It Was a Tulip Craze

Posted on Categories Business Regulation

This article from Wired Magazine (somewhat similar to this article from the N.Y. Times a month ago) seems to me to confirm that the present financial meltdown was caused by a sort of modern tulip mania, this time for collateralized debt obligations. A taste:

What is the chance that any given home will decline in value? You can look at the past history of housing prices to give you an idea, but surely the nation’s macroeconomic situation also plays an important role. And what is the chance that if a home in one state falls in value, a similar home in another state will fall in value as well?

Enter [David X.] Li…. Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps. . . . It was a brilliant simplification of an intractable problem. . . .

The effect on the securitization market was electric. Armed with Li’s formula, Wall Street’s quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li’s copula approach meant that ratings agencies like Moody’s — or anybody wanting to model the risk of a tranche — no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.

As a result, just about anything could be bundled and turned into a triple-A bond — corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them — an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn’t matter. All you needed was Li’s copula function.

The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

The problem was that the model was only as good as its inputs, and the data being input was all drawn from a bad sample: the short period of time when the market for credit default swaps actually existed, which just happened to be a time when housing prices were rising. The risk of correlated mortgage defaults in a housing downturn therefore wasn’t priced, it was excluded. A fact, it seems, which almost everyone ignored, no doubt entranced by the millions, or billions, everyone else was making. At least the tulip mania generated a lot of pretty flowers.

7 thoughts on “It Was a Tulip Craze”

  1. Fact is, every meltdown that happens in our market immediately follows a massive expansion of credit. The reasoning behind this is a fallacy in the Efficient Market Hypothesis. This hypothesis is the market fundamentalist, anti-regulation theory propounded by conservatives. It’s wrong, but not flat out wrong.

    The theory works fine with basic supply and demand. If you are looking only at goods, then the hypothesis holds. You have too many potatoes in your crop, lower the price and sell more of them. The market for potatoes will reach equilibrium. The fallacy people make is leaping from goods to assets while still maintaining they will behave in the exact same manner. This is false. And dangerously so.

    In the case of the tulip craze. The price of tulips went up. These tulips are a good. However, the idea behind them became an asset. The same is true of the housing debacle. The house is a good, but behind it was a synthetic asset known as a CDO. This CDO was bought and sold for one reason, the expectation of profit. There the difference between the good and the asset lies. Once a good, tulips, is divorced from its actual use, flowers, and becomes a pursuit of profit, it becomes an asset. Assets lead to credit. And credit behaves entirely irrationally.

    For example: When the houses appreciated 40% between 2000 and 2005, many people got access to money in their homes. This was done through a home equity loan. As their asset, the homes, appreciated in value greater credit resulted. The cycle of appreciation fed on itself. Home prices went up, which led to greater credit, which lead to increased purchases, which led to the creation of more collateral, which led to more credit, leading to even more purchases. This got so bad that our national savings rate went negative in 2005.

    That’s how our system works. It is designed to expand as fast as possible (bubbles) and contract as violently as it expanded (here and now).

  2. I applaud the economic analysis that has been explored thus far, and the implicit conclusion that the free market does not police itself effectively during periods when the value of underlying assets become divorced from the normal contraints of supply and demand. I would only add that these episodes of financial bubbles also reflect the basic and unchangeable facets of human nature. Markets are made up of people, and people are susceptible to greed and irrational impulses. Regulatory oversight of the financial markets is necessary not only because our economic theory demonstrates its utility, but also because regulatory oversight (done correctly) helps to protect traders from the worst aspects of their own nature. While contraints on the freedom of traders to pursue any trading scheme that they desire smacks of paternalism to some, it is a necessary component of the overall financial stability that benefits everyone.

  3. Quite right, well done.

    But what of a willful ignorance of the regulators? According to Keynes’ paradox of thrift, if people save, or if institutions do not lend, profits are negatively impacted. Therefore, regulators (political appointments) have incentive to turn a blind eye to new trading schemes (CDOs, CDSs, and other wacky uses of leverage). By permitting people to buy new debt backed securities, the overall market expands and profits appear as if by magic.

    And ever since the dissolution of Bretton Woods and the advent of fiat currency, profits do simply appear from thin air and debt. (Fiat currency prevails globally with minor exceptions that keep the prices at Wal-Mart low, and the oil dollars stable enough to predict cash flows. For more, see the amounts of foreign-held U.S. treasuries.)

    The real rub is simply this: the movements of the economy are complex, so complex that the vast majority of people are barred from its comprehension. This is not because of their lack of intellect, rather it is due to the time constraints placed upon people by everyday life (dropping off the kids, making copies, balancing the checkbook, etc.).

    Such a complex system, whose subjects are largely ignorant of its workings, lends itself to a diabolical usage of its sheer volume of data. Spin on the data directly benefits politicians and their constituents. And THAT is why Haliburton quadrupled in value, the middle class’s real wages were held flat, and trillions of dollars of federal deficit spending continues unabated.

  4. This is why I am a proponent of loosening restrictions on private rights of action on the part of aggrieved investors. Public enforcement alone cannot regulate the market. Market participants are not deterred from fraud or unwarranted speculation by the prospect that regulators will catch them. In my experience, it is the prospect of private litigation that serves to bring sober reflection into the boardroom or the corporate suite. However, we have allowed our fear of frivolous litigation to place obstacles in front of all private litigation, even if meritorious. There is not enough deterrence in the current enforcement scheme.

  5. I entirely agree. What rules need to be loosened to permit causes of action? Also, what is an aggrieved investor? People’s 401(k)s became 201(k)s because of the system itself. However who will be culpable in the cause of action? In rare cases, there are unscupulous individual brokers like Madoff. However, the exorbently stiff penalties applied to brokers or advisors should curtail fraudulent behavior, and the vast majority of brokers are honest, ethical people. If the investors are aggrieved at the loss of money, perhaps they should have read their prospectus more carefully and not simply relied on charm and confidence of their advisor. (I like to make sure that my clients understand that a thing is only worth what someone else is willing to pay for it, including dollars.)

    Excuse my digression, but I submit that the frivolous lawsuits would chiefly involve suits against the advisors, while the meritorious lawsuits would involve the institutions themselves that provide clearly misleading averages over the past 25 years (the super bubble as Soros calls it), and have incentive to get your money and keep it (just like your bank), and use methods of valuation based upon credit (debt) that have positive feedback loop attributes. And what about suing Greenspan for his more than tacit endorsement of the housing bubble, or other Efficient marketers that claimed the business cycle cured as recently as 2003? We put our trust in experts only to find out that they were playing with our money in the Land of Makebelieve.

    Granted, 401(k)s began to gain momentum in the tax laws of 1981. Therefore, Americans began dumping money onto Wall Street. I wonder if they now wish they would had rather simply bought more cash value life insurance. Compound interest and dividends lead me to believe that Americans should have bought guarantees instead.

  6. I have to admit that the distinction between a “good” and an “asset” eludes me. Nor do I see how the housing bust was a product of a loosening of the normal constraints of supply and demand. I do agree that the fallibility of humans played a role.

    It seems that what happened is that the demand curve shifted because people came to believe that housing prices could only go up and that interest rates never would. This lead to speculation and a desire to get in before it was too late.

    There is nothing inherently wrong with that or in seeking to profit from appreciation of an asset. Indeed, it is the desire to buy low and sell high that fuels productive investment.

    The problem is that the belief was wrong and that the government fueled it in a variety of ways including attempts to relax lending standards and, most importantly, lowering interest rates. It also seems that no one understood that the way in which CDOs were priced assumed this ongoing increase. (Although even if they had, perhaps they would have had no problem with that assumption.)

    But that doesn’t mean that “credit” behaves “entirely irrationally.” In this case, the financial world overinvested in housing but not because they were lending against the value of assets. The problem is that they overvalued the assets.

    I doubt that it is possible to prevent this from ever happening, although, in this case, the Fed could have done a lot better. I don’t know that subscribing to the efficient market hypothesis means that markets will be perfect or not susceptible to booms and busts.

    Nor do I think that financial markets don’t need regulation. In this case, though, it’s hard to imagine that there could have been any helpful regulation that would have gotten political support. One way or another, it would have required tightening credit and it seems that neither political party was interested in that.

  7. As happens with abstract ideas and notions clarity is elusive. Perhaps I did not sufficiently explain the difference between a good and an asset. A good is a product where the law of supply and demand tends towards equilibrium. An asset is a product where the law of supply and demand tends towards fictional prices (bubbles and crashes). The application of the law of supply and demand is something that should be tailored more narrowly.

    For example:

    We’re lawyers, so imagine that we have a booth at a town square selling law. For this imagination, a law is a small, orange root that looks much like a carrot. We have a limited supply of laws, and fix the price accordingly. However, across the town square is another booth staffed by a sheriff, and he is selling units of justice. For this imagination, a justice is a tuber much like a potato. And in this market, law and justice are substitutions. The sheriff has baskets and baskets of justice. The consumers at the market notice the value of justice, and so buy more of it. This causes the lawyer to lower the price of his laws in order to stimulate demand. This arrangement of goods (items which are bought for consumption) will tend towards an equilibrium.

    An asset does not behave accordingly. Our market for assets results in wild swings of price tending not towards equilibrium, but rather extremes. Esenberg was entirely right in low interest rates causing cheap money.

    Hypothetically, this cheap money went on to cause a one dollar rise in a construction company’s stock. This stock is held as collateral and has now appreciated, taking their credit quality along with it, making their ability to get more of that cheap money loaned to them. This is a virtuous price cycle, basically a positive feedback loop. It works on the way down as well.

    Goods are purchased for consumption, while assets are purchased for their ability to change price. This difference in the nature of the two things means that the laws which apply to them probably are not universal. Sure, there may be similarities. But in law we don’t treat all people the same way. Why do economists have the gall to treat all prices in a market the same way? Maybe if they had the Nobel prize in law, things would be different.

    And Esenberg is right again. All of this, or most at least, could have been prevented if interest rates rose, but that neither party wanted to do anything about it. Strange, isn’t that why our central bankers are not elected? And didn’t our longest serving Fed Chair say that the job of central banker is to take away the punch bowl just as the party really gets going? (Answer for both is yes)

    Perhaps had we not convinced ourselves that assets follow the law of supply and demand as efficiently as goods, things would have been different. But, sometimes children are tried as adults.

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