Dorothea Lange's portrait of destitute California pea picker mother and children during the Great Depression.
The U.S. and the global economy, except for a few isolated places, is in a world of hurt, the worst since the Great Depression. The good news — and a really important part of the solution — is that officials around the world (now including the U.S. Congress, who have been until recently largely on the sidelines) are not in denial about the imminent threat. Their cooperation and decisive action is not all that’s needed, but it is nevertheless critical to success.
As you know from Flirting With Disaster, psychological denial is an all too common response to risk. As in this case, it often takes of form of refusing to accept the magnitude of the potential catastrophe, or ignoring the signals of danger, a justifiable criticism of various financial leaders such as Alan Greenspan, who were concerned, to be sure, just not concerned enough to change the status quo.
Denial is a far more commonplace and powerful a motivator than we typically acknowledge, since it affects our perceptions of our own weaknesses as well as our views about our contribution to things that go wrong. As a result, most of us find it easy to avoid responsibility by blaming others, and we find it very difficult to learn from our mistakes. There is a lot of finger pointing going on now, and we should expect that it will get more intense as time passes — it is a lot more satisfying to blame people than systems.
To break through such denial and precipitate decisive action, it usually takes a full blown catastrophe. We are truly fortunate that the economy is not in a far deeper crisis, as bad as things are at the moment.
Ben Bernanke, Chairman of the U.S. Federal Reserve
One reason we may have been saved from disaster is that many of the current financial policy-makers have been through the S&L debacle, 1987’s Black Monday, the 1990s Asian financial crisis, the 1998 Russian bond default, and the collapse of Long Term Capital Management. Ben Bernanke, chairman of the Federal Reserve and the brains behind the current corrective strategy, is an expert on the mistakes of the Great Depression and Japan’s 1990s property market collapse. Together, the U.S. financial leadership knows all too well how bad things will get if the current crisis is not stemmed, and they have not minced any words with the U.S. politicians about how serious the current situation really is.
The bad news, however, is that in spite of considerable wisdom and a clear bias for action, human beings are generally pretty terrible at understanding the nasty nature of complex, non-linear systems, like the behavior of the financial markets. I don’t want to turn this post into a technical treatise, since I discuss these topics in FWD and on my web site, but the tightly integrated, derivative-based, global financial system simply does not behave the way many policy-makers, financial gurus, and Wall Street titans often imagine. Deregulated derivatives and the frictionless globalization of financial markets, in particular, have created surprising instabilities and massive world-wide risk. It is entirely fair to say that we do not really understand extreme market behavior, periods characterized by a volatile mix of widespread fear, economic reality, and radical government intervention that unpredictably rewrites the rules of the game in mid-play.
The late Fischer Black, co-creator of the Black-Scholes-Merton options pricing model that arguably created the modern world of derivatives nearly forty years ago, worried greatly about the departure of financial models from reality. But Black was often a lone voice, and other financial gurus and their minions that populate today’s financial centers often behave as if they can price products accurately, mark them to market effectively, and accurately quantify the money at risk if events turn against them.
Fortunately, most of the time they get things right, but sometimes they are spectacularly and catastrophically wrong. In the current case, being wrong might mean precipitating a global economic disaster of previously unseen magnitude and duration. This is not hyperbole, it is simply a statement that no one really knows how close we are to the precipice, how deep is the abyss, and how long it might take to climb out if we slip. We are, as has now been publicly acknowledged, in uncharted territory. Fortunately, no one in a responsible position appears to think that this is a risk worth taking, and we must be very thankful for that.
Of course, courting danger and dangerous excesses are not unusual in the case of new technology (which is what derivatives are), as MIT professor Nancy Leveson makes clear in her insightful discussion of steam power during its early days. What is different in this case is the emergence of realistic systemic risk. Unlike an exploding steam engine on a new freighter, the likelihood that a failure in one part of the financial system could uncontrollably propagate to create a global catastrophe in the same way that a local rock slide can, under certain conditions, precipitate an avalanche. Although the world is actually no stranger to financial crises preceded by a run up of asset prices and mountains of debt, today’s risks appear to be a new development in the global financial system.
I should also remind you that the current crisis fits the characteristics of a “normal accident,” the term coined by Yale sociologist Charles Perrow, who cites high interdependence and the “tight coupling” of the system’s parts as the worrisome preconditions because they can lead to crises that are quickly “overtaken by events.” This is exactly the situation we have created in global finance, but the irony is that many features of this system, such as Value at Risk measures, mark-to-market rules, and credit default swaps, were created to reduce risk. As we have learned to our horror, however, these powerful tools are swords that cut both ways, and it is now clear that we are in the path of the back stroke.
One of the questions that many people are asking is “How come no one saw this coming?”
Brooksley Born, Chair of the CFTC, 1996-1999.
To give credit to the experts, some of the technical financial literature was far more honest about the current state of knowledge and risk than the marketing materials issued by the investment firms. In addition, Brooksley Born, head of the U.S. Commodity Futures Trading Commission (CFTC) issued a stern warning about derivatives in a 1997 speech to the New York State Bar Association. She presciently claimed that the proposed deregulatory legislation — eventually enshrined in the Commodity Futures Modernization Act of 2000 or CFMA — would allow trading “to operate in a lawless environment, completely free from government oversight or market regulation.”
Neither the 1998 collapse of Long Term Capital Management or that of Enron in 2001, both of which revealed large scale risks related to derivatives, did much more than generate heated arguments pro and con greater regulation. The CFMA was, in fact, the result of a considerable lobbying effort by the financial industry as well as a follow-on to the hundreds of millions spent in lobbying and campaign contributions that had resulted in the 1999 Gramm-Leach-Bliley Act that dismantled Glass-Steagall, the 1930s legislation that had separated banking from Wall Street from insurance.
After derivatives were, for all intents and purposes, completely deregulated by the CFMA, the Bank of International Settlements issued a worrying 2003 report that identified growing systemic risk as a result of derivative products, and by 2006 — even prior to falling house prices (see graph below) — it was clear to some that subprime mortgages represented a serious threat to the financial system as a whole. But greed and denial continued to dominate short term actions, and toxic mortgage-backed products continued to be flogged and no corrective actions were taken in spite of the worries. This is not that surprising since there was virtually no regulation, and the strong free market ideology of the Bush White House and Wall Street combined with considerable financial incentives to dampen any interest in revisiting the issue.
Beyond this, one more factor was the tremendously powerful psychological force. It goes by the curious name of “moral hazard.” Simply stated, moral hazard reflects the tendency of people to take less prudent care if they believe that they won’t have to bear the full consequences of their risk-taking. It shows up in subprime crisis in four diabolical ways.
The first bit of nastiness flows from “securitization,” the bundling of groups of mortgage loans (or other assets) that are then sold like traditional bonds. While securitization is not inherently bad — in fact it is an important financial tool to move risk from a party that has too much of a particular type to someone who would like to assume that risk in order to get its return. The problem in the subprime case arises from the erosion of standard financial prudence during the loan underwriting process. The psychology is simple: if the originating mortgage company does not have to take financial responsibility for repayment (they make their money “up front” from fees and then sell rather than hold the mortgages they originate), they do not have to be that concerned about the quality of the borrower.
In consequence, many unregulated mortgage companies made large numbers of imprudent, arguably irresponsible loans that had a far lower probability of being repaid — especially under untested adverse conditions — than the historical averages suggested. This imprudent underwriting is ultimately the root cause of the current crisis. It was also one of the few areas in which the Fed could have intervened within existing regulations.
While the bet (and the sales pitch) was that rising home prices would allow the risky subprime borrower’s mortgage to be restructured, thus avoiding default, it was clear to many that such refinancings (and rising housing prices) could not go on forever. While this was not a problem for many mortgage originators — i.e., those who never planned to hold the mortgages — it was a problem for the buyers of the securities which depended on those mortgages, although they did not realize it at the time because they were told by the credit rating agencies (CRAs) that the fancy bond-like securities being sold were “investment grade”.
The second part of the moral hazard problem, therefore, was the cooperation of Moody’s, Standard & Poors and Fitch, in particular, in the securitization of structured mortgage-backed products. For reasons that are still unclear, but have been linked by some observers to conflicts of interest between the CRAs’ commercial objectives and their role as independent risk assessors, these agencies were willing to rate subprime mortgage-based assets as investment grade, even though they were composed of risky subprime mortgages or other derivative products based on such mortgages.
This counter-intuitive vote of confidence was based upon the elaborate structure of the mortgage-backed products which, according to the rating agency’s mathematical models and the historical default rates they used, created the statistical likelihood of financial performance emulating that of many traditional corporate bonds. One can easily imagine that with the rating agency’s stamp of approval, institutional and well-healed private investors thought that they were making safe and prudent investments, especially since the same bond rating nomenclature was used to categorize these new structured products as had been used to rate traditional corporate bonds. (Note that both enhanced returns and common rating labels were exactly what the institutional investors wanted, since regular corporate bonds had very low yields during this period, and there was commercial pressure to improve performance.)
It might be reasonable to say, therefore, that if the credit rating agencies didn’t “rob the bank,” they certainly “drove the getaway car,” albeit in what appears to be a perfectly legal manner. They were often deeply involved in the structuring of the new products (from which they extracted a sizable portion of their total revenues), and it is clear that many institutional investors lacked either the expertise or the information to evaluate the risks of the new products on their own. To make matters worse, it appears that the CRAs did not aggressively seek detailed financial information from the issuers about mortgage borrowers or current home prices that might have provided better insight about the changing likelihood of default as conditions evolved. Furthermore, while the CRAs did provide an additional range of advisory services to institutional investors on the quality of the derivative-based assets they owned, they neither comprehensively re-rated them, nor fully assessed the magnitude of the potential losses as circumstances changed and rating methods improved.
Of course, there was still some residual risk, and it demanded capital reserves from the buyers. This brings us to credit default swaps (CDSs), the third moral hazard contributor. Basically, a CDS is a derivative, a contractual form of insurance protection that pays off if a loan, bond or complex securitized product loses money because of defaults. It is easy to see that owning such insurance would let you sleep more soundly if the securities you had bought ultimately rested on loans made to people with questionable credit histories and uncertain employment — i.e., the sub-prime borrower. (It’s worth noting that since the new securities paid such good rates of return, it appeared to remain a good deal even considering the additional cost of insurance.)
It is important to recognize that while the risks from mortgage defaults had to go somewhere (I like to think of this as the “conservation of risk,” not unlike the conservation of matter and energy), this fact did not bother most investors. They were, after all, holding an “investment grade” security and an insurance policy — “belts and braces,” as they say. However, beyond an obvious concern about their individual holdings, investors were largely unaware of — and perhaps unconcerned about — the collective risk that was building up as the total amount of risky mortgages, derivative products based upon them, and CDS-based insurance ballooned astronomically in the marketplace. This shared risk is an example of the “tragedy of the commons” in which rational individual action can lead to lower prosperity for all.
But let’s examine this from the investor’s point of view: In order to appreciate this larger risk, they would have had to believe that historical default rates were going to change, that the rating agencies didn’t know what they were doing (or were colluding with the issuers), and that the insurance they had purchased (often from very large, well known firms like AIG) would not pay off. For most investors, such circumstances were simply unthinkable, or at least of exceedingly low probability. They were, in fact, both irresponsible and in denial — but perhaps understandably so in light of the dramatic increase in complexity of these new products and the changing nature of the marketplace that derivatives had wrought.
The final element of the moral hazard problem was a belief that the U.S. government would not allow large financial institutions to collapse, even if they got into trouble by their own hand. This is often described as “too big or important to fail,” and there was no reason to doubt the existence of such a safety net since bailouts, guarantees, and private sector arm-twisting have always been part of the U.S. economy, including the rescue of the S&Ls during the 1980s, and loans to Mexico during the 1994-95 peso crisis, and the Fed-orchestrated liquidation of Long Term Capital Management in the wake of the Russian bond default in 1998, to name but a few.
Of course, there was little thought of bailouts during the expansion phase of the housing bubble. Nevertheless, a government cushion has doubtless been a factor preventing internal corrective action by the banks or their counterparties when the first serious signs of trouble started. Based upon recent actions, assumptions of a government rescue were a pretty safe bet.
When the wheels came off
Case-Schiller Home Price Index 1987-2008
The housing bubble that had propelled house prices upward by over 10 percent in 2002 and by over 25 percent per year from 2004 to the middle of 2005 finally burst in August 2005. With its collapse, home sales slumped, and, with lower demand, house prices started to fall in 2007 for the first time since 1991.
Not surprisingly, the subprime industry collapsed in the first part of 2007, marked by the bankruptcy of New Century Financial, the largest U.S. subprime lender. By August, the crisis is in full swing, and many financial institutions reluctantly revealed that they had subprime mortgage backed securities in their portfolios. The damage spread to the UK in September with a very public bank run on Northern Rock Bank followed by the British government’s takeover of the institution. The collapse was triggered by credit problems related to subprime.
In 2008, things have gotten much worse after a period of relative calm. In March, Bear Stearns — a major player in the subprime market — was acquired to avoid bankruptcy in a government guaranteed fire sale. In September, in rapid succession, the federal government took over Fannie Mae and Freddie Mac, massive players in the U.S. mortgage market; Merrill Lynch was sold to Bank of America; Lehman Brothers collapsed when unable to secure financing; and giant insurer and sub-prime CDS issuer AIG was effectively nationalized by way of an $85 billion dollar federal loan that effectively transferred 80 percent of the firm’s equity to the government.
What’s next, and what happens after that?
The capacity for denial is so great, self-interest so powerful, and the dominance of linear short-term thinking so pervasive that for quite a while many leaders believed that things could be fixed with the usual tinkering and modest funds. Such reasoning is often correct because the self-correcting behavior of financial markets are reinforced by many overlapping forces.
Sometimes, however, such complex systems become fundamentally altered by deliberate changes, or they are simply pushed into a new state in a transformation that physicists call a “phase change.” Mixing iron with the right other elements can dramatically transform it into stainless steel, and no one would think that water below 32 degrees F behaves the same way it does when it is warmer. In an analogous way, unregulated derivatives, the tightly bound global counterparty network, and mark-to-market rules have altered global finance at a fundamental level, not just superficially. While day-to-day business appears to be much the same as before, the system itself is very different than it was even a decade ago.
Despite the efficiencies and greater robustness celebrated by free market advocates, global finance is capable of catastrophically dangerous modes of behavior. Never before, for example, do we face trillions of dollars of financial products so complex that they cannot be easily valued, or have we seen a freezing up of credit on a global scale despite a world awash with cash, or the need to raise a total of nearly a trillion dollars to fund the U.S. bailout, yet have no idea whether it will be too much or not enough. Like global terrorism, this is a different class of problem than we have previously faced, even if many of its elements have been around for decades.
Going forward, therefore, we must tackle two quite different challenges, both enormously difficult. First, we will need to bail ourselves out of the mess we have made. This will take sound judgment, political cooperation, and an unprecedented amount of public money in combination with leadership capable of standing up to the vested interests that have already started to lobby to shift the cost of their mistakes to the taxpayers. Don’t think for a moment that finding a solution will be easy, that we can’t screw it up, or that our best efforts will necessarily work. There are simply no guarantees.
Particularly vexing is the valuation of the assets to be bought under the current bailout proposal. With the economy largely frozen and mortgage defaults rising, many of these assets are worth little (even assuming that they can be valued at all under these conditions), but if the bailout works, economic conditions will improve and foreclosures will fall, making the assets worth more. Such “widening spreads” between buyers and sellers is a generic characteristic of illiquid markets, but in the absence of trading there are no guidelines to establish rational prices.
Even more problematic is sharing the cost of past mistakes with the executives and shareholders of the companies participating in the bailout. Some critics have argued that equity in these firms should accompany any asset purchases. Further, that the responsible parties should not benefit in any way from the rescue. While this may be equitable, and despite considerable support, it may yet prove to be a hard sell that may dangerously delay implementation.
Second, we will have to redesign the regulatory system and market structure to deal with finance’s new reality, a reality that we have failed to recognize is as dangerous as it is a powerful engine for growth. The Black-Scholes-Merton formula has become for finance what E = mc2 was to physics: the gateway to the atom bomb as well as to nuclear power and a deeper understanding of the universe.
When we redesign banking and the markets and the rules they both live by, I hope we are sufficiently humbled by the fact that we very nearly blew ourselves up. Next time, we may not be as lucky — although this seems to be a lesson humankind never seems to learn.