Friday, October 31, 2008

Further thoughts on the economic slowdown


I’m running off to Amsterdam today, but wanted to make a few quick comments on the ongoing economic problems

* Many commentators are focused on the mortgages as the source of the crisis: too many house loans were made to too many sub—prime borrowers with little or no vetting.  Remedies have thus focused on propping up lenders, asset prices, mortgage payments, or homebuyers.  But, in fact, the problem is broader: bad loans were made on everything from credit card debts to student loans, shaky business schemes to questionable public works projects.  All of these were securitized, diced up into principal and interest, tranched by risk, and converted to bond-like cash flows.  Many of these sources can still go bad, and many of the cash flows are still highly risky.  I think that there will be wave after wave of support as various loan types continue to default, long after we have stabilized the mortgage market.

image * There has also been a lot of talk about this being a ‘black swan’ event, one which has a vanishingly low probability of ever occurring.  I think that it may have been historically true that the underlying asset price movements were uncorrelated and the likelihood of them moving together, by chance, was extremely low.  But, as strategies evolved for taking advantage of these asset combinations and the adoption became widespread, I believe that links were formed between previously uncorrelated factors.  These lead to causal cascades that ripple through the markets when previously isolated assets suffer a downturn.  Far from being random events, I think that instability was built into the system as the underlying assumptions failed.  The current downturn is a failure of understanding of how the financial system changed, not a black swan birthed within the context of the old system.

image * When is an industry too important to be allowed to fail?  And does the financial industry meet those criteria.  As government support for using bailout funds to increase liquidity spreads from the financial to the insurance to the auto industry, it begs the question of where this began and where it should end.  Many basic industries, from raw materials to health care to food production to transportation, arguably have a greater impact of producing and moving the goods that individuals and businesses rely on.  Yet the financial system has uniquely been identified as worthy of government-sponsored rescue and reorganization.  The rest have to muddle through.  This still feels wrong to me.

image * How much of the financial community is a community and how much is it a club?  I think that it is very much of a club, excluding participation except for those admitted to membership in the circle, self-protective and self -interested.  While government officials and regulators are promising strict laws and accountability, we are already seeing hand-in-glove partnerships between various government and financial institutions.  For example, the forced takeovers of marginal banks by stronger banks is consolidating the industry rapidly.  There will, in the end, be a few government-sanctioned winners, with much stronger financial positions and influence than they had previously.  There will be similar evolution in ratings agencies, insurance, and financial services.  In the end, the barons of capitalism will be stronger, not weaker.  And I still fear that the taxpayers will foot the bill for a new system that will ultimately work to our disadvantage.

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