Relevant and even prescient commentary on news, politics and the economy.

Predatory borrowing

I have pulled two quotes from comments from a reader that state a view that might not occur to us. They are out of context, but I think might have some discussion value about perspectives. The first appears to stem from some of Greenspan’s ideas in a post on OCC regulation and state regulation. The thought was the risk was not recognized by anyone important enough to sound a real warning.

There are tons of regulation and oversight of the financial industry. There were no warnings, new regs, nothing, zero, zip from them regarding the mortgage crises except deer-in-the-headlights until it was too late. They were as oblivious as the bankers and the homebuyers were.

On the OCC post, an interesting view about responsibility was also stated.

The states’ original beef with subprime was that it was unfair to the consumer or “predatory lending.” Since subprime mortgage providers are almost all bankrupt, it was really the subprime customer that fleeced the mortgage investors.

Implications then are that policies of banks red lining were a spur to de-regulation? Or that predatory borrowers caused the crash?

Rdan here. Many of us have little snippets of thought that are basic to points of view and are not ‘rational’ in long thought out treatises, but gut level reaction sometimes too quick for examination. I myself have to be careful of “authority and abuse of power” situations, private or public.

But then the last comment was lost in the shuffle I believe. The key at least for this blog: The basic perception that markets invariably create optimized results over time was shaken. It was a small statement, and simple, but I came back to it later and was struck how powerful it actually was for the reader.

Markets and trade involves mutual benefit and mutual aid as a fundamental driver of behavior in the big picture of why we trade. Why else would we trade? Personal and cohort gain is part of the story, but so is mutual benefit and aid. This notion is fundamental to society.

If one takes the notion that a market has no morality but somehow is truth, then that market self-destructs. Our notions of fairness probably are quite wide, but I suspect if we let ourselves be involved in the process of markets with a sense of some sort of fairness and mutual benefit, the pie would be more willingly shared. But the first step often is not an economic decision as we define economics today.

Update: Minor edits to syntax and punctuation.

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One Ring, to rule them all

The Chicago Tribune carries this story:

New Orleans – If you think the prescription drug you took for headaches caused your heart attack, the Food and Drug Administration says you can’t sue the maker for injury if it met agency standards.
The Consumer Product Safety Commission says you can’t sue a mattress maker if your mattress bursts into flame despite meeting CPSC standards. Companies making sport utility vehicles would get similar protection from suits brought by people injured or the families of those killed in rollovers under National Highway Traffic Safety Administration proposals for stronger roofs.

Plaintiffs’ attorneys call it “silent tort reform.” But it’s part of tension existing since the nation’s founding: conflict between state and federal law.

If they clash, state laws give way. That’s in Article Six of the Constitution. But in areas where there is no federal law, federal courts must defer to laws of the state where a lawsuit is heard. That includes product liability.

A developing body of judicial opinion could place new limits on the rights of those who buy or use products, consumer advocates say. It also could mean the savings of billions of dollars by companies insulated from lawsuits.

What’s riling plaintiffs’ lawyers, consumer groups and some regulators is agencies’ assertions their rules override state product liability laws. Most such claims are rooted in statements in the introductions to their rules, not the rules themselves.

“These pre-emption preambles may be only the beginning,” New York University law professor Catherine Sharkey wrote in the DePaul Law Review. She projected preambles may “displace competing or conflicting state regulations or common law as a matter of course.”

We have seen how the OCC has pre-empted financial regulation from states through administrative action without much discussion. Devices have been pre-empted from the injury lawsuit as well.

Now, is this giving new meaning to the word captured, and what is being captured? And what words describe the process? And are other areas of life be captured in similar fashion?

And we are shrinking their resources?

Update: The real issue here is the stealth issue, massive changes without public discussion. I would have as much concern if federal law was torn to shreds by “states rights” advocates. My assumption is the issue is used to screen and confuse the real interests behind the push, which usually is public policy and needs lights and transparency before the impact is felt that the changes cause, and then forced into the open, for “good” or “bad”. The second issue is what the changes are about, which at least is debated in the examples in comments. The rather glib “sue the FDA” answer turns our current system on its head.

The shutting down of court redress for product liability is huge whether you think it should be changed or not. The strangling of a regulatory agencies resources to provide reasonable assurances of safety and that provides a shield for product liabilities, intended or not, creates far reaching impacts on our legal system.

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45 trillion credit swap market…how big is that?


The ABX.HE index, which is based on credit default swaps on different tranches of subprime mortgage-backed securities. (Federal Reserve Bank of Cleveland)

Hat tip to Jim Satterfield for this link to Marketplace public radio. Bob Moon is the Senior Business Correspondent.

MOON: OK, I’m about to unload some numbers on you here, so I’ll speak slowly so you can follow this.

The value of the entire U.S. Treasuries market: $4.5 trillion.

The value of the entire mortgage market: $7 trillion.

The size of the U.S. stock market: $22 trillion.

OK, you ready?

The size of the credit default swap market last year: $45 trillion.

RYSSDAL: OK, I’m with you, but let me ask you this. We just had the secretary of the Treasury yesterday with a big policy announcement. If these things are so bad, what’s being done about it?

MOON: The irony here is that the former Fed Chairman Alan Greenspan, a couple of years ago he called credit default swaps “probably the most important instrument in finance,” because they were supposed to spread risk around and stabilize the market. Well, critics now say that they’ve had exactly the opposite effect. One of the leading critics of these things is Christopher Whalen. He’s an expert on financial risk at Institutional Risk Analytics. And he told me that this is nothing more than government-guaranteed gambling:

CHRISTOPHER WHALEN: They are the most hideous kind of speculation. To have a federally insured bank like JPMorgan as the largest dealer in this market, to me says we don’t know what we’re doing anymore, and we don’t understand the difference between real work — real economic activity — and something that’s essentially wasting.

MOON: And Whalen points out that Bear Stearns had more than $2.5 trillion in credit default swaps. He suspects that that’s why JPMorgan came to the rescue, so it didn’t get pulled down.

Update: Do you know what notational means? Comments are a must read.

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Sallie Mae couldn’t have predicted…Model Validation Part 3


Higher Ed Watch reports on Sallie Mae:

Last week, we wrote that Sallie Mae and its promoters on Wall Street claim the company was “blind-sided” by the rising default and delinquency rates on subprime private loans it made to low-income and working class students at poor performing higher education trade schools. It’s a convenient argument considering that the loan giant is facing at least one, and possibly several, class action lawsuits by angry shareholders who accuse the company of deliberately misleading them about the amount of risk it was assuming. But the argument is disingenuous at best.
Financial analysts have long raised red flags about Sallie Mae’s private lending practices. During earnings calls and at shareholder meetings and investment conferences, analysts regularly peppered Sallie Mae officials with questions about whether the company, which is used to having government backing on its loans, had the expertise needed to assess the risks associated with lending unsecured, private loan debt to financially-needy students.
….
In 2005, Fortune Magazine brought attention to the analysts’ worries in an article entitled, “When Sallie Met Wall Street.” That piece specifically raised concerns about the loan company’s dealings with schools owned by Career Education Corporation, which it noted had had been accused “in multiple lawsuits in several states of using hard-sell tactics to recruit students, promising them high-paying jobs that don’t materialize and leaving them with mountains of debt that they can’t pay off.”
The article’s author — Bethany McLean (who, by the way, helped break the Enron scandal) — proved prescient in predicting the predicament in which Sallie Mae now finds itself. McLean wrote:
[A] big question looms in Sallie Mae’s private credit business: How many students who take out these high-interest loans will end up defaulting? After all, private credits are basically unsecured loans to people without jobs. Sallie argues that there won’t be a problem. Each quarter it books a reserve for potential losses; at this time its loss on private credit loans in repayment are running at only 2.4%. Plus, Sallie says, almost half its private credit loans are guaranteed by a parent.
But because private credit is a new business and because students are taking on unprecedented levels of debt, there are no historical measurements by which to gauge potential defaults. As Sallie’s financials note, “the provision for loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes.” And the current low delinquency rate may be misleading, because as of the end of 2004 nearly half the students to whom Sallie has lent private money hadn’t left school yet.

Lots of financials are changing.

Update: PGL posted on Student loans and default risk in January, 2007.

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Bank risk models and regulation

Here is Avinash Persaud, writing on Willem Buiter’s blog, with his take on the problem:

Why Bank Risk Models Failed and the Implications for what Policy Makers Have to Do Now, by Avinash D. Persaud: Sir Alan Greenspan, and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.

The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed … by Harry Markovitz and George Dantzig. …

In today’s flat world, market participants from Argentina to New Zealand have the same data on the risk, returns and correlation of financial instruments and use standard optimization models, which throw up the same portfolios to be favoured and those not to be. Market participants don’t stare helplessly at these results. They move into the favoured markets and out of the unfavoured. Enormous cross-border capital flows are unleashed. But under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. …

When a market participant’s risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues of vertical price falls prompting further selling. Liquidity vanishes down a black hole. …

Policy makers cannot claim to be surprised by all of this. The observation that market-sensitive risk models … were going to send the herd off the cliff edge was made soon after the last round of crises*. Many policy officials in charge today, responded then that these warnings were too extreme to be considered realistic.

This brings us to the philosophical problem of the reliance of supervisors on bank risk models. The reason we regulate markets over and above normal corporate law is that from time to time markets fail and these failings have devastating consequences. If the purpose of regulation is to avoid market failures, we cannot use … risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

In terms of solutions, there is only space to observe that if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse. This is the approach we have stumbled upon. Central bankers now consider mortgage-backed securities as collateral for their loans to banks. But the asymmetry of being a buyer of last resort without also being a seller of last resort during the unsustainable boom will only condemn us to cycles of instability.

The alternative is to try and avoid booms and crashes through regulatory and fiscal mechanisms designed to work against the incentives … for traders and investors to double up or more into something that the markets currently believe is a sure bet. This sounds fraught and policy makers are not as ambitious as they once were. …

Regulatory ambition should be set now, while the fear of the current crisis is fresh and not when the crisis is over and the seat belts are working again.

Another good angle on models and validation. Incentives count too.

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Angry Bear on the rise

Angry Bear has been steadily increasing its readership, but in the last three months especially has seen a significant rise in visits. For the first time ever we had over 100,000 visits in March, which is a milestone given that around 60,000 was common. (Real figures can be evaluated on the sitemeter. January saw 90,000, February saw 80,000).

Of course our friend Calculated Risk refers many to Angry Bear over several years, but I also want to especially give a hat-tip to Real Clear Markets for consistent reference to Angry Bear in their Off the Street section.

Salon-The Blog Report has carried Angry Bear posts consistently recently. Readers from Naked Capitalism have come by more often as well. Mark Thoma at Economist’s View carries posts from Angry Bear in the weekly links update, listed by author, but seems to be including more of our posts. Thank you.

I want to take the time to thank Calculated Risk and Real Clear Markets readers for their vote of confidence.

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21st century economics just starting

Mark Thoma carried a post on a piece The sting of poverty, by Drake Bennett, Boston Globe on a fresher look at the reasons poor people are ‘irrational’ in neo-liberal economic terms regarding diminishing returns of marginal utility.

Many familiar names are in the comments. It is a great start to bringing economic theory out of the limits of a mechanistic approach that purports to explain human behavior but includes little of any other science in explanation.

While the article looks at some kinds of decision making for the poor, I also will have other works and ideas about ‘fair’, ‘wealthy’, ‘rich’, and ‘value’, ‘responsibility’. I do know our pithy sayings just don’t describe much. So it is well worth going over.

That can be the first admission of some kinds of ignorance, and a chance to take another look into the more real world of humans and their apparent messiness.

Update:

[Charles] Karelis, a professor at George Washington University, has a simpler but far more radical argument to make: traditional economics just doesn’t apply to the poor.
When we’re poor, Karelis argues, our economic worldview is shaped by deprivation, and we see the world around us not in terms of goods to be consumed but as problems to be alleviated. This is where … bee stings come in: A person with one bee sting is highly motivated to get it treated. But a person with multiple bee stings does not have much incentive to get one sting treated, because the others will still throb. The … poorer one is … the less likely one is to do anything about any one problem. Poverty is less a matter of having few goods than having lots of problems.
Poverty and wealth, by this logic, don’t just fall along a continuum… They are instead fundamentally different experiences… At some point between the two, people stop thinking in terms of goods and start thinking in terms of problems, and that shift has enormous consequences. …

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