Source: NPR News Investigations
Credit: Stephanie D'Otreppe/NPR
Another issue with quantitative risk models that even many of their creators acknowledge is that when a particular method of modeling risk becomes popular enough, it begins to affect market behavior and creates new risks that the model cannot see. I think this may have been a major contributing factor to every financial panic of the past 25 years, starting with the 1987 crash. (Well, except maybe the dot-com bubble and crash. I can't really blame that on risk models. Although it is perhaps telling that the dot-com collapse wasn't really a panic.)
You can't prove the cause-and-effect, but it is clear that financial risk models have repeatedly broken down after years of seeming success. Which shouldn't be all that surprising: It is in the nature of financial markets that every good (that is, money-making) idea eventually becomes a bad one. The difference between a momentum-investing formula and a risk-management model is that a risk-management model is supposed to, um, manage risk. And so I guess the question remains: Are all financial risk-management models ultimately a joke?
The ever-entertaining hedge fund manager Hugh Hendry drops by BBC Question Time tonight, with an appearance that pissed people off so much that he briefly made it onto Twitter's trending topics. When's the last time a hedge fund manager pulled that trick off? [-]
Ownership rights were not particularly solid in the ancient world; there was always the risk that someone with more clout or simply a bigger band of thugs would dispossess you. Outside Song Dynasty China, the first attempt at a society with solid ownership rights occurred in the reign of England’s Henry VII. He established the rule of law, even applying it to the baronage and setting up a system of Justices of the Peace to enforce prohibitions against random thuggery. His Tudor and early Stuart successors violated property rights frequently, but after the Restoration the protection of property rights increased rapidly – an increase that coincided with Britain’s economic take-off and to some extent caused it.
The high point of property rights in Britain came under the great Tory governments of 1783-1830. By that time, the legal system worked well, under the benign guidance for most of the period of Lord Chancellor Eldon. With a sound monetary system, property rights could thereby be preserved over astonishingly long periods. In Anthony Trollope’s first Barchester novel The Warden, published in 1855 the plot revolves around a bequest for Hiram’s Hospital that had been made in 1434. By the time of the novel, roughly the late 1840s, the bequest has increased in value, providing an excellent income for the hospital’s warden, Septimus Harding.
The gradual erosion of property rights after 1830 is however illustrated by the novel’s central struggle to update the terms of the bequest more in line with the money values and moral principles of the Whig 19th Century, depriving Harding of most of his income. Harding and his supporters the Bishop of Barchester and Archdeacon Grantly base their case on the values of their pre-1830 youth; in the Whig world of two decades later they are eventually defeated. However the protection and expansion of the Hiram’s Hospital property rights for 400 years is a notable example of the stability of both money values and society as a whole that emerged in the centuries following John Hiram’s death.
Thus in Trollope’s world, 400-year old documents kept in strong boxes by family solicitors (or, in that case, those of the Diocese of Barchester) were still rock-solid evidence for the disposition of substantial sums of money. Those property rights had already begun breaking down in 1855 and were sadly further eroded by the 20th century tendencies of governments toward expropriation, ruinous taxation and currency debasement. The virtualization of records has now taken that unhappy process a massive stage further.
One has only to think of the chances of making a successful claim in the year 2410 based on today’s computerized records to realize how far property rights have sunk. Computer databases are updated every 2-3 years and after a few “generations” of such updates become unusable. Even ten years ago, the massive panic over the Y2K problem, based on inadequate programs that were at that stage only 20-30 years old, shows how quickly data stored in virtual form can be rendered inaccessible. In addition, there’s the destructibility of the computers themselves, which has become a far worse problem with the new migration of data to cell-phones and tablets. (Desktops were equally likely to be smashed when you dropped them, but they were much less likely to be dropped, since they were not considered “portable.”)
If John Hiram’s will were made today therefore, and kept in virtual form, it would become a major data recovery problem by 2030 and entirely unavailable by 2050 or so. (Bizarrely destructive monetary policies might well also make his legacy valueless in that time!) Within a tenth of the period for which the original Hiram’s will was preserved by the Diocese of Barchester’s solicitors, and the value of his property preserved by good management aided by mostly sound monetary policies, the property of a new John Hiram would have b
But away from all “qualitative” arguments about why this is unlikely, and there are many, I think there is a problem with the arithmetic of reserve currency accumulation. If the rest of the world is going to use the renminbi as a reserve or trading currency, clearly it needs a mechanism by which to accumulate renminbi. This is something on which a surprisingly large share of people who talk about the future of reserve currencies don’t seem to focus.
Leave aside the fact that foreigners are prevented from having renminbi accounts and that it will probably be many years, if not decades, before the PBoC is willing to allow full convertibility, with limited government intervention and no control over the setting up and trading of its currency. The world still needs a way to accumulate renminbi in order for it to be a major trading or reserve currency.
How does the world accumulate sufficient renminbi to acquire reserve status? There are basically two ways. First, China can run a current account deficit. Second, foreign capital inflows into China can be matched by Chinese capital outflows. The second way does not result in a net foreign accumulation of Chinese assets, but it allows foreigners to hold renminbi bonds and other assets to the same extent that Chinese hold assets abroad (above the current account surplus, of course)
Let’s examine the first. Since the 1950s the US has typically run current account deficits of, I think (this is a back-of-the-envelope calculation), around 0.25-0.50% of global GDP which also, needless to say, is the rate at which net foreign acquisition of US dollar assets has occurred (in the past decade it rose to around 1.5% of global GDP).
There have been periods in which the US current account was substantially lower, or even positive, for example in the late 1940s and early 1950s, but during these periods the world complained mightily about a dollar shortage and its impediment in the development of world trade. In fact one of the driving reasons for the US Marshall Plan was to provide dollars to foreigners to facilitate trade.
The reason Obama makes such baldfacedly phony statements is twofold: first, his pattern of seeing PR as the preferred solution to all problems, and second, his resulting slavish devotion to smoke and mirrors over sound policy.
The savings & loan crisis led to FDIC takeovers of dud banks and the creation of a resolution authority to dispose of bad assets. That produced costs which were largely funded by the Federal government. I’ve heard economists repeatedly peg the costs at $110 to $120 billion; Wikipedia puts it at about $150 billion. This approach, of cleaning up and resolving banks, has been found repeatedly to be the fastest and least costly way to contend with a financial crisis.
The reason Obama can claim such phony figures is that many of the costs of saving the financial system are hidden, the biggest being the ongoing transfer from savers to banks of negative real interest rates, which is a covert way to rebuild bank equity.
The Obama Administration is also engaging in phony accounting on its expected TARP losses, the latest sleight of hand being magically reducing its expected losses from AIG by $40 billion through a reclassification process. But the biggest source of his false accounting is extend and pretend. The biggest banks are carrying second/junior mortgage portfolios at huge premiums to their real values, which is close to zero. Merely marking the seconds down to something a tad more realistic would easily create $150 billion of losses to Citigroup, JP Morgan, Bank of America, and Wells, in a worst case scenario, much more
$150 billion happens to be over 1% of GDP. And that’s before you get to the writedowns smaller banks need to take. Since the big banks have just under 50% of the total market for seconds, you can double that to $300 billion. Now of course, not all of those losses would necessarily lead to a government rescue, but the odds are high a big percentage would, if not in explicit rescues, then via continued hidden subsidies which ultimately do come out of our collective hide.
Then we get to the fact that regulators are engaging in other forms of regulatory forbearance (finance speak for letting them cook their books), plus asset values are generally artificially high due to near zero policy interest rates. So we have what amount to baked in losses if rates ever get back to something resembling normal levels.
And that’s before we add in the costs of yet another aspect of the financial crisis, the failure to come up with a decent mortgage mod process. If the powers that be had been willing to resolve and restructure the debt of homeowners who could have been saved, ironically, the widespread failing of the mortgage securitization process might never have come to light. But we are now instead having a slow motion train wreck in the biggest asset class in the world, US residential mortgages. Anyone who thinks this isn’t going to result in a real toll on the balance sheets of the biggest banks is unduly optimistic. Banking industry experts Josh Rosner and Chris Whalen each expect another bailout in the not-terribly-distant future. So add more to the ultimate cost of the financial crisis.
While he promised to stick to the EU-IMF austerity plan, he threatened to go to the country if upcoming local elections fail to give his socialist PASOK party a clear mandate. "There can no deadlock in democracy, the people have the power to decide," he said.
The main opposition group New Democracy has yet to give a watertight pledge that it would abide by the terms of the EU's €110bn (£97bn) rescue, or the "Memorandum" as it is known.
PASOK itself is fraying at the edges in any case. A socialist rebel candidate from the "anti-Memorandum" bloc leads the polls for the Athens region.
Mr Papandreou is responding with populist gestures, granting pensioners a €300 bonus and rejecting calls by Brussels and his own central bank for further belt-tightening. "There will be no new measures on wage-earners or pensioners, they have paid enough," he said.
The fiscal picture is extremely delicate. Eurostat is expected to raise Greece's budget deficit for 2009 to 15.1pc of GDP from 13.3pc. Public debt will rise to 127pc instead of 115pc, bringing the country closer to a debt compound spiral.
Mohamed El-Erian, chief executive of Pimco, said the EU-IMF package prevents Greece from growing its way out of the crisis and will test political consensus to destruction. He said it would be healthier for both Greece and Europe to opt for orderly debt restructuring.
One problem here, if the safe-seat explanation for the success of bipartisanship adduced here is accurate, is the current volatility of the electorate. Voters’ preferences tended to remain stable and steady from 1995 to 2005. They have been unstable and volatile ever since, with a sharp trend away from Republicans in 2006 and 2008 and, if polls are correct, a sharp trend away from Democrats in 2010. If many Republican members of Congress had reason to fear defeat from 2006 to 2008, so too do many Democratic members have reason to fear defeat in 2010. It’s possible that members of both parties will have reason to fear defeat in 2012.
As already suggested, the essence of most bipartisan compromises is that they contain provisions unpopular with constituencies of both parties and often provisions that are unpopular with a majority of voters. That’s why such measures tend to be passed by bipartisan coalitions of members with safe seats. The most recent example of that, TARP, is unsettling to those who hope to see bipartisan legislation in the years ahead; some members who voted for TARP have seats considerably less safe than was generally thought. One example is Republican Senator Saxby Chambliss, who failed to get 50 percent of the popular vote in November 2008 and so, under Georgia law, was forced into a runoff. He won that contest, but other TARP supporters have not been so fortunate, as with the aforementioned Bob Bennett of Utah. And it has been cited by challengers to both Democratic and Republican incumbents in many states.
In such an unsettled political environment, it may be difficult—maybe impossible—to round up the votes needed for bipartisan legislation. Politicians will not be inclined to take on additional and avoidable risks. And that difficulty means that legislators in a position, whether because of expertise or committee membership, to cobble together such legislation may just conclude that it’s not worth the trouble. The Obama White House’s minimal interest in accommodating Republican ideas and initiatives, perhaps understandable in light of the temptation exerted by the existence of Democratic supermajorities, is not a positive indicator either. Policy experts can make a strong case for bipartisan legislation on major issues, but it is not clear that political actors are prepared to pay much heed to, much less act on, such arguments.
Absent large congressional majorities, therefore, it looks like we are stuck for a while—not only, or mainly, because of ideological polarization and party sorting, but because of electoral volatility. When you think about it, this suits the definition of irony. Why are voters so willing to “throw out the bums”? Because they think they can’t get much of anything done. Why can’t they get much of anything done? Because they’re afraid that bipartisan compromise will get them thrown out of office.