trying to lure Fannie and Freddie with his Syron song"? ot that they should have ignored "the wail of the Syron"?

Thanks again for a wonderful and insightful post.

nelsonal writes:

I think when people speak of the problems with Basel II, mark to market etc, they don't mean that those are bad per se, rather that capital standards as they are currently formatted are exceedingly pro-cyclical and don't work once a crisis has begun.
Capital standards are a lot like setting height requirements and engineering standards for a levee. However, once the storm begins it's rediculous to try start construction to reach the standard height. In the case of risk based capital standards once the flood begins the perscribed levee height is increased as the storm progresses.

Dan writes:

Re: Manager profits vs. shareholder profits

This is a tax policy issue, no? If all executives were required to have their skin in the game as the sole method of compensation, then there would not be the pyramid scheme of diverted profits to managers while they run the company into the ground.

Barkley Rosser writes:

Regarding the mark to market and Basel II issue, it is the combination of the two that generates the unpleasantly pro-cyclical outcome. It is fine to have accounting do mark to market. It is when insists that because of some standard coming out of Basel that when the current accounting shows sufficient paper losses that the institution must therefore go out and "raise capital," that then leads to a further devaluation of assets and therefore more mark to market/Basel-enforced selloffs that we have a problem, which we do.

Barkley Rosser writes:


I am not as prominent as Dean or Paul or Bob, but I was calling it a housing bubble back in 2005 both on maxspeak and in comments here, just for the record.

Greg writes:

The piece on the ratings agencies is a bit confusing. If AIG's default risk insurance was really the basis for assessing mortgage-backed securities, not the ratings agencies, how did AIG come up with a price? And isn't the broader implication that ratings of mortgage securities are basically useless? Why are they there if people don't rely on them?

aaron writes:

I'd add d) increase in commodity prices. This sparked inflation, and not just the inflation that only affects rich people. It seriously skeward peoples risk return models. Cost were up, margins were thin, and real incomes down, and with asset prices down more than down payments; default became a much more likely option.

aaron writes:

Oop. Don't know what skeward means. Meant skewered.

TheFinanceDude writes:

I have a hard time believing rating agencies share zero culpibility when they sent the models to the ibanks so they could hit the number they wanted. The pathetic SEC duopolizes the entrance into this lucrative market and we act suprised when they all act in the same manner assigning triple AAA to junk? AIG insured CDO's because they were presumed to be riskless at TripA. What am I missing here to absolve them of their blood?

Lord writes:

They won't make the exact same mistake again, but they are creative and find a new way to make it. That is the foundation of the finance industry; it isn't very profitable without them in the short term, or very profitable with them in the long term. It is called separating fools from their money. (No, it is not down payments but lack of verifiable rigorous income qualification that is central to the matter. Do you really think 20% is so much when prices are rising by more than that yearly?)

Les writes:

I think it is incorrect to blame "mark to market" accounting for the financial crises. Interest rates are currently very low, so market prices of financial instruments are very high with respect to current interest rates. Therefore it is not logical to attribute low prices for financial instruments to "mark to market" accounting.

Much more probably low prices for financial instruments are based upon high risk premiums due to serious credit concerns that impair the value of financial instruments.

Walt French writes:

Since you're interested in how these things evolved, how about a recent history of legislation around GSE regulation? Mike Oxley (ex R-Ohio) is recently on record as blaming the White House for killing (with a "one-fingered salute") enhanced regulation that he maneuvered thru the House; the White House points to a do-nothing Congress that the GSEs controlled, despite Republican dominance of all the committees and majorities. Can both of these histories be true?

My own belief is that the free-market ideologues are purposefully blind to externalities such as systemic failure, and with them in ascendancy, we allowed the principles that underlay the creation of the SEC and FRB to atrophy. I'd like to see full Pigovian taxes to offset Too Big To Fail businesses, and required insurance for ALL businesses that hold client monies above and beyond what ordinary bankruptcy laws can handle well. (And the insurance can also be market priced, by requiring SRO type self-insurance with the Feds providing re-insurance.)

The purpose of these taxes aka "required insurance", as with any externality tax, is to provide minimal but effective regulation, while letting Business Be Business. 'Cuz I'm all in favor of businesses taking huge risks if they deem it in their interest. (Most shareholders reign in their CEOs if they get too crazy, but egg them on to push the envelope.)

They're welcome to run their companies into the ground. Believers in Creative Destruction Theory should cheer, even. Just as long as they're playing with their own money, not mine.

Jim writes:

Now, that was June of 2004, and the last upward lurch of home prices took place afterward. But in thinking that it would take a rise in interest rates to put a damper on home prices, I was clearly wrong.

So what makes you think you're right, now?

Oskar Shapley writes:

Well, if your competitors make X% a year for seven years for their clients, you can not possibly make 0.5*X% for your clients and hope to keep your job that long.

It's not simply about greedy fund managers risking long-term to reap short-term bonuses (aka Enron). Ruthless natural selection PREFERS the guys who's strategy looks great today but has to blow up every 10 years.

It's also herding: "we have to invest in China, we have to go into subprimes, because we can not leave those markets to the competition".

Dave writes:

'Risky moves cost CEO his life savings.."

Dick Fuld of Lehman.

Insider writes:

The op-ed reads "Bear Stearns, Lehman, Fannie Mae, Freddie Mac, and AIG Insurance, have their own internal tools for assessing mortgage credit risk."

Calling finger-in-the-air guesses "internal tools" is a bit of a stretch.

NancyB writes:

What ever happened to private mortgage insurance? I thought if the down payment was less than 20% borrowers were required to get PMI for their mortgages. Is PMI paying off here? I have not seen any mention of it in the articles I have read.

W.C. Varones writes:

Why are there no protections for taxpayers in the Paulson bailout? Such as:

1) Treasury gets extremely dilutive warrants from any bank that touches this facility. This is what happened at AIG: the taxpayers may lose a lot of money, but at least Wall Street's profit from the scheme is minimized and the taxpayers get something back in a best-case scenario.

2) Executive compensation is capped at any bank that touches this facility. Nobody makes more than 10x or 20x the median employee, and no more stock options. Maybe even a clawback for ill-gotten gains during the bubble. Executives don't go along? Push them out.

3) A huge new program for the Justice Department to prosecute mortgage fraud and securities fraud for everyone that caused this problem, from Angelo Mozilo and investment bankers all the way down to speculators who committed fraud on their loan applications.

Small Cap Manager writes:

One of the biggest problems the equity markets face is that shareholders do not act like owners of the companies. They don't go after Boards until something horrific has already happened. In my own fund, we went after a couple of Boards for absolutely ludicrous executive compensation packages. The reaction from our fellow fund managers in the sector was shocking; they were angry at US for making a stink. Predictably, the Board members knew that this was the prevailing attitude and did not do anything to address complaints.

When the institutional shareholders view activism and criticism as "rocking the boat," companies are free to do what they want without being held to account.

Steve Roth writes:

Mr. Kling:

I just came across this thanks to a pointer from a freeexchange commenter.

>The Rating Agencies Were Not the Problem

Makes sense. Except:

"investors used the price of this insurance, rather than the rating agency grades, to measure the risk of the securities."

Did AIG et. al. consider the bonds' ratings when setting the price of the insurance?

I don't know the answer, would be curious to hear. Seems like they woulda, no?

If yes, then the ratings agencies--and their collusively developed ratings--are still culpable except at one remove. They'd still be the key point for regulatory leverage to encourage an efficient market.

Alternatively: are you saying that the ratings were perfectly reasonable given what everyone knew of the market?

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