The credit bubble and the market

Matthew Parris makes an interesting point:

So amid all the doom-mongering and recanting, I have an assertion to make. The market has not failed. The present collapse is evidence that the market is working. Confidence bubbles are an inherent feature of a free market system. Panics — confidence vacuums — are an inherent feature too. The test of the theory of market capitalism is whether the system provides from within itself the means to prick both.

It does. The first — a confidence bubble — has been pricked. We are now sucking ourselves the other way: into a confidence vacuum. In time this too will be pricked. The market will steady.

The bubble that has just burst was based, worldwide, on financial services. Financial services are a product. It is true they are a product critical to the efficient functioning of the market (so is electricity, so is oil) but that just makes them an unusually important product. From time to time products fail in any market. They may fail through force majeure — droughts, floods, pestilence. They may fail due to inherent flaws — airships, Thalidomide, blue asbestos. Or they may fail through ignorance, trickery or the credulity of human beings — Madoff, the property bubble, the repackaging of sub-prime debt.

The present financial crash has been precipitated by product failure of the third kind. Trade in financial instruments too opaque for even those who traded in them to assess them properly, and bonus incentive schemes that acted against the interests of the companies offering them, fuelled a banking bubble that has now burst.

But ask: what pricked it? Did politicians rumble the trade? Did governments, or international forums or symposiums, provide the sharp instrument? Did academic research and expertise expose the dodgy product? Did statutory regulators apply the pin? No, the free market wised up and pricked this bubble. Politicians and finance ministers (if they had had the power) would have tried to keep it inflated. The market puffed itself up, and then, without intervention — despite intervention — the market let itself down. The speed with which this has happened has been awful, but however inconvenient for many or catastrophic for a few, correction is not a failure of the market, but a success.

The Credit Crunch: What the lenders were doing

From "The Crunch", by Alex Brummer, pages 42-43:

To get an idea of how all this worked in practice, and to understand why it was built on such shaky foundations, take the fictional example of Mr and Mrs Jerome Smith of downtown Cleveland. They are persuaded by Fast Talking Mortgage Brokers Inc. (FTMB) to buy their shabby clapboard property with a $100,000 mortgage. The interest rate of 10 per cent is being waived for the first two years. In fact, interest has not been forgiven but is being rolled up with the original mortgage, increasing the debt to $120,000. FTMB, having taken an arrangement free from the Smiths, then sells on the mortgage to Grasping Investment Bank (GIB) of New York, which pays the broker a commission for the mortgage. GIB wraps up the Smiths' loan with dozens of other loans to other Smiths from poor neighbourhoods around the country and renames it Smith Mortgage Obligation (SMO), and then pays its favourite credit rating company, Stamped & Correct, to certify the SMO as good quality debt. The attraction of this SMO is its 10 per cent return at a time when government bonds are getting between 2 and 3 per cent.

But rather than selling SMO directly to clients, GIB takes another route. It creates a new company --- a special purpose vehicle called GIB Capital --- and this borrows from other banks cheaply and uses the money to buy Smith Mortgage Obligation. GIB then offers shares in GIB Capital, now the proud owner of SMO, to clients, who lap up the shares because of the high return.

Grasping Investment Bank benefits from the process in several ways. It has collected profits and commission on the sale of the SMO and also benefits from leverage (borrowing) because it is using someone else's money. GIB has also cleverly placed the SMO off its balance sheet in the special purpose vehicle, which it does not have to disclose on its accounts as a liability. It can stretch its capital further and will not have the regulator on its back.

Thus not only are mortgages given to people who are likely to find it difficult to pay them, but they are rated on a dubious basis, responsibility for them is diffused amongst several players, proper accounting of the debt is obscured by creating the special purpose vehicle and extra borrowing from banks is used to facilitate the whole process. It seems to me this process was bound to hide the riskiness of the mortgages from the investors.

Note that SMO in this scenario is an example of a collateralized debt obligation.

Why do "bubbles" occur in the financial markets?

Virginia Postrel, writing for the Atlantic magazine, discusses experiments some economists have been running that seek to provide insight into the behaviour of financial markets.

The basic idea is simple. You offer the subjects investments which provide 15 regular dividends of $0.24 during the course of the experiment (alternatively you offer a range of possible payments that average $0.24). The subjects then trade those investments with each other. There are 60 rounds of trading, with dividends paid every fourth round.

In theory, no one should pay more than the expected value of the investment at each round of trading, namely the amount of money that is still left on that dividend. At the start, this is $3.60. After the first payment, it falls to $3.36 and so on. This is not what happens. Postrel writes:

Here, finally, is a security with security—no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.

At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.

So much for security.

Why should this be? Postrel suggests:

Experimental bubbles are particularly surprising because in laboratory markets that mimic the production of goods and services, prices rise and fall as economic theory predicts, reaching a neat equilibrium where supply meets demand. But like real-world purchasers of haircuts or refrigerators, buyers in those markets need to know only how much they themselves value the good. If the price is less than the value to you, you buy. If not, you don’t, and vice versa for sellers.

Financial assets, whether in the lab or the real world, are trickier to judge: Can I flip this security to a buyer who will pay more than I think it’s worth?

Why can't I do the same thing with non-financial goods and services?

My suggestion is as follows. Obviously, for some cases, it is simply not possible (I cannot sell my haircut onto someone else!). In most cases people will buy something in order to use it (rather than to sell it on) and what they will pay for a good limits what anyone else will pay for the good in order to sell it on. In markets where people regularly sell things second hand (books, computers, cars, etc) they do not expect to get the price they got for the new product.

In these cases a used product has less value than an unused product - it may be less shiny, it may have developed some faults, and its lifetime will be shorter than for a new product. The same cannot be said of financial products such as shares or futures. The fact that someone owned a share before I did does not, by itself, devalue the share.

Postrel continues:

In an experimental market, where the value of the security is clearly specified, “worth” shouldn’t vary with taste, cash needs, or risk calculations. Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But—here’s the wrinkle—you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.” That’s rarely the case. Rather, “if you put people in asset markets, the first thing they do is not try to figure out the fundamental value. They try to buy low and sell high.” That speculation creates a bubble.

Thus bubbles seem to be an inherent feature of financial markets. Those who profit most buy early and sell midway through the bubble:

In fact, the people who make the most money in these experiments aren’t the ones who stick to fundamentals. They’re the speculators who buy a lot at the beginning and sell midway through, taking advantage of “momentum traders” who jump in when the market is going up, don’t sell until it’s going down, and wind up with the least money at the end. (“I have a lot of relatives and friends who are momentum traders,” comments Noussair.) Bubbles start to pop when the momentum traders run out of money and can no longer push prices up.

Does this mean that no one is to blame for the "credit crunch"?

Well there's more to this story. After a few repeats of the experiment with the same subjects, you no longer get bubbles. This is not because the participants learn the true value of the dividends though:

But work that Noussair and his co-authors published in the December 2007 American Economic Review suggests that traders don’t reason that way.

In this version of the experiment, participants took part in the 15-round market four times in a row. Before each session, the researchers asked the traders what they thought would happen to prices. The first time, participants didn’t expect a bubble, but in later markets they did. With each successive session, however, they predicted that the bubble would peak later and reach a higher price than it actually did. Expecting the future to look like the past, they traded accordingly, selling earlier and at lower prices than in the previous session, hoping to realize a profit before the bubble burst. Those trades, of course, changed the market pattern. Prices were lower, and they peaked closer to the beginning of the session. By the fourth round, the price stuck close to the security’s fundamental value—not because traders were going for the rational price but because they were trying to avoid getting caught in a bubble.

“Prices converge toward fundamentals ahead of beliefs,” the economists conclude. Traders literally learn from experience, basing their expectations and behavior not on logical inference but on what has happened in the past. After enough rounds, markets work their way toward a stable price.

There is a twist here. The traders end up with behaviour that is optimal for a given environment. Change this environment and their experience may no longer apply. Indeed further experiments confirmed this:

In research published in the June 2008 American Economic Review, Vernon Smith and his collaborators first ran the standard experiment, putting groups through the 15-round market twice. Then the researchers changed three conditions: they mixed up the groups, so participants weren’t trading with familiar faces; they increased the range of possible dividends, replacing four possible outcomes (0, 8, 28, or 60) averaging 24, with five (0, 1, 8, 28, 98) averaging 27; finally, they doubled the amount of cash and halved the number of shares in the market. The participants then completed a third round. These changes were based on previous research showing that more cash and bigger dividend spreads exacerbate bubbles.

Sure enough, under the new conditions, the experienced traders generated a bubble just as big as if they’d never been in the lab. It didn’t last quite as long, however, or involve as much volume. “Participants seem to be tacitly aware that there will be a crash,” the economists write, “and consequently exit from the market (sell) earlier, causing the crash to start earlier.” Even so, the price peaks far above the fundamental value. “Bubbles,” the economists conclude, “are the funny and unpredictable phenomena that happen on the way to the ‘rational’ predicted equilibrium if the environment is held constant long enough.”

One can draw various implications from this. Postrel mentions two:

• That people should beware markets where lots of cash chases a few good deals. Presumably she has in mind the research showing that increasing the amount of cash increaases the risk of a bubble occurring.
• That big changes in the financial markets can cause bubbles even with experienced traders since their knowledge is no longer valid.

I'd add that it follows that if state intervention in financial markets causes an increase in the amount cash in those markets, it risks generating a bubble. There is also an increased risk if state interventions (or anything else) nullify the experience the traders in those markets have, or if such interventions encourage large numbers of inexperienced people to enter the markets.

Both Postrel and Charles R. Morris, author of The Trillion Dollar meltdown, point out that the cutting of interest rates by the Federal Reserve frees up more cash to buy financial instruments. Morris blames Greenspan for cutting interest rates and keeping them low during the 2000s, thus causing a flood of cash into the financial markets. The findings reported in Postrel's article suggest he might have a point.

However interest rate changes are only part of the story. There are other forms of state intervention in the market and there were other factors feeding into the bubble (e.g. trading in new, complex financial instruments came to dominate the markets for example, as Morris shows). I hope to cover these other aspects in later posts.

Review: The Trillion Dollar Meltdown

A question I have regarding the current financial/economic woes being attributed to the "credit crunch", is this: Why did the money lenders give out loans on easy terms to people who were likely to default on them? The prime example of this is the so-called ninja loan.

Providing an answer to this question (in terms of the decision making of those managing the loans) is perhaps the most useful aspect of "The Trillion Dollar Meltdown", by Charles R. Morris, a US centric examination of the credit crunch. By explaining complex financial instruments such as collateralized debt obligations (CDOs) and credit default swaps, Morris illustrates how several factors drove the accumulation of toxic debt:

• The originators of loans would simply end up selling them on, thus weakening their dependence on the ability of the borrowers to pay the loans back.
  
• The subsequent handling of the loans was then split up amongst many different parties, aggravating what Morris describes as the "Agency problem", the problem of ensuring that an employee, contractor or other party performing a service for you does not act against your interests.
  
• There was increasing reliance on complex, mathematical constructs to guide investment decisions. The models the constructs were based on only imperfectly modeled the real world and break down in times of economic stress.

On this basis, it seems to me that the use of difficult to understand models to package loans up into complex financial instruments along with the diffusion of responsibility for managing the loans amongst those trading such instruments may have enabled high levels of risky debt to accumulate.

The originators of loans were incentivised simply to sell as many loans as they could, since they were no longer dependent on the loans being paid off. They'd simply be paid for arranging the loans in the first place.

The people who were subsequently managing the loans, and thus had an interest in ensuring they didn't buy too much risky debt, were those trading in the financial instruments. The complexity of the instruments (combined with optimistic ratings by the credit rating agencies) obscured the real risks from those people.

This is by no means the full story, since one also has to consider the legal/institutional framework within which this was taking place. For example, there is the role of financial regulators and other forms of government intervention in the financial system to consider as well. There is also the behaviour of the borrowers to consider too.

Morris does address the role of the financial regulators in the US. He blames Alan Greenspan for keeping interest rates low thus enabling a sustained period of cheap credit to develop, and he also blames "free market" ideology and financial deregulation. However here I find him less convincing. My main point is that in many significant respects, the financial system is not a "free market". For example, the very fact that the Federal Reserve has a monopoly on printing money and sets interest rates shows we're not talking about a "free market".

Moreover, Morris himself argues that the financial services sector in the US enjoys "inordinate privileges", pointing out for example that in a free market, a sector that takes high risks, like the financial sector does, would occasionally endure periods of big losses, as well as enjoying periods of high profits. But while the industry certainly enjoyed the high profits, its losses are often offset by government bailouts (NB: Morris was writing before the recent bailout programmes announced by Western governments).

Morris cites an example where Countrywide was paid $22 billion by the Atlanta Federal Home Loan Bank when they incurred losses that were likely to lead to insolvency. Providing bailouts to loss making companies is most definitely not a "free market" approach. Nor is it a "free market" when a privately run student loan organisation gets subsidies from the state (to take another example Morris criticised). The privileges enjoyed by Freddie Mac and Fannie Mae (the two big mortgage providers in the US) are also incongruous with a "free market" approach, and the role of these privileges in the credit crunch is not examined by Morris.

My point here is not to argue for the "free market" but to suggest that blaming "free market" ideology for failures in a system that enjoys considerable state intervention that goes beyond merely setting the rules of the game is perverse, especially when you simultaneously argue that some of the interventions directly contributed to the failures concerned!

Overall, the book may well prove useful to people wishing to understand the behaviour of the lenders in the credit crunch, but Morris's attempt to blame it all on "deregulation" and the "free market" going too far is not convincing.