Care about my thoughts on current market events? Read below.

PTC asks

How bad do you think this is going to get David?

I would appreciate a good post from an Eph Economist on the state of our economy, and the reasons we are seeing so many banks go under.

Blogger Steve Hsu notes:

Here is a NYTimes graphic illustrating the decrease in market capitalization of financial firms. In 2007 they were 20% of the total stock market capitalization of $20 trillion dollars. By today they comprise about 17% of a $15 trillion market. (In other words, financials as a group are down about 15% relative to the market as a whole.) If you mouse over a particular company (on the Times flash version, not here) you can see how much its shares have lost over the last year.

This brings to mind a conversation I had a couple of years ago with hedge fund manager David Kane on whether “financial games” necessarily lead to more efficient allocation of economic assets in our society. I think everybody agrees now that we had (and still have — 20% to go!) a massive housing bubble in which assets were overallocated to investment in homes. The use of leverage to make these investments is what has led to the destruction of so many major financial firms. Interestingly, many people predicted a few years ago that hedge funds would be a source of systemic risk, but so far in this crisis they haven’t played a big role. Perhaps that is yet to come.

On the benevolence of financiers (December 2006)

Money talks (January 2007)

David, if you are still reading this blog, I would love to hear your thoughts on current market events!

1) If you are a normal person, you shouldn’t care about turmoil. It does not directly affect you much and, to the extent it does, there is nothing you can do about it. You should follow Scott Adam’s advice on personal finance. You should invest in index funds, whether stock or bond.

2) We are in a recession.

3) How bad will things get? No one knows. Perhaps the bottom was at 11:30 this morning. Perhaps we are just beginning the worse financial crisis since the Great Depression. I don’t know.

4) Democrats who think that this could have been avoided to any meaningful extent by better regulations are kidding themselves. What regulation would have mattered?

5) Republicans who think that this could have been avoided to any meaningful extent by decreasing government involvement (i.e., getting rid of Fannie and Freddie) are kidding themselves. What cutback in government would have mattered?

6) This was a classic credit bubble. There have been others in the past. There will be others in the future. See my recommended reading list.

7) If you had to point at a central driving cause of the bubble, you would look too stupid capital. Who was buying all those hard-to-value illiquid bonds, whether they were backed by California track houses, ill-advised LBO deals, or bubblicious commercial realestate? Stupid capital, in large amounts. As long as someone was willing to buy those things (kidding themselves that the yield was real and the risk low), Wall Street was going to provide it. The problem was not the supply for dodgy assets. The problem was the demand.

8) Who was this stupid capital? Everyone and anyone. Imagine you are the Bank of China (or the Teachers Pension Fund of the State of Florida or Lehman Brothers or . . .). You have billions of dollars. What are you going to do with it? Well, you could just invest it in Treasuries. That would be safe. But the returns are so low! Instead of earning 3% (or 1% in 2004!), you want to earn 4% or 5% or even a bit more. You know that you should not invest in stocks. (Or you may not be allowed to.) But your board of directors wants/needs a high return. So, you go “chasing for yield.” You think that you are willing to take on some more risk in order to get that return. So, you purchase a bond that you don’t really understand and which you don’t even try very hard to understand. But it yields 5%. And it seems safe! And the person who sold it to you tells you it is safe. In fact, the person selling it to you even paid a credit rating agency to tell you that it was AAA, just as good as Treasuries. And you need that higher yield! And you are too busy/lazy/stupid to look too closely at the actual terms of that bond, to actually figure out what you are buying. What could happen? Everyone else is buying that stuff!

9) Think of what a money-making machine Lehman Brothers used to be. They were able to borrow at 3% (or some very low rate because they borrowed short term) and then lend at 7% (because you could charge a lot of money to people/companies/countries with lousy credit). And you make the spread. Even better, you can accrue that money each year, even before the bond you own has actually paid much of anything. And, better than that, you can lever that machine up. Start with just $10 million of capital. Borrow $100 million. Lend $100 million. (What is ten times leverage between friends?) You make the 4% spread on that $100 million or $4 million per year. And that is 40% of the $10 million of capital you started with. You are a genius!

10) Imagine that you are the smart guy at Bank of Chine (or Lehman or Florida) and you point out in 2003 that this is ridiculous, those bonds are very risky, there is a big chance of collapse and so on. In a sense, you are correct. But you were wrong in 2003 and 2004 and 2005. Do you still have a job in 2006? Is anyone listening to you in 2006? No.

11) All this is compounded by agency problems. Is the person at the Bank of China or Lehman or Florida actually investing his own money? No! He is investing someone else’s, some of it yours. Can you make him care about your money as much as you care about your money? Never.

12) With regard to Steve Hsu’s comments and our previous debates:

First, note how little of this financial destruction is coming from hedge funds. Although hedge funds did make some poor investments and some will go under, Lehman alone has destroyed more value than all the hedge funds put together. Hedge funds aren’t perfect, but they are much more focussed on risk/reward than Bank of China and Lehman and Florida because: a) They are smaller so it is easier to keep track of things. b) The people who run them have much more of their net worth invested alongside their clients. It really is “their” money. c) Their clients are very more careful in keeping an eye on them. This whole bubble would have been less destructive if, in 2000, Lehman, Goldman, Bear and so on had been split into several hundred separate firms, each doing different sorts of stuff. (I am not in favor of the government doing this or trying to do things like this going forward.)

Second, imagine how much worse this all would have been without hedge funds. It was hedge funds (especially people like John Paulson) and the hedge fund-like parts of larger firms (like Mike Swenson ’89 at Goldman) that first realized that the bubble was out of control. Their initial shorts in this market (their bets that prices would start to fall) prevented the bubble from growing to even more destructive heights.

Again, the argument is never that all is for the best, that the magic pixie test of unfettered capitalism allocates money perfectly. It doesn’t! People do all sorts of foolish things. But free market capitalism, especially in the context of financial firms, and especially when more resources are in the hands of people like Paulson and Swenson who can predict, however imperfectly, create the most efficient alloction of capital possible. There is no better way.

13) Now, on the margins, there is always room from improvement. A centralized clearing house for credit default swaps would be a good idea. Fannie and Freddie should be decommissioned. The less capital controled by the federal government, the better. But all this is on the margins. No matter what you list of improvements, there would have been a bubble. No matter what you do tomorrow, there will be another.

Best of luck to all!

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