Academic Views of the Financial Mess

We’ve been bringing you a pretty steady diet of guest bloggers who’ve addressed several different elements of the ongoing financial crisis.

These have all been pieces written by economists for lay readers.

Here’s a sampling of what economists have been writing for each other lately — i.e., new working papers issued by the National Bureau of Economic Research — about different facets of the crisis:

Gary Gorton of Yale has written “The Subprime Panic.” The abstract reads as follows:

Understanding the ongoing credit crisis or panic requires understanding the designs of a number of interlinked securities, special-purpose vehicles, and derivatives, all related to subprime mortgages.

I describe the relevant securities, derivatives, and vehicles to show: 1) how the chain of interlinked securities was sensitive to house prices; 2) how asymmetric information was created via complexity; 3) how the risk was spread in an opaque way; and 4) how trade in the ABX indices (linked to subprime bonds) allowed information to be aggregated and revealed.

These details are at the heart of the origin of the Panic of 2007. The events of the panic are described.

Anil Kashyap of the University of Chicago, who has co-written two excellent guest posts on this blog, has co-authored a new working paper with Takeo Hoshi of the University of California, San Diego, called “Will the TARP Succeed? Lessons From Japan.” Its abstract:

The U.S. government is hiring asset managers to purchase up to $700 billion of toxic real estate securities that are the center of the current credit crisis. Buying up assets, if done properly, might address the collective under-capitalization that is the fundamental problem plaguing the financial system.

But, experience with financial crises in other countries suggests that success is by no means guaranteed. Japan was the largest other country where the banks were seriously undercapitalized, and where asset purchases were a critical part of the government’s response to the problem.

The U.S. bailout plan is similar to the Japanese approach in that it does not clearly identify the capital problem as critical, and instead proposes using AMC’s to remove distressed assets from bank balance sheets. When Japan used AMC’s, their effectiveness was limited in part because they did not purchase enough assets. AMC’s did not help recapitalization either, and Japan had to come up with different mechanisms to use public funds for recapitalization. Both these risks are also present for the U.S. plan.

And finally, Fernando Ferreira, Joseph Gyourko, and Joseph Tracy have written a paper with some surprising news about what happens after homeowners achieve negative equity in their houses. It’s called “Housing Busts and Household Mobility,” and here’s the abstract:

Using two decades of American Housing Survey data from 1985 to 2005, we estimate the impact on household mobility of owners having negative equity in their homes and of rising mortgage interest rates.

We find that both lead to lower, not higher, mobility rates over time. The impacts are economically large, with mobility being almost 50 percent lower for owners with negative equity in their homes.

This does not imply that current worries about defaults and owners having to move from their homes are entirely misplaced. It does indicate that, in the past, the lock-in effects of these two factors were dominant over time.

Our results cannot simply be extrapolated to the future, but policy makers should begin to consider the consequences of lock-in and reduced household mobility, because they are quite different from those associated with default and higher mobility.


science minded

I find the english hard to understand. Why not state the problem simply--people (including corporate groups and our government borrowed more than we can afford and banks have lent us the money in ways that made us think we could afford it when we could not.

not irresponsibility, but ignorance due to belief in free market- there are no free lunches

ken

In response to #2: I agree with you in wondering "why is reduced mobility unexpected?" because if I were one of the unfortunately homeowners, I would likely stay put. On the other hand, negative home equity should make defaulting a more attractive option for some homeowners. I guess it is similar to saying that in a stock market crash (like the one unfolding now), stockholders would do better to cut their losses rather than stay on in expectation of higher prices in a distant future (which is what I'm doing right now). I guess the findings of the Ferreira et al. paper are important because they may influence the way policy makers react to the crisis. The other papers are also interesting, but their findings are pretty much common knowledge.

Phillip

Steve Forbes has a great new article on this very topic. I wanted to add this to the discussion: http://www.forbes.com/hcome/forbes/2008/1110/018.html. His says regulation, not the oft blamed deregulation, was the cause of the financial crisis and he proposes capitalism as the cure for our economic ills. It makes a lot of sense if you think about it. When has government intervention lead to economic growth and prosperity? It has been free market principles over the past 25 years that have lead to the largest increase in wealth in American history. Adam Smith was on to something. Too bad only academicians still read his work.

steve long

The political bias in the analysis is that the derivative problem is solely connected to subprime mortgages. A look at the full impact of derivatives and their inherent instability makes it clear that is not true. Derivative in fact created the traffic in subprime and a huge variety of other securitized debts. Regulation or even accurate accounting of the risks or values of derivatives is often next to impossible, and so they became a hot bed for the bubble that is now bursting -- and for the misrepresentations that responsible regulation could have prevented.

If it was not subprimes, it would have been imaginery factories in Malaysia or off-shore drilling rights in Florida. The oportunity to mislead is going to be taken, and paper wealth will be expand until the chips are called in.

science minded

I agree Adam Smith was on to something- but it was not an absolutely free market. Knowing this, it can be fixed and needs to be externally monitored as we all need to do a bit more self monitoring.

willy

In response to Jacob (#4):

Your illustration is a solid analogy. The only issue is that Paulson and the Treasury neglected to require the financial institutions who received capital to use it to improve how they underwrite real estate lending and manage risk.

Joe

Predicting the success of any plan requires a definition of success. The goal should be to support the banking system, not any individual banks. Buying up troubled assets at MARKET prices will remove much uncertainty from the market and allow banks to lend based on health of borrowers, not government prodding. Buying these troubled assets at market prices will force many banks under. But that is not a bad thing. Growth is onle possible with occasional deaths. Banks and businesses that grew too quicky and were undercapitalized need to be allowed to fail. JPM and BAC are already stepping up their lending to credit worthy borrowers.

Which brings me to my second point. The problem is not really one of liquidity, nor is it truly about the troubled assets. True, banks have difficulty ascertaining the solvency of borrowers with those assets on the borrower's book. They also have trouble evaluating their own solvency because those same assets simply aren't trading. Creating a market for these assets will solve those two problems. But the more central problem to me is the economy as a whole, of which banking comprises a mere 9%. Banks will not resume lending fully regardless of solvency or certainty, because they are coming off a bust and they see a bleak future. Why would they lend to borrower's with uncertain repayment abilities - that is exactly why the system is in peril (along with many faulty policy decisions).

In order to alleviate the true problem, and restore health to the financial system and the economy (long term health), the government should indeed proceed with creating a market for troubled assets. They should not be buying up stakes in banks, as government ownership is a minefield on many levels.

Instead, the government should begin investing in the country's infrastructure. I normally favor minimal spending, but our infrastructure needs the TLC anyway. We need to update our bridges, ports, airports, roads, etc. Investing in the infrastructure will create long term benefits, as well as help pull us out of the recession, and restore credit-worthiness to borrowers, as opposed to forcing banks to lend to unworthy debtors.

Lastly, there should be a recognition that in the short term government deficit will rise. These expenditures should not be offset by tax increases, because we need to stimulate business investment and competition, and an increasingly onerous tax burden on businesses will not encourage them to grow, something which we need to be very sensitive to in the near term. After the turmoil has passed, we can then begin to clean up some of the policy mistakes and ensure stable long term health.

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dan

Many of these posts have facts blantantly wrong while the posters appear to be 100% sure of themselves. If you're going to tell someone the "answer" to their question, at the very least double-check with Wikipedia.

In reply to 25: I guess you didn't read the Times op-ed piece from two days ago, http://www.nytimes.com/2008/10/21/opinion/21stein.html?scp=1&sq=dividends&st=cse, which discourages the use of dividends (specifically concerning banks which have received capital from the government). Only around 20% of stocks pay dividends, and they are certainly not the backbone of the stock market.

In response to the idea that the stockmarket is meaningless: Don't be so quick to belive that you can outsmart the global finance system. Yes, individual investors are essentially making a bet, but many many bets combined result in an aggregate estimator of a company's progress using all information publicly available at the time. It is possible that the market has some inefficiencies, perhaps described by behavioral finance, but it is clear that the market is largely efficient (look at the efficient market hypothesis, which is largely accepted by academics and heavily backed up by empirics). To get a better understanding about how individual bets, each made using limited information, combine to produce a probabilistic estimator with maximal information, look at the intrade prediction market (www.intrade.com), as well as the many Times articles that describe it.

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Jacob

Compare the financial crisis to an automobile manufacturing crisis. Let's say Ford produced cars for ten years that turned out to be unusable. They looked nice and shiny at first, but they all broke down beyond repair after just two years. It is evident that there is something seriously wrong with the manufacturing process in the Ford factories. The politicians decide to intervene with government money. Which of these two plans makes the most sense?

1. buy all the faulty cars so that Ford does not have to take a loss on their poor production methods, or

2. pump money into making the factories better and improving the manufacturing processes

It's perfectly simple. Number 1 is the TARP, and number 2 is the bank rescue plan.

www.usparliament.blogspot.com

R Wilkinson

I think there is an opening to a solution for the whole array of problems we are facing.

Someone with some measure of authority should open exploratory talks with Mr.Putin to discuss selling Alaska back to Russia for a sum adequate to cover our Bush era losses

Web Smith

When you ship million of jobs offshore, allow millions of illegal aliens into the country who take jobs from the poor, issue millions of H-1B visas to millions of cheap foreign workers who take jobs from the middle class, meddle with energy until you are sending 100s of billions of dollars per year out to foreign oil producers, strike trade agreements where we buy their stuff and they don't buy our stuff until we run out of money, allow your military to be used to transfer trillions of dollars worth of wealth, transfer a trillion dollars worth of wealth to banks who have backed themselves into a corner with derivatives, and borrow, spend, give away, and waste $11 trillion, you tend to have an economic problem.

What happen to the emergency $700 billion, which is heading towards $2.5 trillion, that we told them not to spend? Now Congress wants to give us $150 billion that will temporarily ease our pain just in time for the election so the public servants who went against our wishes can get re-elected?

The population no longer has the money to buy goods and services and companies have no one to sell anything to.

http://ewebsmith.com/Finance/therealproblem.html

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RPW

It is doubtful the capital crisis can be resolved until the cause of it is stopped. It will just happen again, and soon Laws must prohibit the creation of private wealth simply by schemes that transfer risk and debt to unsuspecting stockholders and an ignorant Public.

Mergers and leveraged buyouts are architected to reduce corporate capital requirements then pull the slack capital created out of the corporations as personal wealth for the architects. When the business cycle falls, the lack of backup capital creates corporate crises which require the government to refresh the corporations with capital from the treasury.

Employing this means of creating personal wealth, by pulling slack capital from corporations, requires that the government eventually replace it with public capital – corporate capital that is personalized during the up business cycle phase must be replaced with public capital in the down business cycle phase. In other words using mergers and leveraged buyouts to create personal wealth for their architects eventually requires the government to replace those moneys with public money, to replace the slack capital that was eliminated.

The risk (cost) of business cycles is effectively transferred to the public, and the value of this risk is turned into immediate personal wealth for the architects, before the business down cycle phase occurs. For the merger architects, this is a perfect “Heads I win, tails you lose” situation.

It is unrealistic to expect the Public to continue to subsidize this process, especially now that it has been demonstrated that corporate mergers – a few large companies replacing many smaller ones – increase risk to the total economy. In return for the economies of scale of a larger company, they provide nothing but liabilities for the their corporate stockholders and the Public. The only people who make money off mergers and leveraged buyouts are the perpetrators of these high finance scams. Everyone else has to pay them for becoming rich, and then live in the politically unstable world they create, which rests on an economy so brittle and thin that a category-2 hurricane could wipe it out.

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Dr. Charles

Regrading the current meltdown there was a banking committee meeting that involved various non-partisan watch dog organizations. It was aired on C-Span. The conclusion was unanimous:

-Freddie and Fannie have minuscule contribution

-Minority borrowers are not major contributors

-Upper income borrowers had bigger contribution

-60-65% of the black borrowers were tricked into sub-prime loans when they were eligible for prime loans. This was pushed by "financial advisers". Hopefully some of them will be convicted.

joseph davidovic

I think it's time that the media in general reflect on the impact of what they portray to the general public has on the psyche of their audience, beyond the obvious. Surely the bright minds and graduates of the best journalism schools are able to understand the concept of self-fulfilling prophecies. All the pundits have oodles of self-serving information to dish out after the horses have left the barn, but where were they when we really needed them? Oops, I forgot, teaching of course. To wit: the sky is falling, the sky is falling, the sky is falling, or 1 million people did find employment in this economy, or actually several companies did report a profit, or xyz company is actually doing well, etc, etc...you get the drift...c'mon people now!

Jack

Why is reduced mobility unexpected? The vast majority of homeowners I would guess are hit hard enough in these situations that they can't easily make big life changes, but not so hard that it's worth going into bankruptcy, and people hate to sell for a loss.

So a long period of "debt slavery" in existing houses until either prices rise again or people start to accept the new reality seems predictably, depressingly expected.

DJH

Chaotician (#6) asks a salient question: What, exactly, is the stock market? What is bought and sold there? If I buy, say, shares of IBM, does IBM get any of that money?

No. The money goes to whoever owned the shares before I bought them.

So we cannot say that stock market trades "capital" because it doesn't -- except in those specific cases where a new stock is issued and the issuing company is being purchased directly. Once stocks are "in the wild," whatever is traded is no longer "capital," it's ... well, whatever.

The amount that stocks are traded for has nothing to do with the value of the company. Most companies trade on the stock market for much more than the sum of the company's actual assets minus liabilities. So the amounts stocks are traded for are not based on the company itself, they're based on ... well, whatever. A stock can be issued initially at, say, $10/share, but after that, it can be traded for any value at all.

The plummeting of the stock markets has caused government to launch fiscal-management programs whose costs will be staggering. But they're dealing with a problem based on ... well, whatever.

The problem is that the "well, whatever" is ... nothing. Nada. Zip. Zilch. Nichts. Zero.

Has the lunacy of this situation occurred to anyone? We are bankrupting the nation in order to fix ... well, whatever? An extraterrestrial looking down at all of this would likely be laughing his/her/its head off ... at all these humans who are frantically trying to fix a problem which really has no basis whatsoever and need not exist at all, except that everyone in power has decided that it does exist, so it does.

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marcel duchanp

No mention of the word GREED?

These U. Chicago folks and friends are a little self-serving. And self-satisfied (even though their sky is falling).

Dr. Charles

Regarding the current meltdown there was a banking committee meeting that involved various non-partisan watch dog organizations. It was aired on C-Span. The conclusion was unanimous:

-Freddie and Fannie have minuscule contribution

-Minority borrowers are not major contributors

-Upper income borrowers had bigger contribution

-60-65% of the black borrowers were tricked into sub-prime loans when they were eligible for prime loans. This was pushed by "financial advisers". Hopefully some of them will be convicted.

Quinn

Government and Religion are not allowed to fail. Both are institutions created by fallible humans (I said religion, not God!) to unite themselves and to provide security and support for all members. The volume of pork that was attached to the bank assistance program is stunning. Too bad that the government cannot buy out a major bank, capitalize it heavily, and use that as the source of the much-needed liquidity in the American public and corporate financial markets. Then, this bank could later be sold and privatized, recompensing the taxpayers for the federal investment. Warren Buffet, do want a new job?

frankenduf

huh?- Kasyap's abstract is dated- he is critiquing the Paulsen plan, basically a giveaway to the banks- that plan was thankfully trashed weeks ago- the current US bailout involves recapitalization through public ownership- we should all be thankful to Gordon Brown, who showed strong leadership in aggressively recapitalizing early on- Paulsen has just shown to be yet another Bush crony from the corporate world whose knee-jerk instinct was to steal money from the taxpayers and give it to his old investment bank buddies