Wednesday, January 20, 2010

Wall Street wizards

First: quote Krugman (extensively)
Next: mock the Wizards of Wall Street
Finally: show a couple of graphs

From Paul Krugman's Op-Ed (14 Jan 2010):
The official Financial Crisis Inquiry Commission ... began taking testimony on Wednesday. In its first panel, the commission grilled four major financial-industry honchos. What did we learn?
... But the bankers’ testimony showed a stunning failure, even now, to grasp the nature and extent of the current crisis. And that’s important: It tells us that as Congress and the administration try to reform the financial system, they should ignore advice coming from the supposed wise men of Wall Street, who have no wisdom to offer.
But the truth is that the United States managed to avoid major financial crises for half a century after ... Congress enacted major banking reforms. It was only after we forgot those lessons, and dismantled effective regulation, that our financial system went back to being dangerously unstable.

As an aside, it was also startling to hear Mr. Dimon admit that his bank never even considered the possibility of a large decline in home prices, despite widespread warnings that we were in the midst of a monstrous housing bubble.

Still, Mr. Dimon’s cluelessness paled beside that of Goldman Sachs’s Lloyd Blankfein, who compared the financial crisis to a hurricane nobody could have predicted. Phil Angelides, the commission’s chairman, was not amused: The financial crisis, he declared, wasn’t an act of God; it resulted from “acts of men and women.”
But there was nothing accidental about the crisis. From the late 1970s on, the American financial system, freed by deregulation and a political climate in which greed was presumed to be good, spun ever further out of control. There were ever-greater rewards — bonuses beyond the dreams of avarice — for bankers who could generate big short-term profits. And the way to raise those profits was to pile up ever more debt, both by pushing loans on the public and by taking on ever-higher leverage within the financial industry.

Sooner or later, this runaway system was bound to crash. And if we don’t make fundamental changes, it will happen all over again.

[emphasis added]
No one could have predicted the coming crisis, the collapse of the housing market and its attendant - man-made - repercussions. (You know, all those Credit-Default-Swaps based on the belief that housing prices would just keep going up)!

No one could have predicted...
Hmmm... where have I heard this before.

And for it's worth: hurricanes and 100-year-storms ARE foreseeable!... so are earthquakes.
The prudent man plans for 'em - you know, by buying insurance, building storm- or earthquake-resistant buildings, building levees.
In the context of financial markets, this means creating financial instruments that will OFFSET - mediate, dampen - the effects of a meltdown.
What did the Wall Street Wizards do?
They created financial instruments that AMPLIFIED the effects of a real-estate meltdown - under-priced insurance policies ("Credit Default Swaps") and over-priced mortgage-backed securited ("Collateralized Debt Obligations")!

[aside: one of my summer jobs in college was coding FORTRAN for Amoco - the oil company. The group I worked for designed off-shore drilling rigs. Design criteria - which my FORTRAN code enabled - included designing for a 100-year storm... that's the way prudent businesses operate: they design for the 100-year storm!]

But I digress.
So... just what did the Wizards of Wall Street miss?... and how hard was it to see?
Here are a couple of graphs, one stolen from another source, one mine (but based on source's home-price data).

First, from Bubble Meter:
Okay, it's a bit tricky to see the bubble coming when the over-all trend is upwards - but by 2002 it sure looks like housing prices - either 'real' or 'nominal' are getting just a bit ahead of the historical curve.

To make this easier to see, here's another graph - this one displaying the ratio between median home prices and the 60th percentile of household incomes. The choice of the 60th percentile is arbitrary - my readily available data don't include median household incomes.
The horizontal lines (red) are standard control limits around a median of 2.62.
In 2002, this ratio went "out of control". In 2008 it came back "in control" (barely).

Note: Bubble Meter's data - which he makes available in Excel format - is quarterly. I used Q4 median home price as the numerator, with the Census Bureau's historical nominal household 60%-ile as the denominator for each year.

The moral: readily available standard statistical techniques would have highlighted the housing bubble, had anyone cared to look!

Thanks to Bubble Meter.
I've added him to my blog list!

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