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August 4, 2014

Judging the Risk of Future Black Swans | Some Policy Implications

Economists and policy wonks are still intrigued by the events of 2007-8.

This is a guest post from Bernie Munk, author of "Disorganized Crimes: Why Corporate Governance and Government Intervention Failed, and What We Can Do About It?" http://www.amazon.co.uk/dp/1137330260, which was previously published at his website and is re-published here with his permission.

Economists and policy wonks are still intrigued by the events of 2007-8. The basic question is how to account for the fact that financial specialists extensively trained for judging risk got run-over by the collapse in the collateralized mortgage market. It has been well documented that the housing price run-up and its sudden stabilization was followed by a sudden and sharp collapse. This sequence displayed the same generic pattern of prior boom-bust price scenarios. One key to understanding such scenarios is that the process of “leveling out” in prices followed by a flattening is the precursor signal to a subsequent sharp fall in prices. It seems that the flattening period creates somewhat of a “panic” situation and, after a brief period of flat prices at the elevated level of the prior boom, huge doubts creep in. A rational investor will rush to sell these assets. When the music stops, it is time to quickly find an empty seat.

What kind of an expectation model underlies that kind of seemingly quixotic behavior? A number of writers have produced models that seem to explain this behavior as a rational process produced by significant change in available information. A recent attempt is by a well known Professor of Finance who had an intimate connection as a consultant to one of the archetypal “failure” companies, (AIGFP). [Note 1 below] The critical element in the financial crisis is the collapse of the overnight repo market, whose collateral was often mortgage backed securities. Gorton and Ordoñez have created a “rational” model of this “regime shift” by asset holders. First, these asset holders were believers in the underlying trend and as prices rise, they become more “sure” that they are on the right side of the market. Being “long” is rewarded at this stage. Being “longer,” can be even more rewarding.

To purchase more of the collateral, asset holders borrow frequently overnight in the repo market. Their assets grow (both because of rising prices in a mark to market world create higher balance sheet values) but perhaps even more importantly, because access to the repo market creates seemingly unbounded opportunities to leverage their portfolios of what will become risky assets at a later stage. The essential question to ask is why asset holders allow their leverage to grow to such high levels? Their behavior is not strange. The same behavior was observed in the underlying housing market. A borrower who watches his house rise quickly in value can easily sell the house and buy a bigger and better house by taking on a larger mortgage. Alternatively, new buyers, not previously accorded credit, find mortgages easy to obtain.

Where do the new mortgages generators come from? They come from a pool of house buyers who previously couldn’t qualify for a mortgage. But to create more “qualified” buyers, credit standards are reduced. As some writers on the crisis put it, ‘as long as the buyer could fog a mirror held in front of his (her) mouth, they could get a mortgage.’ It was a self re-enforcing process. Another way to say this is that the leverage in the household sector rises sharply, and the same leverage expansion takes place in financial markets that deal in mortgages.

At some point, the system begins to run out of fresh buyers and home prices begin to level out. That is a trigger to a sharp decline in housing prices and the decline triggers a fresh appraisal by collateral holders of the quality of their collateral. Haircuts rise on these derivative assets, creating a demand for cash collateral by financial intermediaries who have overly indulged on risk. The market begins to price risk much more sharply. Market players begin to think there is a “black swan” in their future. Housing markets never decline, right? Wrong assumption!

Leverage is a two way street. In the beginning, increased leverage leads to high earnings on the same equity base. Earning increases by financial intermediaries are reflected in the share prices of these intermediaries. Intermediaries such as investment banks, commercial banks, and companies that provide shadow markets for this collateral seemingly benefit. Earnings for the financial sector have been rising, even in spite of modest interest rate increases. Finance becomes King of the Mountain.

The growth of the financial sector, in terms of the percentage of corporate profits, was one of the highlights of the first decade of this millennium…until the finance sector developed the major infarct of 2007- 8. Then the story shifted to one of Government rescuing the overindulgence in risk and the excessive leverage by large financials. We learned that rescue can occur in a somewhat indiscriminate fashion. Beneath those struggling financials was a long history of abnormally low interest rates, stimulated by the Fed’s fear of deflation and deficient corporate governance by each of the monitors of our corporate system. [Note 2 below]

One particularly sad note in this history is the elevation of “too big to fail,” as national financial policy. Financials that significantly enlarged their assets were in fact being subsidized by the implicit “rescue” embedded in this ‘too big to fail’ doctrine. Of course, if one listens to the politicians and the current government regulators, they will tell you that Dodd-Frank and its huge regulatory apparatus is designed to prevent another financial calamity. The government now says it will not underwrite financial firms that get into trouble through excessive leverage and ignoring the risks of future black swans. Do we really believe that another “Lehman” will occur? We think that is nonsensical. What politician or regulator is willing to agree to a financial bigger than Lehman to fail the next time. This contention is a diversion from the real difficulties. Government produced the underlying drivers that led to 2007- 8. In particular, Government has never applied stringent liability standards that attach to the various corporate monitors supposedly acting in the interest of shareholders. There is no “punishment to fit the crime” when it comes to monitoring failure. That is a huge failure in political governance, and one not likely to be soon rectified.

Effective corporate governance depends upon transparent political governance. Given the lobbying done by large financial institutions and politicians’ continuing need for funding their electoral campaigns, what has evolved in the United States is a form of crony capitalism. That is precisely the opposite of what is needed, but that is another story that needs to be told. The first step is to realize that there are Black Swans (rare events that are not impossible) and that “rare events” do occur, often more frequently than we can foresee. Our focus must be on the incentives that poor policy often provides. To paraphrase a former President, “it’s the economy [economic incentives], Stupid.”

[1] See Gorton & Ordoñez Collateral Crises AER Vol 104 Number 2 February 2014 and Gorton’s account of the collapse of the repo market in “Understanding Financial Crisis” (2012)
[2] See our book Disorganized Crimes (2013) particularly Chapters 1-5. See also Chapters 6-15!


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