Subprimes and such

[Winstonm]

"There is much to be worried about.....zero regulation is not the issue."

 

I refer you back to my main point:

 

"If you keep demanding stability you will just keep introducing long term fragility.

 

Much more important is to accept variation, randomness, as part of a long term economy and learn how to benefit from it!"

 

I'm sorry, but when credit default swap derivatives were sold by parties who could not cover the losses when they occurred, and those devivatives were bought and relied upon by too-big-to-fail banks that ended up having to be bailed out to prevent a total economic meltdown, it is impossible to dismiss the incident as "not the issue".

 

Credit default swaps are insurance products, and as such should be compelled to hold loss reserves in the same manner that insurance companies must - that there was no such regulation in place and no regulating body to enforce, credit default swaps were a major contributor to the Great Meltdown Recession.

 

The amazing thing is that no major changes to regulations has taken place since the meltdown.

 

Totally free markets are like announcing that we are playing a baseball game, but in our game anyone can play at any time, any position they want, and by any rules they want to apply - if they're good at stealing second, they are allowed to wear razor blades instead of cleats; if they pitch well, the mound is only 10 feet from home plate; and if the still lose the game, the viewing public must pay off all losing bets.

 

To work well, free markets must have boundaries that are established by rules created by a central decision-making apparatus so it applies universally. Once these rules and regulations are in place, free markets have the guidance they need to effectively compete and create.

 

There are many examples of the market innovations, but those innovations came only after regulations forced change - toilets are a simple example as federal law changes required less water usage, from almost 4 gallons per flush to the now-lawful 1.6 gallons per flush. The power-assist toilet is a direct market-response result of the change in law.

 

In other words, regulators decided for the good of the many that less water usage was required and created a law that compelled the marketplace to invent and adapt.

[blackshoe]

Totally free markets are like announcing that we are playing a baseball game, but in our game anyone can play at any time, any position they want, and by any rules they want to apply - if they good at stealing second, they are allowed to wear razor blades instead of cleats; if they pitch well, the mound is only 10 feet from home plate; and if the still lose the game, the viewing public must pay off all losing bets.

 

To work well, free markets must have boundaries that are established by rules created by a central decision-making apparatus so it applies universally. Once these rules and regulations are in place, free markets have the guidance they need to effectively compete and create.

I don't think you understand free markets at all.

[Winstonm]

I don't think you understand free markets at all.

 

The market for derivative products called "credit default swaps" is an example of a totally unregulated free market system - what is there about these products and the part they played in bringing about the Great Recession and financial meltdown of 2008 do you not understand?

[barmar]

Where to begin.

 

We already have plenty of bank and investment regulations. What they're missing is adequate resources to monitor investment firms for compliance.

 

As mike777 says, all investing is gambling. It's just the case that some investments are more risky than others. But you can't eliminate all risk.

 

Protecting against investment losses is like fortifying levees or building earthquake-proof buildings. It's only practical to make them so strong -- eventually there will be a flood or quake that's bigger than you planned for, and they'll break.

 

I'm reminded of a year or two ago when one of the big banks announced that they'd incurred a multi-billion dollar loss on some investment. Did anyone ever mention how much they stood to gain if it had gone well?

 

Imagine playing craps, and it pays out 1.1:1 on every roll, but if you roll snake-eyes 5 times in a row (60 million to 1 odds against) you lose your entire stash. It's like the reverse of the lottery, and you'd be a sucker not to play.

 

Much of the cause of the Great Recession wasn't because of lack of bank regulation. It was because most of the experts in the banking industry simply didn't understand what they were doing. Conventional wisdom was that when you package up a bunch of securities, you reduce risk because of diversification. They failed to see how everything was correlated, so instead of some investment losses being balanced out by other gains, they all dropped in lock-step, and there were feedback effects that caused chain reactions of losses (if I default on my mortgage and the bank forecloses, my neighbors' property values also fall, and if they go under water they may decide to abandon the loan, and so on).

 

There were a handful of economists who saw this coming. But when you buck conventional wisdom, it's hard to get everyone to believe you. And most investors didn't want to hear bad news like that, they were happy as pigs in slop just raking in the dough.

 

It also seems to have much in common with climate change. Even though the science is credible, many people in the relevant industries, not to mention the general public, cover their ears because it's too painful to contemplate. People like the comfortable life we have when we pretend that we have unlimited, cheap energy at our disposal. And businesses like selling that energy and all the dependent products.

[Winstonm]

Where to begin.

 

We already have plenty of bank and investment regulations. What they're missing is adequate resources to monitor investment firms for compliance.

 

As mike777 says, all investing is gambling. It's just the case that some investments are more risky than others. But you can't eliminate all risk.

 

Protecting against investment losses is like fortifying levees or building earthquake-proof buildings. It's only practical to make them so strong -- eventually there will be a flood or quake that's bigger than you planned for, and they'll break.

 

I'm reminded of a year or two ago when one of the big banks announced that they'd incurred a multi-billion dollar loss on some investment. Did anyone ever mention how much they stood to gain if it had gone well?

 

Imagine playing craps, and it pays out 1.1:1 on every roll, but if you roll snake-eyes 5 times in a row (60 million to 1 odds against) you lose your entire stash. It's like the reverse of the lottery, and you'd be a sucker not to play.

 

Much of the cause of the Great Recession wasn't because of lack of bank regulation. It was because most of the experts in the banking industry simply didn't understand what they were doing. Conventional wisdom was that when you package up a bunch of securities, you reduce risk because of diversification. They failed to see how everything was correlated, so instead of some investment losses being balanced out by other gains, they all dropped in lock-step, and there were feedback effects that caused chain reactions of losses (if I default on my mortgage and the bank forecloses, my neighbors' property values also fall, and if they go under water they may decide to abandon the loan, and so on).

 

There were a handful of economists who saw this coming. But when you buck conventional wisdom, it's hard to get everyone to believe you. And most investors didn't want to hear bad news like that, they were happy as pigs in slop just raking in the dough.

 

It also seems to have much in common with climate change. Even though the science is credible, many people in the relevant industries, not to mention the general public, cover their ears because it's too painful to contemplate. People like the comfortable life we have when we pretend that we have unlimited, cheap energy at our disposal. And businesses like selling that energy and all the dependent products.

 

The primary cause of the housing bubble which led to the Great Recession was non-bank lending - banks had little to do with it other than create and trade in MBS and crdit default swaps.

[kenberg]

I tend to at least begin with the obvious.

 

It is so, is it not, that in the run up to the crash loan applications were being approved that in previous times would have been rejected? If you bundle a bunch of bad loans then you have a bundle of bad loans instead of several individual bad loans, but you still have bad loans.

 

Discussion of the past is only useful if it helps with the present or the near future. My application of this experience to current life is that I agree with the tightening of qualifications for loans for college education. Lending money to people who are unlikely to be able to pay it back sounds simply stupid. It was a mistake with the houses, and so it is with college education loans.

 

Helpiong people is a good idea. Pretending that reality is different from what it is is a bad idea.

[Winstonm]

I tend to at least begin with the obvious.

 

It is so, is it not, that in the run up to the crash loan applications were being approved that in previous times would have been rejected? If you bundle a bunch of bad loans then you have a bundle of bad loans instead of several individual bad loans, but you still have bad loans.

 

Discussion of the past is only useful if it helps with the present or the near future. My application of this experience to current life is that I agree with the tightening of qualifications for loans for college education. Lending money to people who are unlikely to be able to pay it back sounds simply stupid. It was a mistake with the houses, and so it is with college education loans.

 

Helpiong people is a good idea. Pretending that reality is different from what it is is a bad idea.

 

Exactly.

[blackshoe]

The market for derivative products called "credit default swaps" is an example of a totally unregulated free market system - what is there about these products and the part they played in bringing about the Great Recession and financial meltdown of 2008 do you not understand?

I was right. You don't understand.

 

More government regulation of the market is not the panacea you seem to think it is.

[dwar0123]

I was right. You don't understand.

 

More government regulation of the market is not the panacea you seem to think it is.

I would think that largely depended on the regulations?

 

No one is suggesting that random regulations, made for no reason, are a solution to anything; an absurd statement. Just as absurd as your point of view, that all regulations, made for any reason, has never solved anything.

[mike777]

The primary cause of the housing bubble which led to the Great Recession was non-bank lending - banks had little to do with it other than create and trade in MBS and crdit default swaps.

 

 

That is far from clear that a housing bubble caused a great recession.

 

It may be true that the great recession caused the real estate market to crash.

 

One possible theory for the cause of the recession is a decrease in the future value of labor.

 

Another theory is that a credit bubble, from the fed to the banks to etc, created the recession..

 

An open debate.

---

 

 

In any case rent seeking seems to be increasing.

 

In public choice theory, rent-seeking is an attempt to obtain economic rent by manipulating the social or political environment in which economic activities occur, rather than by creating new wealth.

 

http://en.wikipedia.org/wiki/Rent_seeking

 

I think this is a much more important issue rather than debating the finer points of the value of new regulations.

[onoway]

This may be obvious to everyone else but me, but what exactly is stopping the whole thing from going pop? It seems as though everything that had people planning for an economic doomsday - like the level of governmental debt - hasn't gone away but now people are happy and marching forward with a smile on their face and a song in their hearts, so to speak. What did I miss?

[mike777]

hope springs eternal?

 

or after a while depression...end of the world just gets boring..

[kenberg]

This may be obvious to everyone else but me, but what exactly is stopping the whole thing from going pop? It seems as though everything that had people planning for an economic doomsday - like the level of governmental debt - hasn't gone away but now people are happy and marching forward with a smile on their face and a song in their hearts, so to speak. What did I miss?

 

As Rudyard Kipling out it:

 

If you can keep your head when all about you

Are losing theirs

You probably don't understand the situation

 

 

Attempting a more serious answer: I think that the situation is not good at all. I also think that many problems are not easy to understand. But meanwhile there is life. I have problems to deal with that have little to do with the government, and pleasure to enjoy that have little to do with the government. I am interested in passing on a functioning democracy to the kids and grandkids but I am more than a little pessimistic. I liked the world that I grew up in.

[barmar]

I tend to at least begin with the obvious.

 

It is so, is it not, that in the run up to the crash loan applications were being approved that in previous times would have been rejected? If you bundle a bunch of bad loans then you have a bundle of bad loans instead of several individual bad loans, but you still have bad loans.

Let's say you have a bundle of loans, and each of them has a 10% chance of default. As long as the income from the 90% that keep paying makes up for the losses from the 10% who default, you're OK.

 

This expectation is reasonable if they're all independent. That's the basis behind the insurance industry, too: everyone pays their premiums, but only a few of them will make claims.

 

But they're not necessarily independent. The housing bubble was to the loan industry as a natural disaster is to the home insurance industry: the losses are correlated and widespread, and the income doesn't compensate for them.

 

Another way to look at it is this. If they're independent, the expectation is that only about 10% of the loans will default. The chance that 20% of the loans will default is only 1% , and the chance that all of them will default is 0.00000001%. At the other end of the spectrums, if the loans are perfectly correlated with each other, the chance that all of them will default is the same as the chance that any one will default: there's a 10% chance of losing everything that has been loaned out.

 

The flaw in their thinking was that loans were mostly independent, when there's actually a strong correlation.

[mike777]

To be fair local banks have always known there is a strong correlation. They live and die with their local community or local city and state and that is ok. Failure is ok and an accepted part of purging the system quickly to help recover and grow again.

[hrothgar]

To be fair local banks have always known there is a strong correlation. They live and die with their local community or local city and state and that is ok. Failure is ok and an accepted part of purging the system quickly to help recover and grow again.

 

Aside from those cases where the local bank was investing in CDOs...

Or, worse yet, the county that the local bank was in was investing its funds in CDOs

[hrothgar]

That is far from clear that a housing bubble caused a great recession.

 

It may be true that the great recession caused the real estate market to crash.

 

One possible theory for the cause of the recession is a decrease in the future value of labor.

 

Another theory is that a credit bubble, from the fed to the banks to etc, created the recession..

 

An open debate.

---

 

 

it may be true that the earth is a solid ellipsoid circling the sun

 

One possible theory is that the god Helios drives a chariot containing the sun each day.

 

Another theory is that the earth is solid disk sitting atop a giant turtle

 

An (equally) open debate

[dwar0123]

it may be true that the earth is a solid ellipsoid circling the sun

 

One possible theory is that the god Helios drives a chariot containing the sun each day.

 

Another theory is that the earth is solid disk sitting atop a giant turtle

 

An (equally) open debate

It may be a theory to you, but tell that to the guys living on the edge of the disk dropping down under to see what they can see.

 

They can SEE the turtle.

 

And the 4 elephants too.

[barmar]

To be fair local banks have always known there is a strong correlation.

Which is why local banks usually sell their mortgages to aggregators.

[mike777]

Which is why local banks usually sell their mortgages to aggregators.

 

 

They may but keep in mind they still make most of their loans locally, cars, business, etc. They do live and die with their local communities.

 

As for the big money center bnks, they are aware that correlations change over time and that in time of great crises all correlations go to one.

----------------------------------------------------------------------

---------------------------------------------------------------------

The Possible Misdiagnosis of a CrisisFinancial Analysts Journal

 

 

Richard Roll

 

March/April 2011, Vol. 67, No. 2: 12–17

(doi: 10.2469/faj.v67.n2.3)

 

 

View Table of Contents

 

Abstract Abstract

Summary Summary

PDF PDF (267 K)

PDF Linked PDF (268 K)

Audio File Audio File (4129 K)

 

Abstract

 

 

Most explanations of the 2007–08 financial crisis—including excessive leverage, subprime mortgages, exotic derivatives, reckless risk taking, and easy money that spawned a housing bubble—are inconsistent with elementary principles of finance. The author explains the inconsistencies and suggests an alternative diagnosis that is fully compatible with rationality

-------------------

 

http://www.cfapubs.org/doi/abs/10.2469/faj.v67.n2.3

[Winstonm]

Let's say you have a bundle of loans, and each of them has a 10% chance of default. As long as the income from the 90% that keep paying makes up for the losses from the 10% who default, you're OK.

 

This expectation is reasonable if they're all independent. That's the basis behind the insurance industry, too: everyone pays their premiums, but only a few of them will make claims.

 

But they're not necessarily independent. The housing bubble was to the loan industry as a natural disaster is to the home insurance industry: the losses are correlated and widespread, and the income doesn't compensate for them.

 

Another way to look at it is this. If they're independent, the expectation is that only about 10% of the loans will default. The chance that 20% of the loans will default is only 1% , and the chance that all of them will default is 0.00000001%. At the other end of the spectrums, if the loans are perfectly correlated with each other, the chance that all of them will default is the same as the chance that any one will default: there's a 10% chance of losing everything that has been loaned out.

 

The flaw in their thinking was that loans were mostly independent, when there's actually a strong correlation.

 

 

The trouble is you are only talking about some of the loans - from around 2006-2008 the majority of loans were more like 99.9% guaranteed to default. And with no transparency no one knew which loans (and thus MBS) were toxic and which were not. This threatened a collapse of the entire MBS market, spawning credit defaut swaps which had been sold by institutions without sufficient reserves to pay those losses.

 

At its heart, the cause of the Great Recession was the pursuit of yield.

[Winstonm]

Which is why local banks usually sell their mortgages to aggregators.

 

But local banks were simply not the problem when it comes to the Great Recession - non-bank lenders made the vast majority of loans that later defaulted, and they sold those loans to Wall Street banks who then packaged the loans into Mortgage Backed Securities. This group of mortgage lenders became known as the "shadow banking industry" because they fell outside normal regulatory channels, while the Federal Reserve, who did have the power to regulate them, chose not to do so.

[Winstonm]

They may but keep in mind they still make most of their loans locally, cars, business, etc. They do live and die with their local communities.

 

As for the big money center bnks, they are aware that correlations change over time and that in time of great crises all correlations go to one.

----------------------------------------------------------------------

---------------------------------------------------------------------

The Possible Misdiagnosis of a CrisisFinancial Analysts Journal

 

 

Richard Roll

 

March/April 2011, Vol. 67, No. 2: 12–17

(doi: 10.2469/faj.v67.n2.3)

 

 

View Table of Contents

 

Abstract Abstract

Summary Summary

PDF PDF (267 K)

PDF Linked PDF (268 K)

Audio File Audio File (4129 K)

 

Abstract

 

 

Most explanations of the 2007–08 financial crisis—including excessive leverage, subprime mortgages, exotic derivatives, reckless risk taking, and easy money that spawned a housing bubble—are inconsistent with elementary principles of finance. The author explains the inconsistencies and suggests an alternative diagnosis that is fully compatible with rationality

-------------------

 

http://www.cfapubs.org/doi/abs/10.2469/faj.v67.n2.3

 

In the first paragraph or so there is a problem with this thinking when the author correlates "easy money" with "interest rates". Such was not the case in this instance. Easy money was the easy availability of mortgage loans to non-qualified applicants and the flexible loan products developed, not just interest rates.

[blackshoe]

But local banks were simply not the problem when it comes to the Great Recession - non-bank lenders made the vast majority of loans that later defaulted, and they sold those loans to Wall Street banks who then packaged the loans into Mortgage Backed Securities. This group of mortgage lenders became known as the "shadow banking industry" because they fell outside normal regulatory channels, while the Federal Reserve, who did have the power to regulate them, chose not to do so.

Interesting that a private institution should have the power to regulate anything.

[Winstonm]

Interesting that a private institution should have the power to regulate anything.

 

It is surprising to me that someone with your background and obvious intelligence continues seemingly to fail to grasp that not every situation can be simplified to binary equation - the federal reserve is a classic example.

 

The Federal Reserve is a system, not a single entity, and that system has components that are both public and private. Regardless, the federal reserve was created by an act of Congress, it is still answerable to Congress, and it turns over its profits each year to the U.S. Treasury.

 

Hardly a scary monster from Spooky Island.