What the financial crisis isn’t: Part 1, the situation itself
Abandon all logic, ye who write about the financial crisis
So far a lot of nonsense has been written – mostly in the popular rather than professional press – about what the financial crisis is. In fact, the Panic of 2008 is a global repricing of risk, the hangover from a decade of binge financial risk-taking by just about everybody who could do so.
If we’re to find our way back to prosperity and confidence, we have to start by not misunderstanding our situation. Here, to give the truth a fighting chance, are the most common misperceptions and why they’re false:
A. What’s going on here?
What in fact is this mess, and where did it come from?
1. It’s not an asset bubble
What this worth 4,000 florins?
In financial terms, a bubble arises when a commodity’s price rises dramatically all out of proportion to its intrinsic value. Suddenly, everybody has to have one, and this scarcity, coupled with an emotional unreason, drives the commodity’s price up. The most famous are the Dutch Tulip mania, where a single bulb cold sell for 4,000 florins, and the South Sea Bubble, the 1720 “Enron of England,” where the company’s price soared on speculation, only to crash afterwards.
Bubbles are fueled by speculation – much of the Roaring Twenties stock market was driven on hint, innuendo, and rumor – and when they crash, the resulting reform normally involves greater disclosure and penalties for false or misleading statements.
This isn’t that; houses didn’t suddenly become rare and exotic; they’re omnipresent. Nor did we have the panic-shortage-buying mind set that characterized (say) the 1974 Arab Oil Embargo, or the grocery-store shelf denuding before any spectacular hurricane you care to name.
Rather, risk got devalued, and credit got too cheap. As a result, relative to the true cost of capital, the price of everything rose. [Why did capital get so cheap? Stay tuned for my incisive post on this fascinating Financial Times article. – Ed.]
2. It wasn’t caused by subprime lending
This false premise has led to a veritable plague of finger-pointing. What has happened to us isn’t an epidemic – one sick sector (subprime) infecting the others – but rather saturation – where the first splat (subprime) is merely the initial raindrop in what has become a tempest.
Tidal waves ahead?
Subprime was an indicator, as I explained when I called the top – in December, 2005:
Out of all that apparent chaos, how does one prospectively determine major trends? (Anybody can determine them retrospectively, but that’s very cold consolation.)
Enter the miner’s canary — the sensitive universal leading indicator. And mine has just started wobbling, as this article from the Washington Post reveals:
Mortgage delinquencies among homeowners with high-cost loans will rise by 10% to 15% in 2006, as borrowers struggle with higher interest rates, high debt levels and higher energy costs amid flattening home prices, a new report from investment analyst Fitch Ratings predicts.
Why is subprime lending a leading indicator? Because by definition, subprime borrowers are at the edge of the bankable frontier (as my AHI colleague David Porteous has discussed on his blog), and as such, they are the most sensitive to changing economic circumstances. [Snip]
Up to now, I’ve read innumerable frothy insubstantial Chicken-Little-market top articles, and found all of them utterly unpersuasive. But this modest story — the newspaper equivalent of a green salad! — is different; this feels like a leading indicator.
“I don’t like my role in this ecosystem“
So here it is, folks. I’m calling the market top.
All predictions accurate or your money back! Oh, wait …
As I reported long ago, subprime was also prone to abuse – but it’s by no means the only form of capital transaction prone to abuse: securitization, CDOs, CDSs, adjustable-rate mortgages, adjustable-pay loans, all were over-used and over-revved.
If guns don’t kill people, people kill people, then fancy risk products don’t make people take stupid risks, people take stupid risks. Why? Because they can.
3. It’s not principally about the GSEs
It’s easy to point fingers at the GSEs.
For more than a decade, critics like Alex Pollock and Bert Ely, among others, have questioned the GSEs’ business model.
What is a business model?
A description of the mechanism by which an enterprise generates its revenue.
Dunkin Donuts’ business model is “Using our donuts as a lure, we sell coffee to highly loyal regular customers at prices much higher than our cost of brewing it.”
All of us who work with them learned to adopt the doublethink mentality that they weren’t guaranteed by the Federal government, yet could borrow favorably on the risk curve:
Where do we put the GSEs, Fannie Mae and Freddie Mac, on this chart?
If they were evaluated purely as private companies, their spreads ought to be in the AAA range. (Some would argue they should have their securities downgraded because the GSEs maintain very low capital ratios, but let’s give them AAA.) Yet in reality, GSE spreads are barely above Treasuries. They are, in other words, under the risk curve … except for the widespread perception that they are, in fact, safer than a AAA, because Uncle Sugar will bail them out.
Sheltering under the risk curve is why the GSEs make money, and in particular why they are so eager to expand their lending into as many arenas as possible. Lever that spread advantage over more and more dollars, and your profits go ever higher.
Blaming the GSEs fails on paired comparisons. If the GSEs were the problem, why does Countrywide go upside down? (It sold its risks to the GSEs, remember.) Why WaMu? Why Merrill?
Just follow the signs
4. It’s not just about housing
Emphasis on ‘just’.
Housing is by far the world’s biggest asset class, so any compression of spreads, any desensitivity to risk, will naturally push up housing prices more than other asset classes, just because there are more of such assets to price-inflate.
Housing also has the biggest mismatch between capital sums deployed and the sophistication of those deploying them. That’s a polite way of saying that most people incur their largest financial obligation ever with astonishing incuriosity about the details. The same people who agonize over the 59¢ versus 89¢ toothpaste, who will scrutinize the Burger King calorie-count charts, show a breathtaking incuriosity about the fine print in their mortgage loans.
If only it were that easy …
Is it credulity (I trust my broker), despair (I’m never going to figure it out anyway, so why try), or mere unfamiliarity (I’ve never done this before, and I don’t want to look stupid, so I’ll just shut up and let the jargon wash over me)? I don’t know, but I do know that the continuing quest for proper consumer disclosure and consumer education exists because of this scale-sophistication mismatch.
5. It’s not specific to the
Until quite recently, the good German word schadenfreude was the order of the European day.
Taking delight in the misfortunes of others – it’s not just for Germans any more!
Those colonials, the major editorials tut-tutted, they’re always experimenting and blowing themselves up (somehow they were able to shrug off the collapse of Northern Rock), but we on the contingent have a much longer history and are wise to such things.
(The Germans in particular have a homeownership savings scheme called bausparkassen, of which their housing experts are inordinately proud … and a 38% homeownership rate, the lowest homeownership rate in Europe.)
Then came the collapse of Fortis and its rescue purchase by BNP Paribas; the implosion of Bradford & Bingley (whose business involved buy-to-let, a subject about which I’ll post); the threats to Royal Bank of Scotland and HBOS.
I don’t feel quite so superior right now
Now the moral ascendancy is reversed; what looked before like a purely
Certainly, the chaotic individual-national responses by
All right, if that’s what the situation isn’t, what about the culprits? Whose fault is this mess?
Scapegoats, dammit! I demand scapegoats!
[Continued tomorrow in Part 2.]
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