Wednesday, December 31, 2008

The Fall of AIG

The Washington Post has a three part series on the downfall of AIG, and the role of the Financial Products Group. This is a story of how a subsidiary that was started making hedged transactions in derivatives expanded into credit default swaps. The idea was to leverage AIG's AAA credit rating and provide insurance against what seemed extremely low risks. As AIG's credit rating fell the cost of supporting the swaps increased as counterparties demanded more collateral. And the group's model did not adequately forecast the risks inherent in CDO's built from sub-prime lending.

It is an important story. What we see is that a business that started out limited expanded beyond its original horizons. As the business morhped risks increased in ways that were not recognized.

Justin Fox has some interesting comments on the series.

Monday, December 29, 2008

The Weekend Investment Banking Died

The Wall Street Journal has an article recounting the weekend that Lehman failed, Merrill was sold, and Goldman, Sachs and Morgan Stanley became commercial banks. Inside Wall Street stuff.

Felix Salmon has some good commentary about the implications of this story.

Sunday, December 28, 2008

Predatory Lending and Bailouts

Tyler Cowan argues in today's NYT that we would be in better shape today if the Fed had not arranged the bail-in of Long Term Capital Management in 1998. He argues that:
The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.
We should remember though that the investors in LTCM essentially were wiped out. So much for moral hazard. Cowan's argument, however, is that we were better prepared in 1998 to absorb such a crisis since we had a budget surplus and the economy as a whole was much better. But could the FED really imagine that we would have 8 years of disastrous fiscal policy that we have experienced in the 21st century?

Moreover, it is not clear that this would have dealt with the fundamental psychosis that fueled the real estate bubble. The history of WAMU, described here, is really chilling. The bank was so intent on making loans it used photos as substitutes for documents:
As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers’. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.
The article also describes WAMU's policy of paying real estate brokers to bring loans to WAMU. What is important about this episode is the policy of not even bothering with risk. Earning fees now when the bubble was expanding was the sole concern of the bank. I suppose one can argue that if LTCM had failed we would not have seen widespread securitization of loans, and the whole ideology that the market could police itself would have never crystallized. So sure, failure would have prevented this crisis, but at what cost.

A better scenario would have been a proper response to LTCM. This would have involved more attention to the problems of leverage and more vigorous regulation. And what would have happened to regulators who allowed LTCM to fail in 1998? They would have been vilified for causing a crisis (what happens to any policymaker who tried to stop a Ponzi scheme).

Perhaps the only benefit might have been the ruin of Bob Rubin's reputation, and this might have helped Citigroup marginally.

Friday, December 26, 2008

Chinese Predatory Lenders

This article in the New York Times examines how Chinese savings fueled the US bubble. In accord with Bernanke's Global Savings Glut theory it argues that excessive savings in the rest of the world is the source of our deficits and there is nothing we could have done about it, except pressure China to revalue the reminbi.

The essential parallel is with subprime lending. The Chinese were the predatory lenders and Americans were the ill-informed borrowers. It is a hard story to maintain. The fact that China saved excessively and lent to the US did not mean that we had to use these flows to finance a housing bubble. We could just as easily have used it for investment not consumption, or for building roads in the US instead of in Iraq. The fault for what we did with Chinese savings lies with us. If we had used low-cost finance effectively we would be better off now. The fact that we used it poorly is just a reflection of how short-sided our leaders were and how foolish investors were to believe that a bubble can go on forever.

Wednesday, December 17, 2008


I have noted before that Wall Street incentives promoted risk taking because the bonuses are earned before the losses are realized. This article in the NYTimes uses the experience of Merrill Lynch to illustrate the problem. There is a very nice graphic there as well.

Friday, December 12, 2008

Excess Returns

Investors often report performance that beats the market. Successful investors are treated as superstars who prove that markets are not really efficient. While such cases are possible there are often other explanations. Today, the superstar investor Bernard Madoff was arrested for essentially running a Ponzi scheme, as reported in the here and here. Madoff reported very high, and very stable, returns for a very long time, and rich people invested in his funds. Now he reports that he paid the returns out of new investments, a classic Ponzi scheme.

Just the other day we learned that William Miller, "the era's greatest mutual-fund manager" has seen all of his superior returns wiped away in the last year. According to this article in the WSJ:
A year ago, his Value Trust fund had $16.5 billion under management. Now, after losses and redemptions, it has assets of $4.3 billion, according to Morningstar Inc. Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index.
What these, and many other cases illustrate, is that one cannot tell from observing a string of good years (or of merely reports in the Madoff case) that excess returns are really being earned. This is another case of excess risk masquerading as high "alpha." The problem for investors is that reports of past performance are no guide to future risks, as the disclosure statements always repeat, and as most investors usually ignore.

An important economic point is that prior to the crash the superstar investor is treated as a true Master of the Universe. And those who question this based on efficient markets reasoning are treated as ostrich-like academics, or worse. The investors on a hot streak earn more than those who are more cautious, so over time the latter get replaced. The market is filled with superstar investors and those who aspire to be them. They are encouraged by their management contracts to take on excessive risk and are rewarded. The big problem is that the losses tend to be more broadly felt. They get socialized.


Virginia Postrel has an article in the Atlantic on experimental results concerning bubbles. Even though the participants in the experiments can easily determine the fundamental value of the assets they are trading bubbles and crashes still appear. What seems to happen is that traders are not sure if others realize that there is a bubble and try to profit before the crash.

Although she does not mention it, these results are not surprising given the work by Abreu and Brunnermaier on bubbles and crashes. In their work
The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period.
The key point is then is that even if I know a stock is overvalued I may still participate in the bubble if I do not realize that you are similarly aware of it. After all, if I short the stock and am by myself I may lose big time, while if I ride for a while I may profit till enough short sellers are ready to attack. So the sequence of learning is essential.

It is just this phenomenon that the experimenters seem to be pointing at. But Brunnermaier has already shown that similar phenomena were at play in previous bubbles, looking at the trading strategies of informed traders.

But there is another problem regarding bubbles that is worth discussing. That is the bias in the benefits. Think of the housing bubble. While it is taking place who is losing? Certainly those priced out of the markets, but who else? Everybody else is gaining, whether they are construction workers, bankers, financiers, governments dependent on tax payments...Now what happens if the bubble bursts? Everybody who was riding the bubble now suffers.

Suppose that the bubble was burst by the actions of a concerned policymaker. Would this policymaker be applauded? Seems unlikely. Everyone who suffers would blame the messenger. Certainly, everybody hates short sellers -- the only difference being the latter try to profit from their information. But still, if a bubble collapses it is hard to believe that the policymaker would be anything but blamed.

If this is correct, then there is a bias in favor of bubbles. Cheering on the asset price increases the politicians can say how we have a new economy. The old rules do not apply, and look at the prosperity we have brought. The gloomy official who tries to prick the bubble will be pilloried.

Tuesday, December 9, 2008

Flight to Safety

Treasury bills are now trading at the lowest rates in history. This article in Bloomberg news has the details:
The Treasury sold $27 billion of three-month bills yesterday at a discount rate of 0.005 percent, the lowest since it starting auctioning the securities in 1929. The U.S. also sold $30 billion of four-week bills today at zero percent for the first time since it began selling the debt in 2001.
Essentially, the government is being lent money at zero cost. This, at the same time that the government is bailing out banks and the budget deficit is approaching $1trillion. One would expect a risk premium for lending to this government. But instead the flight to safety is causing interest rates to the minimum barrier of zero. This is truly a new kind of crisis.

Fannie and Freddie Knew the Risks

This article in the Washington Post reveals emails that show analysts at Fannie Mae and Freddie Mac knew of the risk associated with subprime and Alt A loans, but that top officials refused to get out of this market. Fear of being irrelevant in the mortgage market drove their decision apparently.

The chief credit officer of Fannie Mae

warned that securities backed by these loans might not be as safe as they seemed. Fannie reported them as carrying the top grade given by credit-rating agencies, AAA, but Marzol cast doubt on that. "Although we invest almost exclusively in AAA rated securities, there is concern that rating agencies may not be properly assessing the risk in these securities," he wrote.

Despite these concerns, Fannie continued to push into this new market. A business presentation in 2005 expressed concern that unless it didn't, Fannie could be relegated to a "niche" player in the industry. Mudd later reported in a presentation that Fannie moved into this market "to maintain relevance" with big customers who wanted to do more business with Fannie, including Countrywide, Lehman Brothers, IndyMac and Washington Mutual.

This certainly does not mean that Fannie and Freddie caused the crisis, but it shows the extent to which they played along, and joined the party at the worst possible time.

Tuesday, December 2, 2008

Joining the Club

The financial crisis is causing some countries to reconsider their opposition to adopting the euro. As this article notes, even Denmark, which twice rejected membership in referendums are now considering a third try. The experience of currency crises in Iceland, Hungary and Poland are causing governments in those countries to try to push towards the euro. What good is monetary sovereignty when you have to go the IMF for emergency funds to save your currency?

As one Polish economist noted: “'When there’s a threat, find God,’ goes the proverb in Poland,” said Rafal Antczak, an economist at Warsaw University. “And that is what has happened.” Substitute the euro for God.

Monday, December 1, 2008

Beware what you say

Perhaps I should be more careful about what I say about the financial crisis. In Latvia, economist Dmitrijs Smirnovs was arrested for "for bad-mouthing the stability of Latvia's banks and the national currency, the lat. Investigators suspect him of spreading 'untruthful information,'" according to this article in the Wall Street Journal. In October Smirnovs "took part in a discussion organized by a small local newspaper, Ventas Balss. Predicting serious trouble ahead for Latvia, he said: "'All I can advise is this: First, don't keep money in banks. Second, don't keep money in lats.'"

The problem, of course, was the Smirnovs was correct:

After insisting its banking sector was healthy, Latvia last month took over the largest locally owned bank, Parex, to save it from collapse. After denying it needed aid from the International Monetary Fund, the government is now in talks with the IMF.

Finance Ministry officials acknowledge that secret police won't save the country from economic crises. But they do believe Security Police vigilance makes the public think twice before spreading uninformed gossip about banks.

"It is a form of deterrence," says Martins Bicevskis, Finance Ministry state secretary.

Arresting people for spreading rumors, or the truth, about the economy is an old Soviet practice. The Latvian officials are afraid of the effect of rumors on speculative flows of capital. But it is not clear that such policies are anything but counterproductive. The less information people have about the economy the more subject they are to rumors and fears.