Lets begin with Adam Smith and his masterpiece The Wealth of Nations in which he argued that all human actions are rooted in self-preservation and directed towards self-interest, and that personal ambition is not a vice, but a virtue, leading to hard work and prosperity. He propagated that businesses and workers, left to themselves are motivated by self-interest to put their capital and labor to uses where they are most productive. Facing keen competition from other companies, a businessperson has to build high-quality products at the lowest possible prices, and to get ahead of the competition, everyone has to work to their best potential. That's how self-preservation works. He did not denounce avarice, which is inborn in most of us; in fact a lot of modern monopolists have invoked his ideologies to rationalize their income levels. The United States was the first country which adopted the practices he had preached, and with open arms embraced the spirit of individualism that was already sizzling among its freedom fighters, who were typically averse to federal intervention in matters of pursuit of profit in a business enterprise. The nascent US industry advanced at a brisk pace, and early enterprises provided keen competition to each other. The power of domestic rivalry became a dynamic force in a free-market economy, and importing capital from abroad and combining it with domestic factories, they sold their products primarily to consumers at home. By the end of the nineteenth century the US had forged ahead of the previously dominant economies of England, Germany and France and emerged as the world's economic leader. The invisible hand of Adam Smith provided a most visible success story to the globe. Free enterprise, thus became a mantra for economists and politicians, and the rest as they say, is history.[3]
Or so it seemed till recently.
Several accounts of the crisis now often seem to place the ultimate blame squarely on the shoulders of free market capitalism embodiments - Wall street bankers, hedge funds, mortgage lenders and rating agencies, or even on the mistakes of former Fed chairman Alan Greenspan. It would not be accurate to say that we as a collective mass of civilization with a rich history of preceding financial disasters had absolutely no foresight. Former Federal Reserve governor Edward M. Gramlich privately warned Federal Reserve Chairman Alan Greenspan about abusive lending behavior in subprime mortgage markets in 2000, but the warning was swept aside. Gramlich went public with his worries in 2007 and published a book on the subprime bubble just before the crisis broke. Charles Kindleberger, an expert on bubbles, warned of the housing bubble in 2002. Martin Feldstein, Paul Volcker(former Fed chairman)and Bill Rhodes(a senior Citibank official) all made bearish warnings. Nouriel Roubini predicted that the housing bubble would lead to a recession in 2006. But as the WSJ noted, there were many hedge funds taking a bearish stance on housing but they suffered such painful losses waiting for a collapse that they eventually gave up their positions.[2] To the extent that even in 2007 the then CEO of Citibank Chuck Prince was quoted as saying "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing".
It would now seem that the housing bubble that created the crisis was allowed to grow as big as it did because we as a society do not yet completely understand, or know how to deal with speculative bubbles. At its root, there was never an attempt to thwart the epidemic of irrational public exuberance for housing investments, even though the most well-informed people knew what was going on was a bubble, yet carried away by an illusion of a Goldilocks economy, a majority of them continued their nap in paradise. Clearly there was no active segment in society that was critically evaluating the real-estate market for any potential of its speculative excess. The perception that real-estate prices could only go up, year after year, established an atmosphere that encouraged lenders and banking institutions to loosen their standards and risk default. This, if anything serves as a lesson in human behavior and its capriciousness.
Banks sold off their riskiest mortgages by repackaging them into collaterized debt obligations ( CDOs) which channeled the cash flows from thousands of mortgages into a series of tranched bonds with risks and yields tuned to different investor tastes. The top tier tranches, which comprised perhaps 80 percent of the bonds, would have first call on all underlying cash flows, so they could be sold with a AAA rating. The lower tiers absorbed first-dollar risks but carried higher yields. In practice, bankers and rating agencies grossly underestimated the risks inherent in absurdities like no-documentation (ninja) loans.[2]
Securitization in fact was meant to lower risks through tiering and geographic diversification. Instead it ended up increasing the risks by transferring ownership of mortgages from bankers who knew their customers to investors who did not. Loans were were sourced by brokers, temporarily warehoused by thinly capitalized mortgage bankers, then sold en bloc to investment banks, who manufactured CDOs, which were rated by rating agencies and sold off to institutional investors. All income from the original sourcing was fee based - the higher the volumes, the bigger the bonuses. The prospect of earning fees without incurring risks encouraged lax and deceptive business practices. Around 2005, securitization became a mania. "Synthetic" securities that minimized the risk of real securities but did not incur the expense of buying and assembling actual loans were mass produced , well beyond the actual supply in the market. Enterprising investment bankers sliced up CDOs and repacked them into CDOs of CDOs or CDO2s, and CDO3s. The highest slices of lower-rated CDOs obtained AAA ratings, creating more AAA liabilities than there were AAA assets. Synthetic products towards the end accounted for more than half the trading volume[2].
Even though the US has weathered several financial crisis, like the international lending crisis of the 1980s and the savings and loan crisis of the 1990s, the current one, as is unanimously agreed upon by all who know, is entirely different in character. It spread from one segment of the market to others, particularly those which employed newly created structured and synthetic instruments. Distress spread from residential real-estate to credit card debt, auto debt, and commercial real estate and the credit default swaps market.[2] Even the seemingly benign municipal bond market, which had lately ventured into insuring structured products has been disrupted.
In 2003, the Fed cut its federal funds rate to 1%, roughly the period of most rapid home-price increase. In fact, the inflation-corrected federal funds- rate was actually negative from Oct 2002 to April 2005. (This was driven by economic conditions created by the bursting of the stock market bubble of the 1990s, and the real-estate boom was itself in some ways a repercussion of that same bubble.) The impact of this loose monetary policy was amplified by the large number of adjustable rate mortgages issued after 2000, particularly to subprime borrowers. These mortgages were more responsive than the fixed rate mortgages to the cuts the Fed had made. ARMs became common because those who were influenced by bubble thinking wanted to heavily get into real-estate investments, despite the realization that interest payments would be going up soon. They expected to be compensated by rapidly increasing home prices, which would in fact allow them to refinance at a lower rate. In another vein, subprime borrowers wanted these mortgages because they were consumed by the thought of somehow merely gaining a foothold in the housing market. In addition, the demand of more loans with ever increasing flexible standards was accommodated by the lenders because they themselves believed in the bubble. As a result no-documentation loans, option ARMS and other questionable new mortgage types proliferated. Moreover, rating agencies persisted in giving AAA ratings to ultimately vulnerable securities even if they harbored some unconfirmed doubts about the weakly held notion that home prices at some point may actually fall, in the favor of other business decisions that were easier to make, until it was too late. In the 2000s a "shadow banking system" emerged consisting of non-bank mortgage originators who were allowed to develop without any of the regulations to which banks are normally subject. Ever since the Monetary Control Act of 1980 ended state usury laws and made it possible for originators to make a profit with subprime lending by charging a high enough interest rate to offset the costs of inevitable foreclosures, there had been an ever-increasing need for expanding regulation. [1]Which never came.
How does one explain the axioms behind the kind of psychology in society that drives us towards financial catastrophes of such massive proportions as we see today? In behavioral economic terms, Robert Schiller analyzes that what seems to be absent from the thinking of many economists is an understanding that contagion of ideas is consistently a factor in human affairs, and the changing zeitgeist - which drives common opinion among the members of society at any given place and time, transforms itself as new ideas gain prominence or recede in prominence within the collective thinking. Speculative markets are excellent places to observe the dynamics and the ebb and flow of the zeitgeist. If there are certain economic arguments that are more in evidence, almost everyone appears (albeit falsely) to think that they are increasingly heard only because of their true intellectual merit. The idea that the prominence of the arguments is in fact due to a social contagion is hardly ever broached, at least not outside university sociology departments[1]. The media gets caught up in weaving "new era" stories with hyped attention around price movements that are fashionably upward , feedback loops appear as price increases encourage belief in these stories and leads to further price increases. At this point, speculative price increases encourage genuine economic optimism, hence more spending, hence greater economic growth and hence further bidding up of prices. Somewhere in the maze of gaining a grip on the actuals involved, most people can be forgiven for not seeing that the sense of economic prosperity is actually caused by a bubble and not by economic fundamentals. Economic theorists Sushil Bikhchandani, David Hirshleifer and Ivo Welch suggested the term "information cascades" to characterize this phenomenon. An information cascade occurs when those in a group disregard their own independent , individually collected information, which might otherwise yield a more pessimistic or realistic view of the boom, because they feel that everyone else simply cannot be wrong. And with this they disregard their own independent information, act instead on the general perceived information, and as a result squelch their own information. It is no longer available to the group and so does not feature in further analysis. Over time, the quality of group information gets distorted.
In a related vein, George Soros in his book A New Paradigm for the Financial Markets asserts that our understanding of the world in which we live in is inherently imperfect because we are part of the world we seek to understand. "There may be other factors that interfere with our ability to acquire knowledge of the natural world, but the fact that we are part of the world poses a formidable obstacle to the understanding of human affairs". He introduces the idea of "reflexivity" - which can be interpreted as circularity, or two-way feedback loop, between the participants view and the actual state of affairs. "People base their decisions not on the actual situation that confronts them but on their perception or interpretation of the situation. Their decisions make an impact on the situation (the manipulative function) , and changes in the situation are liable to change their perceptions(the cognitive function). The two functions operate concurrently, not sequentially."
John Cassidy in the New York Review of Books states an example to expound this theory into a real-world example:
"Imagine that ABC Corp. makes profits of $W per share, pays dividends of $X a share, and is growing at Y percent per annum. If you assume that this rate of earnings growth will persist indefinitely, it is a matter of high school arithmetic to figure out what ABC Corp.'s stock is worth on a fundamental basis, an amount I will call $Z. In the world of the Chicago economists, well-informed investors bid the price up to $Z and stop there. If prices rise above that level, they step in and sell; if prices fall below $Z, they buy. All is rational: all is efficient.
Now imagine that a group of irrationally exuberant investors come to believe that ABC Corp.'s growth rate is about to accelerate to 2Y percent, and, as a result, they bid up its stock up $2Z and keep it there for a while. What happens next? One possibility is that ABC Corp. could issue more of its highly rated shares and use them to purchase a rival, DEF Corp., whose stock price has been lagging—hence presenting a relative bargain. Thanks to the magic of acquisition accounting, the mere act of ABC Corp. buying DEF Corp. would make it appear that its earnings per share were growing rapidly. Voilà, the inflated earnings expectations that drove up ABC Corp.'s stock would have turned out to be justified. Most likely, the stock would rise even further—for a while, anyway."
Although it can be argued that he is stating the obvious, the crux of reflexivity is not so obvious as it challenges established theories pertaining to efficient markets and equilibrium - it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but EVENTUALLY self-defeating process[2]. The currently prevailing paradigm which asserts that financial markets tend towards equilibrium has led to the notion that actual prices deviate from a theoretical equilibrium in a random manner. Soros states that while it is possible to construct theoretical models along those lines, the claim that those models apply to the real world is both false and misleading. It leaves out the possibility that the deviations may be self-reinforcing in the sense that they may alter the theoretical equilibrium. When this happens, risk calculation and trading techniques based on these models are likely to break down. In 1998 Long Term Capital Management, the highly leveraged hedge fund advised by Nobe Prize winning economists, employing such trading techniques, ran into trouble and had to be rescued with the help of the Fed. The techniques and models were modified, but the basic approach was never abandoned. And the use of mistaken models , particularly in the design of synthetic financial instruments - continued to spread.[2]
What was lamentable was also the fact that the newly invented instruments were so sophisticated that regulatory authorities lost the ability to calculate the risks involved. They came to rely on risk controls developed by the institutions themselves, as was the case with Basel 2, which allowed the largest banks to rely on their own internal risk management systems. The risk models of the banks were based on the assumption that the system itself is stable. But, going back to Soro's staunch disbelief in the market fundamentalist beliefs, the stability of financial markets is not assured - it has to be actively maintained by the authorities. Specifically, VAR calculations are based on past experience, and with unchecked credit expansions, the past becomes a poorer guide[2].
Robert Schiller, in outlining what he believes is the Subprime solution[1], notes that in the long run, we need to develop stronger risk-management institutions to inhibit the growth of bubbles, and to better enable the members of our society to insulate themselves against them when they do develop. This practically means embracing two goals. First, improving the financial infrastructure so that the greatest number of people can avail themselves of sound financial practices, products and services. He believes that this would enable the common man to make the best possible financial decisions based on intelligence and fact rather than mere whimsy. Better financial information and decision making would itself check the incidence of bubbles. Second, extending the scope of financial markets to cover a wider array of economic risks. Third, creating retail financial instruments - including continuous-workout mortgages and home equity insurance to provide greater security to consumers. As opposed to current standard mortgages which provide little protection against difficulties in repaying the lender in a changing marketplace, mortgages should be designed to compensate for these changes by including provisions to ensure homeowners against their major risks.[1]
There are several assumptions in this so-called democratizing of finance. The first is the need to better understand the risks inherent in real estate and to acquire the know-how to more efficiently spread these risks. The subprime mortgages, for all their democratic appeal were launched with an ultimate failure to understand real estate risks. The second assumption is that the democratic extension of the innovations of modern financial technology must be done with a clearer understanding of human psychology, so that the spreading of risk can further prosper economic incentives and limit moral hazard. The democratization of finance has in a limited fashion already manifested itself in the success of the so-called micro finance revolution - consisting of novel institutions that make loans to the tiniest of businesses, in some of the least developed parts of the world.
Schiller believes in the power of information technology to provide the effective tools to implement the subprime solution. IT has captured the imagination of mathematically inclined people, from traditional economics departments to engineering to management schools to newer financial engineering programs, and to numerous quant groups at investment banks and hedge funds. Having worked for a few years in the investment banking space creating financial and trading systems and tools to further the potential of an ever changing business landscape, Schillers ideas captured my own fascination with their refreshing potential and scope for reform at the individual level, and were not just mere policy change suggestions which would simply tweak the way were work or lead to unforeseen repeated bailouts of the sort we are witnessing today . Of course, most of them are propositions that would need to be tested and validated, but are nevertheless enlightening steps in the right direction.The full potential of risk management technology, especially when it is implemented on a sufficiently large scale, will be a major advancement. Moreover, modern financial theory when applied in Agency theory, explains how to motivate agents to behave as much as possible in the interests of all parties to a transaction, not just themselves. This keeps moral hazard under control by structuring financial institutions with just the right balance of initiatives. Additionally, with recent revolutions in the past few decades in behavioral economics and finance, which capture the insights gained by the other social sciences, they open up the hitherto unqualified mathematical models of old school financial theorists for far richer and more successful applications. [1]
He proposes six major ways of improving the information infrastructure key to the process of democratizing finance:
1. Comprehensive Financial Advice
Most financial advisors ignore middle-to lower-income customers because they can make money only by charging a fee based on the fraction of assets under management. However, most people need broad and elementary financial advice from knowledgeable and trustworthy sources. If the government makes the business of providing useful and impartial advice economically viable by subsidizing it(for instance,reform its tax policy to subsidize the services of fee-only advisors), then it is likely that business will make the necessary investments to deploy new information technology on a significantly expanded scale. Financial engine web sites will be reinvented so that they operate hand-in-hand with the personal advice offered by advisors and thus work effectively for most people. These sites might further evolve - wiki-style - into places where people can share financial information with each other and a variety of experts.
2. A New financial watchdog
In response to the present inadequacies in the information infrastructure, as outlined by Elizabeth Warren, the government needs to set up a financial product safety commission, modeled after the Consumer Product Safety Commission, which would provide a resource for information on the safety of financial products and impose regulations to ensure such safety.
3. Default -Option Financial Planning
A default option is the choice that is automatically made if an individual fails to make an intentional choice among available options, which operates well when people are inattentive and fail to act. Careful research has revealed how immensely susceptible people are to whatever they see as a standard provision in their decisions about investments. Just as participation in an employer-sponsored retirement savings plan is immensely boosted by automatic enrollment, designing standard contracts including prudent default options will pave the way for widespread adoption of such plans.
4. Improved Financial disclosure
Those who bought residential-mortgage-backed securities based on subprime mortgages typically did so with little more information than that contained in ratings given by rating agencies. John Moody in 1915 offered to the public a securities rating system, and this was an early step in democratizing finance. Disclosure of information was furthered by the creation of SEC in 1934. The SEC now sponsors EDGAR which provides access to filings made to it. When plain English was brought into securities documentation in the 1990s, and with the issuance of Regulation Firm Disclosure(directing firms to post their announcements electronically in real time), this was another step forward in the right direction. However, people today still find it very difficult to evaluate the risk of securities, and no one outside the rating agencies understood the information enough to correctly gauge the soundness of the mortgages they were based on. With costs of providing information continuing to fall, and technology advancing, the scope for creative and meaningful disclosure should widen with time. Standardized disclosure modes, analogous to standardized nutrition labeling on packages of food, would make it easier for people to assess risks.
5. Improved Financial Databases
There are already large private databases of information on the incomes and economic activities of individuals, but are usually fragmented and rarely used for good economic purposes. A protocol for sharing the information among such databases needs to be developed, so that the current fragmented sources can be pooled, and the enlarged pool be used for beneficial purposes, such as providing consumers and homeowners with more accurate pictures of their financial situations. As is the case with income tax filings today, large publicly available databases of privacy-protected data are a real possibility. This could permit, for instance , the construction of an array of up-to-date personal income indices by occupation, demographics, health status, which could serve as the basis for the settlement of individually tailored risk-management contracts. Risk-management engines could access the complete, fine-grained picture of a country's economic situation - a degree of transparency that remains impossible today.
6. A New System of Economic Units Measurements
Units of measurement should be defined for many common economic values including income, profits, wages, but most of all - for inflation (Similar to the unidad de fomento developed in Chile in 1967). Inflation indexed units - simply called - baskets - would make clear that they represent the value of the market based basket of goods and services upon which the consumer price index is calculated. Given the public's difficulty with understanding inflation, this would render it less confused by so-called money illusion, the tendency to think of prices in nominal, not real terms. Schiller claims that if we had been accustomed to quoting home prices in baskets since 1890, then people would generally have known that home prices haven't changed in a hundred years(until the recent bubble), and they would never have gotten the idea - that home prices ALWAYS go up.
Of course, this long-term solution proposed suggests further development of the financial markets, and free them further to work better, a view that is not well taken in today's chaotic financial climate. There are those who have argued that the whole financial sector itself has been a bubble, and there are those who imagine that the entire solution to the subprime crisis lies in either sidestepping or punishing the financial sector - bailouts followed by regulations, rules, penalties and prison sentences. A lot of industry mammoths have already been beaten down in their own mess. In a nod to how far its brand has fallen, the notorious AIG removed its name from its New York headquarters recently. The followup to the subprime crisis has invoked enough finger-pointing in ascribing the blame to some combination of evil movers and shakers. Roubini and Taleb think that bonuses to bankers are a problem in the sense that they drive a mentality in which they work for the money and not responsibility. Although its argued that the bonuses paid out are a fraction of the problem, it is the system in place which needs to be fixed, invoking the need for radical changes like nationalization. And, although there has been unscrupulous and irredeemable cronyism hiding behind the veils of corporate correctness,as well as top executives hitherto entitled to exorbitant amounts in compensation, waging war on the financial elite really goes beyond our desire for retribution and reforming the powerful technology called Finance which if reformed correctly, can be used to better everyone off, and deal with the unmanaged risks leading to economic inequality. Indeed, the danger with the emphasis on placing blame may cause us to lose sight of the real solution. As a historical analogy, the stock market crash of 1929 led to considerable anger in parts of Europe, and intensification of nationalism, fascism and racism, which resulted in further weakening of the continent's financial system. In contrast, in the US the reaction was to try to strengthen the financial sector.
Call it what you will, but for now, class anger is back.
Of course, bolstering major banks to start lending again is crucial if the economy has to recover. With the Treasury's plan to team up with private investors to rid the banks of troubled mortgage assets, it aims to create investment partnerships that will combine government cash with equity capital from private investors. The government will then lend those partnerships money at below-market rates so they have more funds to buy up the banks bad assets. By providing much of the funding- and limiting private investor potential losses, the Treasury hopes to spur competitive bidding that will establish realistic prices for toxic assets and get them off the banks balance sheets. Of course, if the government lends to the partnership at too low a rate, bankers would complain that they are being forced into big writeoffs if the prices for the troubled assets remains too low. Administration officials need to make clear that they expect banks to take the haircut given the stakes. In any case, a lot of banks that do poorly on the so-called stress tests may have little choice but to cooperate[11].
As far as home prices is concerned, it is in fact no bad news for the public if home prices fall. If home prices go down relative to our incomes, we become wealthier, better able to invest in new homes. The idea that public policy should be aimed at validating the real estate myth, preventing a collapse in home prices from happening, is an error of the first magnitude. In the short run a sudden drop in home prices indeed disrupts the economy, producing undesirable systemic effects. But in the long run, home-price drops are clearly a good thing. The short and the long run, must indeed be considered separately[1].
Often the systemic effects on the economy have to do with investor confidence and psychological or social contagion.The loss of trust and belief in the economic system can have consequences not only for the economy itself, but for the social fabric as whole. The events of the 1930's are best remembered in photographs of long bread lines and soup kitchens , middle aged men selling apples on the street - these images burned into the national psyche became a symbol of the times. The more subtle ones, according to Frederick Lewis Allen in this book Only Yesterday: An Informal History of the 1920s, were changing women's fashions : short skirts disappeared and a more formal and less provocative style emerged. Romantic and poetic plays reappeared, replacing others that challenged contemporary values. Admiration for enterprenuers and savvy businessmen waned. Delight in the then-shocking theories of avant-garde Freudian psychologists became less common. Harvey Klehr in his 1968 book The Heyday of American Communism: The Depression Decade detailed how Americans, both workers and intellectuals, began to be won over to communist theories ; the 1930s have often been cited as "The Red Decade". [1]
Today the recession has created a huge slack in the economy in terms of unemployment and excess production capacity. Even after the economy starts to grow again, many economists believe it will take a couple of years to return to the ideal 5% jobless rate and 80% utilization of industrial capacity. Right now unemployment is at 8.1% and likely to rise throughout 2009, the industrial operating rate being at a record low of 67%. The biggest problem also is that the Fed plans to hold a large volume of longer-term assets, such as mortgage back securities and Treasury notes, which take much longer to unwind because rapid sales push up mortgage rates and borrowing costs. It is important to find the right level for its target rate, which if missed, could send the economy back into recession or cause inflation to spiral out of control[10].
A lot of strategists tend to keep an eye on the people who really know what's happening in the economy - business leaders. You know corporations are getting confident once they start buying back their own shares and acquiring other companies. Right now, announcements of share buybacks are down 90% from a year ago, as most companies show no such bravado.[12]
A recession in the US and the overall resilience of China, India and the oil-producing countries will likely reinforce the decline in the power and influence of the United States[2]. China, today the world's largest holder of US debt - recently proposed overhauling the global monetary system by boosting an alternative to the US dollar. Although there could be several theories behind explaining the economic prospects of the US dollar, such a proposition was unthinkable in the past. Conventional wisdom used to state that when the United States sneezes the rest of the world catches cold. That used to be true, but no longer.
May we all perpetually live in interesting times.
Note: This essay was compiled with my own thoughts after reading the following sources (and other hyperlinks elucidated in the passage). Certain lines were taken from the books mentioned below, indicated by those contained in paragraphs preceded by markers to their sources. In the interest of time, I have not given detailed markers to the pages from where the lines were borrowed.
References and readings
1.The Subprime Solution - Robert Schiller
2.The New Paradigm for Financial Markets - George Soros
3.Crash of the Millennium - Ravi Batra
4.The return of depression economics and the crisis of 2008 - Paul Krugman
5.The ascent of money - Nail Ferguson
6.The Big Takeover - Matt Taibbi
7.Triple-A Failure - Roger Lowenstein
8.Recipe for disaster - The formula that killed Wall Street - Felix Salmon
9.The End - Michael Lewis