Markets and Trading – Page 14

Thom Yorke wrote a song called “Black Swan” that resonated with me in terms of the financial crisis of 2008-2009 (and today) commonly called “The Great Recession”. He wrote the song in 2006.

The “Black Swan” was a metaphor used by Taleb in his excellent book “Fooled by Randomness“. The point of that book (broadly stated) is that people under estimate randomness and long-tail events; Taleb is an options trader specializing in the valuation of far-out-of-the-money options and whether or not they are fairly priced. The metaphor specifically for the Black Swan is that no one ever anticipated that there was a black swan; all swans were expected to be white and it would be viewed as a very remote or unanticipated event if a “black” swan were to turn up. When settlers reached Australia, however, they were surprised to find black swans, meaning that they had significantly under-estimated the probability of this event occurring.

While you can’t directly tie art to a particular business concept I liked the part of being “ground in the bitumen” and then general feeling of being lost and angst that is summarized as “this is f*cked up, f*cked up”.

How Politicians and Regulators Caused the Sub-Prime Financial Crisis of 2007 and the Subsequent Crash of the Global Financial System in 2008, and Likely Will Again

November 29, 2010August 9, 2010 by Kevin Villani

This is a summary of a working paper available at the links for which comments are welcome. (A later post on related topics appears here.)

Download the paper (1 MB pdf).

That the US financial system crashed and almost collapsed in 2008, causing a globally systemic financial crisis and precipitating a global recession is accepted fact. That US sub-prime lending funded the excess housing demand leading to a bubble in housing prices is also generally accepted. That extremely imprudent risks funded with unprecedented levels of financial leverage caused the failures that precipitated the global systemic crash is a central theme in most explanations. All of the various economic theories of why this happened, from the technicalities of security design (Gorton, 2009) to the failure of capitalism (Stiglitz, 2010) can be reduced to two competing hypotheses: a failure of market discipline or a failure of regulation and politics.

While still sifting through the wreckage and rebuilding the economy in mid July, 2010, the Congress passed the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to prevent a reoccurrence of this disaster. The disagreement in the debates regarding the appropriate policy prescription reflected the lack of a consensus on which of these two competing hypotheses to accept. The risk was that, following the precedent established in the Great Depression, politicians will blame markets and use the crisis to implement pre-collapse financial reform agendas and settle other old political scores. By having done just that, this Act worsens future systemic risk.

That there was little or no market discipline is obvious. Contrary to the deregulation myths, regulation and politics had long since replaced market discipline in US home mortgage markets. Regulators didn’t just fail systemically to mitigate excessive risk and leverage, they induced it. This didn’t reflect a lack of regulatory authority or zeal, as politicians openly encouraged it.

The politically populist credit allocation goals that promoted risky mortgage lending, whether or not morally justifiable, are fundamentally in conflict with prudential regulation. The system of “pay-to-play” politically powerful government sponsored enterprises (GSEs) was a systemic disaster waiting to happen. The recent advent of the private securitization system built upon a foundation of risk-based capital rules and delegation of risk evaluation to private credit rating agencies and run by politically powerful too-big-to-fail (TBTF) government insured commercial banks and implicitly backed TBTF investment banks was a new disaster ripe to happen. Easy money and liquidity policies by the central bank in the wake of a global savings glut fueled a competition for borrowers between these two systems that populist credit policies steered to increasingly less-qualified home buyers. This combination created a perfect storm that produced a tsunami wave of sub-prime lending, transforming the housing boom of the first half decade to a highly speculative bubble. The bubble burst in mid-2007 and the wave crashed on US shores in the fall of 2008, reverberating throughout global financial markets and leaving economic wreckage in its wake.

By the time the financial system finally collapsed bailouts and fiscal stimulus were likely necessary even as they risked permanently convincing markets that future policy will provide a safety net for even more risk and more leverage. Given this diagnosis, how to impose market and regulatory discipline before moral hazard behavior develops is the most important and problematic challenge of systemic financial reform.

The public policy prescription is simple and straightforward. Prudential regulation remains necessary so long as government sponsored deposit insurance is maintained, which seems inevitable. Prospectively the traditional regulatory challenge of promoting market competition and discipline while safeguarding safety and soundness remains paramount. But the prudential regulation of commercial banks needs to be de-politicized and re-invigorated, with greater reliance on market discipline where public regulation is most likely to fail due to inherent incentive conflicts. This means sound credit underwriting and more capital, including closing the off balance sheet loopholes typically employed by big banks and eliminating the incentives for regulatory arbitrage. Universal banking should remain, but divested of hedge fund and proprietary trading activity. In addition, firms that are “too big to fail” (TBTF) are probably too big to be effectively controlled by regulators and should either be broken up or otherwise prevented from engaging in risky financial activities by reducing or eliminating their political activities.

Most importantly, the two main sources of TBTF systemic risk and subsequent direct government bailout cost, Fannie Mae and Freddie Mac, no longer serve any essential market purpose. The excess investor demand for fixed income securities backed by fixed rate mortgages that fueled their early growth is long gone and now easily met by Ginnie Mae and Federal Home Loan Bank securities alone, as fixed nominal life and pension contracts have largely been replaced by performance and indexed plans. Fannie Mae and Freddie Mac should be unambiguously and expeditiously liquidated subsequent to implementing an adequate transition plan for mortgage markets.

Download the paper (1 MB pdf).

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Kevin Villani is former SVP/acting CFO and Chief Economist at Freddie Mac and Deputy Assistant Secretary and Chief Economist at HUD, as well as a former economist with the Federal Reserve Bank of Cleveland. He was the first Wells Fargo Chaired Professor of Finance and Real Estate at USC. He has spent the past 25 years in the private sector, mostly at financial service firms involved in securitization. He is currently a consultant residing in La Jolla, Ca. He may be reached at kvillani at san dot rr dot com.

Mini-Book Review — Ridley — The Rational Optimist

June 30, 2010June 30, 2010 by James McCormick

Ridley, Matt, The Rational Optimist: How Prosperity Evolves, Harper Collins, New York, 2010. 438 pp.

Matt Ridley is a well-known British science writer who, in recent years, has specialized in writing books for the general public on new research in biology … evolutionary biology, genomics, plus a biography of Francis Crick, co-discoverer of DNA.

For well over a decade I’ve enjoyed his books and been very impressed with the quality of his writing, so “on spec” I put a library hold on Ridley’s latest without paying much attention to what it was about. That decision turned out to be a wonderful piece of serendipity. I’ve been reading about European “trading republics” (ancient and modern) for a few years, and trying to assemble an amateur theory about how economic dynamism and technological innovation follow, or are reinforced by, republican values. Whether Athens, Rome, Venice, Genoa, Antwerp, Amsterdam, London, Liverpool, Glasgow, Boston, or New York and Montreal, trade under republican regimes creates massive relative wealth and huge leaps in human knowledge and standards of living.

Now Matt Ridley looks at the innate human capacity for “exchange” … and how that unique capacity affected the course of prehistory, the introduction of agriculture and “civilization,” and more latterly, the shape of the industrial revolution and the modern world. Underlying the politics of republicanism, and individual freedom, we can see the human appetite for exchange creates persistent economic advantage. Trade flows from comparative advantage, in the words of David Ricardo, and comparative advantage relentlessly rewards more specialized use of the natural environment … from the labor of humans carrying sea shells inland for trade 80,000 years ago, to the labor of domesticated horse and sheep and dogs largely for human benefit, to the use of vast quantities of ancient vegetable matter (in the form of petrochemicals), to extend the efforts of humans out of all proportion. Our species is most prosperous when most specialized, when most dependent on the differentiated talents of thousands of others. We now can live lives like the Sun King, without a retinue of thousands.

In this book I have tried to build on both Adam Smith and Charles Darwin: to interpret human society as the product of a long history of what the philosopher Dan Dennett calls ‘bubble-up’ evolution through natural selection among cultural rather than genetic variations, and as an emergent order generated by an invisible hand of individual transactions, not the product of a top-down determinism. I have tried to show that, just as sex made biological evolution cumulative, so exchange made cultural evolution cumulative and intelligence collective, and that there is therefore an inexorable tide in the affairs of men and women discernible beneath the chaos of their actions. A flood tide, not an ebb tide. p. 350