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

McMegan, Discrimination, and Inappropriate Loans

Susan of Texas has an immortal post on the housing crisis, McMegan’s ratiocination, and the persistence of ignorant memes. The money quote:

McArdle doesn’t refute facts, she hen-pecks at the methods used to gather information. That way she doesn’t actually have to prove anything, she just casts enough aspersions on the data to confuse the issue. When source after source after source after source brings up a problem, dismissing it out of hand begins to look like bigotry and callous indifference instead of honest disagreement. [links from original]

Go Read the Whole Thing.*

(Cross-posted and expanded from Marginal Utility)

*Yes, rdan, this is another blog we’ve been keeping from you.

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Reverse Robin Hood applies to banks too

The next time someone tells you that “the banks need help,” just refer them to Barry Ritholtz:

Talk about burying the lead: The Times also noted — in the very last paragraphs — how the big incompetent banks and their very pricey bailouts are screwing these small healthy banks:

“Isn’t that the American way?” [Donald E. Goetz, the president of DeMotte State Bank] says, folding his arms. “Whoever is left standing, whoever was prudent, is always the one who has to pick up the pieces.”

The Geithner Put: making American banking worse, little by little and piece by piece.

Which means, Brad, that the total cost of the bailout will be higher than it would be if we just pulled some plugs now.

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Back-of-the-Envelope: Making Sense of TARP

Suppose I told you that there was a crisis with a stock, say, GE. That the price of the stock had dropped around 75% in the past year. And you responded, “But the problem is solved; the prices of long-term Call Options (say, the January 2011 20s) has gone up, as has their Open Interest.

You will (rightly) point out that this won’t revitalise the assets themselves and I will (rightly) note that option markets rather saved the equity markets in 1987, for instance. You will note that I am too optimistic, and I will agree, holding up a Brad DeLong mask (since I’d rather have DeLong’s [relative to mine] abundant hair than Geithner’s abundant forehead).

Then I will drop the other shoe and say that the toxic (“legacy”) assets should be priced as if the Fed-supported trades were options, with the underlying current price worked out by Black-Scholes. (As I’ve noted before, B-S is specifically INappropriate for this exercise, as it will overvalue the option. And therefore anyone suggesting the toxic [“legacy”] assets should be priced—or carried on their books—at a level higher than that model will clearly be insane.)

Ladies and Gentlemen, welcome to The TARP Solution. Details beneath the fold.

TARP is the Treasury Department’s attempt to confront two realities: (1) it isn’t a “market” in any reasonable sense of the word if the Fed is putting up 85% of the cash. (People who tell us that this means firms are committing a “large amount” to the process either do not understand the English language,or are hedge fund managers trying to sell something.) So let’s put some random numbers together.

Those “legacy” assets are trading in the market around 30. The Big C and others are carrying them on their books around 80. Several people who should know better (Summers, Geithner, DeLong) have conflated “the market is underpricing the assets” with “the true price of the assets will make the banks solvent again.”*

So we know three things. (1) People are willing to pay 30% of their own money to buy these assets, (2) the Fed is only requiring them to pay 15%, and (3) the fair value is between 30 (the current market price) and 80, and probably closer to the former than the later.

So again, using back-of-the-envelope principles, let’s pretend that we think the recovery will be soon, that the defaults will slow (or at least that resales will be quick and frictionless), and that the market reaches that consensus quickly. And so fair value should be around 50.**

So let’s say the Fed offers to buy a MBS for 50. How, as an investor, do I make money off this? Three possible ways:

  1. If I own securities for which I paid
  2. If I own securities for which I paid >50, and which I cannot sell for 50 without revealing myself to be insolvent, I buy securities at 50 along with the Fed and “average in.” (This is the “how to stay solvent longer than the market can be rational” act.)
  3. If the Fed is buying securities at 50 so that I can no longer buy them at 30—I buy a LONG-dated Call Option on the security.

It is that last that explains TARP. Effectively, the co-investors with the Fed will be buying a Call option at 7.5 on the security at 50.***

Of course, it may not be an at-the-money Call option. More likely, the hedge fund effectively will be buying an out-of-the-money option (say, a 49.5 Call for 8) where some portion of the purchase is put up by the government.

Now you will note that, technically, TARP requires the hedge fund to buy the asset. So you might argue that this is not an option. But let’s look at the generic payoff diagram to the hedge fund of the two scenarios.

Amazingly, you can’t tell the difference on the payoff diagram as the security gains.**** In both cases, the hedge fund manager has just gone long volatility.

Expect that to have a ripple effect—I’m guessing dampening, cet. par.—on other option volatility trades.

All that is left is to back out what actual value of the security was assumed by the hedge fund when they bought the option. Which I will also leave as an exercise to the reader, while suggesting that a fair indication is min[x, TotalFedContribution] s.t. x a.s. approaches TotalFedContribution.

Will this bring the markets back, or make bank balance sheets more stable? I’m still saying “No,” and hoping to be proved wrong.

But what it should do is reduce volatility buying, especially in the other debt markets, for the foreseeable future. So if any of those Bankrupt “legacy asset constrained” institutions has a long volatility position, there will be even more “Unintended Consequences.”

*In fairness to Brad DeLong, I don’t believe he believes this. As Dr. Black noted, George Voinovich “wants to see a pile of money in flames before he’s willing to vote for what’s necessary,” and DeLong therefore sees this as a necessary evil. Having seen no evidence from the Obama Administration that they Have a Clue, I am naturally suspicious that this particular idiocy will do anything other than waste time and money—both of which are in increasingly short supply—but, since Larry Summers has shown his brilliant foresight before and clear has no skin in the game, I am reassured that there is no Principal-Agent problem at work here, as they was when Christopher “I never saw a regulation I like” Cox was named head of the SEC by the Previous Administration.

**While we’re at it, can we pretend that Amber Benson will be my next wife, which is probably very little less likely than those other possibilities (especially since I’m already married to an sf-writing actress/director)? (Amazingly, even without those conditions, we would be using a BotE number of 50: though there is a legitimate argument that 60 would be easier to work with, I’m assuming no one is that stupid.)

***This is why 60 would have been easier; 15% of 60 is 9, so I wouldn’t have to pay attention to decimal places. 40 would also have been easier—and both certainly more realistic than 60 and arguably more realistic than 50, but I want to maintain the pretense of the U.S. Treasury that this is a liquidity, not a solvency, crisis. (They’re wrong, but it’s their game.)

****The reason we can tell the difference on the losses is the possibility that the hedge fund treats the position as if it were an in-the-money Call option for which the Fed paid the in-the-money portion; the real returns to the hedge fund of the position in a TARP security are the same in both cases; there would be differences in the way the rest of the portfolio was managed, though, which are left as an exercise to the reader.

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Miami Vice

Reality (h/t Dr. Black):

In certain ZIP codes in places like Homestead and Florida City, around 25 percent of the homes are in one stage of foreclosure or another. Countless others were built by developers and sit vacant in ghostly subdivisions, with not a buyer in sight.

In the days after Andrew, then-Dade County Emergency Management Director Kate Hale famously said on national TV: ”Where the hell is the cavalry on this one?”

The same could be asked now, in this new disaster. People in south Miami-Dade — just like people in foreclosure-strewn cities across the nation — are wondering: How did we get here?

Fantasy (via The Sports Law Blog):

The stadium did undergo some renovations in 1999 to make it more baseball-friendly, but the Marlins have been drawing low attendance figures. The Marlins averaged 16,688 fans last year, their third straight season averaging under 17,000 per home contest.

As Marc Edelman notes at the link above:

Last year, the Marlins team payroll was just $22 million…by far the lowest in the league. Rather than investing in their own team, Marlins President David Samson often used the threat of keeping a low payroll as part of his strategy in demanding public subsidies.

Miami-Dsde officials, as those from Montreal know well, must be really stupid if they think Jeffrey Loria is going to invest in making the team competitive just because they just wrote him a Very Large Check. Then again, maybe they figure one more vacant property won’t make a difference.

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Dear Brad and Mark (et al.)

This is why we don’t believe the bailout will work the way you think it will (i.e., to increase lending):

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

Instead of using the bailout monies to lend, or even make their balance sheets more creditworthy, the firms have been doubling-down on the assumption that they will be fellated by Timmeh and Larry. (At least Bill Gross and PIMCO (h/t Robert) did it when there was still a chance of sane monetary policy.)

I take back part of what I said earlier: this isn’t comparable to hitting on 17 because you’re drunk; it’s hitting on 19 because you’re desperate and insane. As Barry R. closes:

If anything, this argues against bailouts and in favor of nationalization, firing management, wiping out S/Hs, zeroing out debt, haircutting bond holders, etc.

Some economists may need to spend less time reviewing brilliant analysis from Barry Eichengreen (link is to PDF) and more reviewing Friedman and Savage (link is to PDF) in the context of principal-agent problems.

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Thought-Experiment: Assets and Securities

Ken Houghton

wants to sidebar today into looking at the general application and implications of an Accounting Identity:

Assets = Liabilities + Equity (A=L+E, or the ALE Rule).

Let us assume that, since the housing bubble burst, I believe that my house has fallen in value by too much. I would understand a 20% decline, but the “market price” that the experts (realtors) tell me I can get is 40% below the price of the last “comparable sale” (a smaller house in perfect condition).

But there are ancillary factors—proximity to NYC, good public transit infrastructure, good schools, convenience to the airport and major roadways—that I believe the market is undervaluing. So I “carry” the house in Quicken at 80% of the last sale.

Since I refinanced a couple of years ago, someone out there owns the Mortgage-Backed Security that was formed from that refi. Let us pretend it is Citibank, who are carrying that security on their books at 80, even though the last similar trade in the market was 60.

I think you can see where this is going.

So along comes the U.S. Treasury to “fix” the crisis and Get Banks Lending Again. (Apparently, they can’t lend because the market values their assets as being less than their liabilities plus their equity.)

In doing so, the Treasury will supply so random number—say, 85%—of the capital required so that a Private Investor can swoop in and Save Citibank’s Securities, by buying them “closer to their real value.”

So the Private Investor says, “Yo, Big C! I see you own the MBS that covers Ken’s house. Even now, his house is worth more than he owes on it, so I want to buy that security from you.”

Big C says, “I’m carrying that security on the books at 80. And there are a few billion others just like it.”

Private Investor: “Well, the market says all those securities are worth 60.”

Big C: “I can’t sell it at that level. I would have to mark down everything else, and people would see that my liabilities exceed my assets, leaving me with negative equity. And everyone is still pretending that my equity shareholders should not be revealed to own bupkus.”

PI: “Well, I’ll tell you what. Since we can foreclose on Ken for more than the amount owed, I’m willing to pay a little more.”

Big C: “I need you to pay something close to 80, or The Truth will out.”

PI: “Well, since the U.S. taxpayer is going to support 85% of my purchase in the worst of scenarios, I can pay you–how about 76?”

Big C: “Make it 78 and you have a deal.”

PI: “All right; I’ll do that. After all, I’m only having to put up $11.70 of that.”

Big C: “And I’ll be able to pretend we’re solvent. After all, we have some Inside Investors who need loans, and the Fed wants us to loan more.”

But wait a minute: the real value of that security is supposed to be the cash flows from The Underlying Assets. In short, it’s based on my (and others) ability to pay the mortgage. So let’s look at the other side.

I carry my house in Quicken at 33% (20/60) over what the realtors tell me it is worth. So Quicken shows me that cool Net Assets thing, and I have a Net Asset Value $30,000* higher than “the market” believes.

But it’s not liquid, and I don’t run a Treasury operation, nor am I necessarily required to abide by the ALE rule. So in general I feel more solvent, but may not (or may, but let’s assume not) change my behavior because of it.

So tomorrow I have a heart attack and can’t work for a while.** And my wife needs to help me with recovery, as well as keep the kids going to school and activities, so we spend six months to a year living on savings and whatever safety net there is. And finally we realise we have to downsize our life and move to Northern Indiana where my family can help us out for a while.

So we put the house on the market, at the price the realtors said it was worth.

But—as happened last summer—there are no bidders. And when there might be a bidder, they can’t get a bank loan from The Big C.

Eventually, we realise we’re not going to move back and stop making payments on the property, which stays on the market until it is foreclosed. And then the bank that owns the mortgage sells the house short to a developer who pockets a quick few bills.***

We file for bankruptcy.

Now, in the real world, the Securitized Asset that looked so great above is now a losing proposition. But in GeithnerWorld, the asset is secured by the U.S. Treasury, and the “investor” takes no hit at all; indeed, Private Investor is made whole with…taxpayer funds!

In short: Debt that my child will have to pay.

The Geithner Plan is the ultimate in Financial Reality. Derivatives were at least based on underlying assets; if the five-year Treasury price fell, the five-year swap was worth more.**** GeithnerBuys have no relation to the “securitized” asset at all, except to add to the expenses of bankrupt taxpayers.

It is the final Decoupling of Wall Street and Main Street, so while Arlen Spector makes certain that workers can’t organize and Ellen Tauscher ensures that mortgages can only be reset to market value if it is a Vacation (or “second”) Home (despite an earlier agreement), Tim Geithner and Larry Summers—with the support of Some Economists who Should Know Better—are ensuring that any damage to the real economy is not felt in the financial sector.

Welcome to Brighton Rock. Or maybe Faust.

*Possibly not the real number.

**Knock wood, this is not real either.

***Anyone got the link on this one? Saw a piece earlier today about Citi selling a foreclosure for $131K to a developer who flipped it, doing nothing, for $249K.

****Reminder: lower price = higher yield.

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If Ever There Were a Tipping Point in the Nationalisation Discussions…

Willem Buiter, whose early posts at Maverecon were the epitome of restraint, calls for nationalisation:

By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.

There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles. Managers could be incentivised by linking remuneration to multi-year profitability. The incentives for excessive liquidity accumulation and for excessively cautious lending policies that exist for partially nationalised banks and for banks fearing nationalisation would, however, be eliminated.

He also addresses the sticking point on the formation of the “bad bank”: if the government already owns the assets, the sale price becomes an accounting question. Not that that is necessarily good, but at least it limits some of the profiteering.

Read the whole thing.

Via Krugman, who was via Robert.

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Reads of the Day for the start of 2009

All (somewhat***) via Mark Thoma:

Thomas Frank in the WSJ tells me why I always disagree with Robert (and the Other Economists) on the role of rating agencies:

And who makes sure that Moody’s and its competitors downgrade what deserves to be downgraded? In 1999 the obvious answer would have been: the market, with its fantastic self-regulating powers.

If you look at the spreads of various debt products, you can see that the market was doing that type of job even in 2007. For instance, the debt market priced [“rated”] Bear Stearns’s five-year bond issue in August 2007 at 245 over: rather closer to “junk” status than its rating would have implied. If you compare the debt and stock markets, it’s easy to see which is closer to “rating.” Unfortunately, the area where information is more valuable* is not the one discussed and understood in the press, where BSC kept trading up for several more months.

If a market “regulates” but no one notices, does it make the WSJ?

Brad Setser finishes the destruction of Tyler Cowen’s LTCM “argument” begun by Buce, while revealing its underbelly:

The big banks called to the New York Fed were the creditors of LTCM and they were in some sense “bailed-in.” To avoid taking losses on the credit that they had extended to LTCM, they had to pony up and recapitalize LTCM. [footnoted exception for BSC]

It just so happened that the market recovered and it was possible for LTCM to exit many of its positions without taking large losses, or in some cases any losses. The banks that took control of LTCM when LTCM was on the ropes were able to unwind LTCM’s portfolio in a way that didn’t result in additional losses. But the result Cowen desired — large losses for the banks and broker-dealers who provided credit to LTCM – was quite possible if LTCM’s assets weren’t sufficient to cover all its liabilities. No creditor of LTCM was able to get rid of its exposure as a result of the Fed’s actions. [emphases mine]

It used to be a standard rule that if you wanted to bury something in a newspaper, you published it on a Friday, or the day before a holiday. This seems to be what the NYT is doing with Casey Mulligan (previously discussed here here), who dropped the other shoe yesterday and was, amazingly, worse than expected. PGL at Econospeak does the read and calls out the deed:

Mulligan is essentially saying that those poor saps who have lost their jobs actually quit so they can game the mortgage system. In other words, there is no such thing as involuntary unemployment or being forced to either lose one’s home versus enter into one of these mortgage modification programs.

As noted in the WaPo two weeks ago (via Stan Collender at Capital Gains and Games),** qualifying for the “mortgage modification” program (i.e., reducing the principal on your loan to not more than 90% of the current market value) is an onerous task:

He was hoping he could qualify for the federal government’s Hope for Homeowners program, which allows the Federal Housing Administration to insure a new mortgage if the lender voluntarily writes down the mortgage principal to 90 percent of the new value of the home. But when he asked his bank about that, he was told he would have to be on the brink of foreclosure or have an adjustable-rate mortgage.

So Mulligan is basically blaming (1) those whose ability to keep their home depended on keeping their job and (2) those who took Alan Greenspan’s venal advice to go into ARMs just at the point at which he started raising rates. Class act.

And, finally, lest you think I’m always bashing Tyler Cowen, he notes a phenomenon in chess and suggests a reasonable conclusion:

I also see a general principle operating: the more exact a “science” the game becomes, the smaller is the value of accumulated experience relative to sheer skill.

The sheer is dicey, but the identification of the shift in proportionality may be accurate, and probably has applications in economics as well.

*The debt market is less liquid and therefore considers information more valuable. This is effectively the corollary of the DeLong, Shliefer, Summers and Waldmann papers: if you can’t depend on momentum trading, you take more care not to be the “greater fool.”

**Yes, I saw the Collender-bashing in my previous post. I’ve said before that CG&G became significantly less readable after the election, and am foolishly optimistic enough to believe that they may be returning to rationality. Besides, he happened to be correct: any given from increased military spending is definitionally no better (and likely worse) than spending the same amount on public infrastructure.

***I read PGL’s piece before seeing it in the links, but they’re all there.

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Random Notes, or, More Posts I Don’t Have to Write

Greg Mankiw presents Yet Another Reason to regret skipping the AEA this year, though somehow the word “intentional” was left out of the description.

Stan Collender, of all people, does the job I wished someone would do on Martin Feldstein’s WSJ op-ed. I may have beaten him by a day in calling it out, but there’s nothing so perfect as Collender’s conclusion:

Finally, something that’s not in the Feldstein piece: dollar for dollar, military spending doesn’t provide as much an economic return as domestic spending. Building an extra tank or missle that then sits idle because it’s not needed provides a one-time boost to the economy. But building a road, bridge, tunnel, sewer, or information superhighway that is needed continues to provide benefits as people, goods, and information travel faster, less expensively, and far more productively than would have otherwise been the case.

That means that starting with the headline, Feldstein was seriously mistaken.

Differences between now and 1992, positive version: In 1992, Dave Barry made a legendary appearance at the National Press Club. At some point during the Q&A, he declared that he was going to end all of his answers with the phrase “failed Clinton Administration.” (There may have been cheering.)

UPDATE: I was trying to think of a nice way to be rude about Tyler Cowen’s NYT piece on how “the seeds of the crisis” were planted by the resolution of the LTCM crisis.* () But Buce at Underbelly saves the day with a two-point takedown (not the three-pointer of Collender, but still aces) called Long-Term Confusion:

Tyler Cowan has an amazingly confused piece in this morning’s NYT arguing tht we owe our current plight in large part to the “bailout” (I use the term advisedly) ten years ago of Long-Term Capital Mangement (link). But the point of LTCM, as Tyler’s own piece acknowledges (but Tyler ignores) is precisely that LTCM was not a bailout, except perhaps in the sense that the Feds provided lunch.** Okay, and a little bit of arm-twisting. But I should think that would be on the approved list for even the most hairy-chested libertarian. The message was: look, we love ya, and we will work with ya, but we will not put skin in the game. [italics mine, but they could have been his]

In 2008, the NPC appearance of note is by Paul Krugman (h/t EconLib, again of all places), whose six part presentation and q&a session is available on YouTube and therefore easier to watch for the Internet-impaired than his Nobel Lecture.***

McMegan Wuz Robbed! Then again, that’s nothing compared to the abomination of this voting, where something that’s already remainder and long-forgotten appears to be winning.

And, finally, proof that it’s really TOUGH to live in Hoboken.

Happy New Year!

*If Robert Samuelson had published the same piece, Brad DeLong would not have been nice. As it is, we can just assume DeLong hasn’t read it yet amidst his globetrotting.

**Meaning in this case literally the food for the sixteen conversants, fifteen of whom anted up.

***Yes, I assume anyone who accesses YouTube from a non-networked machine has a downloading program. Also, am I the only one who just realised that YouTube is maintained on a Linux-based server?

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The Alpha and the Omega of mid-2007

Sometimes, Blog Posts Write Themselves: Cleaning up a hard drive of old files, I ran across these two articles from the middle of last year.

First, the WSJ, arbiter of business sanity and purveyor of a positive meme whenever one is to be found, on 28 July 2007—nine months after the general supply of securitizable mortgage loans went away, at least six months after even those with their own origination capacity realised the game was over, and about two weeks before Bear Stearns would issue bonds at the then-junk-bond-area yield of 245 over:

The economy grew at an annual rate of 3.4% in the quarter, reversing the anemic 0.6% growth in the first quarter, the Commerce Department said. Increases in exports and government spending drove much of the improvement. A rise in commercial construction spending and building of inventories offset a drag from housing and sluggish consumer spending.

But the positive drivers aren’t expected to persist, and recent indicators cast a darkening shadow over the rest of the year. The latest readings for spending on plant and equipment, which grew at a tepid 2.3% pace in the quarter, are disappointing. Rising inventories of unsold homes, falling prices and tighter lending terms on subprime loans for marginal borrowers offer little hope that housing is stabilizing. The downturn in stocks crimps Americans’ wealth, and turbulence in credit markets is sparking fears that loans will be costlier or harder to get….

Some business executives expect things to get worse. “This idea that there’s been no spillover from housing into other segments is just faulty,” Mike Jackson, chief executive of auto dealer AutoNation Inc., said in a conference call. “I think it’s extreme economic distress out there right now. It’s one of the toughest environments I’ve ever seen since I’ve been in the business.”…

Some forecasters say the gloom is overdone. As long as businesses continue to hire, the jobless rate remains near its current low 4.5% and energy prices don’t go higher, they say overall consumer incomes should be strong enough to support a healthy level of consumer spending. In a favorable sign, the University of Michigan said Friday its consumer confidence index rose to 90.4 in July from 85.3 in June.

Corporate earnings outside of financial services remain robust, although companies have been worrying for months about higher input costs crimping profit margins. “The real risk for consumer spending is if for some reason companies slam on the brakes and stop hiring,” said Brian Bethune, an economist at Global Insight. “The employment market is still reasonably solid.”…

“The big picture is that you’ve got an inventory problem in both markets — you’ve got too many homes for sale and too many bonds for sale,” says Mr. Kiesel. “So prices need to adjust: You need lower house prices and much bigger credit spreads. It means the economy is going to slow.”

Downward revisions to growth from the first quarter of 2004 through the first quarter of 2007 added to concerns because they offer more evidence that the pace of productivity growth has slowed, and with it estimates of the speed at which the economy can grow without higher inflation. Economists at Bear Stearns, for instance, said that estimates of the economy’s potential growth rate are likely to fall below 2.5% a year.

Let’s ignore for the moment the delusion that it was All About Subprime—even though some idiot on CBC was making exactly that claim Friday, trying to explain Why Canada is Different. (I’ll take Stephen Gordon’s analysis, instead.) This is an attempt at being positive: in the wake of an annualized 3.4% growth rate, that should have been much easier. But the harbingers had landed by then.

Next, the guy who keeps getting slammed in comments here and elsewhere, often for no good reason (or, in the case of Stanley Fish, in the throes of full hypocrisy). Larry Summers about a month later, 27 August 2007, in the LA Times. First, he gives the lie to the “once a century” meme:

Over the last two decades, major financial disruptions have taken place roughly every three years — the 1987 stock market crash, the savings and loan collapse and credit crunch of the early 1990s, the 1994 Mexican peso devaluation, the Asian financial crises of 1997, the Russian default and Long Term Capital Management implosion of 1998, the bursting of the technology bubble in 2000, the disruptions of 9/11 and the 2002 post-Enron deflationary scare in the credit markets.

This record suggests that, by the beginning of 2007, the world was long overdue for a major financial disruption. And sure enough, the difficulties around sub-prime mortgages “went systemic” in the last month as the market seemed to doubt the creditworthiness of even the strongest institutions and rushed to buy Treasury debt.

Soon, he gets to the heart of the matter:

[A]s investors rush for the exits, the focus of risk analysis shifts from fundamentals to investor behavior. As some liquidate, prices fall, then others are forced to liquidate, driving prices down further. The anticipation of cascading liquidation leads to still more liquidation, creating price movements that seemed inconceivable only a few weeks before. Reduced credit feeds back negatively on the real economy.

Eventually — sometimes in a few months, as in the U.S. in 1987 and 1998; sometimes in a decade, as in Japan during the 1990s — there is enough liquidation and price adjustment to make extraordinary fear give way to ordinary greed, and the process of repair begins.

It is too soon to draw policy lessons from the current crisis or to determine exactly where in the cycle we are now. But it is not too soon to highlight the questions it points up. Three stand out.

From that point on, the article goes downhill:

First, the current crisis has been propelled by a loss of confidence in rating agencies, as large amounts of debt that had been very highly rated has instead headed toward default….But there is no doubt that, as in previous financial crises, the rating agencies have dropped the ball.

In light of this, should bank capital standards, Federal Reserve discounting policy and countless investment guidelines still be based on credit ratings? What is the alternative? What if any legislative response is appropriate?

It seems more likely to assume that rating agencies are lagging, not leading, indicators of credit crises, as investment products develop based on iterative variations of current products, whose risk profile is therefore (definitionally) somewhat less well defined, and (again definitionally) are likely to have thicker tails that will not be captured by standard modeling. (See Robert’s discussion here.)

Summers continues:

Second, how should policy respond to financial crises centered on nonfinancial institutions? A premise of our system is that banks accept much closer supervision from public authorities in return for privileged access to the Federal Reserve payments system and its “discount window,” which allows banks to borrow directly from the Federal Reserve. The problem this time is not that banks lack capital. It’s that the solvency of a range of non-banks is in question because of cascading liquidations and doubts about their fundamentals. In an old-fashioned phrase, central banks that seek to instill financial confidence by lending to banks or even by reducing their cost of borrowing may well be pushing on a string.

With the admission of insolvency of the financial institutions still at least six months away, Summers was already discussing the limits of liquidity provision.

His third point is only slightly less prescient:

Third, what is the right public role in supporting credit to the housing sector? The lesson learned from the S&L debacle was that it is catastrophic to finance home ownership through insured institutions that borrow short term and then offer long-term fixed-rate mortgages. Now a system reliant on adjustable-rate mortgages and non-insured institutions has broken down.

I might argue Summers took the wrong lesson from the S&L crisis, which grew in large part from primarily Texas-based S&Ls that loaned large amounts of money based on the idea that some barren desert land was valuable because it had oil under it. It does not seem coincident that the first wave of housing market collapses (ca. mid-to-late 2006) were all in similarly-desert areas—Phoenix, Lost Wages, the tracts of land near I-5 between LA and SF. But at least he knew what not to do:

[I]f there is ever a moment when [Fannie and Freddie] should expand their activities, it is now, when mortgage liquidity is drying up. No doubt, credit standards in the sub-prime market were way too low for way too long. But now, as borrowers face the reset of adjustable mortgages, it is not the time for authorities to get religion and encourage the denial of credit.

The next time someone tells you that “no one predicted” this phase of the current crisis, point them to Larry Summers fifteen months ago. Or even, in broad outline, the WSJ.

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