Financial Meltdown: The Conventional Wisdom

John Lanchester has a discursive review of a number of high-profile financial books in the latest New Yorker. Some of his points are well taken: He finds an old quote of Warren Buffett's, for instance, about junk bonds, which applies uncannily to adjustable-rate mortgages as well. He also hones in on a great quote from Charles Morris: "Overpriced assets are like poison mushrooms. You eat them, you get sick, you learn to avoid them. A credit bubble is different. Credit is the air that financial markets breathe, and when the air is poisoned, there's no place to hide."

But Lanchester comes rather unstuck on the subject of derivatives. "It is difficult for civilians to understand a derivatives contract," he concedes, "or any of a range of closely related instruments, such as credit-default swaps." But he tries to do so anyway, which is a problem.

The problem is that Lanchester seems to have convinced himself, without any obvious evidence, that derivatives are at the heart of this crisis. He does the notional-numbers thing, and then disappears into a peculiar reverie about modernism and post-modernism:

It seems wholly contrary to common sense that the market for products that derive from real things should be unimaginably vaster than the market for things themselves. With derivatives, we seem to enter a modernist world in which risk no longer means what it means in plain English, and in which there is a profound break between the language of finance and that of common sense...

If the invention of derivatives was the financial world's modernist dawn, the current crisis is unsettlingly like the birth of postmodernism... According to Jacques Derrida, the doyen of the school, meaning can never be precisely located; instead, it is always "deferred," moved elsewhere, located in other meanings, which refer and defer to other meanings--a snake permanently and necessarily eating its own tail. This process is fluid and constant, but at moments the perpetual process of deferral stalls and collapses in on itself. Derrida called this moment an "aporia," from a Greek term meaning "impasse." There is something both amusing and appalling about seeing his theories acted out in the world markets to such cataclysmic effect.

There might be something to this, in a pretentious sort of way, if the world of derivatives had "collapsed in on itself" -- something which is certainly possible, but which equally certainly hasn't actually happened. If there's any market collapse which has caused the present cataclysm, it's that of the credit markets, not the derivatives markets.

But Lanchester has at this point convinced himself that derivatives are things of pure evil, with the result that he's far too dismissive of Robert Shiller:

Shiller's basic idea is that there should be more market activity. He has a number of suggestions for spreading the risk of homeownership: "continuous workout mortgages," in which loan terms are adjusted monthly against economic conditions and the borrower's ability to pay; comprehensive financial advice targeted at the poor (an idea that nobody could argue with, and that nobody will want to pay for); a "financial product safety commission," as proposed by the Harvard legal scholar Elizabeth Warren; improved disclosure on the part of financial institutions; and the expansion of housing-futures markets. These would mean that "any skeptic anywhere in the world could, through his or her actions in the marketplace, act to reduce a speculative bubble in a city." Anyone who thought property prices in an area were too high could bet against them by selling them short--which would, the theory goes, exert a downward pressure on prices. This would help all of us, by reducing the bubble-and-bust cycle of property prices. We need every tool we can get to help reduce the risk of having all our capital tied up in a single heavily leveraged, highly illiquid asset--that is to say, our homes. Shiller approvingly quotes an argument that "the introduction of derivatives tends to improve the liquidity and informativeness of markets," which, given what has just happened, might be the worst-timed assertion ever to have been made by a prominent economist

Oh, I can think of many assertions by prominent economists which were much more badly timed than that one. And Shiller's suggestions are much more substantive than Lanchester gives them credit for. Continuous workout mortgages are a great idea, although it's worth noting that one needs a very well developed derivatives market in order to be able to price them. Financial advice for the poor is something which quite a lot of people are happy to pay for; that isn't the problem. The problem is that payday and subprime and high-interest credit card lenders have perfected the art of appealing to the poor in a way that financial educators haven't found any way to compete with.

And the problem with Shiller's idea about housing futures is not that they're derivatives, but that he's talking his own book, and his book has been shown not to work. That's partly because his housing futures are extremely illiquid, but it's also because they're an imperfect hedge: the correlation between the future value of your house and the future value of houses in your city is positive, but a long way from 1.

Still, it's always interesting to see what happens when a generalist like Lanchester reviews a pile of financial books. There will surely be many more such reviews over the next couple of years, as the big histories of the credit crisis start to appear, and book reviewers are very important in terms of laying out the conventional wisdom on big subjects. The conventional wisdom already demonizes credit default swaps; I suspect it's only going to be amplified as those new reviews come out.

Comments

[Big Al45:]

Felix

Given your continuing defense of derivatives, can I assume you make your living packaging CDOs? Or perhaps selling CDS'?

2008 Nov 05 02:31 PM

[Stimpy:]

Felix doesn't really understand CDS, but he doesn't let that stop him from writing about them every day.

It is hardly "demonization" to point out that what we don't know about something can, and often does, hurt us.

The problem with CDS is not their theory, felix. It is their practise.

The collateralisation of WHATEVER the net notional turns out to be is where the system is breaking bdown.

Lehman could no more return the Billions in posted collateral they had received from thousands of counter-parties (who wanted it back virtually all at once) than a bank could give depositors all their money back at the same time.

Lehman (and all the dealers) REHYPOTHICATE the colateral they take in, reversing it out instantaneously and using the cash to fund countless other investments.

Once they are hit with the calls (which cross collateralize to render all CDS null and void if one failure to deliver happens) the problem gets worse as Lehman is sold as a refence entity and funding costs (in this case trying to borrow collateral to return and thus stay solvent) explode.

Filing becomes inevitable.

The REAL BAD NEWS is that once they do file, there is nothing left for conventional creditors--including commercial paper investors like the unfortunate Reserve Funds.

It is SIMPLY IRRESPONSIBLE for a money fund to lend to any BD (or anyone really, besides the Government) as long as the CDS market remains a classic Black-Hole) creating structural uncertainty is what it means to have a balance sheet.

Felix, like ISDA would have you believe the Lehman CDS auction was a "success" at "only" $6Billion.

Of course that doesn't count the 100B (and counting) we have pumped into AIG and the fact that the money markets now require Government guarantees to function.

Demonization is EXACTLY what these WMDs deserve.

Now we need an exorcism.

CDS are DOA.

RIP.

2008 Nov 05 02:53 PM

[Smarty_Pants:]

It should come as no surprise that derivatives can outvalue the underlying.

As an equivalent, think of the underlying as flipping a coin. Heads the mortgage gets paid off normally, Tails it defaults. Let's say the mortgage is for $100,000.

If 1 million pairs of people each 'bet' $1 on the outcome, the derivatives total $1 Million.

Even though the total of these derivatives exceeds the underlying by 10:1, the risk of large scale defaults is small. Each party can probably afford the $1 loss.

However, if only 10 pairs of people each 'bet' the entire amount of the underlying on the outcome, then the risk of default might be much, much higher.

Still, it's not difficult to see how $1 Million of "derivatives" might ride on the outcome of flipping a quarter. It happens all the time in a casino.

2008 Nov 05 02:54 PM

[Rokjok777:]

The financial markets right now remind me of an old joke:

A farmer's donkey dies. He tells his friend "I'm going to raffle him off for $2 bucks per ticket".
Later his friend asks how it went. "Great! I sold 500 tickets! Everybody's happy except the winner... so I gave him his two bucks back..."

2008 Nov 05 03:22 PM

[selene:]

I was a comp lit major in undergrad and read a lot of Derrida in the original during the heyday of deconstructionism (the school of which Derrida was a doyen -- related to but not identical to postmodernism).

This is without doubt the silliest, most poorly thought out attempt to apply his theories I have ever seen, including everything my friends and I wrote in undergrad. Yikes!

2008 Nov 06 09:21 AM

[dr.doolittle:]

keep it coming, brother. The whole thing is a pile of poo. Or is it pooh as in Winnie the Pooh? And perhaps after that we can discuss the Dao of Pooh. Right now, though, it seems to be the WOW of POO.

2008 Nov 06 12:28 PM

[Matt Blackman:]

Felix, I agree with Stimpy. Your understanding of derivatives is poor at best. The only reason Shiller's book "is not working" is because housing derivatives are relatively new and volume low. Your argument falls apart as volumes pick up and I for one prefer to have the ability to short or go long the housing market without having to buy and sell property to do so. The only traditional way to make a bet to the short side on housing before housing futures was to sell property. Let's hope Shiller is successful in talking his book and increasing volume to a level that makes them thoroughly liquid.

2008 Nov 06 12:49 PM