Clif's Book World

From time to time I like to read about the recent financial collapse in an effort to try to understand what happened. This book is written by an author who normally writes novels, so he knows how to explain things very simply. In the early part of the book it was so simple that I thought it might insult my intelligence. But my mind got stretched soon enough. He used simple fictional examples to try to illustrate how each new financial instrument worked. I think I almost understand now what derivatives are, but don't ask me to explain it.

When it's all over and we look back on what happened, it's a case where all the profits from the boom years went into private hands, and when things went bust it was public money (taxpayers) that cleaned up the mess. It's anything but fair. Looking to the future the author says that we will probably look back on the 20 years prior to the financial collapse as the golden years because our future economy will be weighted down paying off the rescue payments. Even if the resulting national debts are not paid off, the lingering burden of paying the interest costs will limit public spending in other areas.

It’s all a lesson in how financial incentives can lead intelligent people to do stupid things. When I say stupid, I’m thinking of the college educated math whizzes who calculated the odds of a nation-wide collapse in housing prices to be less than on in a billion (i.e. impossible). The problem was that their models were based on history that did not include a boom in subprime mortgages (i.e. a changed condition).

The following quote from the book is a good illustration of why statistics are not good at predicting financial markets:

“…how do we know that the normative distribution applies to events in financial markets? The way in which people move and jostle around a room might be plotted and mapped with statistical tools and shown to resemble something like a normative distribution—sometimes people are over here, somewhere in the middle. But shout “Fire!” and the movement of people in the room will look very different—it will feature a stampede toward the exits.”

Perhaps those math whizzes need to study more chaos theory.

One interesting observation is that not a single bank in Canada has gone broke during the past couple years. The author suggests (presumably in jest) that they were spared because of their propensity of not act like their ultra free wheeling capitalistic neighbors to the south. Their desire to not be like us saved them from doing stupid stuff like us. So they owe us a big word of thanks for our being such a positive influence on them. Actually there is a rational explanation for the Canadians conservatism in banking. They had their own banking crisis about a decade ago, and they fixed it with stringent banking laws. The rest of the world in contrast moved into the direction of total deregulation.

On the lighter side, here’s my favorite quote from the book:

“I’d like to think he would have enjoyed the old joke about accountants: “What’s two plus two?” “What would you like it to be?” "

The above quote is referring to the fact that Luca Pacioli, the first person to write (in the 15th Century) a book that laid out the method of double-entry bookkeeping was also a writer about magic, in the sense of conjuring. No doubt if he were living today he would have also written a book about mortgage backed derivatives.

Speaking of big words, have you heard of the following words?
--Collateralized Debt Obligations
--Collateralized Debt Swaps
--Synthetic Asset-Backed Security
--Off-Shore Special-Purpose Entity
This book does a good job at trying to explain what these words mean. Using tools such as these the big investment banks figured out ways to make money available for loans “risk free.” Their system allowed them to keep loaning the same dollar hundreds of times over without any of the corresponding risk obligations showing up on their balance sheets. This led to an increase in the amounts of funds available to be loaned. With lots of new money to loan there was more money than good borrowers. Suddenly subprime loans to people who had previously been considered not credit worthy looked very appealing. The loan creator didn’t care if it could be paid off because the mortgage was immediately sold to others. This in-flow of money to the housing market increased the completion among buyers, thus resulting in an artificial increase to the cost of houses.

I think the core cause of the financial collapse can be summarized by the following three statements:
1. Risk was separated from the originator of the loan.
2. Investors and insurance companies who took on the risk were willing to believe statistical equations--based on historical data--that indicated the risk was virtually nonexistent.
3. When lots of money is suddenly being made by others, nobody wants to be left out.

This book leaves me with this unanswered question. How can something so obviously crazy in hindsight not be recognized as such when it was happening?

The following review is from PageADay's Book Lover's Calendar for 10/23/12:
CURRENT AFFAIRS
The New York Times calls it “angry enough to clear your sinuses,” as well as “thoughtful, funny, and unpretentious.” There have been many books explaining the real-estate and credit-market crashes and the resulting recession, but few are as witty and easy to swallow as I.O.U. British journalist John Lanchester gives us the big picture and synthesizes the data in a way that is pleasurable for insiders and financial amateurs alike.
I.O.U.: WHY EVERYONE OWES EVERYONE AND NO ONE CAN PAY, by John Lanchester (Simon & Schuster, 2010)