"This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.
Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that “great contraction” of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this “the Great Repression.” This is the Depression they are hoping to bottle up—a Depression in denial."
So, here we go again. It's the system that has broken down. An article purportedly about human agency begins by blaming the system. Then, although the Fed was important in managing this crisis, there is no consideration of the fact that the implicit and explicit government guarantees played any role in this crisis. They're purely benign institutions.
"By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.
Nearly all of us did it. And the bankers were there to help."
So, we go from:
A: I want to invest in something that appreciates more than the rate of inflation ( However you're measuring that ) ( Makes sense )
to:
B: Borrow to the hilt and leverage your investments idiotically ( Idiotic )
What did I miss?
"The future is in large measure uncertain, so our assessments of future asset prices are bound to vary. If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria."
So, from:
1) The future is largely uncertain ( True )
2) Humans aren't calculating machines ( True )
3) Humans are moody ( True )
4) When investments all go up, our mood becomes euphoric ( Not buying it )
5) When euphoric, we invest idiotically ( I supplied this one ) ( Not sure )
The Spigot Theory appears. Turn on the tap too high, the tub floods. Again, this might be a necessary condition, but it's not sufficient. For one thing, what's easy? Do you mean lending foolishly? So, if Bank A lends foolishly, Bank B will follow, and then... By the way, what's a false bubble? This is a purely mechanistic explanation, disguised as being about behavior because a lot of people are choosing to do the same thing at the same time. Surely that absolves individual agents, and creates a mania, a bubble, which is the system's fault, not individual human agents.
"What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble...
I thought that you just agreed with the Spigot Theory. If not, the alternative is that easy money didn't create the crisis. At best, it was a tool that was misused, by people.
"Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset."
So, the alternatives are:
1) Put money in mattress ( No interest )
2) Put money in bank safe ( Interest? )
3) Idiotic borrowing to gain massive interest ( Self-Explanatory )
"So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue."
If people borrow to finance houses, a bubble will ensue. That's just nonsense. What else could brainwashing imply? It must be idiotic, and needs brainwashing to be overcome.
"There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago."
It worked for me, and all I did was read Jane Bryant Quinn.
"Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.”
And yet this guarantee is not part of the problem.
"These changes swept away the last vestiges of the business model depicted in It’s a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later."
Finally something I agree with. The lenders should know enough about the borrowers in order to make the loan reasonable.
"As a business model, subprime lending worked beautifully—as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last.."
See, to me this obvious, and I'm not a banker.
"The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard “to arrive” futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.
Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a “call” option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller (“writer”) of the option at a certain time (the expiration date) for a certain price (known as the “strike price”). Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is “in the money”—and so is the smart guy who bought it. A “put” option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.
A third kind of derivative is the interest-rate “swap,” which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds."
I included this just because I like explanations.
"But how exactly do you price a derivative? What precisely is an option worth?"You'd better figure that out if you plan to make money on them.
"The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational..,"
Postulate away, as long as your not silly enough to think that's this planet.
"But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash"
Please don't tell that this means they were making statistical predictions of future events and only looking back five years. I must be missing something here.
"But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The Asian savings glut was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts. And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets."
Here we go again with the mechanistic explanations. The Giant Sloshing Pool Of Money that need be invested idiotically against all human will or knowledge. I'm sorry, again, at best a necessary condition. At best.
"But back here on Planet Earth it suddenly seems like an extraordinary popular delusion."
The delusion here on planet earth is reducing this crisis to:
1) Low interest rates
2) Giant pool of money
3) Complicated investments
4) The behavior of crowds
Individual human agents don't appear here. How could they? They have to be dealt with individually, and that's too hard and messy. Or is it?
The causes of the crisis are:
1) Poor lending
2) Poor borrowing
3) Fraud
4) Negligence
5) Fiduciary misconduct
6) Implicit and explicit government guarantees
7) Poor compensation schemes
8) Lack of supervision
9) Wishful thinking
10) Overlooking risk
A motley list of human frailties that we see or hear about on most days. That's what got us into this mess. The only difference was the number of people involved. To the extent that these events are explained mechanistically, expect it all to happen again. Only risk borne at the individual level can solve this problem, and that means ridding individuals of the chance of a bailout.
Does that mean not having a decent and just social safety net? Of course not. It simply means that private businesses cannot transfer their losses to the taxpayers, by having too much concentrated power and wealth to ensure that.
The simple application of anti-trust laws, enforcing fraud, and minimal but effective regulation can solve this. That's the sad truth.
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