Thursday, September 18, 2008


They were selling junk. They were selling it for lots of money. People were paying lots of money. They were borrowing to buy more and selling to borrow more. They could put down one dollar and borrow 30 more. For a while the junk was expensive. Then it was cheap. It was just junk again. And there was no end of the stuff.

In the Financial Times, Gillian Tett says the markets are disoriented. No they're not. They're soaking up all the public money in sight, revalidating their credit, and waiting to see what will run up next.

On Tuesday and Wednesday newspapers described the markets as "panicked." The Financial Times described investors' "flight to safety" (to bonds and gold) as the most acute since early in World War II. The information was already known, and the current pattern was predicted by the FT in August 2007, and by Warren Buffet in 2003. It is minefield investing, in which half the moves you make will blow you up. And you have no idea which moves those are.

The main thing that was lost was belief that all the structured investment vehicles weren't junk. They'll start believing again. On Wednesday the Dow lost more that 400 points. On Thursday it gained them all back again.

The political shock was the markets' need to be saved by governments. Rep. Barney Frank put it well: "this is one more affirmation that the lack of regulation has caused serious problems. That the private market screwed itself up and they need the government to come help them unscrew it.” Can we finally stop bowing to self-regulating markets?

Financially, the best summary of this week's trigger is John Gapper's:
The thing that frightened me was that Mr Paulson put up US government money when he so obviously did not want to. Having examined the heart of darkness – AIG’s $60bn book of derivatives written on other derivatives based on bad residential mortgages – his resolve crumbled.

Lord knows where this leaves us, since only He knows what a credit default swap (CDS) on a collateralised debt obligation (CDO) is worth.
Actually we do know where this leaves "us," that is, regular folks who work for cash. It leaves us without our play money, the stuff we used via stock run-ups in the 1990s and housing run-ups in the 2000s to supplement the real-money raises we weren't getting.

Causes and critiques are flying in every direction, so let's sort them out:

1. the markets were corrupted by the government. This is the argument that government guarantees, like those for mortgage-lenders Freddie Mac and Fannie Mac, allowed executives to take ridiculous risks without the market discipline of looming sudden death for big mistakes. Look for the phrase "moral hazard," a technical term from neo-classical economics that is being used even by financial journalists I respect, like John Authers.

2. the markets were corrupted by too little government. This was the meaning of Frank's comment above. Nearly everyone is calling for some kind of reregulation, as are both McCain and Obama. But nobody is saying what kind of regulation would have or will actually work.

Just to make things more confusing, most outfits are saying (1) and (2) at the same time. The FT is a good example, since it calls for more regulation while also calling for the end to government protection for financiers and, by implication, very few bailouts like the one for AIG.

It would be more accurate to say this:

3. The crisis was supposed to happen, because it follows from normal market incentives.

It works like this. Financial instruments have no intrinsic value. They are worth exactly what people are willing to pay for them. People paid what they think these things are worth. Some people made up new financial instruments with bizarre, complicated, arbitrary rules - Credit Default Swaps, whatever. If you land on Go, collect $200 dollars, unless you took more than seven rolls to go around the board and your last roll was a three, in which case you collect $200 minus the average of each of your 7 plus rolls. Other people made up stories about why this made sense, usually consisting of saying if prices go down you get paid something, and if they go up you win big. Still other people bought this stuff by the ton - pension and mutual fund managers, etc.

here's John Gapper again, but this time missing the point:
The word “irresponsible” does not begin to describe AIG’s behaviour. Like Bear, Lehman and others, it saw a way to get in on the growing action in mortgage-backed derivatives. Its bankers were soon earning huge fees for themselves and AIG by piling up unimaginable risks.

Call me a spoilsport, but I do not believe that AIG or any other capital markets institution should be allowed to play like that with my money (I am a US taxpayer) in future
OK, you can call them names, but that represses your knowledge that AIG's bankers were heroes and geniuses in their time, doing exactly what they were supposed to do - take risks and maximize shareholder value. Why is this arbitrary process with huge cuts for the players OK when prices go up but bad when they fall?

There's also the sucker's rationality to think about. After 9/11, the prime rate went to 1 percent. Stocks went sideways or down. Housing prices were going up. If you stayed in the market or in savings accounts, you were by definition economically stupid. Only a stupid person would get 1.5% a year when she could get ten times that. Everyone piled into houses. It was logical and rational. This made housing prices go up even more - helped by deliberate financial policies that kept interest rates low. Why stick with 1 percent instead of 10?

This is true for ordinary people, and also for financial professionals. If you stuck with low-risk instead of high, and 3.5% instead of 18, you wouldn't stay a financial professional for long. If you avoided leverage, you were a fool. I can't tell you how many university faculty I've heard complain about the University of California's low pension return by comparison to Yale's, without having any idea of the content of the private placements - the Structured Investment Deals, maybe the CDSs tied to CDOs - that Yale was using to get more than 20 percent.

All this talk of moral hazard etc avoids the nature of market rationality, which is herd instinct. The contrarians often do well, but they are few. Overall, "the trend is your friend." You buck the trend, you lose. You ride the trend, you win. Add in the stagnation of US wages and the conversion of traditional pensions to investment funds - 401(k), 403(b) - and the trend became your ONLY friend. Then throw in "mental hazard." This refers to the absence of actual knowledge about investment vehicles, e.g. what's in them. These vehicles had names and marketers, and it was all press releases, TV authorities, what I think this morning as opposed to yesterday afternoon. It's also proprietary investment models whose assumptions are not only too abstruse for most people, but deliberately, systematically, and legally veiled. They are models created by companies that profit from them. They are there to benefit me, but not to benefit you. Meaning that you, the regular investor, had to buy a model and stick it out to the end.

Which is where we are now, with widespread market failure and damage done. But market failure was happening all along, and never should have been left to themselves

Tax them properly, regulate them, bring them back into society. This will take lots of the profits out of them, but that would be good. We'd have more money back in the real economy.

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