Why did very knowledgeable people fail to predict the financial crisis?
Robert Samuelson discusses why the Fed failed to see the housing bust coming:
Hardly anyone asked whether lax mortgage lending would trigger a broad financial crisis, because America had not experienced a broad financial crisis since the Great Depression. A true financial crisis differs from falling stock prices, which are common. A financial crisis involves the failure of banks or other institutions, panic in many markets and a pervasive loss of wealth and confidence. Such a crisis was not within the personal experience of members of the FOMC — or anyone. Nor was it part of mainstream economic thinking. Because it hadn’t happened in decades, it was assumed that it couldn’t happen. There had been previous real estate busts. From 1964 to 1966, new housing starts fell 24 percent; from 1972 to 1975, 51 percent; from 1979 to 1982, 39 percent; from 1988 to 1991, 32 percent. Declining home construction had fed economic slowdowns or recessions. So the natural question seemed: Would this happen now? The answer seemed “no”…
There’s a paradox to economic policy. The more it succeeds at prolonging short-term prosperity, the more it inspires long-run destabilizing behavior by businesses, banks, consumers, investors and government. If they think basic stability is assured, they will assume greater risks — loosen credit standards, borrow more, engage in more speculation, relax wage and price behavior — that ultimately make the economy less stable. Long booms threaten deep busts. Since World War II, this has happened twice. In the 1960s, the so-called “new economics” promised that, by manipulating the budget and interest rates, it could stifle business cycles. The ensuing boom spanned the 1960s; the bust extended to the early 1980s and included inflation of 13 percent, four recessions and peak monthly unemployment of 10.8 percent. The latest episode was the so-called Great Moderation, largely paralleling Greenspan’s Fed tenure (1987-2006), when there were only two mild recessions (1990-91 and 2001). We are now in the bust. The Fed slept mainly because it overlooked the possibility of boom-bust.
(We certainly did not understand what was happening when we first noticed the sub-prime mortgage market in early 2007. Nor did we understand it well when the Bear Stearns conference call tanked the market in August of that year.) We think there’s another factor that was in play as well: computer models. Recall that the largest investment banks were allowed to write their own capital rules at this time by the government, because they were so smart and had very sophisticated computer models showing that they had excess capital even at ratios as low as 4-5%. GIGO as it turned out.
January 26th, 2012 at 12:40 pm
Computer models – better called “Play Station” models. If Mann Made Global Warming “models were not enough to wake people up. But, I guess you have to WANT to be woken up, you HAVE to be interested in the TRUTH!
GIGO – but you should be able to recognize garbage.
January 28th, 2012 at 4:55 am
Until late in 2007 assets were valued based on actual experience, (or historical performance) asset by asset. A loan that was never delinquent was carried at par. A loan that was 90 days past due was written down, but not lower than the liquidation value of the collateral. As this was the norm for years and years I suspect no one would think to revalue assets in a different manner.
The Financial Accounting Standards Board (FASB) adopted the mark-to-market rule effective in late 2007 that dramatically changed the manner in which assets had to be valued. Instead of historical performance assets now had to be valued based on their sale value in the market. When a subprime loan portfolio could not be sold early in 2008, for mark-to-market valuation purposes the portfolio lost most of its value and had to be written down immediately, even though most of the subprime loans in that portfolio were performing and not delinquent. The result was a disastrous and immediate loss of liquidity based on this new method of asset valuation. Such a result had been predicted by many commenters to the FASB, who indicated that it had had a similar and awful impact on bank values in the 1930′s. I don’t think that the investment banks were aware how immense its effect would be on their very existence.
Sure, there were misallocations in the market that resulted crappy subprime loan portfolios being sliced and diced and sold (oversold?) to investors throughout the world. And, the fact that many of the loans in these portfolios were reaching their first rate and payment increase points brought a growing realization that the crap in those portfolios was really crap, no matter how it had been sold to unwary investors with the implicit backing of FNMA/FHLMC. But, if historical asset valuation had been in place in 2008 rather than mark-to-market, these portfolio values might have been written down 15% to 20%, not 80%, and the market could have worked its way through the mess.
The fact that mark-to-market is not a true measure of the value of non-liquid financial assets can be demonstrated by the refusal of the holders of subprime loans to sell them “at market” but rather to hold them and collect payments on these loans that they had previously been required to write down or write off.