Krugman on the economic shockwaves from the subprime crisis. The lesson that I take from this is that the individuals and institutions that are responsible for creating financial disasters like this (or the savings and loan debacle) should not be able to escape paying a severe financial penalty. Cashing out (at the individual and institutional level) before the **** hits the fan, should not be an option. If financial leaders knew they would not be able to evade the consequences of their decisions, we would see a lot less sketchy behavior. December 3, 2007 Op-Ed Columnist Innovating Our Way to Financial Crisis By PAUL KRUGMAN The financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance. How bad is it? Well, I’ve never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world. This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created. Before I get to that, however, let’s talk about what’s happening right now. Credit — lending between market players — is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole. But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged. “What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.” The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one. Behind the disappearance of liquidity lies a collapse of trust: market players don’t want to lend to each other, because they’re not sure they’ll be repaid. In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble — I mean, there wasn’t even a glamorous new technology to justify claims that old rules no longer applied — but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk. Thus, “super-senior” claims against subprime mortgages — that is, investments that have first dibs on whatever mortgage payments borrowers make, and were therefore supposed to pay off in full even if a sizable fraction of these borrowers defaulted on their debts — have lost a third of their market value since July. But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn’t supposed to have tens of billions of dollars in subprime exposure; it did. Florida’s Local Government Investment Pool, which acts as a bank for the state’s school districts, was supposed to be risk-free; it wasn’t (and now schools don’t have the money to pay teachers). How did things get so opaque? The answer is “financial innovation” — two words that should, from now on, strike fear into investors’ hearts. O.K., to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends. But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized. Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis. And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary? Now, Mr. Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem. The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess. http://www.nytimes.com/2007/12/03/opinion/03krugman.html?hp=&pagewanted=print
Krugman gave up on being objective (and credible) a long time ago. Really the only people that don't see him as a political pawn are the naive ones who may be new to politics or economics.
A lot of people are paying a severe financial penalty - see Merrill, Bear Stearns, Countrywid, MBIA, etc. The only institution making money on this is Goldman which shorted a bunch of positions and effectively bet against the subprime market which proved to be a winning bet- of course their global alpha hedge fund hit the toilet because of it too so they are not untouched. Granted - Stan O'Neal has a 150 mm severance package to fall back on. But that's kind of a separat issue related to the lunacy of executive compensatoin. THe trend in corporate governance has been more shareholder input on executive comp (a couple of say on pay resolutions were passed at the board level this year - Verizon & Aflac) so this problem may finally begin to be addressed in coming years.
Please highlight how your qualifications allow you to dismiss the opinion of an economist who earned his Ph.D. from MIT in 1977 and has been working in the field since. Rice is a good school, to be sure, but your Bachelor's degree from Rice does not give you the credentials to dismiss Krugman's well thought out and documented pieces with two sentences that have nothing to do with the substance of his arguments. IOW, discuss the substance or leave and let the adults have a conversation. TIA
The irony is that you somewhow think that Structured Investment Vehicles - which you don't understand, I know I don't- have a political affiliation that you can score vital BBS points with. Krugman is making a fairly valid and non-politicizd argument here about transparency in financial markets that is not exactly novel and that other (the PIMCO guy e.g) commentators have been making for months/years. I am not sure why you think this is cause to drag out the Enron hatchet and start assailing. Perhaps you saw Trader Jorge make a trolling post and decided that you somehow had to come out against whatever it was that Krugman was writing about (You are a big fan of CDO's and Structured Finance? Head down to the unemployment office to be with like-minded souls).
Looks like he is only looking at this from one angle. He didn't mention anything about the role of credit rating agencies have in this. When you rate a bunch of crap AAA, you bet its going to come back and bite you. The problem isn't the innovations, (CDOs, RMBSs are not exactly recent innovations, they have been here for quite a while now). Innovations provide more liquidity, more options for investors who otherwise would not have the opportunities. The problem is caused by people chasing high returns without spending much time or money on analyzing the products, without using the correct hedging tools. The rating agencies give crap AAA ratings, and the fools blindly follow them. The system is working it self out now, some people are getting hammered because of their own stupidity. The rating agencies are scrambling to correct their mistakes. Hopefully this will lead to more transparency and investors will do a lot more homework. Krugman should step back and look at the big picture, its innovations that make wall street the leader in world financial markets.
His argument: The innovations are the problem. Maybe we shouldn't let wall st introduce things like CDO, RMBS, SIV etc. My point: Innovations are not the problem, idiots who doesn't do their homework is the problem. O.T. Sam I think you are a big fan of ETFs, that's an innovation had taken off recently. Would you feel the same if some folks lost their money because they didn't understand it?
I think that's really two sides of the same coin though - i don't think he'd disagree with that. But anyway i guess the market will eventually tell us if CDO's and SIV's were a good idea if they ever come back. I think the regulatory regime in place for ETF's (which is essentially the regime in place for the public companies that make up the portfolio) is pertty transparent and easy to understand vis-a-vis the CDO/MBS game - at least for ETF's that concentrate in US -filing companis, even for small time investors. But, you know, if say, tomorrow all ETFs based on China collapsed because the fund managers did not understand the China market, well then I'd be pretty disappointd in ETF's of that nature (and I'd be crying cause I'd have lost a chunk of change).
Please provide a link for your assertion that the rating agencies are scrambling to correct their mistakes
LOL, from my computer screen I can see all the downgrades that came out, when a tranche used to be AAA now its BBB that would be correcting mistakes. From the conversations I and others had with people at the big 3 rating agencies, they are working hard to update their models, change ratings. Maybe you know something I don't, please do share
Enron et al bonds were investment grade back in the day. Rating agencies got caught not doing their job. This prime lending mess also caught the rating agencies not doing their job. I recently read (in the quaterly Vanguard letter?) that some bond fund managers only use the rating agencies as a starting point. Rating agencies likely see themselves as the final say. As a bond investor going forward, I can not trust the rating agencies to do their job. Can you?
A rating agency scrambling to correct its mistakes as far as rating CMOs is like putting a "hey horses, stay here" sign on the open barn door. It's like a weatherman amending his forecast retroactively.
Did you read the part of my post where I said rating agencies were big part of the problem? If rating agencies can't rate the bond accurately, then people will stop using them. That's how market corrects itself. There is more than just one available. Plus a bond investor that was only looking at the ratings is an idiot and deserves to lose his/her job.
Would you rather them not fixing the mistakes? Maybe the ratings in the future will be more accurate? CMOs are not going away.
