Models of the banking crisis

Posted on April 24, 2009 by jjn1

I’m an engineer. I don’t understand finance, but I know something about how systems work, about feedback and complexity and emergence. And when I watch or read media ‘explanations’ of the banking crisis I invariably find that some aspects of the story seem to be missing.

All open dynamic systems, for example, have inputs which they transform into outputs — like so:

We know that the global financial system went into overdrive creating products that turned out to be unbelievably toxic. So an obvious question — to an engineer at least — is: where did the money come from to make these dodgy loans possible? What were the inputs to this crazy system? The answer turns out to be incredibly cheap money from China and the oil-rich Middle Eastern countries:

So: cheap money in, dodgy financial products out. As the Greenspan-sponsored post 9/11 economic boom gathered pace, China found itself running an enormous balance-of-trade surplus. So, to a lesser extent, did those countries which produce crude oil. They all found themselves with huge revenues and nowhere to put them to productive use. So they lent wholesale — at very low interest rates, because after all the supply of funds outstripped demand, thereby driving down interest rates — to Western banks and financial institutions. These, in turn, finding themselves able to obtain vast quantities of money cheaply, looked for ways of turning a profit on it. They could — and presumably did — lend some of it to credit-worthy institutions. But that was a finite market. So they looked around for a marketing opportunity — and found it in all those hard-up folks who aspired to buy a house but had hitherto been unable to obtain a mortgage. As one banker said on Dispatches the other night, it got to the point where “if you could breathe” someone would offer you a mortgage.

Now you might argue that these simple input-output models are too crude to be taken seriously. And perhaps they are. But I’ve just come on an interesting paper by an American economist, James Hamilton, which he presented at a conference organised by the Brookings Institution, a very fancy Washington-based think tank. Professor Hamilton is a student of oil prices and their impact, and he had previously published some stuff about the long-term impact of the oil-price rises in 2003. On his blog he wondered what the recent spike in oil prices might mean.

One of the most interesting calculations for me was to look at the implications of my 2003 model. I used those historically estimated parameters to find the answer to the following conditional forecasting equation. Suppose you knew in 2007:Q3 what GDP had been doing up through that date and could know in advance what was about to happen to the price of oil. What path would you have then predicted the economy to follow for 2007:Q4 through 2008:Q4?

The answer is given in the diagram below. The green dotted line is the forecast if we ignored the information about oil prices, while the red dashed line is the forecast conditional on the huge run-up in oil prices that subsequently occurred. The black line is the actual observed path for real GDP. Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.

He goes on:

“The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don’t fully believe myself. Unquestionably there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

This is intriguing, but it’s also another black-box, input-output model. In Professor Hamilton’s case it’s oil-shocks in, economic downturn out.

Deep waters, eh, Holmes? But wouldn’t it be funny if we could predict large-system behaviour with such crude models.

Larry Summers & Harvard’s endowment (contd.)

Posted on April 14, 2009 by jjn1

Well, well. Dave Boyle pointed me to this story from the April 3 edition of Boston.com:

Back in 2002, a new employee of Harvard University’s endowment manager named Iris Mack wrote a letter to the school’s president, Lawrence Summers, that would ultimately get her fired.

In the letter, dated May 12 of that year, Mack told Summers that she was “deeply troubled and surprised” by things she had seen in her new job as a quantitative analyst at Harvard Management Co.

She would go on to say, in later e-mails and conversations, that she felt the endowment was taking on too much risk in derivatives investments, and that she suspected some of her colleagues were engaging in insider trading, according to a separate letter written by her lawyer that summarized the correspondence.

On July 2 Mack was fired. But six years later, the kinds of investments she allegedly warned about did blow up on Harvard. The endowment plunged 22 percent last summer, in part due to the collapse of the credit markets. As a result, the school is cutting costs and under criticism that it took on too much risk in its investment portfolio.

Mack, who holds a doctorate in mathematics from Harvard, had been with Harvard Management for just four months when she approached Summers. She asked him to keep her communications confidential, or risk making her life “a living hell.”

But on July 1, Mack was called into a meeting by her boss, Jack Meyer, then the chief of Harvard Management.

The next day Meyer fired her, according to the letter from her attorney, Jonathan Margolis, a copy of which was obtained by the Globe. Meyer told Mack that she was fired for making “baseless allegations against HMC to individuals outside of HMC,” according to the Margolis letter…

A Continent Adrift

Posted on March 16, 2009 by jjn1

Paul Krugman is worried about Ol’ Europe.

Europe has fallen short in terms of both fiscal and monetary policy: it’s facing at least as severe a slump as the United States, yet it’s doing far less to combat the downturn.

On the fiscal side, the comparison with the United States is striking. Many economists, myself included, have argued that the Obama administration’s stimulus plan is too small, given the depth of the crisis. But America’s actions dwarf anything the Europeans are doing.

The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates (it actually raised rates last July), and it has shied away from any strong measures to unfreeze credit markets.

The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.

[…]

But such “automatic stabilizers” are no substitute for positive action.

Why is Europe falling short? Poor leadership is part of the story. European banking officials, who completely missed the depth of the crisis, still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany’s finance minister you have to listen to, well, Republicans.

But there’s a deeper problem: Europe’s economic and monetary integration has run too far ahead of its political institutions. The economies of Europe’s many nations are almost as tightly linked as the economies of America’s many states — and most of Europe shares a common currency. But unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.

This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to run up large debts to finance a stimulus that will convey many if not most of its benefits to voters in other countries.

Never waste a good crisis

Posted on March 15, 2009 by jjn1

Simon Caulkin has an interesting column reflecting on an academic conference he’s been to in which people tried to extract the lessons of the financial crisis. One conclusion: the worship of “shareholder value” was one driver of the catastrophe.

Other workshop participants were quick to extend the diagnosis from the banks to publicly quoted companies in general. If – as it is now becoming permissible to suggest – shareholder value is indeed the problem, then, as Einstein said, “the significant problems that we face cannot be solved at the level of thinking we were at when we created them”. A wholesale recasting of today’s unfit-for-purpose corporate governance becomes another urgently necessary response. In short, we are a very long way from business as usual.

Of course some people argue that the situation is now so bad that preventing a future crisis takes a distant, second place to getting things moving again. One inhabitant of the real economy feared that the squeeze would suck so much life out of companies like his that we wouldn’t even care about the possibility of another bubble.

Assuming it doesn’t go that far, the dilemma is poignant. The softer the landing, the more the government will be tempted to shore up the crumbling orthodoxy, making another crisis certain. The worse the depression, the better the chances that Whitehall can be pressurised into a fundamental rethink. Neither prospect is a cheerful one. But as the Obama team keeps repeating: “Never waste a good crisis.”

Lucy Kellaway Twaddle Awards

Posted on January 4, 2009 by jjn1

Bullshit is still thriving.

And now for the most eagerly awaited part of the awards: the jargon section.

● The first award in this group is for Nouns Moonlighting As Verbs, which was so popular that the judges are giving out three gongs. The 2008 Olympics introduced the world to the verb “to medal”. This entry medals with a bronze. The Silver medal in this category goes to “to auspice”, while gold goes to the verb “to sunset”. AOL used the verb to great effect last summer in declaring that it was canning some products. “Bluestring, Xdrive and AOL Pictures will be sunset. [They] have not gained sufficient traction in the marketplace or the monetisation levels necessary.” In other words, they were flops.

● In recognition of the economic climate the judges are giving a special award this year for Best Term For Sacking People. An honorary mention goes to the new phrase “dynamic rightsizing”, which means regular sackings, only more exciting and souped-up. The winner, for its sheer disingenuity, goes to “upgrade”. A reader reports that when she was fired by her US company in mid-2008 she was told: “We are going to upgrade you with immediate effect. We are going to allow you to move on in order that you can you use your talents and skills more effectively and thus upgrade your career and opportunities.”

So what really happened?

Posted on January 4, 2009 by jjn1

Michael Lewis and David Einhorn have written a devastating analysis in the NYT of why the banking catastrophe happened. It’s a great read. Sample:

OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

The credit-rating agencies, for instance.

Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.

Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”

The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

This is a subject that might be profitably explored in Washington. There are many questions an enterprising United States senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt — and a plausible triple-A rating.

By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.’s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.

Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)

At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)

There’s lots more in that vein, including some pretty scarifying stuff about the SEC.

We will know how serious a president Obama will be when we find out what he proposes to do about regulation of the financial services industry. The current system is comprehensively broken. It’s incapable of doing what needs to be done if banking is to be kept prudent and honest. The political temptation will be to fiddle with it (as Gordon Brown will probably do). But it really needs to be re-engineered from the ground up — by people who understand systems as well as banking.

The insanity of RAE

Posted on December 21, 2008 by jjn1

Those happy souls who live in the real world will not know that last Thursday saw the culmination of nonsense on stilts in the British university world — the release of the latest Research Assessment Exercise (RAE) results. In a nutshell, RAE is the extension of ‘targets’ and bean-counting to the world of ideas, and it’s a crazy system. In one major academic department I know, the most creative and original member of the department was excluded from the RAE by his colleagues because his pathbreaking work “didn’t fit the narrative” — i.e. the story being carefully crafted to impress the bean counters.

The mainstream media know nothing of this, however, so it’s really nice to see my Observer collleague, Simon Caulkin, turning his withering fire on it. He examines the consequences for universities of having to play the ‘targets’ game.

The first and most obvious of these is colossal bureaucracy. Government blithely assumes that management is weightless; but the direct cost of writing detailed specifications and special software, and assembling 1,100 panellists to scrutinise submissions from 50,000 individuals in 2,500 submissions, high as it already is, is dwarfed by the indirect ones – in particular, the huge and ongoing management overheads in the universities themselves. As with any target exercise, the RAE has developed into a costly arms race between the participants, who quickly figure out how to work the rules to their advantage, and regulators trying to plug the loopholes by adjusting and elaborating them.

The result is an RAE rulebook of staggering complexity on one side and, on the other, the generation of an army of university managers, consultants and PR spinners whose de facto purpose is not to teach, nor make intellectual discoveries, but to manage RAE scores. As in previous assessments, a lively transfer market in prolific researchers developed before the submission cut-off date at the end of 2007, while, under the urging of their managers, many university departments have been drafting and redrafting their submissions for the past three years.

Missing links at Princeton

Posted on November 27, 2008 by jjn1

For years Ed Felten of Princeton has been one of the best (most thoughtful, smart, informed, perceptive) bloggers on the Web. His Freedom to Tinker, has become a must-read for me and thousands of others. But in recent times, Freedom to Tinker has morphed from Professor Felten’s personal property into a collective blog hosted by Princeton’s Center for Information Technology Policy, a research centre devoted to the intersection of digital technologies and public life. The blog now publishes comment and analysis written by the Centre’s faculty, students, and friends.

All of which is fine and dandy. There’s still lots of great stuff on Freedom to Tinker. But in the process of morphing from a personal space to a collective blog, Professor Felten’s archive seems to have gone awol. The result is that all the links I have to his writings — and use in my teaching and journalism — no longer work.

The problem applies inside the blog itself also. For example, its search engine returns two of the archive entries to which I had linked.

But when one clicks on either link, one is taken to the top page of the blog. So it seems that deep linking to content on Freedom to Tinker has effectively been disabled.

This is the kind of thing one expects from clueless media organisations. But one would have thought that Princeton was a cut above that.

The incorporeal body politic in Merrion Street

Posted on October 5, 2008 by jjn1

Mark Hennessy has an enthralling account of the frantic 24 hours in which the Irish government came up with its dubious wheeze for bailing out the country’s banks.

IRELAND’S top bankers do not usually play a supplicant’s role.

Sitting, however, in Taoiseach Brian Cowen’s oak-lined office shortly before midnight on Monday underneath a portrait of Éamon de Valera there was little doubt about how much trouble they were in.

The bankers uneasily waiting there were Eugene Sheehy and Dermot Gleeson, chief executive and chairman of Allied Irish Bank (AIB) respectively, and their two counterparts from Bank of Ireland, Brian Goggin and Richard Burrows.

Four hours earlier, following a disastrous pounding for Irish bank shares on the stock markets, the four had hurriedly sought a meeting with Cowen and Minister for Finance Brian Lenihan.

Having arrived at Government Buildings at 9.30pm, they were taken to the Sycamore Room, once so beloved of Charles J. Haughey, and left to wait, and wait. Nearby, Cowen was chairing another meeting, involving Central Bank governor John Hurley and the chief executive of the Financial Regulator, Pat Neary.

Two hours elapsed before the bankers, who had been left on their own, were called in before Cowen and Lenihan, who asked some questions, but mostly listened. The bankers’ message was not that Anglo Irish Bank was about to collapse; or that Irish Nationwide was on the brink, though both had cash shortages to face on Tuesday and Wednesday. Instead, it was that they themselves were facing crisis…

Hennessy claims that the option eventually chosen – to guarantee “the deposits, loans and obligations” of the six Irish banks – had “been circulating within the Department of Finance, the Central Bank and Government Buildings for over two weeks”.

So the government knew what was likely to happen.

There’s a good deal of Yes, Minister comedy in the story. For example, it was decided that the decision would be made via a virtual Cabinet meeting conducted by telephone. Apparently this is known in Irish constitutional parlance as an “incorporeal” meeting.

While a number of senior Ministers had already been put on notice, the Cabinet secretariat contacted the remainder, telling them to be ready for the “incorporeal” meeting between 1am and 2am. Even then, most Ministers were not told exactly of the decision’s scope. Willie O’Dea was woken shortly after 1am by his ringing mobile, but it had gone to voicemail by the time he got to it. The landline by his bed rang seconds later.

Green Party leader John Gormley had more knowledge than most of an imminent banking crisis but, up until then, the secretariat had failed to make contact with him because his mobile had run out of power. In the end, Irishtown Garda station was called, and they sent a garda to his Ringsend home to wake him and ask him to ring the Taoiseach’s office.

It’s gets better. The banks left out of the deal were furious.

The statement entered the public arena at 6.45am, causing consternation among the banks not immediately included along with the six Irish institutions. And the consternation made itself heard very, very quickly – and directly to the man next in line for the throne of England.

Furious at the news, Sir Fred “The Shred” Godwin, chief executive of Ulster Bank’s parent, Royal Bank of Scotland, called Prince Charles, as well as the British prime minister Gordon Brown, sources say.

Brown’s chancellor of the exchequer, Alastair Darling, quickly called Lenihan. “He was very unhappy, let’s put it that way,” said one closely involved in the night’s events. Demanding a reversal of the decision, Darling warned that money would flood out of British banks. Lenihan listened, but gave no succour and said he had to protect Ireland’s interests. Later, he called again.

Brown rang Cowen later. Though he expressed concern, he did not ask for the guarantee to be stopped, but he did urge Cowen to do something for UK bank subsidiaries operating here. Replying, Cowen, no doubt conscious of the lack of warning by London when it nationalised Northern Rock 12 months ago, said Ireland had to look after its own banks.

Hennessy also says that

“One senior banker turned up at the Department of Finance offices in Merrion Street without an appointment, demanding to see Lenihan. Sources say he declared: “You’re trying to screw us.”

Well, it made a nice change. The banks have been screwing the Irish consumer for decades.

UPDATE: European Union Competition Commissioner Neelie Kroes said today that the Irish Government’s plan to provide unlimited guarantees on deposits in Irish banks contravenes EU law.

Ms Kroes said there was a discriminatory element to unlimited guarantees on bank deposits and that she expected Ireland to modify its guarantee plans.

She also said she had received assurances from her contacts in Dublin that the Government intended to modify the proposal before presenting it to Cabinet early this week.

MEANWHILE… Frank McNally has been enthralled by the Second October Revolution. In the first one, you will recall, the workers took ownership of the means of production. In October 2008, Irish citizens took ownership of the means of losing money. “Certainly”, he writes,

“I find myself caught up in the new revolutionary fervour. As a taxpayer – and to use Bertie’s terminology – I now ‘have it in my mind’ that I own the AIB and Bank of Ireland. I don’t feel the need to buy a large public building with ATMs and cashiers and toxic loans on its books and all that, because I can go down the road 10 minutes, and there’s one I bought already.

Of course, unlike the Bots [Dublinese for the Botanical Gardens, which Bertin Ahearn famously said he felt, as a taxpayer, that he ‘owned’], the banks are not open on Sunday afternoon. And I don’t want to visit them on Sundays, necessarily. But now that I own them, I’d like the management to work all weekend anyway, just for the hell of it. All this power is intoxicating.”

The aphrodisiac effect of power