The Big Short on Outsider Personalities

This weekend I watched The Big Short. The movie makes a big deal, as does the book, about the odd personalities of the investors who saw the financial crisis coming more clearly than others. Some thoughts on that:

1. If the typical normal person (or normal investor or normal regulator) saw a financial crisis coming, then it would not occur.

2. At any one time, there are lots of outsiders forecasting extreme events. If you bet on outsiders all the time, most of the time you will lose.

3. The challenge for insiders is to filter out the noise from outsiders without filtering out the signal.

4. You filter out signal when you hold as sacred hypotheses beliefs that really should be questioned. As the movie points out, the hypothesis that AAA-rated securities are safe was sacred. The hypothesis that house prices never go down in more than a few locations at the same time was sacred. The hypothesis that new risk management techniques made old-fashioned mortgage underwriting standards obsolete was sacred.

5. People with outsider personalities are less likely to fall into the trap of holding hypotheses as sacred. If you don’t need to get along with the insiders, then you question them. You question them when they are right and you question them when they turn out to be wrong.

6. As you know, I think that MIT economics has produced a set of insiders who hold sacred hypotheses. Math equals rigor. AS-AD. Market failure always justifies government intervention. Etc. The Book of Arnold is an attempt to call them out on it.

Market Monetarism Watch

David Beckworth, with Romesh Ponnuru, makes the NYT.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy.

In a way, this is an easy argument to make.

1. A recession is, almost by definition, the economy operating below potential.

2. Operating below potential is, almost by definition, a shortfall in aggregate demand. The only other type of adverse event is a supply shock, which reduces potential but does not force the economy to operate below that reduced potential.

3. The Fed controls aggregate demand.

4. Therefore, all recessions are the fault of the Fed. Either by commission or omission, the Fed has messed up if we have a recession.

It is an easy argument to make, but I believe close to none of it. I do not believe in the AS-AD framework. And I do not believe (3). If you do not know why I have my views, go back and read posts under the categories “PSST and Macro” and “Monetary Economics.”

My view is that the housing boom and the accompanying financial mania helped hide some underlying adjustment problems in the economy. The crash, the financial crisis, and the response to that crisis all helped to aggravate those underlying adjustment problems. I suspect that, on net, the bailouts and the stimulus diverted resources to where they were less useful for maintaining employment than would have been the case if the government had not intervened. My basis for this suspicion is my belief that people who do not need help are often more effective at extracting money from the government than people who do need it.

There has been much other commentary on the op-ed–see Scott Sumner’s post.

Greg Ip on The Big Short

He says,

But what I think it’s not including in that story is the extent to which these Wall Street guys honestly thought that what they were doing wasn’t that risky. They thought that a Double-A- or Triple-A-rated security had so much protection through various ways, there’s just no way this thing could blow up. And I would say that, in terms of going forward, one of the challenges we as the public and citizens and our government is: How do you create a financial system, how do you create an economy that both gives us the safety that we need to both be happy and to prosper and to take risks without destroying our selves but doesn’t create those fatal levels of complacency?

This is from a Russ Roberts podcast, with much more in the conversation.

Opaque Leverage and Self-Deception

Regarding the movie The Big Short, Tyler Cowen wrote,

There is no central villain, none whatsoever. The filmmakers succeed in showing how the collective actions of many, operating together, can give rise to structural problems and systemic risk. And yet the story remains suspenseful.

People prefer stories with villains.

I think that the story of the financial crisis has to include leverage. Individual home buyers did not put up much of their own capital. The lenders did not put up much of their own capital. The mortgage securities were structured and rated so that banks could hold them with minimal capital.

However, some of this leverage was opaque. People did not understand the way that AIG was contractually obligated to put up billions in collateral if prices moved against them. People did not understand that while Fannie Mae and Freddie Mac were reporting that their sub-prime exposure was less than 2 percent, their exposure to risky loans was closer to 30 percent. People did not understand that mortgage securities rated AAA were not really comparable to AAA-rated bonds. People did not understand that banks had created “structured investment vehicles” and other dodges that made them much more levered than they appeared to be. And by “people,” in all cases I mean regulators and investors.

But finally, the opaque leverage was less intentional bad behavior on the part of financial executives than it was self-deception. Suppose that you had asked executives in 2007 to answer honestly, “Relative to what people outside the firm think, how exposed are you to a decline in house prices and problems in the mortgage market?” My guess is that almost all of them would have said, “We are less exposed than other people think.” And they would have been telling the truth from their point of view.

That is what made the speculators in The Big Short so special. They managed to dig through to reality.

And don’t forget that I coined the term, “Suits vs. Geeks Divide.”

Narayana Kocherlakota on How the Fed Spoiled the Economy

Scott Sumner correctly sees Kocherlakota as supporting Sumner’s view of Fed policy during the financial crisis and its aftermath. Kocherlakota says,

I use the public record to document that, as of late 2009, the FOMC felt that it would be appropriate to use its monetary policy tools to foster a relatively slow recovery in both prices and employment. (The recovery that actually unfolded was slower than the FOMC intended in terms of employment, but close to the FOMC’s intentions in terms of inflation.) I argue that the FOMC’s guarded response can be traced back to its pre-2008 policy framework—that is, to the Taylor Rule. Indeed, because of this baseline “normal” policy framework, the FOMC and many outside observers actually saw the Committee as pursuing a highly accommodative policy.

Read the entire speech, or at least read Sumner’s excerpts from it.

Kocherlakota has lobbed a grenade into the macro establishment’s room. If he (and Sumner) are correct, then history will not be kind either to the Bernanke Fed or to the Taylor rule.

Much as I would love to see those icons brought down, for the moment I am going to stick to my view that the Fed did not set the course for the economy.

Spare the Bank, Spoil the Economy

George Selgin writes,

In contrast to the Fed’s actions in August 2007, its subsequent turn to sterilized lending had it, not buying, but selling Treasury securities, with the aim of preventing its emergency lending from resulting in any overall increase in the supply of bank reserves. Financial conditions were thus “eased,” not generally, but for particular institutions and their creditors. For the rest, credit was actually tightened. Because it serves to redistribute credit rather than to alter its overall availability, sterilized lending is properly regarded, as Marvin Goodfriend insists, as an exercise in fiscal policy rather than one in monetary policy in the strict sense of the term. The principle beneficiaries of this fiscal policy were the creditors of the aided institutions, while the losers were those prospective borrowers who were denied credit because the Fed had directed the reserves that might have supported lending to them elsewhere.

The bailouts were done in the name of saving the economy. What Selgin points out (read the whole thing) is that the Fed went out of its way to offset whatever stimulative effects the bailouts might otherwise have had on the economy.

Also, go back and read what I wrote on September 27, 2008.

What macroeconomic theory says that we run the risk of a Depression if we don’t have a bailout? Try to come up with an argument that is either already in a textbook or that you would put in a textbook. If macro is a genuine discipline, it has to consist of something more rigorous than “If Bernanke is worried, then so am I.”

I was angry then, and I am angry now. Leading pundits and economists will tell you that the bailouts were heroic. They have no use for any thinking that contradicts that narrative.

Good Turner, Bad Turner

In Between Debt and the Devil, Adair Turner writes (p. 61),

Textbook descriptions of banks usually assume that they lend money to businesses to finance new capital investment…But in most modern banking systems most credit does not finance new capital investment. Instead, it funds the purchase of assets that already exist and above all, existing real estate.

…Different categories of credit perform different economic functions and have different consequences. Only when credit is used to finance useful new capital investment does it generate the additional income flows required to make the debt certainly sustainable. Contrary to the pre-crisis orthodoxy that the quantity of credit created and its allocation between different uses should be left to free market forces, banks left to themselves will produce too much of the wrong sort of debt.

What is good about the book is that he invites us to examine how credit is created and where it goes. As he points out, standard macro models have totally ignored this issue.

What is bad about the book is embedded in the last sentence quoted above. We are left to assume that the huge allocation of credit toward housing was the operation of “free market forces.” I do not know about other countries, but for the United States this is totally false. The government was very much involved in channeling credit, and it channeled as much as it could toward housing finance.

Still, I think that what is good about the book makes it worth reading. I plan to say more when I have finished it.

Mishkin Before vs. Bernanke After

In Greg Ip’s new book, Foolproof, he writes,

Frederic Mishkin, an expert on banking who had studied the Great Depression, examined what would happen if housing prices fell 20 percent. The Fed, he argued in a lengthy presentation to other central bankers, would lower interest rates quite quickly, the economy would shrink only 0.5 percent, and unemployment would barely rise.

I have not yet read Bernanke’s new book, but I gather that he thinks that without the bailouts the economy was headed toward another Great Depression. So my point is that there is quite a gap between what Mishkin thought would happen if housing prices fell and what Bernanke was afraid was going to happen. Some possibilities.

1. Mishkin actually was right. The economy easily could have withstood the housing price crash. The problem must have been something else. (Scott Sumner would say that it was tight money.)

2. Mishkin was working with a simplistic model of the economy, which did not include the fragility of the financial sector or the feedback from loss of confidence in banks to the rest of the economy. There are two variations on this view

a) the bailouts helped, just as Bernanke says they did.
b) the bailouts made no macroeconomic difference. They simply served to redistribute losses away from the some of the stakeholders in the bailed out firms.

3. Mishkin actually was right. The economy would have recovered quickly with only a small recession. However, Bernanke and other policy makers did the wrong thing and turned what would have been a short-term crisis and the failure of a few firms into a long, drawn-out period of slow growth.

I think that (2a) is the most generally accepted view. My own view is 2b. I could also make a case for (3). Note that in the Great Depression, both Hoover and Roosevelt thought that destructive competition was a major problem. Both tried to discourage businesses from competing, Hoover through exhortation and Roosevelt through the National Industrial Recovery Act. In hindsight, reducing competition was a counterproductive idea. Perhaps in hindsight TARP and the other bailouts will not look so good, either.

By the way, I can offer a lot of praise for Ip’s economic judgment. However, I think I will end up putting Foolproof in the “very good but could have been even better if. . .” category.

Bethany McLean responds

In an email (which she gave me permission to post), she writes,

So first of all, thank you for your kind words about All the Devils. I’ve always been a fan of your work, and I wholeheartedly second the title of your blog! Secondly, I’m always fine with criticism of my work and disagreement with any interpretation I’ve made. In particular, the GSEs are a nuanced, difficult subject, and frankly, I learn new things all the time. I am always willing to change my mind if someone shows me that I’m wrong.

What I’m not ok with is mischaracterizations of my work, whether deliberate or because you didn’t actually read most of the book [her newest book, Shaky Ground]. My main reason for writing is that you say I dismiss Ed DeMarco as a free market ideologue. That is exactly the opposite of what I actually wrote, which is that you cannot dismiss him as just that! I think Ed is a good man who did the best job he could and held true to his beliefs – saving taxpayers money – under very difficult circumstances. I don’t want people reading your review to think I impugned someone’s character when in fact, I did the opposite. It’s really unfair of you.

You are intellectually dishonest about some other points as well, but frankly, everyone is intellectually dishonest about the GSEs, so I won’t bother with most of it. But since I’m writing, I’m going to point another one out.

You also say that the shareholders made a political bet, which they lost, fair and square. There are many different types of shareholders, but as I detail (gory detail – it’s hard to miss!) a number of them made a purely financial bet, and totally missed the poisonous politics. They did loan level analysis and saw that the GSEs were going to become profitable again. Their bet was not that they could buy special favors, but precisely the opposite: that the government would treat Fannie and Freddie as normal companies – ie, like AIG, like Chrysler, like the big banks. Which, not incidentally, is what Jim Lockhart said would happen at the time of conservatorship. And the government set up this situation by leaving the common and preferred shares outstanding. You can blame the investors for being politically naive, but I don’t see how you can fail to acknowledge that there’s a lot of blame to go around here. (It might be a fair point to say that the GSEs are only profitable again because of government support. But then, you’d have to say the same thing about the big banks. In fact, you’d have to say the same thing about our whole stock market, which is supported by the Fed! Etc, etc. )

I agree with your point about there being a powerful case to be made against the government caving into the housing lobby. Perhaps I do give in too easily to what I view as the political reality. That said, the history of the private market financing residential real estate is not a pretty one either! Look back to the booms and busts in the 1800s and the spectacular default rates in the Great Depression. I also would contest the idea that there is such a thing today as a private sector, as pertains to the mortgage market. If the big banks finance the mortgage market, they too will be GSEs, if they aren’t already. But on this, there is much grist for debate, and criticism is fair.

Anyway, the tag line on your blog, “taking the most charitable view of those who disagree,” is so important. Live up to it! Don’t set up straw men so that you can knock me down.

My remarks:

1. I am glad that she respects Ed DeMarco, and I am sorry that I interpreted her as siding with his opponents.

2. She and I will have to agree to disagree about the hedge fund investors in Freddie and Fannie stock. I see no role for financial calculation, or “loan-level analysis.” Instead, it would have been obvious that the GSEs could be restored to profitability if you kept them going long enough using Treasury funds to borrow while having the entire mortgage market to themselves. The wild, speculative bet was that in the meantime there would be no reform of the housing finance system and that politicians would then decide to return Freddie and Fannie to the status quo prior to 2008. However, neither the Bush Administration nor the Obama Administration indicated any intent to do that. If you bought GSE stock for pennies in 2009 or 2010, you were making a bet that could pay off spectacularly, but only if Congress and the Administration were to do something very different from what they were saying.

In dealing with the crisis, the only purist, follow-the-law approach would have been to put the firms (including big banks) through bankruptcy. I would have preferred that, although I understand the fears that policy makers had about such a process. In my view, the next best alternative would have been to nationalize the GSEs and the failed banks, on the grounds that taxpayers were on the hook for the losses of those firms. Then the government would gradually wind these firms down. Instead, the policy makers chose bailouts, which necessarily involved arbitrary treatment of stakeholders. I do not think that any of those stakeholders has a compelling legal complaint at this point, because the rule of law went out the window with TARP and the bailouts.

Just the other day, some bloggers at the New York Fed wrote,

our view is that an optimal intervention into Fannie Mae and Freddie Mac would have involved the following elements:

The firms would be able to continue their core securitization function as going concerns, supporting the supply of mortgage credit.

The firms would continue to honor their debt and mortgage-backed securities obligations.

The value of the common and preferred equity in the two firms would be extinguished, reflecting their insolvent financial position.

Note that last sentence.

3. For writing my earlier post, I have been subjected to vicious, ad hominem attacks from former members of the Fannie Mae lobbying arm. If nothing else were to convince me that restoring the status quo for the GSE’s is a bad idea, then these crude, juvenile social media posts would suffice. Perhaps government backing for housing finance is inevitable in America. But at least let us hope that the institutions that receive such support do not replicate Fannie Mae’s aggressive and unprincipled lobbying machine.

In an opinion piece in today’s WaPo, McLean dismisses this lobbying with an “everybody does it” line.

One legitimate complaint about the old Fannie and Freddie was the way they garnered political clout through their promotion of homeownership. In their heyday, it was immense and ugly. (“Fannie has this grandmotherly image, but they will castrate you, decapitate you, tie you up, and throw you in the Potomac,” a congressional source told the International Economy in the late 1990s. “They are absolutely ruthless.” That would pale next to the political clout of a big bank that also controlled the mortgage market, and whatever evils grew out of the GSEs’ need to please politicians, there could be worse. Imagine the conversation in a back room between the politicians and the bank executives, where they agree that if the bank will loosen up credit in their states, the politicians will go easy on, say, derivatives regulation. It almost makes the old Fannie and Freddie look pure.

No it doesn’t. And the rest of her piece consists of cheerleading for housing finance subsidies, which is exactly what makes her new book such a disappointment.

Two Stars for Shaky Ground

For the first time in many years, I wrote a review for Amazon. About Bethany McLean’s book on Freddie and Fannie, I say,

I was disappointed with this book, because I think that her earlier work, All the Devils are Here, co-authored by Joe Nocera, is probably the best journalistic account of the run-up to the financial crisis.

On “Shaky Ground,” here are my thoughts:

1. This book might have been titled “Sympathy for the Devils.” There is way too much sympathy expressed for the hedge funds that bought preferred stock in Freddie and Fannie. They were making a bet that the political process would come out a certain way, and they lost that bet, fair and square. End of story, as far as I am concerned. I should note that on several occasions representatives of the hedge funds have felt me out about doing some “research” or writing an article to support their position. I would not have done it for any amount of money. I am not accusing McLean of having succumbed to this, but I would not completely rule it out.

2. The other devil who gets a ton of sympathy is former Fannie Mae executive Tim Howard. McLean endorses all of his self-serving views, which include a claim that he did nothing wrong in Fannie’s giant accounting scandal. Also, his view is that had the Fannie management not been replaced, his team would have averted the crisis. Both claims may be true. In my opinion, Freddie and Fannie were better managed before both of their management teams fell in accounting scandals. But I think that more journalistic skepticism is in order. Regardless of who was in charge, there was pressure on Freddie and Fannie management to dive into high-risk lending, with shareholders seeing profits and regulators seeing a mission to expand home ownership opportunity.

3. She is no fan of Ed DeMarco, who was the only person in Washington working to gradually wind down the GSE’s, which is supposedly what everyone wanted. I think it is fair to say his approach was too unpopular with key players to be sustained. But he does not deserve to be dismissed by McLean with boo-words, like “free-market ideologue.”

4. She says that if you take it as given that the government is going to promote what the housing lobby wants, namely “home ownership” with little actual equity and a mortgage market dominated by the 30-year fixed-rate loan, then keeping Freddie and Fannie is better than the alternatives. If you accept the premise, then I agree. But there is a powerful case to be made against government caving into the housing lobby. The costs of this, including serial financial crises (the S&L crisis, the crisis of 2008) and misallocation of capital, are huge, and the social benefits are miniscule. (The private benefits can be enormous–just ask Tim Howard.) McLean does mention some of the evils of this housing-industrial complex, but her bottom line is, in effect “you can’t beat ‘em, so don’t try.”

Overall, this is not a terrible book. But if you read it, you should keep in mind that she gives the most favorable treatment possible to Freddie, Fannie, the hedge fund investors, and to policy makers who attempt social engineering using housing finance. Although the book is not completely one-sided, she does not give alternative points of view as much respect as I think they deserve.