By Arnold Kling
A bunch of thoughts:
1. On the new Resolution Trust Corporation, several people agree with me that it is nothing like the old RTC, echoing what I wrote
ages ago Wednesday. The old RTC got handed to it the assets of defunct S&L’s. The new RTC will acquire the assets of active firms. Also, amplifying on an issue that I also raised yesterday, Steve Randy Waldman writes,
As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I’d rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let’s spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.
I’d like to see his views get more play. Read the whole thing.
2. No one knows what the real losses are on all this paper. Some people, like Rogoff and Setser, think that the number has 12 zeroes behind it (if I’m counting right. How many zeroes in a trillion?) William Isaac thinks it’s less. He notes that there were $1.2 trillion of subprime mortgages.
The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.
He sees these losses being compounded by mark-to-market accounting, short-selling, and the Basel II capital requirements.
I understand the argument about mark-to-market accounting. When there is a severe imbalance in the market, with nobody buying, mark-to-market feeds on itself to produce lower and lower valuations of assets. I’m just not sure what alternative we have. Book value accounting would be a joke. The term “mark-to-model,” where you estimate the value of a security based on a mathematical model, is an epithet. But maybe if the model has been properly audited, that’s a better intermediate approach. It sounds to me as though Isaac’s complaint about Basel II is that the capital requirements are sort of mark-to-model. So I don’t think he would support mark-to-model accounting.
As to short selling, I am not buying. Perhaps I’m selling the argument short. Read Isaac and decide for yourself.
3. I think that the most over-rated alleged villains are short-sellers and bond rating agencies. I wrote an op-ed for the New York Times on the rating agencies just the other day. You will note, however, that the link takes you to a page on my site. A guy from the Times emailed me soliciting the op-ed. I asked him whether it would have an interesting enough punch line. He said yes. Then I wrote it and sent it to him. He then said, “you’re right. The punch line is too obvious.” So there you go. It’s not just the Times that jerks you around. I’ve had an op-ed sitting at the Wall Street Journal for five months on health care vouchers that they solicited and say that they just love. Anyway, read the op-ed on my site if you want to know the rating-agency story.
4. To me, the three big factors in the crisis are (a) low-down-payment mortgages, (b) the housing bubble, and (c) systemic risk from derivatives and Wall Street compensation incentives
Update: Mark Cuban writes,
Find me the one story where the headline is “CEO has to pay the company losses back for being an idiot” or ” Risky moves cost CEO his lifetime savings” or “Hedge fund manager gives back bonuses and exits with $1500 dollars a month severance”
Rightly or wrongly, my guess is we’ll be hearing a lot more of that rhetoric in the future.a. Without low-down-payment mortgages, you don’t get the housing bubble. The CEO of Freddie Mac, Richard Syron, got sacked. Good. Barney Frank, Syron’s chief sponsor, kept his job, and continues to push the idea of Freddie and Fannie taking their “profits” and using them to fund low-down-payment mortgages. I’m sorry to keep harping on Congressman Frank. He didn’t cause the whole crisis, or if he did he didn’t mean to. It’s just that markets learn from their mistakes, and he doesn’t.
The guys who got it right on low-down-payment mortgage are the Freddie Mac folks that Syron ignored. (There has got to be a siren-Syron pun in their somewhere, but I’m missing it.) See my chapter or the New York Times story.
In fact, I would nominate Freddie Mac’s former Chief Risk Officer, Dave Andrukonis, to head the new Resolution Trust thingy. There are a lot of outstanding Freddie Mac employees who would work for Dave in a minute, and they know mortgage credit risk inside-out.
b. The housing bubble was a bubble. I give props (what are props? I have no idea. I just know it’s a cool thing to say) to Dean Baker, Paul Krugman, and Bob Shiller for calling it. I don’t come off so well. In 2004, I wrote,
If you are worried about house prices being too high, and you would like to hedge or speculate against this, keep in mind that the bubble is more likely to be in interest rates than in house prices. Therefore, if you were to short Treasury bond futures, you probably will earn a profit in almost any scenario in which house prices decline, because a drop in bond prices (increase in interest rates) will almost certainly be necessary to trigger any major setback for home prices.
Now, that was June of 2004, and the last upward lurch of home prices took place afterward. But in thinking that it would take a rise in interest rates to put a damper on home prices, I was clearly wrong.
I still think we’re in an interest rate bubble, by which I mean that rates on Treasuries are unsustainably low. But, based on my track record, you’ve got to be skeptical.
c. Systemic risk caused by derivatives and bad incentives. Derivatives are sort of like private bets that shift risk around. You buy a junk bond, but then you go to AIG and buy insurance that if the junk bond defaults, AIG will buy the bond from you at its face value. That’s one example of a derivative.
For an individual firm, derivatives make a lot of sense. You get to focus on your business and unload unnecessary risk. For example, I’ve said a couple of times that oil companies should not forecast oil prices. Instead, they should explore for oil whenever the futures price is high enough to justify the investment, and sell futures contracts to hedge their risk.
For the market as a whole, derivatives are more problematic. The problem is that, in Talebian terms, risk is a predatory animal that seeks out the weakest victim. There’s kind of a law of conservation of stupidity at work. Derivatives make the best money managers smarter and the worst money managers dumber. Taleb himself thinks that even the smart money managers fool themselves and become over-confident. In any case, this is a tough problem, and I’m not sure what to do about it.
The incentives on Wall Street were a big problem. If you made $X in profits a year for seven years and lose $10X in the eighth year, you got to keep all your compensation for the first seven years, and then maybe you lost your job. But, as Bob Samuelson put it, “Wall Street as we know it is kaput.” The adverse incentive problem may re-emerge somewhere else, in some other form, but it’s not a barn door we need to close now.