Riding the Wave of Uncertainty

The financial crisis has become a national “Whodunit?” and our public watchdogs have finally fingered the prime suspect. It’s been contained in a little black box labeled “systemic risk.” The forensics team has lifted thousands of fingerprints and the national media is doing its part rounding up the culprits. Yet, systemic risk is still an abstraction and a tough explanation to get one’s mind around.

Systemic risk technically refers to the risk that is not “specific” to one company or industry, but to the larger market or economic universe over which no one has direct control. Nature gets hit by systemic risk in the form of ice ages and meteors that wipe out whole species. But mankind created exchange markets, not God or nature, so blaming systemic risk is essentially acknowledging that the entire “system” we created and in which we operate is rotten.

There is some truth to this. During this past annus horribilis the people who should have known better engineered and amplified systemic risk. The blame falls far and wide and has incited populist rage against capitalism and free markets. But, like guns, markets don’t kill people; they are little more than highly efficient information generators and allocation mechanisms. Instead, the fault lies with some of the financial and political rules and practices we’ve adopted that impede competition, obscure information, distort incentives, and constrain our abilities to manage our economic affairs. It doesn’t help that many people made out quite handsomely exploiting this degenerate state of affairs. But let’s not miss the forest for the trees.

The political buzzwords of the day are “uncertainty” and “lack of confidence,” spoken as if all we need do is conjure up a larger Hope that will slay our fears. But uncertainty is an ever-present fact of life. It’s the concomitant of change and it’s not going away. The heightened sense of uncertainty we face today is a function of the rapid pace of technological change, which most futurists expect to accelerate. Our economic crisis truly stems from our failure to adequately manage this change. Through mistakes of both ignorance and hubris, we’ve unnecessarily magnified the risks and uncertainties of our modern world. Just think of the difficulties of valuing a house these days—with a toxic mortgage? This is what’s holding up the world economy? Certainly the Romans must have had an easier time of it. Ultimately, we need to recognize that our problems result from violating the most basic rule of nature: in a world of change, if you want to adapt and survive, diversify.

When we talk about finance we’re talking about an industry that grew out of the need to manage the risks of uncertainty. Banking began with the risks of transporting goods and money across great distances, giving rise to letters of credit. Capital markets started by pooling funds to underwrite the capital investment and risks of fleets of ships laden with goods traveling halfway around the world. Today’s financial derivatives are innovative attempts to repackage risks and allocate them according to the preferences of market participants. When we successfully manage and lower risk, risk-adjusted returns are enhanced, creating value and wealth. This is the logic behind the insurance industry as well. But when we botch it, well, we get financial contagion marked by a sharp contraction of inflated credit and economic activity. After the reset, we begin again at lower valuations.

So how do we avoid botching it? By more diligently applying the lessons of Mother Nature. The recent meltdown of mortgage-backed securities has supposedly discredited the theory of financial asset diversification. But this is a false conclusion. According to Harry Markowitz, Nobel Prize winner and father of modern portfolio theory, the financial wizards who bundled complex mortgage-backed and other collateralized debt obligations violated the first principle of asset diversification. "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero," he says, "but financial engineers should know that's not true of a portfolio of correlated risks."

Basically, securitization is meant to pool uncorrelated risky assets—when one asset goes down in price it’s just as likely that another will go up, insuring the overall valuation of the pool. But since these instruments were all backed by the same worldwide housing bubble driven by low interest rates, all the risks were correlated and the securities went down like a row of dominoes.

Other critics have mistakenly applied the logic of portfolio diversification to firm diversification – arguing that diversified financial firms became too big to fail. But the era of conglomeration taught us there’s always an economic trade-off between diversification and specialization at the firm level. Unfortunately, financial firms were encouraged with implied government guarantees to test the limits of their business models. This was not the fault of diversification or caused by the repeal of Glass-Steagal.

Diversification means not putting all your eggs in one basket. It means not having all your financial wealth in your house, or one stock, one company, or one highly specialized job or skill. Diversification means investing in a varied skill set, a broad education, and social and political capital. Diversification means developing family and community networks. It means taking care of your health, buying insurance, and building self-insurance with savings.

On the national level, diversification means individuation, open competition and exchange markets – a country that marches in lockstep should set off alarm bells in our heads. This applies to economic policy as well as politics. Diversification means freedom, free will and sometimes being different. A diversified society is an interdependent, yet resilient society—it benefits from a diversity of ideas and cultures. It’s not one big cradle-to-grave social insurance pool, but the anti-thesis of universalism and nationalization. Diversification is what makes America great and what saves mankind from going the way of the dodo.

Change We Can Believe In?

Jay Cost, over at RealClearPolitics, had an excellent post yesterday on his HorseRace Blog (the site link is on my link sidebar). You can read it here.
This is his lead-in:

The recent Pew poll has found that President Obama's job approval is the most polarized for any new President in forty years:

He's got a lot more data that shows how this partisan polarization is still driving our politics. As we have long maintained here, this will not be changed from the top down by Obama or anyone else, but only from the bottom up with a change in voters' attitudes and a reconciliation of values across urban and rural spaces.

Making Homes Affordable?

The US Treasury released guidelines to the new “Making Homes Affordable” scheme. Making homes affordable? So, they are priced too high?

Memo to Washington: Let the prices drop.

What kind of Orwellian world are we living in?

Bipartisanship?

Good one.

Scared of the 800-lb. Gorilla?

Went to an interesting symposium on the economic crisis and the Obama policy response/spending bill yesterday. Two economists, Tom Campbell and Barry Eichengreen, gave their interpretations. What struck me was that nobody, especially nobody in politics, seems to want talk about the 800-lb. gorilla in the room. This beast is the pervasive uncertainty associated with price discovery roiling all markets and asset classes. This 800-lb. gorilla is partly psychological but also real, so perhaps we can talk about the big gorilla and his even bigger shadow.

Policymakers don't want to bring too much attention to the gorilla for fearing of scaring the public with his imposing shadow. But in so doing they seem to be pushing a form of denial that is also reflected in the proffered policies. Most of these policies seem targeted to further obscure prices or prop them up. Obama's proposal to throw another $275 BILLION at foreclosures in the housing market is a case in point.

The necessity of price discovery is crucial to clean up the banks and get credit flowing again. What do we think these toxic assets are? They're assets that nobody can agree how to value (most of them based on unrealistic housing prices). The market has depreciated these assets to 30-40 cents on the dollar, but the owners (banks) think they're worth more, but can't sell them and are hoping the government (i.e, sucker taxpayer) will buy them at par. At least that pig didn't fly. But if we don't discover prices on this toxic dump we can expect years of zombie banks in our midst. Expect some nationalizations and then break-ups.

True price discovery is also crucial to getting the housing market off the mat. Nobody is going to buy overpriced housing no matter how cheap and available credit is, and nobody is going to convince them that prices have stabilized by virtue of directives or hopeful words from Washington. What's a house worth anyway? The "bigger fool" strategy is history for now. Let's try a historical metric of cashflows off implicit rents or median incomes and we'll get an idea. A house that rents for $5000 a month is worth maybe $900K. Rents for $1500/mo. = $270K. But policymakers want to stabilize house prices based on inflated mortgages. Ain't gonna work. Just more wasted dollars...

But why? How are we helping things by encouraging people to buy or stay in overpriced homes they can't afford and then sticking them with the bill over the next 20-30 years? Are we searching for new ways to impoverish these people? How are they going to pay for the expenses of old age? Wonder how that's gonna work with our entitlement reform?

Bottom line is that nobody wants to adjust housing prices to the downside. But there's no other way out of this mess. Securitized mortgage money is gone...buying power is a fraction of what it was in 2006. Let's get real instead of throwing good money after bad. Indications are this is gonna take longer than we think.

Joe the Renter?

Date: February 6, 2009
Re: A memo from Joe the Renter

Dear Congresspersons, Senators and Mr. President,

We are in the midst of a serious economic correction and the causes are quite complex. As a prospective home buyer allow me to narrowly focus on the state of the housing market. There have been many calls from the Capitol to save home owners facing foreclosure – a moratorium on foreclosures, new government-subsidized fixed rate mortgages, loan renegotiations, and bailouts for lenders. (BTW, these owners underwater don't want to be saved and tethered to their bad investments - they want to be liberated.) But precious little has been focused on the people who can afford and wish to buy a home. Don’t we want buyers to re-enter the market?

For a home buyer, I have the desired qualifications: middle-aged, recently married, with a combined income that varies between $80-150K, zero debt, a credit score over 800 and roughly $300K cash that could be put toward equity. What matters most to me is the size of the mortgage and the prospects for price stability or, better yet, long-term appreciation. In the long-term it doesn’t matter that I might get a $7500 purchase tax credit or a low interest rate because these factors will just keep asking prices higher and increase the size of my mortgage principal owed. You could offer me limitless funds at 0%, but I still will not borrow to buy an asset that is overpriced based on cash flow fundamentals.

The problem in a nutshell is our national housing stock is overvalued by almost any economic measure we use, whether it be median incomes, imputed rents or national GDP. Currently we rent a 2200 sq. ft. home for $2800/mo. Comparable houses in the area of Los Angeles where we live have asking prices of $1.2-1.5 million. Buying just doesn’t compute. Because we live in a dense urban area of Southern California I know many other families in the same predicament – on the sidelines with cash waiting for a rational market to return. In the current environment we will all continue to rent and put our investments elsewhere.

You might think my take on this is self-interested, and I would wholeheartedly agree. But my actions have been financially prudent. I need to save money for retirement, not throw it away on overpriced housing. I did not “roll the dice” on subsidized housing with other peoples’ money. But the nation is in the same boat.

We made bad investments in an asset bubble. We need to correct these prices, not distort all the other prices in our economy. Otherwise we will be in a deeper hole when it comes to financing our retirements. We can make housing affordable in this country if we stop subsidizing it over other investment classes and let it return to true market value. The political challenge will be how to manage the losses this will incur to those who were not so prudent – buyers, lenders, banks and investors. I suggest you leave us taxpayers out of it as much as possible.

Sincerely, Joe the Renter

P.S. While I am an average citizen and home buyer, perhaps I am not the typical voter. I’m a macroeconomist, finance MBA and political scientist. I hold doctoral, masters and bachelor degrees in these three disciplines, all from top-ranked schools. Thus, I am one of the so-called “experts” you often consult for policy advice. Please take it into consideration.

A Crisis in Prices

Dick Armey wrote an op-ed in today's WSJ applying the lessons of Hayek to the financial crisis. In this case, Hayek provides the right diagnosis - the problem we have is in the price system. Government spending can and usually does distort the price system in unintended and counter-productive ways. And it does little to address the immediate problem of flagging confidence.

The present crisis is marked by the distortion and uncertainty of prices that has instigated a lack of confidence in risk-taking behavior. When prices readjust, confidence will slowly return, but we can't wait that long. A stimulus bill focused on demand will not correct prices and affect the crisis in confidence until it affects the real economy a year or two out, but we can't wait that long. Think how long it took for New Deal policies to have a positive effect on the Great Depression. Anybody want to wait that long?

Policy should be directed at those signals that will have an immediate psychological impact: permanent reductions in taxes on productive activity. Commitment to compensate for the dislocation costs of this economic correction through automatic stabilizers can also help alleviate consumer and employment fears. The system's imbalances need to correct, but it's the continued uncertainty that will exact a greater cost.

Our current crapshoot politics and best-guess economic policy may be the worst alternative that may come all too soon.