Sunday, November 23, 2008

Anatomy of Economic Disaster

Highlights of a really long read in Vanity Fair, whole article here, by Niall Ferguson. If you are into economics at all, it is a brilliant piece. If not, here are my highlights, and for what it's worth some comments.

Not so long ago, the dollar stood for a sum of gold, and bankers knew the people they lent to. The author charts the emergence of an abstract, even absurd world—call it Planet Finance—where mathematical models ignored both history and human nature, and value had no meaning.

In the intro, he outlines what he calls "Planet Finance" and where it came from, postulates that it is a dying planet, and then gives some history of banking.

Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.

This hunt for scapegoats is futile. To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. Only then will you see that we have all played a part in this latest sorry example of what the Victorian journalist Charles Mackay described in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.
Okay, but scapegoat hunting may be futile, but the criminal portion of this crisis HAS to be pursued.

Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that “great contraction” of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment.
True enough. And of course let us not forget that Wall Street fought every single regulation which (so far) has saved our repeating the 1930's Depression exactly. And furthermore, it shall be seen, this downturn was most likely spurred by excessive deregulation in the Bush mis-Administration.

Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000. Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent.
It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1.
so the confusion of economic activity for an economy is a natural one, but a false one. Money needs to have a basis of value, or it loses all value.

Discussing the roots of our current mess, is this interesting factoid...

Why did the Fed allow euphoria to run loose in the 1990s? Partly because Greenspan and his colleagues underestimated the momentum of the technology bubble; as early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak.
Funny. I have heard that 5k number bandied about by some as the true value of the current Dow. Is it possible? Could be that is the actual value of our money/economy intersection. If so, we still have some sledding to do. of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.
Oh boy. Real Estate. The joy. The road to riches. The American Dream. If bank profit were not in it, would we have it? Seriously, think about that.

Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character(in It's A Wonderful Life) knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
which brings us to derivatives.... wtf is a derivative? well, when I took econ some 30 years ago, it was hardly even mentioned in the books, so...

For a farmer planting a crop, nothing is more crucial than the future price it will fetch after it has been harvested and taken to market. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed upon when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected.
Okay, makes sense. We are betting on actual goods to be delivered here. So futures are derivatives and vice-versa. Fine, so we are betting on the return on investment of a said fund, mortgage, or bond then.

But how exactly do you price a derivative? What precisely is an option worth? The answers to those questions required a revolution in financial theory. From an academic point of view, what this revolution achieved was highly impressive. But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math.
Working closely with Fischer Black, of the consulting firm Arthur D. Little, M.I.T.’s Myron Scholes invented a groundbreaking new theory of pricing options, to which his colleague Robert Merton also contributed. (Scholes and Merton would share the 1997 Nobel Prize in economics.) They reasoned that a call option’s value depended on six variables: the current market price of the stock (S), the agreed future price at which the stock could be bought (L), the time until the expiration date of the option (t), the risk-free rate of return in the economy as a whole (r), the probability that the option will be exercised (N), and—the crucial variable—the expected volatility of the stock, i.e., the likely fluctuations of its price between the time of purchase and the expiration date (s).
or... and I am going to lose even the bravest soul here...

Uh huh. Frankly, although it won the 1997 Pulitzer Prize for Economics, seems like BS to me. And turns out, it is. It was based on a faulty assumption that there was only so much money which could be lost on a given day, which allowed huge loans to be made with minimal money on hand.

So, if all this played out the way it did... why did we have to suffer the mess we are in now? Simple. Greed.

The root of all evil, the love of money. Oldest story in the world.

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