Thursday, October 9, 2008

MIT speaks! (with Harvard as a footnote)

Every great academic institution is having emergency panel discussions on the financial crisis. Mark Thoma of the University of Oregon whose blog "Economist's View" has pointed to a good panel review held Oct 8 at MIT:

The quality of this discussion compared to comments by Paul Krugman, Barry Ritholz, Brad DeLong, or Calculated Risk is pitiful. This is typical "academic" reaction to a catastrophe, i.e. while this information is "interesting" it is mostly irrelevant and fails to capture the horror of the situation and the urgent need for a solution. These talking heads are good at analysis and discussion of symptoms. But they aren't really looking at causes and fixes. You would walk away from this panel discussion feeling "refreshed" by wonderful facts and analysis, but you wouldn't have any gut wrenching sense that something horrible has happened and the need for a fix is urgent. You would think that when Andrew Lo points out that it took a Cray supercomputer to calculate "values" for securitized paper that he might pause and wonder: who checks the calculations? how do we know that the underlying models and mathematical formulas correctly capture reality? Why expend all this detailed calculation for something as evanescent as human whim and market sentiment? That Wall Street hired numerical wizzards (math PhDs and physics PhDs) to construct financial models should have given pause to the academics, but as you listen to Andrew Lo you don't sense any horror from him, any indication that there were premonitions that this might blow up or righteous indignation that Wall Street could build academic "castles in the air" on which the financial future of the whole world hung by a thread. No! You find a pleasant panel discussion that discusses the niceties of this current "connundrum". Nobody on this panel worries about soup lines or lines of unemployed workers or families evicted and thrown onto the street. Crazy!

Bengt Holmstrom is incredibly stupid to claim that "pressure on high" on Fannie Mae was to blame for the mess. Nutty! Sure Fannie Mae is one of the institutions that securitized loans. But in reality Fannie Mae was late to the party. Holmstrom wants to claim it was pressure from politicians that caused this behaviour by Fannie Mae. Nuts. It was management at Fannie Mae. I'm shocked at the gibberish coming from a faculty member at MIT. This guy goes on to claim that the slice-and-dice approach to packaging structured investment vehicles (SIVs) was "not a problem". But that is ridiculous. This stuff blew up. This "innovation" was founded on a misapprehension of finance. Andrew Lo had just gone through the fact that having to sell in a crisis devastates prices. Those who constructed these SIVs -- what Holmstrom calls "beautiful, wonderful thing" -- didn't model what Nassim Nicholas Taleb calls the "black swan", a mis-modeled rare event that is in fact far more likely than the "nice" mathematics that mathematicians have used to model it because their approach was tractable, not because the math was shown to accurately model the real world! To show how unconnected to reality that Holmstrom is, he says he is "amazed" that this illiquidity reached back into the banks. It is precisely "mad scribblers" like Holmstrom who taught flawed ideas who are behind the crisis. As Keynes once said:
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
In the discussion at the end Caballero and Lo admit that the modelling was bad (Lo says that a "what was thought to be a parameter ended up being a random variable") and that the understanding of the underlying statistics was wrong (Caballero talks about "rare" events and hints at a "black swan" mischaracterization of the likelihood modeled by the "physicists" who didn't know "enough" economics).

I'm horrified to hear William Wheaton wax glowing over these "fascinating times" to live through. This guy needs to rub elbows with the poor. This economic disaster is going to literally kill people. The people at the bottom. A certain percentage will die. It will make life a good deal grimmer for a large portion of the working class. It will make life much more fearful in a good percentage of the middle class, fearful of falling into the working class or the dispossessed poor. This catastrophe isn't "fascinating". It is tragic. Specialists like Wheaton should not be gloating over the joy of an "interesting" problem. He should be talking about "shouldering the burden" of putting him mind at the service of society, of mobilizing his students with a vision of creating a better society. Only somebody ensconced in an ivory tower can ignore the disaster, the very real disaster, occurring around him.

Who are these talking heads?

Ricardo J. Caballero, the Ford International Chair of Economics at MIT, organized this panel and introduces the discussion

James Poterba, the Mitsui Professor Economic at MIT, and chief executive officer of the National Bureau of Economic Research

Bengt Holmstrom, the Paul A. Samuelson Professor of Economics at MIT

William Wheaton, Professor of Economics and Urban Studies at MIT

Andrew Lo, Professor of Finance at MIT

Here is a summary put out by MIT of what these professors presented:
A panel of five MIT faculty experts in economics and business analyzed the ongoing financial crisis in the U.S. and world markets at a special session Oct. 8... The panelists focused on different aspects of the history, the present unfolding, and the likely future of the financial mess, and emphasized that the situation is far more complex -- and the long-term outcome more uncertain -- than is typically portrayed.

"The popular story is way too simplistic," said Ricardo Caballero ... who organized and moderated the panel.

For one thing, he said, the crisis has been brewing much longer than many people realize. "Things began to change quite dramatically in the summer of 2007," he said, as house values began to flatten out or decline after years of rapid escalation. That's when new financial instruments became widespread that packaged mortgages of varying risk levels into forms that made it difficult to assess their underlying value.

But while the loss of value of these instruments caused investors to panic and began a downward spiral in financial markets that has unfolded over the last year, "the impact of the financial crisis on the real economy, Main Street, had remained contained until only a couple of weeks ago," Caballero said. "All this changed on Sept. 15," when investment bank Lehman Brothers declared bankruptcy and the government decided not to step in to save it. "This changed entirely the dynamics of the game."

William Wheaton, professor of economics and urban studies..., stressed that part of the reason for the real estate bubble -- and its resulting collapse -- had to do with an excess of capital globally. Much of that ended up going into American real estate, as a result of these financial instruments that bundled mortgages in a way that was perceived as greatly reducing the risks involved. That influx added to the pressure for lenders to offer more loans "to people who were incredibly more risky," he said.

While the averaging out created by these securities helped to smooth out the risks of individual mortgages, Wheaton said, that process "really offers no advantage against systematic risk," such as the overall downturn in housing prices -- an event he compared to a "100-year flood" in economic terms. But the storm was created in large part, he said, by an excessive boom of housing construction while the prices were rising. "I actually think it was oversupply" of housing that caused much of the problem, Wheaton said.

To fix the problem, he said, in economic terms it is more important to stabilize house prices than it is to keep people in their homes. While that may seem cold, he said, much of the boom was fueled by what he called "marginal" buyers -- those buying second homes or investment properties on speculation, who had no strong attachment to the properties. The current slump in home construction, he said, may actually be good for restoring the economy.

Andrew Lo,... Professor of Finance..., said the underlying concept of "securitization" of mortgages -- the creation of a secondary market in mortgage-backed paper that helped to create definable levels of risk -- "is a good one, in fact a brilliant one." The problem came when investors around the world began to see these instruments as being so safe that they used excessive leverage to buy into them.

When prices began to fall, though, "when markets are under duress, it's very hard to set values," and liquidity of these assets began to freeze up. Fear has taken hold of the markets, he said, and since "fear by definition does not have to be rational," it's hard to predict the near-term future. "We will be able to get through this, if we can get over the next few weeks," Lo said. In fact, we will "be stronger and better for it."

Bengt Holmstrom,... Professor of Economics, said that contrary to widespread belief, greed on Wall Street, "I don't think is the real problem." Rather, he said, politicians share much of the blame. "Pressure came from the top, from politicians who wanted to increase lending to poor families." While prices were booming, "everybody wanted to get into this game."

While the focus now is on having the government step in to buy up the "toxic" bad loans, Holmstrom suggested it might be wiser for them to channel fresh capital into 100 of the best, strongest banks, and let some of the weaker ones fail.

James Poterba,... Professor of Economics, said that trying to deal with the economic crisis while in the midst of the present turmoil is a bit like trying to keep species alive amidst the swirling dust and debris after an asteroid hits the planet. "We have really shaken to the core the role of the state," he said.

But Poterba, who is also the president and chief executive officer of the National Bureau of Economic Research, said he takes some comfort from the fact that one of those working on handling the crisis is Federal Reserve head Ben Bernanke, who earned his PhD from MIT and much of whose research was on the Great Depression. "He's one of the best people you want to see" in the midst of a crisis like this, he said.

He also emphasized that much of what is seen as spending by the government in this situation is really just a transfer of assets, and that in many cases the government may actually profit from these "bailout" moves.

Here's a similar gathering of graybeards at Harvard to discuss the financial crisis. The nice thing about this discussion is that Robert Kaplan and Elizabeth Warren focus on the middle class squeeze and how that got swept up in this crisis. Greg Mankiw, the Bush admin's CEA head gonzo, puts his two bits in as well. Interestingly, only Mankiw throws political mud in his presentation. Hmm...

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