A Financial North Korea?

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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.

collapse of bull mkt in U.S. treasuries

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.

(Almost) Free At Last

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To replace an old cell phone that suddenly became incompatible with Sprint’s network required:

-3 phone calls to Sprint’s customer-service line.

-3 trips to two different Sprint stores. Each visit involved a long wait and at least one unpleasant interaction with a testy employee.

-Approximately 7 hours.

Sprint’s wireless service has improved over the years but it’s still worse than it should be. It’s consistently bad enough that the problem must be systematic. At first I used it because it had the best set of features for my needs. Now other companies offer similar plans. The only reason I continue with Sprint is that I don’t want to change my phone number. But U.S. cell numbers are about to become portable, so I’ll look into taking my business elsewhere. I imagine a lot of other customers have similar ideas. It will be interesting to see what happens — it’ll be good for consumers, that’s for sure.

bye

Conspiracy theorists revving up

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Not this is a real eye-opener:

BERLIN, July 23 (Reuters) – Almost one in three Germans below the age of 30 believes the U.S. government may have sponsored the September 11, 2001, attacks on New York and Washington, according to a poll published on Wednesday.

And about 20 percent of Germans in all age groups hold this view, a survey of 1,000 people conducted for the weekly Die Zeit said.

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Asked whether they believed that the U.S. government could have ordered the September 11 attacks itself, 31 percent of those surveyed under the age of 30 in the poll answered “yes”, while 19 percent overall gave the same answer.

Die Zeit said widespread disbelief about the reasons given by the United States for going to war in Iraq and suspicion about media coverage of the conflict had fostered a climate in which conspiracy theories flourished.

Granted, huge events like 911 are bound to generate conspiracy theories, especially if they happen this unexpectedly. The anti-globalization crowd and anti-American press (not the majority of publications, but certainly the loudest ones) around the world have done everything they can to capitalize on the situation, but there really is no excuse for this. It seems that about 20% of Germans and about 30% percent of Germans under 30 badly need a reality check. Americans who heard of the poll rightly reacted incredulously; Rachel Lucas summed up very well why:

“They obviously can’t wrap their brains around the concept of transparency – you can get away with certain things in America, but you can’t get away with much. Especially if you’re a politician – everyone watches everyone else, everyone’s out to get everyone else, and that creates an environment where it would be impossible to keep the kind of secrets that would be necessary to hide something like the federal government’s sponsorship of 9/11”.

Of course, claims (in the blogosphere and elsewhere) that France and Germany opposed the war on Iraq because they allegedly had armed Iraq with WMDs as a proxy against America were met here with similar incredulity, for the same reason. What goes for America goes for Germany and France, too. Both countries are democracies, with the same transparency that Rachel claims for America. No German or French government could have armed Iraq with a huge arsenal of nuclear, biological weapons without the opposition parties and the press getting on to them. Don’t forget, all those reports about German arms sales to Iraq were originally published by the German press, for example (something for which it got no credit from the bloggers who posted them). Europe’s economies may be more strongly regulated than the American one, but you couldn’t get away with bad craziness like this over here any more than you could in America. So, and no offense, but a reality-check in regards to this issue might also have been useful. ;)

Twisting history

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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.