24 September 2008

What was the problem?

Since I have claimed that the derivatives involved in the financial system problems were not too complicated, what was the real problem?

There are many candidates, too many to cover right now. The use of irrelevant statistics to justify risky holdings, as I mentioned before, was a large part of the problem. The government pressure to make more and cheaper loans to less creditworthy borrowers has been widely commented on, and may have contributed significantly, but can't excuse the banks' errors.

The actual error made by the banks was very simple - embarrassingly simple, really. They bought mortgages to securitize them. They split the securities into high-risk, medium-risk, and low-risk bits. They valued the bits and found that they were more valuable than the original mortgages, which meant the process was profitable to them. They sold the high-risk bits to speculators and the medium-risk bits to long-term investors. But they kept the low-risk bits. Thats it! That's the error!

Presumably, after they valued the low-risk bits, they found that nobody actually wanted to buy them at that valuation. What they should have done was price them down until people did want them, then re-evaluate the whole business on the basis of the actual market prices that they got for them. I have no idea whether that would have meant that securitization would have carried on or not. But either way, it would not have left the financial system dangerously exposed to the housing crash. At worst, it would have ended up as the "normal" sort of Wall St scandal - clever investment bankers sell a whole load of toxic crap to investors (see auction-rate, internet IPOs, etc. etc. etc.)

Why did the banks hang onto these investments, rather than sell them? I guess that they believed they were "really worth" pretty close to par value, and that buyers didn't want to buy them at that price just because they were uninformed. Also, because they were rated as so safe, the regulators were happy to consider them non-risky for the purposes of capital requirements. That was the regulators' biggest error. Because of course these two justifications contradict each other. If the securities can't be sold at their alleged "real value", then they are tying up the banks' capital, and should be counted as such.

(I'm surprised we haven't heard more about the mezzanine tranches that were sold to fund managers, pensions, insurance, etc. They were never seen as safe, so the bodies holding them could afford to take losses on them.)

It almost seems a shame that this whole crisis is caused by one such straightforward error. It ought to be something like "derivatives are too complex" or "regulators were subverted" or "government forced banks to make bad loans". It's a let-down that it was just "banks held one particular type of investment that it was never their business to hold, just as a by-product of one business line".

1 comment:

A Nonny Mouse said...

When a crisis like this happens everyone blames their favourite bugbear. An elderly Canadian in the McDonalds near where I live, who appears to have worn the same raincoat without washing it for the last 30 years, has explained the reason for the meltdown.
Subprime mortgages involves lending money to Negros.

The debate as I have witnessed it on other sites goes as follows: Capitalism contains within it the seeds of its own destruction: surplus value and all that. O no it doesn’t, the system would have worked perfectly if x y z.

Personally, I see the problem as part of a historical process whereby society is taken over by various interest groups who then proceed to run us all into the ditch.

In Germany, the first stage was the takeover by the military group. They promised world conquest and total prosperity for the master race. They nearly achieved this, but ended up delivering a defeated and impoverished state. They then persuaded the master race that if the war had been fought differently, different regiments at different fronts, they would have won. Result, second war, and total defeat and impoverishment. At this point the German people wised up.

In the world in which we live, militarists have been discredited and bankers are in fashion. Bankers will lead us to disaster just as surely as militarists, and already have done in 1929.

Now the point is, to say “They sold the high-risk bits to speculators and the medium-risk bits to long-term investors. But they kept the low-risk bits. Thats it! That's the error!” is the equivalent of arguing that the war would have been won if Regiment X had been sent to Front Y. Bankers will, if given free rein, infallibly lead us to disaster one way or another, indeed a single trader can wipe out the profits of an enormous bank. Like militarists, they are simply a species of compulsive gambler, who will never stop until completely bankrupt. The words deregulation, demutualisation etc are the signs that this process is about to take place.

An unhealthy nation can often be spotted by the excess numbers of a particular profession it contains. Japan has very few lawyers, which goes some way toward explaining what success it has enjoyed. In Ireland too, the legal profession has for some reason never been a popular career choice among the natives, who seem to operate entirely in terms of farmers, builders, nurses and barmen. This nation will inevitably be well fed, well housed, well looked after in sickness and well oiled.

The disasters which await the American nation and those who cluster round the City of London remain to be seen. The unreality begins when professions such farmer, builder and nurse begin to be regarded as a source of chump change, and banker becomes the only popular and profitable career option.

The Financial World has seen to it that farming has become an optimally conducted industry, with every redundant agriculturalist driven from the land. Equally, major building projects frequently end up with bankruptcy for the undertaker. What we need now is for the practitioners of these professions to club together and slim down the banking world.