Sent: 18-11-2008 11:21:01
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Explaining The Credit Crisis
Since I have been back there have been numerous articles about the effects of the credit crunch and the seemingly never ending bad news. Indeed, according to John Thain the CE of Merrill Lynch, the global economy is entering a slowdown of epic proportions, comparable with the period after the 1929 crash.
He argued that the US economy is contracting rapidly and as a result we are looking at a period of global slowdown. He suggested that this is different from 1987, 1998 or 2001 as the contraction is bigger than anything seen at those times. He went as far as to suggest that we have to go back to the 1929 period to see the kind of slowdown currently underway.
Not very optimistic to put it mildly and something that the new president will have to deal with no doubt. On that note by the way, you have to go back to 1964 to get the same levels of turnout for a Presidential election as happened this year. You have to go back to 1960 to get anything higher, that of course was the year JFK was elected president. (Don't forget, voting is voluntary in the US. Actually it is voluntary in most countries other than Australia.)
I have written extensively on the effects of what has happened and how we got into the mess. However, if you want a very detailed and what I must admit is probably the best explanation of what happened, I would recommend the October edition of The Kitces Report entitled "The Story of a Credit Crisis". This is an extremely comprehensive explanation of how the various toxic instruments were supposed to work and why they did not.
However, a simple description of the mechanics of the situation is not really enough. According to Richard Thaler, a professor of behavioural science and economics at the, University of Chicago Graduate School of Business, & Cass Sunstein, the Felix Frankfurter professor of law at the Harvard Law School, the current crisis was caused by regulators not paying sufficient attention to the role of human nature. They argue that to prevent future catastrophes, regulators should focus explicitly on how to provide safeguards against two all-too-human frailties, bounded rationality and limited self-control.
Whilst the second term is self explanatory, the first term, bounded rationality, may need some explaining.
Humans are, at least some of the time, rational beings. We try to logically understand things and make sensible choices based on that understanding. Unfortunately we do not have the capacity to understand everything (which will be a shock to some) and we also have a limited time in which to make decisions. As a result, our decisions are often not fully thought through and we can only be rational within limits such as time and cognitive capability. So we are not as clever as we like to think we are. This is important as it played a part in the development of this crisis.
Alan Greenspan, the former US Federal Reserve chairman had faith that banks were prudent enough to make sure they were not lending money cheaply to people who could not pay it back. Sadly he was wrong, very wrong. He later said that securities based on sub-prime mortgages were considered a 'steal' by the most sophisticated investors in the world (who mentioned the word greed???).
As we now all know, borrowers did not understand the terms of their loans. I would guess that any who tried to read the fine print felt probably fell asleep. They also no doubt had their mortgage broker assuring them that they had an amazing deal in front of them and should just sign on the dotted line I suspect that in many instances it was a case of 'trust me'.
This is where it gets really disturbing. The incredible complexity on the borrowers' side was child's play compared to what was going on at the banks. Mortgages used to be held by the banks that initiated the loans, but during this period they were sliced into mortgage-backed securities and included esoteric derivative products. As a result, even those buying and selling these products had little idea of what was really going on, no matter how bright they were (or thought they were...).
The second problem involves self-control. Apparently, economists do not suffer from self-control problems and so "temptation" is not a word that exists in the economists' lexicon (yeah right). This has had an unfortunate consequence as regulators have not given much thought to the issue, which given the excesses of the 80s is somewhat surprising.
Many have argued that the current crisis was fuelled by the seemingly irresistible temptation to refinance the mortgage rather than pay it off. Mind you, given the environment of falling interest rates, rising home prices and aggressive mortgage brokers, refinancing (and second mortgages) probably seemed like the 'rational' thing to do, especially as 'every one else' was doing it. As I have previously said, many Americans used their homes like ATMs which financed the boom. When home prices fell and interest rates increased, the party ended and we are now trying to clear up the mess.
As Thaler & Sunstein argue, greed and corruption helped create the crisis, but simple human frailty played a vital role. They go on to suggest that it could all happen again if we rail against greed and wrongdoers without looking in the mirror and understanding the potentially devastating effects of bounded rationality and limited self-control. Personally, I just think it is simply a matter of time before we embark on yet another round of the Gordon Gecko philosophy of "Greed is Good", but I am not a professor at a prestigious university
If you want to know what really happened, I would recommend a visit to the following site. It is an interview by two UK comedians entitled 'How Markets Really Work'. The really disturbing thing is that it is a pretty accurate description of what actually went on.
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