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Ted Harlan emails about this NYT article about Fannie Mae (and about this discussion of it on the Mises.org blog). The NYT article is quite good in pointing out the extent to which FM is a financial black hole in which business-as-usual has consisted of sweeping interest-rate risk under the rug and hoping for the best. This isn’t news, but the enormous extent of the risk, illuminated in the NYT article by an ex-FM employee, and earlier over a long period by the WSJ’s editorial page, has only recently become a mainstream issue.

Essentially, what Fannie Mae is doing, from a risk standpoint, is not much different from what Long-Term Capital Management did (though FM probably uses less leverage). In both these and numerous other cases following a similar pattern, an institution develops sophisticated mathematical models to exploit apparent relationships between financial instruments. The success of such models tends to depend critically on the accuracy of the underlying statistical assumptions about markets. The people who develop the models think they know what market normality — in both the conventional and statistical senses of the word — means. They are often wrong, though their main error is in designing trading systems that depend too much on the accuracy of these assumptions. In plain language: they are fitting their models to a limited data history without taking adequate account of unlikely events, the financial equivalent of hurricanes. Things go well for a while, maybe for years, much money is made, and then the unexpected happens and the firm loses in a brief period more than it made during its entire history. (Better traders design more accurate models, or design models whose success is not so closely tied to the accuracy of their statistical assumptions about markets, or both.)

The recent huge break in the U.S. government bond market (see chart below) may reflect in part a discounting of the risk that Fannie Mae will default on significant obligations and have to be bailed out by Uncle Sam. (An alternative hypothesis, the possibility that the interest-rate increase represents mainly a return of inflationary expectations, is apparently belied by the fact that the price of gold in U.S. dollars has been stable. How much of the bond market’s fall was due to new economic-growth expectations, how much to the fact that the bull market in bonds was overdone, and how much to Fannie Mae’s problems, is the question. Whatever the answer, the FM situation didn’t help.)

Fannie Mae and other big holders of mortgages and mortgage-backed securities chronically underestimate the odds of a big move in interest rates that could devastate the value of their portfolios, said Nassim Nicholas Taleb, a hedge fund manager and the author of two books about risk and the financial markets. In general, he said, Fannie Mae and other companies rely too much on computer models that do not account for rare but devastating breaks in markets.

“The fact that they have not blown up in the past doesn’t mean that they’re not going to blow up in the future,” said Mr. Taleb, who is also an adjunct professor of mathematics at the Courant Institute of New York University. “The math is bogus.”

Taleb is mainly right. Perfect storms do occur every once in a while. When it happens, finely tuned trading models that are optimized to exploit marginal relationships (and which almost by definition don’t predict extreme outliers) tend to fail catastrophically. Fannie Mae may not fail, but the risk is there and we shouldn’t be complacent about it.

UPDATE: I should have linked to my June 25 post on the bond market (press F11 key if post doesn’t display correctly). I had the market’s direction right but, in hindsight, was excessively concerned about inflation. The fact that interest rates have gone up while gold hasn’t rallied much from the US$350/oz level suggests that inflation is not a significant concern for the markets now.

This is a terrible idea:

“…efforts are being made to commemorate the suffering of Germans driven from Eastern Europe. Led by the Association of the Banished, the plan is for a museum and centre dealing with the expulsion of Germans from countries which include the former Czechoslovakia and Poland.

Erika Steinbruch, conservative MP and head of the association, told The Observer: ‘We want to make it clear what happened to these people, the 15 million who were thrown out of their homelands in the Baltics, Romania, so many countries. They were chased out because of their German ethnicity.

‘This discussion is necessary. Every life is equal. The Jews who suffered in Germany were German. There were Germans in the Balkans who lost their homelands after the Hitler-Stalin pact. These were Germans who suffered under Hitler.

‘There is a more relaxed discussion now. That’s necessary. It is part of the process of self-discovery, of the very complicated moral problems Germany has with itself. This is only just starting. I’m very optimistic we can do this.'”

Yes, bad things have happened to Germans and ethnic Germans, during and after the war, not to mention those who went to the concentration camps even before the war. But the people heading the “Association of the Banished” have never really been able to understand that all this would never have happened without the holocaust and the other horrors of an aggressive war started by Germany. Many of those who suffered after the war had been among the active perpetrators of the Nazi atrocities, and also those who didn’t participate in them but approved of what happened, so indiscriminately commemorating them effectively amounts to an attempted white-wash. And saying that “The Jews who suffered in Germany were German” goes even further; it is simply repulsive because it lumps together the perpetrators and their victims (not that every German was a perpetrator, but she isn’t even trying to make a distinction between victims and victimizers).

Having said all that I do disagree with the concept of collective guilt. Bill Quick links to the same article and approvingly quotes this comment at lucianne.com:

Reminds me of the definition of CHUTZPA (ie nerves)– which is a man convicted of killing his parents asks the judge for mercy because he is an orphan.

In my comment at Daily Pundit I wrote :

“This is about individual suffering (and guilt). You basically say that German back then were collectively guilty and deserved whatever they got. There is no collective guilt, though, you have to look at individual cases to decide who was guilty or not. Remember, Hitler also wasn’t elected by a majority and seized power. Dissenters were sent to concentration camps, too, so many simply didn’t dare to speak up. For that reason it was simply wrong to indiscriminately drive out or murder people just because they were German.”

Like I wrote above, it would never have happened without the holocaust and World War II, and its perpetrators needed to be punished. Also, it simply is human to want revenge, and not to look too closely if all of the people you are taking revenge on are guilty or not. It also is understandable that Poles and Czechs didn’t feel like living together with Germans anymore. But, looking back more than fifty years later it is not asking too much to differentiate instead of using a blanket-condemnation.

Update: Bill has told me by now to read Daniel Jonah Goldhagen’s book “Hitler’s Willing Executioners”, on German collective guilt for the Holocaust. Well, here’s a choice quote on Goldhagen and his book:

In his most recent book, Hitler’s Willing Executioners, Goldhagen asserted that blame for the Holocaust should be placed on ordinary Germans and their unique brand of anti–Semitism. When contemporary historians from both sides of the Atlantic challenged him on this point, he eventually conceded that he had underestimated how factors other than anti–Semitism helped lead to the Third Reich’s crimes. “I skirted over some of this history a little too quickly,”

This is from a review of his article “What Would Jesus Have Done? Pope Pius XII, the Catholic Church, and the Holocaust” in the New Republic.

Anti-semitism was an important factor, but in no way the only one, that contributed to the shaping of German society over the ages. I also can’t see why some people see his book as the only authoritative source of information on the issue.

Due to problems with my computer and lack of spare time I had to take a long blogging break. I think I have sorted it all out by now and hope to be able to post again with some regularity.

Paul Marks at Samizdata speculates about the end of Castro. It’s a familiar discussion. Predictably, the reader comments are full of jabs about the U.S. embargo, with one or two blame-the-U.S. assertions thrown in. Most of these arguments are beside the point.

One of the U.S. govt’s bigger blunders in recent decades was not overthrowing the Castro regime when it would have been relatively easy to do so. Instead we played around with tepid subversion and lost our nerve after a half-assed invasion which we allowed to fail.

Since then we haven’t had the will to do anything serious, and the result has been the transformation of the most advanced country in Latin America into a festering dung heap, and the destruction of the dreams, freedom and life potential (and in many cases the lives) of several generations of its citizens. The embargo is a sideshow that won’t change any of this.

Yet God forbid anyone suggests we deal with the root of the problem by overthrowing the Cuban regime. No, can’t have that — we must have stability. (Where else have we heard that recently?) Never mind that the vast majority of Cuban immigrants from the supposedly disastrous 1980 Mariel boat lift have been successfully integrated into U.S. society. Never mind that the Cuban populace is increasingly unhappy. Never mind that Cuba is militarily weak. No, we must take no risks. We must wait Castro out, even though doing so may consign more generations of Cubans to wasted lives; and even though it’s conceivable that, absent external pressure, the communist regime will survive Castro.

If we can consider destabilizing Iran, we should consider destabilizing Cuba. The risks of not acting may not be as great in the case of Cuba as for Iran or Iraq, but neither are the risks of taking action. Cuba is a damaged society and would take years to recover to a point where it would contribute more than emigrants to the Caribbean region, but that’s a reason to start the process ASAP. Just as the Middle East will be a better place with a democratic Iraq and Iran, so the Americas would be better without a dysfunctional communist kleptocracy led by a senile thug. Bush may have more important things on his mind, and our foreign-policy bureaucracy and think tanks may have given up on Cuba long ago, but perhaps it’s time to reconsider our tacit policy of non-intervention.