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Innovating Our Way to Financial Crisis

Op-Ed piece from NYT

Innovating Our Way to Financial Crisis
By PAUL KRUGMAN
Published: December 3, 2007
The financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance.

Paul Krugman.





How bad is it? Well, I've never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.
This time, market players seem truly horrified — because they've suddenly realized that they don't understand the complex financial system they created.
Before I get to that, however, let's talk about what's happening right now.
Credit — lending between market players — is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about "liquidity," is an essential lubricant for the markets, and for the economy as a whole.
But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.
"What we are witnessing," says Bill Gross of the bond manager Pimco, "is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August."
The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.
Behind the disappearance of liquidity lies a collapse of trust: market players don't want to lend to each other, because they're not sure they'll be repaid.
In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble — I mean, there wasn't even a glamorous new technology to justify claims that old rules no longer applied — but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk.
Thus, "super-senior" claims against subprime mortgages — that is, investments that have first dibs on whatever mortgage payments borrowers make, and were therefore supposed to pay off in full even if a sizable fraction of these borrowers defaulted on their debts — have lost a third of their market value since July.
But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn't supposed to have tens of billions of dollars in subprime exposure; it did. Florida's Local Government Investment Pool, which acts as a bank for the state's school districts, was supposed to be risk-free; it wasn't (and now schools don't have the money to pay teachers).
How did things get so opaque? The answer is "financial innovation" — two words that should, from now on, strike fear into investors' hearts.
O.K., to be fair, some kinds of financial innovation are good. I don't want to go back to the days when checking accounts didn't pay interest and you couldn't withdraw cash on weekends.
But the innovations of recent years — the alphabet soup of C.D.O.'s and S.I.V.'s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn't have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.
Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis.
And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, "I don't think we'd want it the other way around." Is that your final answer, Mr. Secretary?
Now, Mr. Paulson's new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won't make more than a small dent in the subprime problem.
The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.
 
...and back out again.

chaos=opportunity.

wall street is known for overselling, overhyping and beating to death even the best of ideas until they turn around and bite back. And that doesn't take into consideration scams.

funny thing is, you couldn't say this to anyone 10, 5, 3, 2 years ago.

probably never been a better time to be a quant.

old traders have a saying: money always returns to its rightful owners.
 
What 07 Headlines Say About 08 Job Market

Charles you sage. This article confirms your beliefs.

3rd to last paragraph says

"What's hot: To avoid repeating history, lending institutions, hedge funds and investment banks are likely to invest more in departments aimed at offsetting such problems, says Michael Woodrow, president and founder of Risk Talent Associates LLC, a New York-based recruiter that places senior professionals in credit, market and operational risk-related positions as well as quantitative and compliance finance jobs. "

WSJ article 12/11/07

What '07 Headlines Say About '08 Job Market - WSJ.com
 
Charles you sage. This article confirms your beliefs.

3rd to last paragraph says

"What's hot: To avoid repeating history, lending institutions, hedge funds and investment banks are likely to invest more in departments aimed at offsetting such problems, says Michael Woodrow, president and founder of Risk Talent Associates LLC, a New York-based recruiter that places senior professionals in credit, market and operational risk-related positions as well as quantitative and compliance finance jobs. "

WSJ article 12/11/07

What '07 Headlines Say About '08 Job Market - WSJ.com

You should read other opinions than headhunters for "Risk Talent" when thinking about the likely quant job market in the near future.

How do you think the immense, continuing writedowns and current macro-economic uncertainty affect hiring plans among the big investment banks?

How do you think the credit crisis and shrinking of associated markets affects the need for quants in (say) ABS/MBS, CDO groups?

How do you think job cuts in hedge funds and banks (in some cases, the elimination of entire business lines) affect quant supply and demand?

This is not a black and white picture, some people will always be hiring - just take these sound bites with a pinch of salt.
 
i'm not a contrarian, but i am a rationalist (made that up...maybe logician would be more appropriate) who doesn't take well to sensationalist writings, which is what i think we have here.

so please don't take my thoughts as "hey, tin foil hat time"

How bad is it? Well, I’ve never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.
This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created.
Before I get to that, however, let’s talk about what’s happening right now.
Credit — lending between market players — is to the financial markets what motor oil is to car engines.

agree...though it depends which engine you are looking at and how dirty the oil is...

The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.
But liquidity has been drying up. Some credit markets have effectively closed up shop.

right, but which credit markets have closed up shop? from what i've read, it seems the most illiquid markets were the ones to close up (complex derivatives based on debt based on subprime & other mortgages). the "real" effect of this (these) markets not trading is nowhere near as important as if, say, the 3mo ED market suddenly shut down.

Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.

that is definitely typical of crisis situations (which i do think we are in if not approaching). but the world didn't end in 1987, nor did it end in 1998. here is a picture:

3mo6moLIBORTbillspread.jpg


these are the compound spreads of 3mo and 6mo daily LIBOR rates above the constant maturity 3mo and 6mo Tbill rates.

so while we are clearly in a crisis in the financial markets as judged by spikes in lending rates, these spreads have also come down recently from the high they hit of 211bps in early december. that they are still high is a problem but there are many reasons for it as i'll go into a bit later in the article.

“What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”

overstatement by a long shot. the modern day banking system has not broken down.

The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.

this is certainly true. if banks are unable to get S-T funding cheaply, then the spreads they make through lending aren't going to go to 0, they'll passt hose costs onto their customers on the whole. this will reduce borrowing and thus consumption. it also reduces their ability/desire to give loans on housing which has been one fo the mainstays of the recent consumption boom.

one indicator of that is the spread of 30year mortgage rates of 30 year treasuries. we've seen the latter fall as rates fall, but the former stayed fairly constant increasing the spread significantly.

what i can't quantify is what Krugman means by a "severe reduction." how much is severe. i'd think we will certainly see (And have already seen) a reduction in overall lending growth. using monthly CCO (consumer credit oustanding) as a guage, we've seen the growth rate there drop from a relatively blistering pace of >.50% to .13% and .19% in september and october (with december's coming out soon). when this indicator turns negative, we typically see a consumption recession:

CCO.jpg


the exception is times like 1998 when lending froze up for other reasons but quickly came back in line. the latest recession we had was a business led recession where the consumer's credit outstanding did fall alot, but didn't turn negative.

so again, i'm not sure what krugman expects in a "severe" recession (i.e. look at the 1976 and 1980 reductions in CCO...i'd call those severe). if we hit those levels, then yes, we will likely have a nasty recession...

...but one thing to keep in mind is that overall, corporate balance sheets are very strong right now (non-farm business) with the exception of financials & homebuilders. so margins will likely compress, but they're doing so from record levels.

Behind the disappearance of liquidity lies a collapse of trust: market players don’t want to lend to each other, because they’re not sure they’ll be repaid.

this is where i'll go into the spike in LIBOR spreads above tbills.

what we are seeing ehre is a number of factors that are likely (and priced) to ease over time (by priced i mean the 3mo spread 3mo fwd is over 100bps lower than the 3mo spread...it is typically only 10-30bps lower).

1) end of year bank reluctance to loan which would reduce equity capital reported in 10Ks.
2) unknown location of bad debts (i.e. banks dont' know who is a good borrower and who is not due to the lack of clarity in markets right now)
3) unknown amt of liquidity that will be needed for banks' own balance sheets. this is a corrallery of #2. banks themselves don't exactly know what their liquidity needs will be going forward until the scale and depth of write downs and on balance sheet moves become clear.

so it isn't exactlyt hat banks are at an apocalypse and don't think they'll be repaid (though that is certianly part of it)...there are other factors that krugman glosses over.

In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble — I mean, there wasn’t even a glamorous new technology to justify claims that old rules no longer applied — but somehow financial markets accepted crazy home prices as the new normal.

actually, there was a glamerous new technology...so to speak.

there was a few things:

1) introduction of MASSIVE moral hazard on the parts of mortgage loan initiators and ratings agencies. the former didn't feel the need to scrutinize borrowers since they simply sold off initiated mortgages to banks for repackaging into securities. the abundant liquidity pushed up demand for these investments since they yielded more than their similarly rated AAA counterparts (Which is always a bad thing if you think they should be rated equally). the ratings agencies were deficient in 2 respects: a) they were getting paid by the same people who wanted the AAA ratings...and advised them how to attain it, and b) they didn't value liquidity at all.

combine this with the biggest investor flaw in existance: the extrapolation of the recent past into the future...and you get a "housing prices never go down, let's all jump in" mentality that did have a "new technology" feel to it.

And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk.
Thus, “super-senior” claims against subprime mortgages — that is, investments that have first dibs on whatever mortgage payments borrowers make, and were therefore supposed to pay off in full even if a sizable fraction of these borrowers defaulted on their debts — have lost a third of their market value since July.

right but that is a red herring since that isn't the trust that engenders spikes in LIBOR spreads....it is the few things i mentioned earlier, of which 1/3 loss of market value is an indicator...but not the "lack of trust" i think he is trying to imply there.

But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn’t supposed to have tens of billions of dollars in subprime exposure; it did. Florida’s Local Government Investment Pool, which acts as a bank for the state’s school districts, was supposed to be risk-free; it wasn’t (and now schools don’t have the money to pay teachers).

yes, definitely that is a huge factor.

How did things get so opaque? The answer is “financial innovation” — two words that should, from now on, strike fear into investors’ hearts.

sure thing Mr. Krugman...futures, options, etc. etc. all have time periods where there is a crises based off of new innovation...but the world adjsuts and continues on. MBSs will be issued again, moral hazard will have the lights shown on it and the markets will continue to do what markets do, innovate, evolve, and adjust.

in 1987, the combination of futures and options (and futures used to replicate options in so-called portfolio insurance schemes) helped engender the massive 20odd % fall in the S&P500 in one day. did we stop using futures or options? what are the notional values today for those contracts? they are huge multiples of what they were then. we will likely see the same thing in the next 30 years as developing coutnries join the fray and their markets become tapped for similar securities...but with the knowledge we learned through this crisis.

O.K., to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends.
But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

partly it was the investors fault too...they wanted returns and didn't care what they had to do to get them. thus is the circle of investing that happens when liquidity is so abundant, almost to a fault.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis.
And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary?

yes. and that is mine too. if regulation got ahead of innovation, we'd never have seen the types of actually important innovations. in fact, the philosophy of regulation would be so distorted that it woudl be disproportionately bad for everybody (imagine a world where any new innovation has to be stalled and scrutinized in order to make sure it is "safe." what would that cost taxpayers? inventors? businesses? etc.)

Now, Mr. Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem.
The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.

right, innovation was 100% at fault here...i dont' think so. it was one factor, but there were obviously a confluence of factors that got us here...

ideally, imo, the market should be left to clear. we'd hit a bad spot for a few years but be the better for it going forward.

Barron
 
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