Best explanation of the financial mess

Wall_street_2 If you want to understand the financial meltdown, read Niall Ferguson's article in Vanity Fair: "Wall Street Lays Another Egg." It logically lays out the causation of the disaster, complete with historical backdrop.

If you're busy, here's my instant summary:

Factor One: Real estate

The belief, going back to Roosevelt, and most recently promulgated by G.W. Bush, that all citizens should own a home.

Factor Two: Converting mortgages into securities

Wall Street bundled mortgages into securities, supposedly attenuating risk, but actually making it hard to ultimately assess the value of the loans. 

Factor Three: Subprime mortgages

The securitization of mortgages theoretically made it possible to take on riskier loans (subprime mortgages), as long as they were bundled with better risk loans. This strategy worked as long as real estate prices kept rising and interest rates remained low.

Element Four: Quants and options

The securitized debt was "insured" via swap options. Options were concocted by quantitative-driven financial analysts who, in their models, failed to factor in irrational human behavior. “To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history.” The result: flawed options models and flawed insurance.

Element Five: Cheap money via China

The Chinese people and companies had high savings rates -- that money was loaned to the U.S. which used the money to make bad loans, start 10,000 hedge funds, and drive private equity. "The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The Asian savings glut was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts...".

Take all five factors, and you come to the nub of the problem: Cheap, plentiful money beget bad loans. When the loans  went bad, the banks were in danger of failing.

I think I'm going to read Niall's new book...


re: Best explanation of the financial mess

George, if you are interested in getting into the macroeconomic minutia I would highly recommend reading some of Hyman Minksy's work. One of his central theories was that regulatory bodies cannot innovate as fast as financial institutions, therefore at a high enough interest rate banks and other lenders have the incentive to "create" money. In this case they created option ARMs and other exotic mortgages and in essence built an infinite money supply. I think we mostly now realize this money supply (in the guise of the housing market) was driving the economy most of the last 7 years.What we are experiencing now is the crumbling of all that "innovation" upon which we built our economy, and the money supply is "correcting."Minsky wrote most of this stuff back in the 1930's but its amazing how relevant it is today. I'll send you the paper once I can dig it up.

re: Best explanation of the financial mess

Yes, Hyman Minsky, Milton Friedman, Thomas Sowell and a few others should be reread at this time. I absolutely agree with Ferguson's analysis. Bad debt was used to PRINT MONEY. I even mentioned it in one of my comments on your blog, George. If you look up my writing for the last three to five years I have been predicting this mess. Not because I need to say now that I was right, but that it was VISIBLE and PREDICTABLE but was chosen to be ignored by governments! Does that not make you wonder why??? I certainly do, as much as I wonder about the incredible willingness of the governments to step in and 'SAVE' the banks. Right! Are you aware that half of the largest European banks have been practically nationalized - or are now under like government influence - in the last three months?In my 2003 novel 'Deity' I wrote about the coming financial meltdown as well as the over-regulation by governments that would follow. Conspiracy theories aside, I do believe that there was a willingness to let the situation culminate because a crash would put the right political message in citizen's head: Capitalism does not work! Not being a respected economist, these ideas obviously can not be mine. I found them in Friedman's and Sowell's writing. 'Capitalism and Freedom' as well as 'The Vision of the Annointed' create the understanding as to not why the crisis happened, but why it was allowed to happen by governments.Maybe you think that I am overreacting, but consider the following: Could it be that the European Union is on the way to become the new Russia? Do you know that the ministers of the EU government are called commissaries and that the EU Chairman (sic) is not elected by EU citizens but by the EU parliament? Are you aware that the EU Constitution overrules member constitutions and that hardly any of the member states gave their citizens the right to vote over its acceptance?Has any of that anything to do with the financial crisis? There is a fair chance that it does as otherwise it is strange that it happened. Our politicians are either incredibly inept and stupid - which would be frightening - or there is another hidden agenda that should be even more frightening. Don't just accept anything ... but you need to look deeper than just the surface.

re: Best explanation of the financial mess

George:I agree. Here's element two-A and six.Two-A: When taking a collection of mortgages, all rated at different levels (AAA, AA, A, B-, C, etc.), and blending them together, don't use a auditing firm that rates the blend as triple A. Get a real rating, like C+. You won't get many buyers on this paper, but that is good. And then, don't act like an insurance company by giving out CDS' (credit default swaps) unless you've got the reserve to cover the loss. In the next two years we're going to see what defaulting on $54 trillion of CDS' do to the world economy.And finally, Factor Six. When you do sell the CDOs (Collateralized debt obligations) to someone who repackges them, who then sells them to someone who repackages them again, make sure that when you buy investments you are not buying your own paper back after the sixth repackage iteration. When the investment goes bad, it looks awful to the board when you find out that the person who wrote the original CDO was your institution, and the person "insuring" it with a CDS was you as well.

re: Best explanation of the financial mess

Richard:Apropos your Factor Six: some of the investment banks are paying their employee bonuses for 2008 in the form of new securities composed of heavily discounted securitized mortgages and other formerly toxic assets owned by the bank. Strangely enough, given the government bailout, these assets could turn out to be quite valuable.