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.

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."

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.

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.

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.

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!

The patience of 8th graders

Something to keep your mind off your 401k. Marco Castillo and Regan Petrie, two visiting economists at GMU, have an interesting study which certainly breaks new ground in education research. From the abstract:

We experimentally investigate the distribution of children's time preferences along gender and racial lines. Black boys have significantly larger discount rates than any other demographic group. Discount rates among Black girls are comparable to rates among White girls. Although White boys exhibit higher discount rates than girls, the difference is small and not statistically significant. These results are robust to alternative measures of patience and to regression analyses that control for socio-economic background and school performance. The measured differences in discount rates are large. All things equal, a Black boy requires expected returns to education 13-15% higher than Black girls to compensate for his larger discounting of future payoffs. Equally importantly, we show that impatience, as measured by discount rates, has a direct effect on behavior. An increase of one standard deviation in the discount rate increases by 5 percent the probability that a child incurs at least 3
school-related disciplinary actions. This result suggests that experiments capture new and relevant information on children. Overall, our results suggests that time preferences might play a large role in setting appropriate incentives for children. Understanding the factors behind these differences in preferences is an important area for future research.

Mind you, given their data limitations, they cannot fully identify the conditions which create such differences in time preferences, e.g. family characteristics such as education of the parents. But this is a start.

Common sense

"I don't think they should bail them out because ... obviously something's not right in the way they're running their business, and why should the American people have to bail them out if they can't figure out how to do it right?" September Quinn, the busy waitress, said after the lunch rush at the Inn Between.

More here. It's people like this that keep the dollar afloat, not the spendthrifts in Congress.

Somalian stimulus plan (SSP)

"There are more shops and business is booming because of the piracy," said Sugule Dahir, who runs a clothing shop in Eyl. "Internet cafes and telephone shops have opened, and people are just happier than before."

More here.

Google's accidental innovators

In their 1998 paper, the Googlers cited Prof. Ben Bagdikian's theory of Media Monopoly. Page and Brin swallowed the idea that U.S. media markets were controlled by a cabal of corporations, manipulating content to protect advertisers, and stifling competitive entry to protect their shareholders. According to Bagdikian, just four megacompanies share the U.S. Media Monopoly: Disney, News Corp., Time Warner and Viacom. (News Corp. is the corporate parent of Dow Jones, publisher of Barron's.) Resistance was futile.

If Brin and Page had been deterred by the bleak forecast offered by Bagdikian, Google today would not be worth some 90% of the capitalization of the four media oligarchs combined.

That's GMU's Thomas Hazlett in Barron's.

Probability of being the swing voter

There are 4 senate races that are still too close to call (I believe they are all in recount), and Missouri is too close to call in the presidential race. By the latest count, Al Franken is within 206 votes of winning the senate race in Minnesota, where the total number of votes was around 2.9 million. From Time:

But Jacobs says he does not expect a huge shift in recounting residual votes. "The bigger issue is how we handle these absentee ballots [which are the subject of the Franken lawsuit]," he says. Mark Jeranek, who voted for Franken, cast an absentee ballot in Beltrami County, located in northwestern Minnesota, that was rejected because he didn't sign the envelope in which he placed his ballot. The Franken campaign sent him an affidavit that he is considering signing. "I don't want to be a cause for revolution, but at the same time I want my vote to count," the 39 year-old environmental consultant says. "It's kind of neat — at least for a senatorial race — that it really does come down to every individual vote."

None of this squares with the typical public choice assumption, going back to Downs and Tullock, that the liklihood of being the swing voter is 1/n, where n is the number of voters. That is, the number of close elections indicates it is not a uniform distrubution, i.e. you need to take into account the median voter theorem. For this reason, I think a binomial distribution is more appropriate, such as that used by Barzel and Silberberg. The following graph illustrates how these two assumptions differ over the size of the electorate. I've assumed p=1/2 for the binomial distribution, and calculated P as the probability of being within 1 vote of a tie.




Clearly, in large elections such as those at the state and national level, both probabilities approach zero. Thus, voters in these elections aren't paying too much attention to this sort of calculus. Rather, expressive voting is probably a more important factor.

Addendum: To illustrate the main point here I've reproduced the same graph below but on a log-log scale. You can now see that especially in large elections the choice of binomial versus 1/n is critical. For instance, in Al Franken's race with 2.9 millions voters, if one assumes a binomial distribution, then there is a 1/711 chance of effecting the outcome. Therefore, if we assume the cost of voting is, say, $1, due to time lost, travel expense, etc., then one need only expect benefits greater than $711 for it to make sense to vote for one's preferred candidate. Compare that to the case of a uniform distribution, where benefits would need to exceed $2.9 million. You can see that the paradox of voting is not such a paradox if one makes realistic assumptions, even if we restict our analysis to non-expressive, i.e. instrumental, benefits.

Remember modesty?

The hubris of the military imperialists was bad enough without adding to it the hubris of the aid imperialists.

That's Bill Easterly on Paul Collier's Bottom Billion. (HT to Tyler)

Stuff I don't usually read

I would not be surprised to see the G-20 monetize at least 20% of the U.S. debt markets. THAT MEANS …

Gold would be priced at over $10,000 an ounce.

Currencies would be devalued by a factor of at least 12 to 1, meaning it would take 12 new dollars or euros to equal 1 old dollar or euro.

That's Larry Edelson at Money and Markets. I don't know what to say. Buy gold.

Also see this montage of clips by Peter Schiff, who predicted our current financial mess whilst being laughed at.

The dangers of complexity

I hope none of you voted for Obama thinking this would put an end to special interest politics, or the wars. It looks like the military-industrial complex, along with all the other government-industrial complexes, will continue unabated. From the New York Times:

John L. White, a former Clinton official charged with overseeing the new Defense Department, is a partner in a firm that invests in defense contractors. Michael Warren, charged with overseeing Treasury, is chief operating officer of a firm that lobbies for clients including the U.S.-India Business Council.

Several of the officials have ties to Fannie Mae, the government-backed mortgage firm whose implosion this fall contributed to the financial meltdown. Thomas Donilon, overseeing the State Department, is a partner in the law and lobbying firm O’Melveny and Myers who until three years ago lobbied for Fannie Mae. Wendy R. Sherman, the other official charged with reviewing the State Department, once headed Fannie Mae’s charitable foundation.

...

The vast majority involved are second-tier officials of the Clinton administration, eager to help another Democrat take control of the White House. With the exception of a few academics, almost all of them spent the intervening years in the private sector, usually capitalizing on the connections and expertise they developed in the Clinton years.

Maybe this is why the Framers preferred a simple solution: strict and severe constitutional limits on the power of government.

Highway robbery

If you're wondering why the stock market is back near 5 year lows, I think it has something to do with the eagerness of Democrats, including Obama, to hand over more billions to the car companies. It certainly frightens me. Bush is no paragon of free-market virtue, but he is apparently the only one standing in the way of this non-sense. Once he's gone, we're looking at two years to life of binging at taxpayer expense. I expected as much from Pelosi and Reid, but I wanted to give Obama the benefit of the doubt. Truly disheartening. Politics continues unabated.

Here's what the Wall Street Journal has to say about it, and they're quite a bit more tempered than I:

Which brings us back to what the government should do. If public dollars are the only way to keep General Motors afloat, as the company contends, a complete restructuring under a government overseer or oversight board has to be the price.

That is essentially the role played by the federal Air Transportation Stabilization Board in doling out taxpayer dollars to the airlines in the wake of 9/11. The board consisted of senior government officials with a staff recruited largely from the private sector. It was no figurehead. When one airline brought in a lengthy, convoluted restructuring plan, a board official ordered it to come back with something simpler and sustainable. The Stabilization Board did its job -- selling government-guaranteed airline loans and warrants to private investors, monitoring airline bankruptcies to protect the interests of taxpayers -- and even returned money to the government.

As for Ford and Chrysler, if they want similar public assistance they should pay the same price. Wiping out existing shareholders would end the Ford family's control of Ford Motor. But keeping the family in the driver's seat wouldn't be an appropriate use of tax dollars. Nor is bailing out the principals of Cerberus, who include CEO Stephen Feinberg, Chairman John Snow, the former Treasury secretary, and global investing chief Dan Quayle, former vice president.

Government loan guarantees, with stringent strings attached and new management at the helm, helped save Chrysler in 1980. But it's now 2008, 35 years since the first oil shock put Japanese cars on the map in America. "Since the mid-Seventies," one Detroit manager recently told me, "I have sat through umpteen meetings describing how we had to beat the Japanese to survive. Thirty-five years later we are still trying to figure it out."

Which is why pouring taxpayer billions into the same old dysfunctional morass isn't the answer.

Also see this and this.