Wednesday, December 31, 2008

Arnold Kling sums it up

Arnold links to his Congressional testimony, in which he provides an exquisite history and explanation of the crisis. Some excerpts:

To understand the problems inherent with securitization, imagine that you are a bank executive faced with two alternative routes for obtaining mortgage loans—a direct route and an indirect route. In the direct route, your loans are originated by your own staff. You establish standards, policies, and procedures for loan origination. You choose the markets in which you would like to originate loans, and you will probably focus on communities where you know the local economy. You hire and train personnel to follow internal guidelines.

Your compensation policies incorporate incentives for them to accept or reject applicants in accordance with company policy. Once the loan has been made, if the borrower misses a payment, your staff follows company procedures for contacting the borrower and resolving the problem.

In the indirect route, loans are originated by persons unknown to you, following guidelines established by someone else. The loans may come from communities with which you are totally unfamiliar. The originators may very well be paid on commission, which they can only receive if they close a loan—never if they reject an applicant. If the loan gets into trouble, you will have no control over how the delinquency is handled.

No sane bank executive would choose the indirect route over the direct route. In economic jargon, the "agency costs" of the indirect route are prohibitive. The originators of mortgages in the indirect route are operating under incentives that are contrary to the bank's interest. The misalignment of incentives between the bank and those acting as its agents in the indirect route will force banks to incur additional costs to monitor and review the work of the originators. Even with most diligent efforts, the bank is likely to incur higher losses from defaults, as originators squeeze bad loans through the cracks of the bank's monitoring systems.

It is surprising, therefore, that as of 2008, nearly three-fourths of mortgage debt in the United States had been originated using the indirect method. To reach this point required a combination of Wall Street ingenuity and regulatory anomalies.

I like this part too:

The suits treated mortgage securities as bonds, ignoring the power of the embedded options. In August and September, when policymakers began to perceive the severity of the crisis, the suits thought that mortgage securities could not possibly have lost as much value as their market prices indicated. Federal Reserve Board Chairman Ben Bernanke insisted that if the securities were "held to maturity" that they would have higher values. Treasury Secretary Henry Paulson proposed to have the government buy and hold these securities in order to "unclog" the financial system. However, this thesis, which in effect was arguing that the geeks had mispriced mortgage securities, proved to be incorrect. The banks that had invested heavily in these securities were truly under-capitalized. The mistakes had been made by the suits, not the geeks.

I always wondered what finance was really about, or rather why it has become this huge behemoth, representing some 40% of U.S. profits. Now I think I know. It's kind of like law, in that the big money is in finding novel ways to subvert the law, causing more laws to be created, and more opportunities for subversion, etc. Looks like a big part of those profits are nothing more than rent seeking.

This also makes me think that no amount of regulation will ever fix the problem, and that maybe the Austrians are right: we should return to competitive banking.

Sunday, December 28, 2008

One word: Mariachi

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.

“I’d lie if I said every piece of documentation was properly signed and dated,” said Mr. Parsons, speaking through wire-reinforced glass at a California prison near here, where he is serving 16 months for theft after his fourth arrest — all involving drugs.

While Mr. Parsons, whose incarceration is not related to his work for WaMu, oversaw a team screening mortgage applications, he was snorting methamphetamine daily, he said.

“In our world, it was tolerated,” said Sherri Zaback, who worked for Mr. Parsons and recalls seeing drug paraphernalia on his desk. “Everybody said, ‘He gets the job done.’ ”

At WaMu, getting the job done meant lending money to nearly anyone who asked for it — the force behind the bank’s meteoric rise and its precipitous collapse this year in the biggest bank failure in American history.

Read the rest here. The really funny part is I owned stock in this company. I recall thinking "the banks always seem to win, I should own a bank."

Wednesday, December 17, 2008

Republicans have a death wish?

Not sure how this works, but my guess is that it's ultimately about cheap land and open spaces. Republicans apparently value these things more than whatever benefits accrue from being around others, which in this case is relative safety.
The death map comes from here, and the red state blue state map is here.

Tuesday, December 16, 2008

Me and Paul: The joys of blogging

Paul Krugman shows you don't win the Nobel prize by thinking small. He's calling for a massive Keynesian fiscal stimulus. Not just here, but all over the world! I just hope he remembers to tell us when to stop:

To understand the problem, think of what would happen if, say, New Jersey were to attempt to boost its economy through tax cuts or public works, without this state-level stimulus being part of a nationwide program. Clearly, much of the stimulus would “leak” away to neighboring states, so that New Jersey would end up with all of the debt while other states got many if not most of the jobs.

Individual European countries are in much the same situation. Any one government acting unilaterally faces the strong possibility that it will run up a lot of debt without creating much domestic employment.

For the European economy as a whole, however, this kind of leakage is much less of a problem: two-thirds of the average European Union member’s imports come from other European nations, so that the continent as a whole is no more import-dependent than the United States. This means that a coordinated stimulus effort, in which each country counts on its neighbors to match its own efforts, would offer much more bang for the euro than individual, uncoordinated efforts.

He even provides us with the math, so there can be no doubt. Except I still have doubts, and so do many others. See all the comments, especially this one. Here is mine:
Sounds like you're claiming there are spill over effects with a fiscal stimulus, which I agree with. Thus you're calling for coordination in Europe. Wouldn't that rosy scenario lead to spill over effects outside Europe? So would you really like to see world-wide coordination? Even if that were possible, and all spill-over effects neatly cancelled each other, then where are we? Yes, we might have a short term benefit of slightly higher demand than otherwise would be, but we'd be stuck with the very real and enduring cost of more government control of the economy. If that sounds good to you, I suggest you go to your local post office and think about it while you stand in line for hours.

Saturday, December 13, 2008

Postrel summarizes the research on bubbles

Read the whole thing, but here's a snipet:

At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.

Incidentally, my dissertation is building upon this work. I'll let you know how it turns out after I corner the stock market.

(HT to Tyler)

Addendum: Where is the next bubble likely to occur? This research tells us it will likely occur where we have little experience, just as the dot com bubble occured in a new technology we had little experience with, and the real estate bubble occured after a generation of flat prices and no record of significant nation wide declines. My guess is that treasury bonds are the new bubble, since it was roughly a generation ago that they performed this well. You'd think knowledge of history would matter more, but it doesn't. Only experience.

Friday, December 5, 2008

Things you can do in authoritarian China that you can't do here

China plans next month to raise tax on regular gasoline by five fold and diesel fuel tax by eight fold, in a move to take advantage of falling crude prices and encourage energy conservation, state-run media reported Friday.


Government officials see the dramatic fall in global crude oil prices -- currently around $43 a barrel, down from a high of about $147 in July -- as "a perfect opportunity" for the increase, the report said.

Read the rest here. Of course, it's a pretty bad time to be raising taxes, but in the long run this is good policy. China and India and many other heavy polluters have been subsidizing gas consumption, not taxing it. You could probably make the argument that we in the US have also been subsidizing gas consumption on balance, when you take into account the highway subsidies.

But is there any country currently proposing to lower taxes, gas or otherwise, in this likely deflationary environment? Has any country ever tried lowering taxes in a deflationary environment? Is there any reason why? I see only two, niether of which make me optimistic about the future:
1) We have only the experience of the Depression, and only the Keynesian reaction, so we are too afraid or stupid to try anything else.
2) With voters paralyzed in fear/stupidity, the most successful politicians, i.e. the most venal, will sieze this "perfect opportunity" to expand their power.

Merry Christmas and to all a good night!