"I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and doubt the ability of regulators to prevent bubbles

From Michael Pettis:

"The fun part – assigning blame
January 7th, 2009 by Michael | Filed under Balance sheets, Global liquidity, Policy.
The piece I wrote for YaleGlobalOnline, which I mentioned in my last entry, was published today, and is called “US and China Must Tame Imbalances Together.” In the article I try to argue that the roots of the current financial imbalance – or, more accurately, of the latest and strongest stage of the current financial imbalance ( THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS ) – are buried in the trade and capital relationship between, primarily, China and the US. It is very important, I argue here and elsewhere, that the US and Europe do everything possible to help what could otherwise be a very difficult adjustment for China( IT WILL BE VERY HARD FOR THEM TO SAY GOODBYE TO THIS SYMBIOSIS. ). The editor’s summary of the piece is:

With surging liquidity and massive trade imbalances, no one should have been surprised by the global economic crisis, because as finance professor of Peking University Michael Pettis explains, this has been the historical pattern. Pettis details the history of the crisis, starting in 1980s, when US policy encouraged( WITH GUARANTEES, YES. NOT THE INTEREST RATES THEMSELVES. ) securitization of mortgages, converting illiquid assets into highly liquid investments; US households shifted money into homes( THIS HAS TO DO WITH MANY FACTORS, INCLUDING RETIREMENT PLANS AND RENT TO OWNERSHIP PRICES. ) rather than savings accounts( WHICH DON'T GO UP MUCH, ESPECIALLY IF YOU HAVE TO PAY RENT. ), and housing prices climbed; China, enjoying a trade surplus, collected US dollars and invested in US assets. A self-reinforcing cycle led( THEY CHOSE. ) US consumers to buy more, Chinese factories to produce more, banks in both countries to lend more, and the bubbles burst in late 2008. US adjustment is more rapid than China’s, which could lead to a new set of problems. Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances( WHICH IS WHAT CHINA WANTS ), and he urges the two nations to act responsibly, coordinating fiscal and monetary policies to ease US overconsumption and Chinese overproduction.( THIS CAN'T BE DONE UNTIL THE CALLING RUN ENDS. )

The argument I am making here is also part of a spirited discussion among a group of China scholars who communicate regularly on China-related themes. At the heart of the discussion is an argument over the monetary and policy mistakes made by the major players in permitting or even encouraging the credit bubble of the past decade. Although at its worst these kinds of discussions can quickly degenerate into a fruitless who-to-blame invective (”It is all the fault of Chinese polices” versus “It is all the fault of the US failures”), at its best – and the discussion has generally been quite good – it is a real attempt to understand the roots of the current crisis and the still-unclear ways in which it may continue to unfold.

I am not allowed to publish or publicize any of the comments among this group since the moderator wants to encourage completely open discussion, but I can say that one of the participants wondered about the sequence of events and questioned my claim that crises are always caused as a result of periods of excess liquidity ( A TAUTOLOGY. IT'S THE WORD "EXCESS" THAT MAKES IT ONE, SINCE THE EXCESS IS DETERMINED AFTER THE FACT. IT'S A USELESS EXPLANATION. ), and that it is difficult for regulators to prevent excessive( THIS HAS TWO MEANINGS, ONE OF WHICH IS USELESS. "EXCESSIVE" CAN MEAN "AGAINST INVESTING RULES", WHICH IS USEFUL, OR IT CAN SIMPLY MEAN"DETERMINED TO HAVE BEEN SO AFTER THE FACT", WHICH IS OBVIOUS, AND USELESS. ) risk-taking when the financial system is forced to accommodate excess liquidity. I think that this is an interesting enough discussion, and very relevant to China, to repeat the argument and my response.

My friend argues that although he agrees excess liquidity is a necessary condition( I'M FINE WITH THIS ) for credit bubbles, it is not at all clear to him that it is a sufficient condition. Besides excess liquidity, he argues, we need misguided regulatory policies to create a bubble and a subsequent financial collapse. In his view, the Fed was primarily responsible for the crisis because of its failure to regulate the financial system with sufficient rigor, and given the expansion of liquidity, it was only a question of time before that failure would lead to crisis.( A MECHANISTIC EXPLANATION AND USELESS. A HUMAN AGENCY EXPLANATION FOCUSES ON INTENTIONALITY AND PRESUPPOSITIONS. IT IS THE ONLY EXPLANATION OF THIS CRISIS. THE SPIGOT THEORY IS USELESS. )

In my response I argued that it is hard to say if excess liquidity growth is both necessary and sufficient condition for crisis since we would need an objective way to measure excess liquidity growth( EXCEPT AFTER THE FACT ), and that is extremely difficult, at best. The late Frank Fernandez, while chief economist of the Securities Industry Association, spent years trying to do so, but always complained that the financial system was too good at developing new and unexpected ways to expand money.( HE WAS CORRECT. )

I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and I doubt the ability of regulators to prevent bubbles. Part of my skepticism about whether or not a robust regulatory framework can truly prevent credit bubbles is theoretical, and part of it is empirical, with the latter resting on two personal experiences. First, in my reading on financial history and current events there has clearly been tremendous improvement over the past 300 years and more in our understanding of financial risks, the functioning of the financial system, the sophistication of our regulatory institutions, and monetary policy, but absolutely no concomitant reduction in the incidence of credit bubbles. ( ARE HUMAN BEINGS STILL INVOLVED SIR? )

Quite the contrary, and if good regulation prevented crises, why wouldn’t we have seen evidence of gradual improvement in the number and viciousness of crises? Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place( I AGREE ). Regulators simply cannot outplay the market, and when too much liquidity leads( IT DOESN'T DO ANY SUCH THING. THERE ARE INCENTIVES AND DISINCENTIVES TO EVERY HUMAN ACTION, OTHERWISE IT'S NOT AN ACTION. THE VIEW OF HUMAN AGANCY HERE PROPOUNDED IS PURELY MECHANISTIC AND FALSE. ) to an increase in risk appetite, the financial system will find a way to take on more risk that might be healthy. As I argue in my piece, “When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.” ( I AGREE COMPLETELY HERE, WHICH IS WHY I DON'T BLAME THE REGULATIONS OR MATH MODElS OR INVESTMENTS VEHICLES. OTHER WAYS TO LOWER CAPITAL REQUIREMENTS WOULD HAVE BEEN FOUND. )

That leaves me a hard-core Minskyite on financial instability, and it is Minsky who creates the theoretical basis for my skepticism. According to Minsky it is not possible even in theory to eliminate financial instability because the very mechanisms used to control one form of instability will cause changes in the financial system (all those smart-ass bankers/traders) that will create new forms of instability( TRUE ). The whole purpose of a financial system is to intermediate risk, and when risk appetites change( I AGREE, BUT I DISAGREE ABOUT THE CAUSES OF THIS CHANGE. ), the financial system will find a way to accommodate that change, whether or not regulators are comfortable with the change.( TRUE )


That doesn’t mean regulations( I DIFFERENTIATE BETWEEN REGULATION AND SUPERVISION. I BELIEVE THAT WE NEED SUPERVISION, WHICH DOESN'T FOCUS ON RULES BUT METHODS AND GOALS. )) are a waste of time. On the contrary, they are extremely important in the proper functioning of the financial system, but we need to be clear where they matter and where they don’t. As I see it, the purpose of the regulatory framework is:


1) To create a financial system that in “normal” times optimizes the ability of the system to allocate capital cheaply and efficiently. This is where issues of transparency, corporate governance, agency problems and information asymmetry matter.( TRUE )

2) To eliminate balance sheet feedback mechanisms that are automatically pro-cyclical and, to the extent possible, create fiscal and balance sheet stabilizers. These don’t eliminate bubbles and crises, but they do reduce the impact and weaken the transmission mechanism into the real economy. ( TRUE )

To bring this back to China, it is for these reasons that I am more skeptical than most about the recent financial reforms in China. As I see it, the financial system here is replete with balance sheet pro-cyclicality, which the government has not directly addressed (in fact many of their interventions increase the risk) and so China runs the risk of a big, “unexpected” jump in volatility when things turn bad.

The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical –for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk( I DISAGREE. IT NEEDS TO BE A LOLR TO STOP A CALLING RUN. WHAT ARE NEEDED ARE BAGEHOT'S PRINCIPLES, WHICH WILL KEEP A CALLING RUN FROM OCCURRING. ). Government control of the banks can prevent banks from behaving in ways that exacerbate a downturn, and usually this is a good thing, but in a very severe downturn – like that which Japan experienced after 1990 – the attempt to control banking activity can actually backfire if it leads to a surge in government debt that threatens government credibility( THIS IS WRONG. THE AMOUNT IS A PROBLEM, BUT THAT'S DIFFERENT THAN THE NEED FOR THE GOVERNMENT TO BE A LOLR. ). This loss of government credibility happened in Japan (yet) but it has happened in a number of other cases.

This is basically why I think the liquidity creation generated by the Chinese recycling of the US trade deficit would have led to crisis anyway, even if there had been stronger regulation within the US financial markets( I AGREE ). And, by the way, although I share in the general horror about the huge breaches in our regulatory framework, I also remember that during the enormous petrodollar recycling in the 1970s, the US regulatory framework was much more robust, regulated, rigid and constrained then it is now, but that didn’t prevent excess risk-taking. The only impact of regulatory constraints was that extremely foolish behavior – massive loans to countries that had no chance in hell ever to repay – still occurred among American banks (to such an extent that by the time I joined the market in 1987 only one – JP Morgan – of the top ten US banks was not insolvent) but they occurred outside the regulatory constraint. For all the regulatory prudence the risky behavior simply migrated ( THIS IS WHAT WILL HAPPEN. TO SOME EXTENT, IT DID THIS TIME. )to London, where international banks were not as strictly regulated by their home countries.

The real fault of the Fed in the current crisis, in my opinion, was not to foresee that this unsustainable system would eventually come to a breathtaking close, and to prepare the stabilizers that would have prevented the decimation of the US financial system and its brutal transmission into the real economy. In fact every time they intervened to prevent the system from clearing, they increased the accumulation of balance sheet mismatches( TRUE. BUT, COME ON, THE BUSH ADMINISTRATION IS THE MAIN CULPRIT HERE. ). The regulators did have a role( COLLUSION ), but it was not to prevent the crisis but rather to mitigate( WORSEN ) its impact. In my opinion the Fed could not have prevented the crisis except by engineering a recession in the US to counteract strong mercantilist policies in Asia, and that is perhaps a lot to ask( IMPOSSIBLE. I HAD A BAD FEELING THAT THIS IS WHERE HE WAS GOING. RECESSION ON A THEORY. SURE, LET'S STOP PEOPLE DOING WELL ON A THEORY. ).

One last thing about the joy of assigning blame, I have read and re-read several times Charles McKay’s Extraordinary Popular delusions and the Madness of Crowds and thought I should post the following selection from his chapter on the South Sea Bubble – after the bubble collapsed brining ruin in its wake:

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South-Sea directors, who, by their fraudulent( FRAUD. DO YOU SEE THAT? FRAUD. ) practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people,—the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.( WELL, THIS IS TRUE. GULLIBILITY ISN'T A CRIME. FRAUD IS. )

This was the almost unanimous feeling of the country. The two Houses of Parliament were not more reasonable. Before the guilt of the South-Sea directors was known, punishment was the only cry. The king, in his speech from the throne, expressed his hope that they would remember that all their prudence, temper, and resolution were necessary to find out and apply the proper remedy for their misfortunes. In the debate on the answer to the address, several speakers indulged in the most violent invectives against the directors of the South-Sea project. The Lord Molesworth was particularly vehement. “It had been said by some, that there was no law to punish the directors of the South-Sea company, who were justly looked upon as the authors of the present misfortunes of the state. In his opinion they ought upon this occasion to follow the example of the ancient Romans, who, having no law against parricide, because their legislators supposed no son could be so unnaturally wicked as to embrue his hands in his father’s blood, made a law to punish this heinous crime as soon as it was committed. They adjudged the guilty wretch to be sown in a sack, and thrown alive into the Tiber. He looked upon the contrivers and executors of the villanous South-Sea scheme as the parricides of their country, and should be satisfied to see them tied in like manner in sacks, and thrown into the Thames.” Other members spoke with as much want of temper and discretion.

Mr. Walpole was more moderate. He recommended that their first care should be to restore public credit. “If the city of London were on fire, all wise men would aid in extinguishing the flames, and preventing the spread of the conflagration before they inquired after the incendiaries. Public credit had received a dangerous wound, and lay bleeding, and they ought to apply a speedy remedy to it. It was time enough to punish the assassin afterwards.” On the 9th of December an address, in answer to his majesty’s speech, was agreed upon, after an amendment, which was carried without a division, that words should be added expressive of the determination of the house not only to seek a remedy for the national distresses, but to punish the authors of them.

Robert Walpole, for those who don’t remember, was the brilliant (if not always scrupulous) statesman – effectively Britain’s first Prime Minister, although the title hadn’t yet been invented – who had been more or less pushed out of favor for speaking strongly and often against the South Sea scheme and warning of its consequences. After the collapse, he was called back to London to clean up the mess – predictable, right? Perhaps because he had been so widely reviled for speaking against the South Sea scheme, he was not fully sympathetic to the claims that the whole thing had been a scam foisted on innocent people by evildoers. He was perfectly happy to avoid the whole orgy of blame and deal with the actual consequences, but needless to say blaming the schemers was always likely to be a lot more satisfying than acknowledging that an awful lot of people participated a little too willingly in the whole thing. Walpole was famously a realist – when there were sufficient incentives for foolishness and fraud, he didn’t doubt that even the nicest people would act stupidly or dishonestly."

I'm puzzled by this. If this view is correct, why is fraud a crime? I believe in blame. One thing is for sure, and that is the fact that not punishing crime is an incentive for more of it.As for the last sentence, it is patently false. Walpole was less a realist than a misanthropist. Thankfully, throughout history, we've have many great people who have turned down great incentives and done the right thing. A Human Agency Explanation assigns blame for committing crimes, and endeavors to investigate and prosecute them. Excusing crime by blaming the victims or saying that we are all possible criminals is useless at preventing anything. Rather, it's a trumpet call for crime. No wonder we're in this mess.

"Markus Brunnermeier provides an excellent summary graph of the financial crisis, told in "spreads".

From Menzie Chinn on Econbrowser, an excellent paper by Markus Brunnermeier. Unfortunately, I can't seem to reproduce the graphs, or I would have commented more on it. But I read it all, and highly recommend it: See also this post.

M.K. Brunnermeier, "Deciphering the Liquidity and Credit Crunch 2007-08," forthcoming Journal of Economic Perspectives, 2009, 23(1):


"To answer this question, it is useful to first recall the three main factors leading up to the housing bubble. First, there are large capital inflows from abroad, especially from Asian countries. Asian countries bought U.S. Dollars both to peg the exchange rate on an export-friendly level and to hedge against a depreciation of their own currency against the dollar, a lesson learned from South-East Asia crisis in the late 1990s. These capital inflows contributed to a prolonged low-interest-rate environment. Second, fearing a deflationary period after the bursting of the Internet bubble, the Federal Reserve adopted a lax interest rate policy and thus did not counteract the buildup of the housing bubble. Third, the transformation of the banking system from a traditional banking model, in which the issuing banks hold loans until they are repaid, to the ―originate and distribute‖ banking model, in which loans are pooled, tranched and then resold, caused a decline in lending standards. Financial innovation that was intended to stabilize the banking system by transferring risk to other market participants led to an unprecedented credit expansion and helped feed the boom in housing prices."

So, the three main preconditions of the Housing Bubble are:
1) A lot of money from foreign countries invested here
2) Low interest rates
3) Banks, instead of keeping loans, bunched them and then sold them, causing them to ease lending standards
4) Investments meant to stabilize banks by transferring risk led to unwarranted lending

For me, 1,2, and 4, are enablers, while 3 is the cause.

"Two trends in the banking industry contributed significantly to the lending boom and housing frenzy that laid the foundations for the crisis. First, instead of holding loans on banks‘ balance sheets, banks moved to an ―originate and distribute‖ model. Banks repackaged loans and passed them on to various other financial investors, thereby off-loading risk. Second, banks increasingly financed their asset holdings with shorter maturity instruments. This left banks particularly exposed to a dry-up in funding liquidity."

So:
3A: Banks use shorter term investments

Warning: Explanation I like:

Securitization: Credit Protection, Pooling, and Tranching Risk
To offload risk, banks typically create ―structured‖ products often referred to as collateralized debt obligations (CDOs). The first step is to form diversified portfolios of mortgages and other types of loans, corporate bonds, and other assets like credit card receivables. The next step is to slice these portfolios into different tranches. These tranches are then sold to investor groups with different appetites for risk. The safest tranche—known as the ―super senior tranche‖—offers investors a (relatively) low interest rate, but it is the first to be paid out of the cash flows of the portfolio. In contrast, the most junior tranche—referred to as the ―equity tranche‖ or ―toxic waste‖—will be paid only after all other tranches have been paid. The mezzanine tranches are between these extremes. Legally, the portfolio is usually transferred to a ―special purpose vehicle,‖a financial entity whose sole purpose is to collect principal and interest cash flows from the underlying assets and pass them on to the owners of the various tranches. The exact cutoffs between the tranches are typically chosen to ensure a specific rating for each tranche. For example, the top tranches are constructed to receive a AAA rating. The more senior tranches are then sold to various investors, while the toxic waste is usually (but not always) held by the issuing bank, to ensure that it adequately monitors the loans."

Okay. CDO= Collateralized Debt Obligation: A bunch of bonds, etc.
Tranches:
Safest= Super senior: Low Interest: Usually AAA: Sold to investors: Paid 1st
Mezzanine= Between extremes: Paid 2nd
Junior= Equity= Toxic Waste: Usually held by bank ( Originating lender ): Paid last

Held by SPV=Special Purpose Vehicle: Collects interest and principal from what's in the bunches, and disperses the proceeds to holders of tranches

"Buyers of these tranches or regulator bonds can also protect themselves by purchasing credit default swaps, which are contracts insuring against the default of a particular bond or tranche. The buyer of these contracts pays a periodic fixed fee in exchange for a contingent payment in the event of credit default. Estimates of the gross notional amount of outstanding credit default swaps in 2007 range from $45 trillion to $62 trillion. One can also directly trade indices that consist of portfolios of credit default swaps, such as the CDX in the United States or iTraxx in Europe. Anyone who purchased a AAA-rated tranche of a collateralized debt obligation (CDO), combined with a credit default swap, had reason to believe that the investment had low risk."

CDS=Credit Default Swap: Insurance, paid with premiums, against default of bunches or what's in them

Good investment= Tranche + CDS

"Shortening the Maturity Structure to Tap Into Demand of Money Market Funds
Most investors prefer assets with short maturities, such as short-term money market funds. It allows them to withdraw funds at short notice to accommodate their own funding needs (see, for example, Diamond and Dybvig, 1983, and Allen and Gale, 2007) or it can serve as a commitment device to discipline banks with the threat of possible withdrawals (as in Calomiris and Kahn, 1991, and Diamond and Rajan, 2001). Funds might also opt for short-term financing to signal their confidence in their ability to perform (Stein, 2005). On the other hand, most investment projects and mortgages have maturities measured in years or even decades. In the traditional banking model, commercial banks financed these with deposits that can be withdrawn at short notice.
The same maturity mismatch was transferred to a ―shadow‖ banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles (SIVs) raise funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year primarily to money market funds. The short-term assets are called ―asset backed‖ because they are backed by a pool of mortgages or other loans as collateral. In the case of default, owners of the asset-backed commercial paper have the power to seize and sell the underlying collateral assets. Asset-backed commercial paper had become the dominant form of outstanding commercial paper by the start of 2006. The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposes the banks to funding liquidity risk: Buyers in the commercial paper market might suddenly shy away. To ensure funding liquidity, the sponsoring bank grants a credit line, called a ―liquidity backstop.‖ As a result, the banking system still bears the liquidity risk from holding long-term assets and making short-term loans.At the same time the maturity mismatch on the balance sheet of investment banks also increased."

This is 3A. Long term loans financed with short term assets= Maturity Mismatch

"In summary, leading up to the crisis, commercial and investment banks were heavily exposed to maturity mismatch both through granting liquidity backstops to their off-balance sheet vehicles and through their increased reliance on repo financing. Any reduction in funding liquidity could thus lead to significant stress for the financial systems, as we witnessed starting in the summer of 2007."

3A again.

"Structured financial products can cater to the needs of different investor groups. Risk can be shifted to those who wish to bear it, and it can be widely spread among many market participants, which allows for lower mortgage rates and lower interest rates on corporate and other types of loans. Besides lower interest rates, securitization allows certain institutional investors to hold assets (indirectly) that they were previously prevented from holding by regulatory requirements. For example, certain money market funds and pension funds that were allowed to invest only in AAA-rated fixed-income securities could invest in a AAA-rated senior tranche of a portfolio constructed from BBB-rated securities. However, a large part of the credit risk never left the banking system, since banks, including sophisticated investment banks and hedge funds, were among the most active buyers of structured products (see, for example, Duffie, 2008). This suggests that other, perhaps less worthy motives were also at work in encouraging the creation and purchase of these assets."

The benefits:
1) Getting around regulations
2) Spreads and lowers risk

In hindsight, it is clear that one distorting force leading to the popularity of structured investment vehicles (SIVs) was regulatory and ratings arbitrage. The Basel I accord (an international agreement that sets guidelines for bank regulation) imposed on banks an 8 percent minimum capital requirement (capital charge) for holding loans on their balance sheets; the capital charge for contractual credit lines was much lower. Moreover, there was no capital charge at all for ―reputational‖ credit lines—noncontractual liquidity backstops that sponsoring banks provided to SIVs to maintain their reputation. Thus, moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel I regulations while the risk for the bank remained essentially unchanged."

Okay. They're trying to get around capital requirements. Now, we're getting somewhere.

"Moreover, in retrospect, the statistical models of many professional investors and credit-rating agencies provided overly optimistic forecasts about structured finance products. One reason is that these models were based on historically low mortgage default and delinquency rates. More importantly, past downturns in housing prices were primarily regional phenomena—the United States had not experienced a nationwide decline in housing prices in the period following WWII. The assumed low cross-regional correlation of house prices generated a perceived diversification benefit that especially boosted the valuations of AAA-rated tranches (as explained in this symposium in the paper by Coval, Jurek, and Stafford)."

This is fine, but, again, people needed to be predisposed to accept this stuff.

"In addition, structured products may have received more favorable ratings compared to corporate bonds because rating agencies collected higher fees for structured products. ''Rating at the edge'' might also have contributed to favorable ratings of structured products versus corporate bonds."

Ratings agencies. Fine. But this also borders on fraud, negligence, and fiduciary misconduct, e.g., conflict of interest.

"While a AAA-rated bond represents a band of risk ranging from a near-zero default risk to a risk that just makes it into the AAA-rated group, banks worked closely with the rating agencies to ensure that AAA tranches were always sliced in such a way that they just crossed the dividing line to reach the AAA rating. As a consequence, CDO tranches must be downgraded when an incremental change in the underlying default probabilities or correlations occurs.Fund managers were attracted to buying structured products because they expected to generate high returns, but with a small probability of catastrophic losses. When the risk-free interest rate is low, this type of investment will be especially attractive to fund managers, whose compensations are linked to a percentage share of the upside but do not become negative in the event of losses. In addition, some fund managers may have favored the relatively illiquid junior tranches precisely because they trade so infrequently and were therefore hard to value. These managers could make their monthly returns appear attractively smooth over time because they had some flexibility with regard to when they could revalue their portfolios. "

A.Banks and Ratings Agencies conflict of interest. AAA Rating right on line, must be downgraded though with slight loss
B. Incentives for Managers to border on fraud, negligence, and fiduciary misconduct.
a. Manager gets paid when goes up, but nothing happens when it goes down
b. Hard to value

"The rise in popularity of securitized products ultimately led to a flood of cheap credit, as lending standards fell."

OKAY: BIG DISAGREEMENT: I believe that the products were used to fill the need, not the other way around. That's a big difference.

"This combination of cheap credit and low lending standards resulted in the housing frenzy that laid the foundations for the crisis."

OKAY: There's no excuse for low lending standards. Period. To say that cheap credit caused it is a mechanistic explanation of human agency. At best, it's an incentive, an inducement, to violate known investment precautions. Don't blame the products, and don't blame the inducements. People had to actually decide to do this. Period.THIS IS A MORAL PROBLEM, if not legal.

"Precautionary hoarding arises if lenders are afraid that they might suffer from interim shocks and that they will need funds for their own projects and trading strategies. Precautionary hoarding therefore increases when 1) the likelihood of interim shocks increases, and 2) outside funds are expected to be difficult to obtain.
The troubles in the interbank lending market in 2007-08 are a textbook example of precautionary hoarding by individual banks. As it became apparent that conduits, structured investment vehicles, and other off-balance-sheet vehicles would likely draw on credit lines extended by their sponsored bank, each bank's uncertainty about its own funding needs skyrocketed. At the same time, it became more uncertain whether banks could tap into the interbank market after a potential interim shock, since it was not known to what extent other banks faced similar problems. These effects led to sharp spikes in the interbank market interest rate, LIBOR, both in levels and volatility."

Here's some stuff I like because it deals with hoarding, which might or might not be rational, and so it's something I'd like to look into.

"Network and counterparty credit risk problems are more easily overcome if a clearinghouse or another central authority or regulator knows who owes what to whom. Then, multilateral netting agreements, such as the service provided by SwapClear, can stabilize the system. However, the introduction of structured products that are typically traded over the counter has made the web of obligations in the financial system more opaque, consequently increasing systemic risk."

Here's a good reason to have a clearinghouse.

These mechanisms also form a natural point from which to start thinking about a new financial architecture. For example, fire-sale externalities and network effects suggest that financial institutions have an individual incentive to take on too much leverage, to have excessive mismatch in asset-liability maturities, and to be too interconnected. Brunnermeier (2008b) discusses the possible direction of future financial regulation using measures of risk that take these domino effects into account."

Too much leverage. That's it, but that's what they were intending to do.

Anyway, this is a great and very clear paper.

The Fed And Bubbles

Justin Lahart with an excellent post on the WSJ about the Fed trying to avoid bubbles in the future:

"Once authorities identify a bubble, the next step is figuring out how to deal with it. Fed officials appear uncomfortable with the idea of raising interest rates to prick a bubble, because rates affect a wide swath of economic activity, and a bubble may be confined to just one area.

"Monetary policy, for which we in the Federal Reserve are responsible, is a blunt instrument with economy-wide effects," said Federal Reserve Bank of Minneapolis President Gary Stern. "We should not pretend that actions taken to rein in those asset-price increases, which seemingly outstrip economic fundamentals, won't in the short run curtail to some extent economic growth and employment."

Fed officials are leaning toward regulating financial firms with more of a focus on how they are contributing to risk throughout the financial system. This approach could also have drawbacks, said Princeton economist Hyun Song Shin.

"These Wall Street people are very intelligent, and their incentives are so vast that they're going to find a way to go around the rules you set down," he said. "Leaning against the wind by raising interest rates in the face of what seems like a credit boom is one way of at least damping down on potential excesses."

This is the issue. If the Fed causes a slowdown in the economy in order to avoid a bubble, will that be accepted, or will people decry their action as limiting growth without enough cause. On the other hand, through lobbying and other means, they might not be able to deal with the problem companies effectively.